Working Paper: CEPR ID: DP9871
Authors: Thierry Tressel; Thierry Verdier
Abstract: We consider a moral hazard economy with the potential for collusion between bankers and borrowers to study how incentives for risk taking are affected by the quality of supervision. We show that low interest rates or a low return on investment may generate excessive risk taking. Because of a pecuniary externality, the market equilibrium is not optimal and there is a need for prudential regulation. We show that the optimal capital ratio depends on the state of the macro-financial cycle, and that,in presence of production externalities, the capital ratio should be complemented by a constraint on asset allocation. We study the political economy of supervision. We show that the political process tends to exacerbate excessive risk taking and credit cycles by weakening the quality of banking supervision when instead it should be strengthened.
Keywords: Banking Regulation; Political Economy; Regulatory Forbearance
JEL Codes: D8; E44; G2
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| low interest rates (E43) | excessive risk-taking (G41) |
| low returns on investment (G31) | excessive risk-taking (G41) |
| supervision quality (L15) | risk-taking behavior (D91) |
| political process (D72) | banking supervision quality (G28) |
| banking supervision quality (G28) | excessive risk-taking (G41) |
| interest rates (E43) | supervision quality (L15) |
| interest rates (E43) | capital adequacy rules (G28) |
| capital adequacy rules (G28) | excessive risk-taking (G41) |
| macro-financial cycle (E32) | optimal capital ratio (G32) |