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Discussion Paper

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