Optimal Prudential Regulation of Banks and the Political Economy of Supervision

Thierry Tressel and Thierry Verdier

No 2014/090, IMF Working Papers from International Monetary Fund

Abstract: We consider a moral hazard economy in banks and production to study how incentives for risk taking are affected by the quality of supervision. We show that low interest rates may generate excessive risk taking. Because of a pecuniary externality, the market equilibrium may not be optimal and there is a need for prudential regulation. We show that the optimal capital ratio depends on the macro-financial cycle, and that, in presence of production externalities, it should be complemented by a constraint on asset allocation. We show that the political process tends to exacerbate excessive risk taking and credit cycles.

Keywords: WP; capital adequacy ratio; expected return; Banking Regulation; Regulatory Forbearance; Political Economy; bank capital; adequacy rule; banking supervision; bank audit; incentive constraint; bank supervisor; Capital adequacy requirements; Bank supervision; Self-employment; Auditing; Global (search for similar items in EconPapers)
Pages: 61
Date: 2014-05-28
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Citations: View citations in EconPapers (7)

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Working Paper: Optimal Prudential Regulation of Banks and the Political Economy of Supervision (2014)
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