The Political Economy of Prudential Regulation

This paper introduces a voting model into a setting with negative borrowing externalities to study voter preferences for prudential regulation. Voters internalize the general equilibrium impact of prudential policy on future asset prices and therefore support a universal limit on current debt. Curbing over-borrowing limits future declines in asset prices, distributing wealth from high- to low-income borrowers. Therefore, the high-income types support lax regulation. Political imperfections such as exemptions of politically connected borrowers distort the marginal value of regulation. This leads connected agents to support excessively strict policy, while the other borrowers may prefer an overly lax debt limit. If connections and income are correlated, political imperfections can reverse the policy preferences of high- and low-income borrowers