Supervisory assessments such as stress-tests gauge banks’ riskiness and allow regulators to impose bank-specific capital regulation. This can improve welfare. Yet, regulation based on noisy supervision can decrease welfare by mis-classifying banks, distorting incentives, and crucially, leading to greater risk taking. Regulation should not be bank-specific in such cases. When bank defaults are costlier, supervision should strive for lower probability that riskier banks go undetected, i.e., reduce false-negatives even if this causes more false-positives. When the supervisor can incur a cost to optimally reduce both false-positive and false-negative rates, the regulator should make capital requirements more bank specific.

We study how a bank allocates capital across its business units when facing multiple constraints over several periods. If a constraint tightens – be it because of stricter regulation or higher risk – capital flows to the more efficient unit, i.e. the unit offering a higher marginal return on required capital. Relative efficiency helps explain how a policy measure targeting a specific business unit – e.g. imposing requirements for market risk, or ring-fencing lending – spills over to another, seemingly unrelated unit. It also helps explain the bank’s response to the tightening of a constraint that is contemporaneously slack but likely to bind later on.

Subsidies should target firms with profitable opportunities and insufficient funding, but this is difficult due to information asymmetry between firms and the government. We study how credit history of firms can help design more efficient subsidies. To this end, we combine data on non-repayable firm subsidies and the credit registry from Hungary. Using subsidy winners and losers as treated and control groups and leveraging variation in access to loans, we identify the differential impact of subsidies. While subsidies lead to an incremental impact on assets of loan-deprived as compared to loan-acquiring firms, the impact is transitory and fades after a few years. The impact on profitability follows a similar pattern despite the higher expected marginal value of capital for loan-deprived firms. Thus, loan deprivation is likely caused by borrower shortcomings instead of credit rationing by banks. In such cases, subsidies need not target loan-deprived firms.