Optimal Supervisory Policy in a Model of Endogenous Bank Opacity

The monetary model uniquely incorporates the collateral misrepresentation problem in the banking sector with the role of external auditors. The novelty of the research presented in this brief is two-fold: (i) the cost of collateral misrepresentation hinges upon the banks’ demand for prime audits and the central bank supervision intensity, respectively, and (ii) the quality of audits, like the quality of mortgages, can be compromised. The yield spread between mortgages and government bonds increases with the fundamental value of housing since an increase in the value of housing creates lucrative opportunities for banks to misrepresent the sub-prime loans as prime loans and use them as collateral to back the newly created deposit liabilities. An opaque audit sector coupled with a central bank’s open market purchase of government debts might deteriorate market imperfections in the banking sector, leading to an overproduction of prime audits and a fall in welfare. The optimal supervisory policy helps mitigate the market imperfections in the banking sector but cannot eliminate these imperfections.