Democratic Political Economy of Financial Regulation

The imposition of adequate regulation on banks and other financial institutions is crucial to maintain the stability of the financial system and macroeconomy. This is because participants in financial markets often have incentives that are not aligned with what is good for society.

Many have argued that insufficient prudential regulation contributed to the 2008 sub-prime mortgage crisis in the United States. However, there is less discussion on why the US government failed to regulate banks and other financial institutions to prevent the crisis.

In this paper, we show that such “regulatory failure” could be an outcome of a democratic political process. This occurs when the beneficiaries of such policy—existing home-owners, who benefit from the increased house prices, and wealth-poor home-buyers, who benefit from lower mortgage interest rates—outnumber its opponents—wealthy buyers and renters, who get exposed to the fragility of the financial system.