"This paper studies bank regulation in the presence of deposit insurance, where banks have private information on their own ability and their investment strategy. Banks choose the mean and variance of their portfolio return. Regulators wish to control banks' risk choice, even though all agents...

Deterministic and stochastic auditing is introduced into a model of bank capital regulation. Low-capital banks are audited the most. Safe banks hold less capital than risky banks, so, counterintuitively, safe banks are audited more intensively than risky banks. The importance of auditing by...