Bank regulation and supervision: A symbiotic relationship

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.