State-contingent regulatory mechanisms and fairly priced deposit insurance

This paper presents a model of incentive compatible bank regulation under moral hazard and adverse selection. We derive a wide range of simple and conceptually implementable mechanisms that can solve each type of incentive problem separately and also achieve the first-best outcome - but only when regulatory instruments involve ex post pricing that is contingent on the bank's performance relative to the market. An important feature of these mechanisms is that they do not involve a subsidy io the bank. When the regulator faces both moral hazard and adverse selection simultaneously, we identify the conditions under which the same mechanism can achieve the first-best solution. (C) 1998 Elsevier Science B.V. All rights reserved.