The recent financial crisis revealed that banks, especially these large and complex banks, are opaque to be monitored by regulators. In an ideal world, regulators are hoping all banks to be self-disciplined. That will reduce a lot burdens for regulators. However, in practice, it is not always the case as there will be by nature information asymmetric or information frictions between banks and regulators. We develop a tractable model to study how banks respond to capital requirements that are based on a self-assessment result about banks’ riskiness, and derive the policy and wealth implications. We use the model to characterize the optimal requirements, and to study the trade-offs a regulator faces in making efforts to ensure bank’s self-assessment more accurate or in disclosing the inspection results to public.
