Optimal Regulation and Investment Incentives in Financial Networks. *

Abstract

We examine optimal regulation of financial networks with debt interdependencies between financial firms. We first characterize when it is firms 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 a firm's financial centrality and its available investment opportunities. Optimal regulation depends nonmonotonically 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: JEL Classification Codes: D85, F15, F34, F36, F65, G15, G32, G33, G38 Financial Networks, Markets, Systemic Risk, Regulation, Financial Crisis, Correlated Portfolios, Networks, Banks, Default Risk, Financial Interdependencies

JEL Classification: D85, F15, F34, F36, F65, G15, G32, G33, G38