Prudential Policy with Distorted Beliefs

This paper studies leverage regulation when equity investors and/or creditors have

distorted beliefs relative to a planner. We characterize how the optimal regulation

responds to arbitrary changes in investors’/creditors’ beliefs, relating 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/creditors, calls for

tighter leverage regulation. Our results apply to environments with i) planners with

imperfect knowledge of investors’/creditors’ beliefs, ii) monetary policy, iii) bailouts

and pecuniary externalities, and iv) endogenous beliefs.