Working Paper: NBER ID: w19572
Authors: Anton Korinek; Jonathan Kreamer
Abstract: Financial regulation is often framed as a question of economic efficiency. This paper, by contrast, puts the distributive implications of financial regulation center stage. We develop a model in which the financial sector benefits from risk-taking by earning greater expected returns. However, risk-taking also increases the incidence of large losses that lead to credit crunches and impose negative externalities on the real economy. Assuming incomplete risk markets between the financial sector and the real economy, we describe a Pareto frontier along which different levels of risk-taking map into different levels of welfare for the two parties. A regulator has to trade off efficiency in the financial sector, which is aided by deregulation, against efficiency in the real economy, which is aided by tighter regulation and a more stable supply of credit. We also show that financial innovation, asymmetric compensation schemes, concentration in the banking system, and bailout expectations enable or encourage greater risk-taking and allocate greater surplus to the financial sector at the expense of the rest of the economy.
Keywords: financial regulation; deregulation; risk-taking; redistribution; credit crunch
JEL Codes: E25; E44; G28; H23
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Financial deregulation (G28) | Increased risk-taking (G41) |
| Increased risk-taking (G41) | Credit crunches (E51) |
| Credit crunches (E51) | Negative externalities on workers (F66) |
| Bank capital (G21) | Credit supply (E51) |
| Credit supply (E51) | Output (Y10) |
| Credit supply (E51) | Wages (J31) |
| Financial innovations (G29) | Increased risk-taking (G41) |
| Increased risk-taking (G41) | Negative impacts on workers (F66) |