Optimal Prudential Regulation of Banks and the Political Economy of Supervision

Author/Editor:

Thierry Tressel ; Thierry Verdier

Publication Date:

May 28, 2014

Electronic Access:

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Disclaimer: This Working Paper should not be reported as representing the views of the IMF.The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate

Summary:

We consider a moral hazard economy in banks and production to study how incentives for risk taking are affected by the quality of supervision. We show that low interest rates may generate excessive risk taking. Because of a pecuniary externality, the market equilibrium may not be optimal and there is a need for prudential regulation. We show that the optimal capital ratio depends on the macro-financial cycle, and that, in presence of production externalities, it should be complemented by a constraint on asset allocation. We show that the political process tends to exacerbate excessive risk taking and credit cycles.

Series:

Working Paper No. 2014/090

Subject:

English

Publication Date:

May 28, 2014

ISBN/ISSN:

9781498338554/1018-5941

Stock No:

WPIEA2014090

Pages:

61

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