Optimal Prudential Regulation of Banks and the Political Economy of Supervision
62 Pages Posted: 2 Jul 2014
Date Written: May 2014
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: Bank supervision, Bank capital, Regulatory forbearance, Prudential bank regulations, Political economy, Moral hazard, Banking Regulation, Political Economy., banking, capital adequacy, banking supervision, capital adequacy ratio, banking capital, bankers, present value, prudential regulation, return on investment, capital adequacy rule, banking sector, banking market, banking supervisor, capital regulation, bank finance, bank credit, bank monitoring, bank supervisor, bank audits, bank risk-taking, banker, bank risk, bank balance sheet, capital requirement, bank finances, capital ratio, monetary authority, banking systems, bank for international settlement, banking supervisors, connected lend
JEL Classification: D80, E44, G20
Suggested Citation: Suggested Citation