This paper deals with the issue of efficient and effective banking policy, and focuses upon the determination of optimal audit policies under two different assumptions about the nature of information obtained through bank audits. In Part I of the paper, it is assumed that once an audit is taken, the quality of each bank as of the audit date is perfectly known to the authority. In Part II, an alternative assumption is made that information obtained through audits contains noise so that the authority never knows the true quality of each bank for sure no matter how many audits are taken. Decision rules for the authority's choice of optimal audit policies are derived, in analytical and numerical ways respectively.
Views expressed in the paper are those of the authors and do not necessarily reflect those of the Bank of Japan or Institute for Monetary and Economic Studies.