AN INCENTIVE APPROACH TO BANKING REGULATION

We examine the optimal design of a risk-adjusted deposit insurance sch eme when the regulator has less information than the bank about the in herent risk of the bank's assets (adverse selection), and when the reg ulator is unable to monitor the extent to which bank resources are bei ng directed away from normal operations toward activities that lower a sset quality (moral hazard). Under a socially optimal insurance scheme : (1) asset quality is below the first-best level, (2) higher-quality banks have larger asset bases and face lower capital adequacy requirem ents than lower-quality banks, and (3) the probability of failure is e quated across banks.