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Macroprudential Policy with Leakages

Working Paper 754 | Published September 11, 2018

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Macroprudential Policy with Leakages

Abstract

The outreach of macroprudential policies is likely limited in practice by imperfect regulation enforcement, whether due to shadow banking, regulatory arbitrage, or other regulation circumvention schemes. We study how such concerns affect the design of optimal regulatory policy in a workhorse model in which pecuniary externalities call for macroprudential taxes on debt, but with the addition of a novel constraint that financial regulators lack the ability to enforce taxes on a subset of agents. While regulated agents reduce risk taking in response to debt taxes, unregulated agents react to the safer environment by taking on more risk. These leakages undermine the effectiveness of macroprudential taxes but do not necessarily call for weaker interventions. A quantitative analysis of the model suggests that aggregate welfare gains and reductions in the severity and frequency of financial crises remain, on average, largely unaffected by even significant leakages.

DOI: https://doi.org/10.21034/wp.754