## Does Financial Tranquility Call for Stringent Regulation?

_IMF Working Papers, May 31, 2018_

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## Bibliographic details
- Authors: Deepal Basak, Yunhui Zhao
- Published: May 31, 2018
- Series: IMF Working Papers
- DOI: https://doi.org/10.5089/9781484357996.001

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### Research question and approach
- Examines whether prolonged financial tranquility calls for increasingly stringent regulation.
- Uses a simple portfolio choice model that features the interaction between learning and externality.
- Evaluates the potential of a macroprudential policy to restore efficiency.
- Characterizes the necessary and sufficient condition for the countercyclicality of the optimal regulation/macroprudential policy.

### Key findings
- Consistent with the Minsky hypothesis and the “volatility paradox” (Brunnermeier and Sannikov, 2014), recent empirical evidence suggests financial crises tend to follow prolonged periods of financial stability and investor optimism.
- Interaction of learning and externality in the model can generate episodes where tranquility precedes increased systemic risk.
- The model identifies a clear condition that is necessary and sufficient for the optimal macroprudential policy to be countercyclical.

### Policy implications and recommendations
- Policymakers should not rely solely on surface cyclical indicators (for example, credit growth); they should closely examine deep structural changes in the resilience of the financial system.
- Macroprudential policy can potentially restore efficiency, but its design must account for learning dynamics and externalities identified in the model.
- Importance of assigning the macroprudential policy function to independent agencies with technical expertise.

### Subjects and keywords (as provided)
- Subjects: 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

*IMF Working Paper — Does Financial Tranquility Call for Stringent Regulation? By Deepal Basak and Yunhui Zhao, May 31, 2018.*

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## Content in this bundle

- **Does Financial Tranquility Call for Stringent Regulation?, WP/18/123, May 2018**
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_Source: https://www.imf.org/en/publications/wp/issues/2018/05/31/does-financial-tranquility-call-for-stringent-regulation-45908_