The Political Economy of Prudential Regulation

This paper introduces a voting model into a framework with negative borrowing externalities to study voter preferences for prudential regulation. While voting, agents account for the general equilibrium impact of prudential policy on future asset prices and consequently, their access to credit. They thus support a universal limit on current debt. Curbing over-borrowing restricts future declines in asset prices, distributing wealth from high- to low-income borrowers, so the former prefer lax regulation. Political imperfections, such as exemptions of politically connected borrowers, distort the marginal value of regulation. This leads connected borrowers to support excessively strict policy and other agents to vote for overly lax debt limits. If connections and income are correlated, political imperfections may reverse the policy preferences of high- and low-income borrowers.​