Discussion Paper Details

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Title: Macroprudential Policy with Leakages

Author(s): Julien Bengui and Javier Bianchi

Publication Date: August 2019

Keyword(s): capital flow management, financial crises, limited regulation enforcement, macroprudential policy and regulatory arbitrage

Programme Area(s): International Macroeconomics and Finance

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 do undermine the effectiveness of macruprudential taxes, yet they do not necessarily call for weaker interventions. Quantitatively, we find that a well-designed macroprudential policy that accounts for leakages remains successful at mitigating the vulnerability to financial crises.

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Bibliographic Reference

Bengui, J and Bianchi, J. 2019. 'Macroprudential Policy with Leakages'. London, Centre for Economic Policy Research.