We build a simple model of banking in the presence of macroeconomic shocks where the comparative roles of private and public monitors can be analyzed. This model provides endogenous justifications for prudential regulation (capital requirements) and emergency liquidity assistance by the Central Bank (lender of last resort). We show that market discipline can be helpful, but does not solve the fundamental problem of regulatory forbearance. We propose some directions of reform of the regulatory system that could improve the management of banking crises.

In a model where banks play an active role in monitoring borrowers, we analyze the impact of securitization on bankers’ incentives across different macroeconomic scenarios. We show that securitization can be part of the optimal financing scheme for banks, provided banks retain an equity tranche in the sold loans to maintain proper incentives. In economic downturns however securitization should be restricted. The implementation of the optimal solvency scheme is achieved by setting appropriate capital charges through a form of capital insurance, protecting the value of bank capital in downturns, while providing additional liquidity in upturns.