The Political Economy of Prudential Regulation
50 Pages Posted:
Date Written: September 3, 2020
This paper studies the equilibrium level of prudential regulation in a framework with negative borrowing externalities. A debt limit is implemented by a politician appointed through majoritarian elections. If she is committed to perfect enforcement, voting allows borrowers to internalize the externality. If politician is captured, she exempts politically connected borrowers from regulation (imperfect enforcement), distorting voters' policy preferences. Depending on the electoral power of the connected borrowers, the outcome may be an either too lax or too strict policy. Additional results highlight the impact of income inequality on the strictness of prudential regulation.
Keywords: political economy, financial regulation, pecuniary externalities, fire sales, regulatory capture
JEL Classification: D62, D72, G28, H23, P16
Suggested Citation: Suggested Citation