Optimal Prudential Regulation of Banks and the Political Economy of Supervision

61 Pages Posted: 2 Jun 2014

See all articles by Thierry Tressel

Thierry Tressel

International Monetary Fund (IMF) - Research Department

Thierry Verdier

Paris School of Economics (PSE); Pontifical Catholic University of Rio de Janeiro (PUC-Rio) - Department of Economics; Centre for Economic Policy Research (CEPR)

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Date Written: March 2014

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, political economy, regulatory forbearance

JEL Classification: D8, E44, G2

Suggested Citation

Tressel, Thierry and Verdier, Thierry, Optimal Prudential Regulation of Banks and the Political Economy of Supervision (March 2014). CEPR Discussion Paper No. DP9871. Available at SSRN: https://ssrn.com/abstract=2444892

Thierry Tressel (Contact Author)

International Monetary Fund (IMF) - Research Department ( email )

700 19th Street NW
Washington, DC 20431
United States

Thierry Verdier

Paris School of Economics (PSE) ( email )

48 Boulevard Jourdan
Paris, 75014
France

Pontifical Catholic University of Rio de Janeiro (PUC-Rio) - Department of Economics ( email )

Rua Marques de Sao Vicente, 225/206F
Rio de Janeiro, RJ 22453
Brazil

Centre for Economic Policy Research (CEPR)

London
United Kingdom

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