Optimal Financial Regulation and Bailouts in Presence of Regulatory Forbearance and Systemic Risk

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 a low cost of capital or low return on investment may generate excessive risk taking. Because of a pecuniary externality, the market equilibrium is ineffi cient, therefore bank capital ratio should be regulated. We extend the model by introducing time inconsistency due to systemic bailout guarantees, externalities in production, and endogenize the political economy of supervision quality. In each case, we characterize the optimal financial regulation which we show should be conditioned on various macroeconomic or institutional factors. Overall, our theory supports the need for macro-prudential regulations of bank capital, but demonstrates that optimal policies may be complex. ∗The views expressed in this paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Thierry Tressel: International Monetary Fund, Email: [email protected]; Thierry Verdier: Paris-Jourdan Sciences Economiques (PSE), Email: [email protected].