Working Paper: NBER ID: w23586
Authors: Sebastian Di Tella
Abstract: I characterize the optimal financial regulation policy in an economy where financial intermediaries trade capital assets on behalf of households, but must retain an equity stake to align incentives. Financial regulation is necessary because intermediaries cannot be excluded from privately trading in capital markets. They don’t internalize that high asset prices force everyone to bear more risk. The socially optimal allocation can be implemented with a tax on asset holdings. I derive a sufficient statistic for the externality/optimal policy in terms of observable variables, valid for heterogenous intermediaries and asset classes, and arbitrary aggregate shocks. I use market data on leverage and volatility of intermediaries’ equity to measure the externality, which co-moves with the business cycle.
Keywords: Financial Regulation; Financial Intermediaries; Moral Hazard; Asset Pricing
JEL Codes: E44; G01
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| tax on asset holdings (F38) | reduction of moral hazard issues (G52) |
| tax on asset holdings (F38) | reduce asset prices (G19) |
| reduce asset prices (G19) | mitigate excessive risk-taking by intermediaries (G21) |
| optimal allocation (with tax) (H21) | mitigate financial amplification channel (E44) |
| optimal allocation (with tax) (H21) | mitigate concentrated financial losses during downturns (F65) |
| unregulated competitive equilibrium (D59) | excessive risk-taking by intermediaries (F65) |