Prudential Policy with Distorted Beliefs

44 Pages Posted: 6 Nov 2020

See all articles by Eduardo Davila

Eduardo Davila

Yale University - Department of Economics; National Bureau of Economic Research (NBER)

Ansgar Walther

Imperial College London; Centre for Economic Policy Research (CEPR)

Date Written: September 17, 2020

Abstract

This paper studies financial and monetary policy in environments in which equity investors and creditors may have distorted beliefs. We characterize conditions under which it is optimal to tighten or relax leverage caps in response to arbitrary changes in beliefs. The optimal policy response to belief distortions depends on the type as well as the extent of exuberance, and it is not generally true that regulators should lean against the wind by tightening leverage caps in response to optimism. We show that increased optimism by investors is associated with relaxing the optimal leverage cap, while increased optimism by creditors, or jointly by both investors and creditors is associated with a tighter optimal leverage cap. In the presence of government bailouts, increased optimism by equity investors may call for a tighter optimal leverage cap too, depending on whether equity optimism is concentrated on upside or downside risk. Increased optimism by either equity investors or creditors is associated with higher incentives to raise interest rates, so monetary tightening can act as a useful substitute for financial regulation.

Keywords: prudential policy, distorted beliefs, financial regulation, bailouts, monetary policy, bank regulation

JEL Classification: G28, G21, E61, E52

Suggested Citation

Davila, Eduardo and Walther, Ansgar, Prudential Policy with Distorted Beliefs (September 17, 2020). Available at SSRN: https://ssrn.com/abstract=3694722 or http://dx.doi.org/10.2139/ssrn.3694722

Eduardo Davila

Yale University - Department of Economics ( email )

28 Hillhouse Ave
New Haven, CT 06520-8268
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Ansgar Walther (Contact Author)

Imperial College London ( email )

South Kensington Campus
Exhibition Road
London, Greater London SW7 2AZ
United Kingdom

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

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