DP9871 Optimal Prudential Regulation of Banks and the Political Economy of Supervision

Author(s): Thierry Tressel, Thierry Verdier
Publication Date: March 2014
Keyword(s): banking regulation, political economy, regulatory forbearance
JEL(s): D8, E44, G2
Programme Areas: International Macroeconomics, Public Economics, Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=9871

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.