Prudential Policy with Distorted Beliefs

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Abstract

This paper studies leverage regulation and monetary policy when 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. 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. Joint work with Ansgar Walther.

JEL Codes: G28, G21, E61, E52

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

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