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Abstract:
Financial regulatory policy in the U.S. has been conspicuously pro-cyclical over the last two decades. A historical look at financial boom-bust cycles shows that pro-cyclicality in financial regulation is a common and recurring pattern. This paper introduces electoral concerns in a model of financial intermediation to study how public opinion, financial innovation, and policy-makers incentives shape financial regulation. We show that politicians' electoral incentives can generate an ex ante inefficient pro-cyclicality in financial regulation. In the presence of incompetent politicians and a polarized electorate, competent politicians take regulatory risks to signal their competence. This leads to an amplification of the impact of public opinion on regulatory policy.