The Political Economy of Prudential Regulation

Abstract

This paper introduces a voting model into a framework with negative borrowing externalities to study how income inequality affects voter preferences for prudential regulation and the resulting equilibrium policy. When voting agents account for the general equilibrium impact of prudential policy on future asset prices and their access to credit. Consequently, borrowers support a universal limit on current debt. Curbing over-borrowing restricts future declines in asset prices, distributing wealth from high- to low-income borrowers, so the former prefer laxer regulation. Imperfections in enforcement distort the marginal value of regulation, so that borrowers who anticipate exemptions support an excessively strict policy. Imperfect enforcement can interact with income inequality to reverse the direction of the policy conflict between high- and low-income borrowers.

Keywords: political economy, financial regulation, pecuniary externalities, regulatory capture

JEL Classification: D62, D72, G28, H23, P16