DP13951 Macroprudential Policy with Leakages

Author(s): Julien Bengui, Javier Bianchi
Publication Date: August 2019
Date Revised: September 2019
Keyword(s): capital flow management, financial crises, limited regulation enforcement, macroprudential policy, regulatory arbitrage
JEL(s): E58, F32, G28
Programme Areas: International Macroeconomics and Finance
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=13951

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.