Dynamics of Regulation of Strategically Complex Financial Products

2022 Fiscal Year Final Research Report

• Project/Area Number: 18K12817
• Research Category: Grant-in-Aid for Early-Career Scientists
• Allocation Type: Multi-year Fund
• Review Section: Basic Section 07060:Money and finance-related
• Research Institution: Musashi University
• Principal Investigator: Franco Pedro 武蔵大学, 国際教養学部, 専任講師 (70791383)
• Project Period (FY): 2018-04-01 – 2023-03-31
• Keywords: Financial Regulation / Financial Complexity / Optimal Contracts

Outline of Final Research Achievements

This project solves the following model: a repeated game where each period a bank receives a new financial product, either good/riskless, or bad/risky with bailout risk, that is, bad products are a moral hazard problem. The bank can then choose to make bad products complicated, making it costly for regulators to monitor banks. The regulator faces limitations in designing its optimal regulation as they cannot use fines or monetary rewards to the bank. Under some parameter restrictions and under commitment the optimal solution is to promise a “reward” phase for banks which allows for a (extended) period where no risky products are used. But once this "reward" phase is reached, banks will continuously use bad products and financial crisis become a statistical inevitability.
This project also shows how quantitative computational methods can be applied to the above theoretical results. And it explored how an empirical calculation of complexity might be achieved via NLP methods.

Free Research Field

Financial Macroeconomics

Academic Significance and Societal Importance of the Research Achievements

This project highlights the difficulties that regulators face as banks/bankers are potentially not punished for taking risky bets. Even in the best case this project is able to explore, it may not be possible for regulators to stop crisis, only to forestall them for a period of time.