Collateral Misrepresentation, External Auditing, and Optimal Supervisory Policy

We develop a theoretical model that combines the auditing literature with the frictional banking system and the monetary and supervisory policies. Banks have incentives to misrepresent the quality of collateral. The cost of faking collateral hinges on the production of auditing services and the central bank’s supervision intensity. The reliance on private auditing creates opportunities for banks to falsify the quality of audits. An increase in dividends of private assets worsens these frictions and increases the haircuts when government debts are sufficiently scarce. A monetary easing coupled with an opaque audit sector—which provides fraudulent audits for a sufficiently small fee—exacerbates the paucity of safe collateral, causing the overproduction of audits and reducing welfare. The supervisory policy that eliminates incentive problems generated by the asset misrepresentation is feasible, but it is suboptimal.