The role of regulatory credibility in effective bank regulation

In a departure from the conventional financial regulation literature that analyzes systems, laws and procedures, this paper analyzes instead the role of regulatory credibility on the stability and productivity of the banking system. The intuition is that the effectiveness of a regulatory framework in terms of the trade-off between the productivity and stability of the system depends crucially on how the regime is perceived and how those perceptions impact the expectations and decisions of the regulated economic agents. The argument is that expectations themselves are endogenous. As perceptions change, expectations change with consequent effects on decision making. To analyze this effect, we develop a model of regulated Brownian motion with an endogenous profit term. We show that when regulatory intervention is perfect and costless, the volatility of the system can be substantially reduced with no loss of productivity. In fact, perfect credibility can actually reduce the volatility of intrinsically risky banking systems below the volatility of intrinsically less risky systems as banks anticipate intervention and mitigate their investment behaviour accordingly. This counter-intuitive effect of regulation on the volatility of the banking system highlights the importance of regulatory credibility and suggests that the potential gain from financial regulation is greater in the inherently riskier financial systems. However, when the credibility of the regime is weakened because of increased uncertainty stemming from regulation, such as random costs or imperfect timing of regulatory intervention, both the stability and productivity of the financial system are impaired. Importantly, we find that in the presence of regulatory costs and imperfect credibility, there is no universal optimal intervention policy rule. The optimal regulatory system depends on the regulator’s level of absolute risk aversion.