Incentive-Compatible Information Transfer And Bank Capital Regulation

This paper presents a model in which one party provides information to another, who makes a decision that affects both. The key features are: (1) there is uncertainty about an outcome of importance to each of the two parties, (2) one party possesses better information than the other about the stochastic distribution of the uncertainty, and (3) a decision for which the information is relevant is taken by the other party. A characterization of the equilibria is provided, and it is shown that preferences must be perfectly aligned in order for the decision maker=s first-best equilibrium to hold. An application to banking regulation is examined. The analysis is supportive of capital regulation that emphasizes supervisory oversight, but not of regulation that relies on posterior penalties to align preferences. JEL Codes: C7, G21, G28