Optimal Regulation and Investment Incentives in Financial Networks

51 Pages Posted: 18 Jan 2019 Last revised: 11 Feb 2024

See all articles by Matthew O. Jackson

Matthew O. Jackson

Stanford University - Department of Economics; Santa Fe Institute

Agathe Pernoud

Stanford University - Department of Economics

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

Jackson, Matthew O. and Pernoud, Agathe, Optimal Regulation and Investment Incentives in Financial Networks (March 1, 2019). Available at SSRN: https://ssrn.com/abstract=3311839 or http://dx.doi.org/10.2139/ssrn.3311839

Matthew O. Jackson (Contact Author)

Stanford University - Department of Economics ( email )

Landau Economics Building
579 Serra Mall
Stanford, CA 94305-6072
United States
1-650-723-3544 (Phone)

HOME PAGE: http://www.stanford.edu/~jacksonm

Santa Fe Institute

1399 Hyde Park Road
Santa Fe, NM 87501
United States

Agathe Pernoud

Stanford University - Department of Economics ( email )

Landau Economics Building
579 Serra Mall
STANFORD, CA 94305-6072
United States

HOME PAGE: http://web.stanford.edu/~agathep

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