Banking supervision with loopholes

Jianxing Wei and Tong Xu

European Economic Review, 2024, vol. 161, issue C

Abstract: This paper develops a model of financial intermediation focusing on the interaction between banks and a regulator. In the model, the regulator chooses its supervision capacity to monitor banks and prevent excessive risk-taking. Meanwhile, banks can engage in loophole innovation to circumvent supervision, diminishing the value of the regulator’s accumulated expertise. In equilibrium, as the regulator’s supervision capacity increases, loophole innovation is more likely to succeed. In the dynamic framework, our model generates pro-cyclical bank leverage and asymmetric credit cycles. After a longer boom, a crisis is more likely to occur, and the consequences are more severe. We analyze the welfare implications of maximum leverage regulation and other regulatory tools in the loophole innovation environment.

Keywords: Risk shifting; Banking supervision; Loophole innovation; Credit cycles; Regulation (search for similar items in EconPapers)
JEL-codes: E32 G21 G28 (search for similar items in EconPapers)
Date: 2024
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Persistent link: https://EconPapers.repec.org/RePEc:eee:eecrev:v:161:y:2024:i:c:s0014292123002702

DOI: 10.1016/j.euroecorev.2023.104642

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