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Economic Quarterly

Fall 2004

Auditing and Bank Capital Regulation

Edward S. Prescott

Deterministic and stochastic auditing is introduced into a model of bank capital regulation. Low-capital banks are audited the most. Safe banks hold less capital than risky banks, so, counterintuitively, safe banks are audited more intensively than risky banks. The importance of auditing by regulators and penalties for noncompliance are discussed in light of the Basel II capital regulation proposals. Emphasis is placed on the importance of supervisory review — Pillar Two of Basel II — of the accuracy of banks' reports on the risk of their assets.

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