Optimal Prudential Regulation of Banks and the Political Economy of Supervision

Thierry Verdier and Thierry Tressel ()

No 9871, CEPR Discussion Papers from C.E.P.R. Discussion Papers

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

Keywords: Banking regulation; Regulatory forbearance; Political economy (search for similar items in EconPapers)
JEL-codes: D8 E44 G2 (search for similar items in EconPapers)
Date: 2014-03
New Economics Papers: this item is included in nep-ban, nep-cba, nep-cta, nep-mac, nep-pol and nep-reg
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Citations: View citations in EconPapers (6)

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