Politically Robust Financial Regulation

The deferred recognition of COVID-induced losses at banks in many countries hasreignited the debate on regulatory forbearance. This paper presents a model where thepublic's own political pressure drives regulatory policy astray, because the public is poorlyinformed. Using probabilistic game stages, the model parameterizes how time consistentpolicy is. The interaction between political motivations and time consistency is novel andcomplex: increased policy credibility can entice the politically-motivated regulator to actin the public's best interest, or instead repel it from doing so. Considering severalregulatory instruments, the paper probes the nexus of political pressure, perverse bankincentives and time inconsistent policy.