Optimal Prudential Regulation of Banks and the Political Economy of Supervision

62 Pages Posted: 2 Jul 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)

Multiple version iconThere are 2 versions of this paper

Date Written: May 2014

Abstract

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

Tressel, Thierry and Verdier, Thierry, Optimal Prudential Regulation of Banks and the Political Economy of Supervision (May 2014). IMF Working Paper No. 14/90. Available at SSRN: https://ssrn.com/abstract=2461726

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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