DP10100 Regulatory Capture by Sophistication

Author(s): Hendrik Hakenes, Isabel Schnabel
Publication Date: August 2014
Keyword(s): banking regulation, complexity, financial stability, regulatory capture, reputational concerns, sophistication, special interests
JEL(s): G21, G28, L51, P16
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=10100

One explanation for the poor performance of regulation in the recent financial crisis is that regulators had been captured by the financial sector. We present a micro-founded model with rational agents in which banks capture regulators by their sophistication. Banks can search for arguments of differing complexity against tighter regulation. Finding such arguments is more difficult for weaker banks, which the regulator wants to regulate more strictly. However, the more sophisticated a bank is, the more easily it can produce arguments that a regulator does not understand. Reputational concerns prevent regulators from admitting this, hence they rubber-stamp weak banks, which leads to inefficiently low levels of regulation. Bank sophistication and reputational concerns of regulators lead to capture, and thus to worse regulatory decisions.