Banking supervision with loopholes

This paper develops a model of financial intermediation focusing on the interaction between banks and a regulator. In the model, the regulator chooses its supervision capacity to monitor banks and prevent excessive risk-taking. Meanwhile, banks can engage in loophole innovation to circumvent supervision, diminishing the value of the regulator’s accumulated expertise. In equilibrium, as the regulator’s supervision capacity increases, loophole innovation is more likely to succeed. In the dynamic framework, our model generates pro-cyclical bank leverage and asymmetric credit cycles. After a longer boom, a crisis is more likely to occur, and the consequences are more severe. We analyze the welfare implications of maximum leverage regulation and other regulatory tools in the loophole innovation environment.