Democratic Political Economy of Financial Regulation

Igor Livshits and Youngmin Park

Staff Working Papers from Bank of Canada

Abstract: This paper offers a simple theory of inefficiently lax financial regulation arising as an outcome of a democratic political process. Lax financial regulation encourages some banks to issue risky residential mortgages. In the event of an adverse aggregate housing shock, these banks fail. When banks do not fully internalize the losses from such failure (due to limited liability), they offer mortgages at less than actuarially fair interest rates. This opens the door to home ownership for young, low net-worth individuals. In turn, the additional demand from these new home-buyers drives up house prices. This leads to a non-trivial distribution of gains and losses from lax regulation among households. On the one hand, renters and individuals with large non-housing wealth suffer from the fragility of the banking system. On the other hand, some young, low net-worth households are able to get a mortgage and buy a house, and current (old) home-owners benefit from the increase in the price of their houses. When these latter two groups, who benefit from the lax regulation, constitute a majority of the voting population, then regulatory failure can be an outcome of the democratic political process.

Keywords: Financial stability; Financial system regulation and policies; Housing; Interest rates (search for similar items in EconPapers)
JEL-codes: E44 E63 G12 (search for similar items in EconPapers)
Pages: 54 pages
Date: 2021-11
New Economics Papers: this item is included in nep-ban, nep-fdg, nep-mac, nep-pol and nep-reg
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Working Paper: Democratic Political Economy of Financial Regulation (2022)
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Persistent link: https://EconPapers.repec.org/RePEc:bca:bocawp:21-59

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