Optimal Regulation and Investment Incentives in Financial Networks
51 Pages Posted: 18 Jan 2019 Last revised: 11 Feb 2024
Date Written: March 1, 2019
Abstract
We examine optimal regulation in a model of financial networks that admits both debt and equity interdependencies. We first characterize when it is that financial organizations have an incentive
to choose excessively risky portfolios and overly correlate their portfolios with those of their counterparties. We then characterize how optimal regulation depends on an organization's financial centrality and its available investment opportunities. Optimal regulation depends non-monotonically on the correlation of banks' investments, with maximal restrictions for intermediate levels of correlation. Moreover, in standard core-periphery networks, it can be uniquely optimal to treat banks asymmetrically: restricting the investments of one core bank while allowing an otherwise identical core bank (in all aspects, including network centrality) to invest freely.
Keywords: Financial Networks, Markets, Systemic Risk, Financial Crises, Correlated Portfolios, Default Risk, Networks, Banks
JEL Classification: D85, F15, F34, F36, F65, G15, G32, G33, G38
Suggested Citation: Suggested Citation