Bank Regulation, Compliance and Enforcement

A model is presented where the question of bank regulation is developed under a principal-agent scenario in a regime where the regulator has limited resources and banks may have an incentive to act ultra virus the regulatory standards. If banks are subject to random audit, then compliance is achieved through a system of fines determined according to the extent of non-compliance. The model shows that the choice of internal monitoring of risk is driven by each bank's choice of the wage contract for its compliance officer who works for the ban for a wage. The officer's incentive for effective monitoring is heightened by the threat of an internal fine from the bank for any contravention of regulations. Moreover, either a fine on the bank or a fine on the compliance officer alone is sufficient to ensure that efficiency is achieved. The model is useful for the bank regulator in a market economy and in transition economies, where the effective constraint on regulatory capacity is addressed using market-based incentives to ensure prudent regulation and effective supervision, and thereby limit the danger of bank failure and contagion