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Optimal Regulation of Financial Intermediaries

Sebastian Di Tella

NBER Working Paper No. 23586
Issued in July 2017
NBER Program(s):Economic Fluctuations and Growth

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.

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Document Object Identifier (DOI): 10.3386/w23586

Published: Sebastian Di Tella, 2019. "Optimal Regulation of Financial Intermediaries," American Economic Review, vol 109(1), pages 271-313.

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