Regulatory Cycles: A Political Economy Model

Abstract

Financial regulatory policy in the U.S. has been conspicuously pro-cyclical over the last two decades. A closer look at historical financial boom-bust cycles suggests that, in fact, pro-cyclicality in financial regulation is a common and recurring pattern. This paper introduces electoral concerns a model of financial intermediation to study how public opinion, financial innovation, and policy-makers incentives shape financial regulation. We show that politicians' electoral incentives can amplify small changes in voters' perceptions of financial innovation: when polarization is large, both over-regulation and under-regulation arise in equilibrium, and even small changes in public opinion can induce substantial regulatory shifts.

Keywords: Financial Regulation, Boom-Bust Cycles, Political Economy, Asymmetric and Private Information

JEL Classification: D72, D82, G18