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Optimal financial regulation under moral hazard

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  • Sebastian Di Tella

    (Stanford GSB)

Abstract

Excessive concentration of aggregate risk can lead to financial fragility and balance sheet recessions, and may create the need for financial regulation. This paper studies the optimal financial regulation scheme, with a focus on the optimal allocation of aggregate risk. I use a standard growth model in continuous-time, and allow agents to write optimal complete contracts to deal with a moral hazard problem in a competitive environment. I then consider the optimal allocation that can be achieved by a social planner who faces the same informational frictions as the market, and show how it can be implemented with a limited set of policy instruments. I show the competitive equilibrium is not constrained efficient due to the presence of a “moral hazard externality†, which is present in a wide class of models, and study under what conditions the allocation of aggregate risk in the competitive equilibrium is not efficient.

Suggested Citation

  • Sebastian Di Tella, 2014. "Optimal financial regulation under moral hazard," 2014 Meeting Papers 1246, Society for Economic Dynamics.
    • Handle: RePEc:red:sed014:1246
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