Financial Crisis And The Paradox Of Under- And Over-regulation

This paper illustrates the paradox of prudential under-regulation in an economy that adopts financial reform, a reform which exposes the economy to future financial crises. There is individual-uncertainty about the crisis incidence, and the probability of the crisis is updated sequentially applying Bayesian inference. Costly regulation can mitigate the probability of the crisis. The authors identify conditions where the regulation level supported by the majority is positive after the reform, but below the socially optimal level. Tranquil time, when the crisis would not take place, reduces the regulation intensity. If the spell of no crisis is long enough, the regulation level may drop to zero, despite the fact that the socially optimal regulation level remains positive.