Financial regulatory cycles: A political economy model

A historical look at financial boom-bust cycles shows that pro-cyclicality in financial regulation is a common and recurring pattern. This paper shows that inefficient regulatory cycles can naturally arise when electoral concerns are introduced into a simple model of financial intermediation. We explore how financial innovations, public opinion and policymakers’ incentives shape financial regulation within this framework. We show that in the presence of incompetent politicians, competent politicians take regulatory risks to signal their competence. This amplifies the influence of public opinion on policy, leading to an ex ante inefficient pro-cyclicality in financial regulation.