Discussion Paper Details

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Title: Optimal Prudential Regulation of Banks and the Political Economy of Supervision

Author(s): Thierry Tressel and Thierry Verdier

Publication Date: March 2014

Keyword(s): banking regulation, political economy and regulatory forbearance

Programme Area(s): Financial Economics, International Macroeconomics and Public Economics

Abstract: We consider a moral hazard economy with the potential for collusion between bankers and borrowers to study how incentives for risk taking are affected by the quality of supervision. We show that low interest rates or a low return on investment may generate excessive risk taking. Because of a pecuniary externality, the market equilibrium is not optimal and there is a need for prudential regulation. We show that the optimal capital ratio depends on the state of the macro-financial cycle, and that,in presence of production externalities, the capital ratio should be complemented by a constraint on asset allocation. We study the political economy of supervision. We show that the political process tends to exacerbate excessive risk taking and credit cycles by weakening the quality of banking supervision when instead it should be strengthened.

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Bibliographic Reference

Tressel, T and Verdier, T. 2014. 'Optimal Prudential Regulation of Banks and the Political Economy of Supervision'. London, Centre for Economic Policy Research.