Financial Policy in an Exuberant World

42 Pages Posted: 20 Mar 2020

Date Written: March, 2020

Abstract

This paper studies optimal financial policy in a world where the financial sector can become excessively optimistic. I decompose the welfare effects of bank capital regulation to demonstrate the effects of exuberance and its interaction with incentive problems in banking. The optimal policy depends not only on the extent, but also on the type of optimism. For example, it is markedly different when the exuberance of banks focuses on neglected downside risk, as opposed to overstated upside opportunities. A central normative conclusion is that “leaning against the wind”, by tightening capital requirements in exuberant times, can be counterproductive. I show that two natural metrics, describing the distortion in perceived upside and downside risk, are sufficient statistics for the policy implications of exuberance. My results shed light on the diverse empirical evidence on the relationship between bank capital and risk-taking. Finally, I investigate the sensitivity of these insights under different assumptions about government rationality and paternalism.

Keywords: banking, behavioral finance, financial crises, macroprudential policy

JEL Classification: G01, G21, G40

Suggested Citation

Walther, Ansgar, Financial Policy in an Exuberant World (March, 2020). ECB Working Paper No. 2380, Available at SSRN: https://ssrn.com/abstract=3557874

Ansgar Walther (Contact Author)

Imperial College London ( email )

South Kensington Campus
Exhibition Road
London, Greater London SW7 2AZ
United Kingdom

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