REGULATORY MONITORING, CLOSURE COSTS AND BANK MORAL HAZARD BEHAVIOR

We theoretically analyze the efficacy of close regulatory monitoring a nd early bank closure policies, introduced by the 1991 Federal Deposit Insurance Corporation Improvement Act (FDICIA), in reducing the FDIC' s losses and curbing bank moral hazard behavior induced by mis-priced deposit insurance. Contrary to conventional wisdom, we demonstrate tha t continuous bank monitoring and early closure may in fact exacerbate the moral hazard problem if bank shareholders face a penalty upon clos ure. Moreover, if reputational disincentives and monitoring costs prev ent the regulator from implementing timely closure then the bank's mor al hazard incentives are significantly altered. These results suggest several new policy implications.