Regulatory Practices and the Impossibility to Extract Truthful Risk Information

We consider a regulator providing deposit insurance to a bank with private information about its investment portfolio. Following current regulatory practices, we assume that the regulator does not commit to audit and sanction after any risk report from the bank. We show that, in absence of commitment, the socially optimal contract leads a high-risk bank to misreport its risk with positive probability in most cases. We also isolate cases when truthful risk report is optimal. We thus establish that extraction of truthful risk information is not socially optimal in most cases given current regulatory practices.