Collateral Monitoring and Bank Regulation

We present a theory of banking regulation affecting procedural compliance in monitoring collateral in secured debt contracts. The theory suggests an externality which creates a gap between the socially optimal level of monitoring and the bank’s privately optimal level. Banks can not be punished ex post for lack of monitoring or otherwise in the bad state of nature. Hence, no ex post strategy is available to the regulator once the bad state has occurred. We argue that the collateral value is monitored optimally when banks are regulated through an ex post auditing and penalty schemes in the good state of nature. In a way it suggests that to avoid bank failure, successful projects should undergo randomised auditing.