Unregulated Finance and Optimal Regulation

63 Pages Posted: 21 Dec 2020 Last revised: 22 Feb 2022

See all articles by Christopher Clayton

Christopher Clayton

Yale School of Management

Andreas Schaab

Columbia Business School

Date Written: February 13, 2022

Abstract

We study financial regulation when some financial institutions or capital flows are unregulated and there are pecuniary externalities. Optimal financial regulation is scaled by a ``regulatory arbitrage multiplier.'' The contribution of an unregulated actor to regulatory arbitrage can be determined using microeconomic price elasticities and aggregate financial flows. Regulatory arbitrage can motivate tighter, rather than looser, optimal regulation due to collateral price effects. We provide a classification scheme for unregulated finance based on the welfare gains from extending regulation to certain institutions or activities. The institutions and markets driving regulatory arbitrage are not necessarily the most valuable targets for regulation. We apply our theory to shadow bank institution regulation and to capital flow management in a small open economy.

Keywords: Unregulated finance, capital flows, regulatory arbitrage, macroprudential regulation, capital controls, pecuniary externalities, fire sales

JEL Classification: F38, G28, D62

Suggested Citation

Clayton, Christopher and Schaab, Andreas, Unregulated Finance and Optimal Regulation (February 13, 2022). Available at SSRN: https://ssrn.com/abstract=3746495 or http://dx.doi.org/10.2139/ssrn.3746495

Christopher Clayton (Contact Author)

Yale School of Management ( email )

Cambridge, MA
United States

Andreas Schaab

Columbia Business School ( email )

3022 Broadway
New York, NY 10027
United States

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