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Regulated firms can be tempted to adopt cost-saving technologies, operating procedures, or capital structures without fully assessing the associated risks. We demonstrate how a regulator can costlessly preclude such behavior if she can impose substantial penalties on the firm in the event of poor realized performance. When these penalties are more limited, the regulated firm secures rent from its privileged ability to assess the riskiness of potential technologies. If these penalties are sufficiently limited, the regulator optimally affords the firm no choice among technologies. Consequently, the regulated firm prefers moderate penalties to very limited penalties.
