Forbearance in Prudential Regulation

We construct a model of a self-interested financial regulator who incurs a private cost when abank defaults. The regulator decides whether to regulate the bank conditional on signal observation,which contains information about the default risk of the bank. The regulator may choose not toregulate a bank even if it appears necessary, which we call forbearance. The forbearance occursdue to the differences of the interests among the regulator, the bank, and the economy. In particular,the regulator postpones the resolution of uncertainty when he expects that the bank will not complywith the intervention. It is also shown that the noise of the signal employed in the monitoringof the bank plays a crucial role for the occurrence of the forbearance.