CFDP 2336

Prudential Policy with Distorted Beliefs


Publication Date: June 2022

Pages: 73


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.

Keywords: prudential policy, distorted beliefs, leverage regulation, robust optimal policy, monetary policy, bailouts, pecuniary externalities

JEL Classification Codes: G28, G21, E61, E52

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