On the Political Economy of Financial Regulation

Igor Livshits and Youngmin Park

No 1465, 2019 Meeting Papers from Society for Economic Dynamics

Abstract: Loose financial regulation encourages some banks to adopt a risky strategy of specializing in 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 or deposit insurance), they offer mortgages at less than actuarially fair interest rates. This opens a door to home-ownership for some young low net-worth individuals. In turn, the additional demand from these new home-buyers drives up house prices. All of this leads to non-trivial distribution of gains and losses from lax regulation amongst the households. Renters and individuals with large non-housing wealth suffer from the fragility of the banking system induced by the lax regulation. On the other hand, some young middle-income households are able to get a mortgage and buy a house, thus benefiting from the lax regulation. Furthermore, the current (old) homeowners benefit from the increase in the price of their houses. If the latter two groups constitute a majority of the population, then regulatory failure can be an outcome of a democratic political process.

Date: 2019
New Economics Papers: this item is included in nep-ban, nep-cba and nep-ure
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