Regulatory Capture by Sophistication

Isabel Schnabel and Hendrik Hakenes

No 10100, CEPR Discussion Papers from Centre for Economic Policy Research

Abstract: 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.

Keywords: Regulatory capture; Special interests; Banking regulation; Sophistication; Reputational concerns; Financial stability; Complexity (search for similar items in EconPapers)
JEL-codes: G21 G28 L51 P16 (search for similar items in EconPapers)
Date: 2014-08
New Economics Papers: this item is included in nep-ban, nep-cba and nep-reg
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (13)

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Working Paper: Regulatory Capture by Sophistication (2013)
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