Working Paper: CEPR ID: DP10100
Authors: Hendrik Hakenes; Isabel Schnabel
Abstract: One explanation for the poor performance of regulation in the recent financial crisis is that regulators had been captured by the financial sector. We present a micro-founded model with rational agents in which banks capture regulators by their sophistication. Banks can search for arguments of differing complexity against tighter regulation. Finding such arguments is more difficult for weaker banks, which the regulator wants to regulate more strictly. However, the more sophisticated a bank is, the more easily it can produce arguments that a regulator does not understand. Reputational concerns prevent regulators from admitting this, hence they rubber-stamp weak banks, which leads to inefficiently low levels of regulation. Bank sophistication and reputational concerns of regulators lead to capture, and thus to worse regulatory decisions.
Keywords: Banking; Regulation; Complexity; Financial Stability; Regulatory Capture; Reputational Concerns; Sophistication; Special Interests
JEL Codes: G21; G28; L51; P16
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| sophistication of banks (G21) | regulatory capture (G18) |
| sophistication of banks (G21) | regulatory decisions (K23) |
| type of regulator (L51) | regulatory outcomes (K20) |
| reputational concerns of regulators (G18) | regulatory capture (G18) |
| sophistication of banks + reputational concerns of regulators (G21) | regulatory decisions (K23) |