Macroprudential Regulation of Banks and Financial Institutions

Abstract

Abstract Regulation of financial institutions to avoid the worst effects of financial crises has become a major topic of research and a focus of regulators’ efforts. Policies designed to reduce crises’ effects on real GDP and employment are called macroprudential. Moral hazard has been introduced by deposit insurance and bailouts of banks and large financial institutions. Too little is known to premise macroprudential regulation on externalities. That said, higher capital at banks and other institutions counteracts one effect of deposit insurance and would make the financial system more resilient. Living wills are likely not to be time-consistent. Regulators will not have an incentive to use them in a financial crisis. Instead, they will bail out firms to avoid adverse effects on the economy. Institutions determining regulators’ choices in a crisis need to be designed to make it equilibrium behavior for regulators to let financial firms fail.