Systemic Risk and Optimal Regulatory Architecture

Until the recent financial crisis, the safety and soundness of financial institutions was assessed from
the perspective of the individual institution. The financial crisis highlighted the need to take
systemic externalities seriously when rethinking prudential oversight and the regulatory
architecture. Current financial reform legislation worldwide reflects this intent. However, these
reforms have overlooked the need to also consider regulatory agencies’ forbearance and
information sharing incentives. In a political economy model that explicitly accounts for systemic
connectedness, and regulators’ incentives, we show that under an expanded mandate to explicitly
oversee systemic risk, regulators would be more forbearing towards systemically important
institutions. We also show that when some regulators have access to information regarding an
institutions’ degree of systemic importance, these regulators may have little incentive to gather and
share it with other regulators. These findings suggest that (and we show conditions under which) a
unified regulatory arrangement can reduce the degree of systemic risk vis-á-vis a multiple
regulatory arrangement.