Concept of crisis with unstable statistic bars
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Weak financial regulation can be the natural result of the democratic process, argues a new working paper from the Bank of Canada.

The paper was written by a pair of researchers — one from the central bank and one with the Federal Reserve Bank of Philadelphia — and it argues that when the beneficiaries of lax regulation make up a political majority, the outcome can be regulatory failure.

The researchers theorize that there are two groups that benefit from lax financial regulation: aspiring homeowners who may be unable to get a mortgage if the rules are too tough, and existing homeowners who benefit from price appreciation when an increase in prospective buyers drives up home prices.

Conversely, lax regulation can harm both renters and households with significant non-housing wealth, with both groups suffering when banks fail and the financial system proves vulnerable.

“If the coalition of old homeowners and young wealth-poor potential home-buyers is large enough, then regulatory failure (inefficiently lax financial regulation) can arise as an outcome of a democratic process,” the paper said.

This phenomenon can also appear in other government policy choices, the paper argues, pointing to measures to help first-time homebuyers.

“Take for example the ‘shared equity mortgage’ program introduced by the Canada Mortgage and Housing Corporation (CMHC) in 2019,” it said. “The idea of the government agency helping first-time home-buyers come up with a down payment on a house is touted as making housing more affordable.”

But in fact, these kinds of policies “make homes more expensive rather than more affordable,” the paper noted, adding that “this policy of stimulating home-buying may well have political support from a coalition of wealth-poor prospective new home-buyers (who benefit from the policy directly) and existing homeowners (who reap the benefit of increased house prices).”

The paper also said that by helping inflate housing prices, lax regulation can also impact the default rate on existing mortgages — reinforcing support for weak rules.

“The popular support for lax regulation is self-perpetuating,” the paper concluded, “as lax regulation today leads to a larger voting group of old homeowners tomorrow.”