Prudential Policy with Distorted Beliefs

62 Pages Posted: 16 Dec 2021

See all articles by Eduardo Davila

Eduardo Davila

Yale University - Department of Economics; National Bureau of Economic Research (NBER)

Ansgar Walther

Imperial College London

Multiple version iconThere are 4 versions of this paper

Date Written: December 1, 2021


This paper studies leverage regulation and monetary policy when equity investors and/or creditors have distorted beliefs relative to a planner. We characterize how the optimal leverage regulation responds to arbitrary changes in investors’ and creditors’ beliefs and relate our results to practical scenarios. We show that the optimal regulation depends on the type and magnitude of such changes. Optimism by investors calls for looser leverage regulation, while optimism by creditors, or jointly by both investors and creditors, calls for tighter leverage regulation. Monetary policy should be tightened (loosened) in response to either investors’ or creditors’ optimism (pessimism).

Keywords: bailouts, distorted beliefs, leverage regulation, monetary policy, prudential policy

JEL Classification: G28, G21, E61, E52

Suggested Citation

Davila, Eduardo and Walther, Ansgar, Prudential Policy with Distorted Beliefs (December 1, 2021). ESRB: Working Paper Series 2021/130, Available at SSRN: or

Eduardo Davila (Contact Author)

Yale University - Department of Economics ( email )

28 Hillhouse Ave
New Haven, CT 06520-8268
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Ansgar Walther

Imperial College London ( email )

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

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