Flexible and Mandatory Banking Supervision

Tighter regulation and more powerful supervision are being enacted after the global financial crisis. Although this trend may have positive welfare effects, it may also impose large social costs due to the strong reliance on supervisory information. We argue that offering banks a Flexible Supervision contract, designed to be chosen by those banks that will otherwise attempt to capture the supervisor, is a mechanism to implement the most efficient regulation under asymmetric information. The result that Flexible Supervision outperforms Mandatory Supervision remains robust to a series of extensions to our baseline model. Policy implications follow directly: Benevolent regulators should enact a Flexible Supervision regime for the less risky, more capitalized and transparent banks in addition to the traditional Mandatory Supervision regime.