DP10100 Regulatory Capture by Sophistication
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.