Thierry Tressel and Thierry Verdier

Introduction

The financial crisis has ignited an intense policy debate on the determinants of incentives in the financial industry, and has resulted in substantial efforts to improve financial regulations to tame risk taking during booms and build capital buffers for downturns.

There is now a consensus among policy-makers and economists that the prudential regulation of banks should be envisaged from a systemic, macro-prudential perspective, and not only from a traditional microprudential approach.

The Basel III framework has introduced the Countercyclical Cyclical Buffer, which is calibrated to mitigate credit cycles over time, and the systemic bu¤er aimed at improving the resilience of global systemically important .nancial institutions. Policy-makers have also established bodies tasked with the design and operationalization of macro-prudential policies, while best practises are being crafted in international fora (IMF, 2011, 2013; European Systemic Risk Board, 2013).

In parallel, the crisis led to a debate on the role played by low interest rates in fueling asset bubbles and excessive risk taking by .nancial intermediaries (Taylor, 2010). In his address at the 2010 Annual meeting of the American Economic Association, Fed Chairman Ben Bernanke argued instead that, based on evidence of declining lending standards during the boom, ‘’stronger regulation and supervision aimed at problems with underwriting practices and lenders risk management would have been a more effective and surgical approach to constraining the housing bubble than a general increase in interest rates’’.

We develop a model to study the incentives of financial intermediaries and borrowers to take excessive risks. We aim at understanding the interplay between the prudential regulation of banks, the quality of bank supervision and the role of the political economy in exacerbating financial cycles.

There are two main features of our analysis. First, we develop a theory of (macro-prudential) bank regulation based on the presence of pecuniary externalities in a model with credit frictions. A novelty of our model is the possibility of regulatory forbearance by the supervisor which allows negative net present value projects to be undertaken in equilibrium.

This justifies ex-ante policy interventions to constrain the leverage of financial institutions. Second, we highlight the interplay between the quality of banking supervision and optimal prudential regulations. We also show that when the quality of supervision can be influenced by the political economy, credit cycles are exacerbated: when interest rates or expected returns on projects are low, agents’ prefer weak supervision to maximize leverage but this tends to exacerbate risk taking and results in lower average return on projects ex-posts. In contrast, when interest rates are high, borrowers and uninformed investors prefer high quality supervision to constrain the rents left to banks.

Following Holmstrom and Tirole (1997), we consider a moral hazard economy in which banks monitor borrowers efforts, but must be incentivized by investing their own capital in the project, in addition to the entrepreneur’s capital. There are two incentive problems: first, banks must monitor projects; second, they must be prevented from colluding with borrowers which they do at the expense of uninformed investors by (sometimes) investing in non-productive projects which only generate non-veritable benefits. Collusion can be prevented by supervision and audits of bank accounts.

IMF