Politically Robust Financial Regulation

IMF Working Papers, January 8, 2021

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The deferred recognition of COVID-induced losses at banks in many countries has reignited the debate on regulatory forbearance.
The paper presents a model where the public's own political pressure drives regulatory policy astray, because the public is poorly informed.
Using probabilistic game stages, the model parameterizes how time consistent policy is.
The interaction between political motivations and time consistency is novel and complex: increased policy credibility can entice the politically-motivated regulator to act in the public's best interest, or instead repel it from doing so.
Considering several regulatory instruments, the paper probes the nexus of political pressure, perverse bank incentives and time inconsistent policy.

Framework: probabilistic game stages.
Key parameter: time consistency of policy as parameterized by the model.
Behavioral drivers: political pressure from a poorly informed public; politically-motivated regulator responses.
Instruments considered: several regulatory instruments (unspecified in the overview).

Public political pressure—rooted in poor public information—can mislead regulatory policy.
Time consistency interacts with political motivations in non-monotonic ways:
- Increased policy credibility can entice a politically-motivated regulator to act in the public's best interest.
- Increased policy credibility can alternatively repel the regulator from acting in the public's best interest.
Perverse bank incentives interact with political pressure to produce time-inconsistent regulatory outcomes.

The analysis bears directly on the debate over regulatory forbearance in the context of COVID-induced bank losses.
Policymakers should account for:
- The role of public information quality in shaping political pressure.
- How changes in policy credibility can have ambiguous effects on regulator behavior.
- The combined effect of political pressure and bank incentives on time consistency of regulation.
The paper examines implications across multiple regulatory instruments to illuminate the nexus of political pressure, bank incentives, and time inconsistency.