Does Financial Tranquility Call for Stringent Regulation?

May 31, 2018

Preview Citation

Format: Chicago

Deepal Basak, and Yunhui Zhao. Does Financial Tranquility Call for Stringent Regulation?, (USA: International Monetary Fund, 2018) accessed September 19, 2024

Disclaimer: IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.

Summary

Consistent with the Minsky hypothesis and the “volatility paradox” (Brunnermeier and Sannikov, 2014), recent empirical evidence suggests that financial crises tend to follow prolonged periods of financial stability and investor optimism. But does financial tranquility always call for more stringent regulation over time? We examine this question using a simple portfolio choice model that features the interaction between learning and externality. We evaluate the potential of a macroprudential policy to restore efficiency, and characterize the necessary and sufficient condition for the countercyclicality of the optimal regulation/macroprudential policy. Our paper implies that policymakers should not only consider the cyclical indicators “on the surface” (for example, credit growth), but also closely examine the deep structural change of the resilience of the system. The paper also highlights the importance of assigning the macroprudential policy function to independent agencies with technical expertise.

Subject: Economic sectors, Financial crises, Financial sector, Financial sector policy and analysis, Financial sector stability, Macroprudential policy, Systemic risk

Keywords: Externality, Externality curve, Financial crisis, Financial regulation, Financial sector, Financial sector stability, Financial stability, Financial system, Global, Investor confidence, Investor optimism, Investor risk-taking, Learning, Learning process, Macroprudential, Macroprudential policy, Network externality, Risky asset, Systemic risk, WP

Publication Details

Pages:

41
Volume:

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DOI:

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Issue:

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Series:

Working Paper No. 2018/123
Stock No:

WPIEA2018123
ISBN:

9781484357996
ISSN:

1018-5941

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