Is when there exists a time inconsistency between setting successful and appropriate regulatory action i.e. what may be optimal ex-poste may not have been optimal ex-ante.
For instance if a large bank is close to failing due to holding insufficient capital, regulation states that the bank should be required to hold more capital to prevent systemic risk. However imposing large capital penalties on the bank could make the bank insolvent, dumping a huge cost on the taxpayer for the central bank to act as a lender of the last resort. Therefore regulators often to prevent failures do not implement tough restrictions when they are supposed too. However, this in effect creates a crisis of confidence amongst economic agents towards regulators and in the long-term increasing the number of bank failures. Below is the logical chain of reasoning for this type of regulatory inefficiency.
