Optimal Regulation and Investment Incentives in Financial Networks

TL;DR

This paper analyzes how optimal regulation in financial networks depends on firms' centrality and investment correlation, revealing complex non-monotonic relationships and the potential for asymmetric regulation of similar banks.

Contribution

It characterizes the dependence of optimal regulation on network structure and investment correlation, highlighting non-monotonic effects and the possibility of asymmetric regulation strategies.

Findings

Optimal regulation varies non-monotonically with investment correlation.

Asymmetric regulation can be optimal for identical core banks.

Regulation depends on a firm's position within the network.

Abstract

We examine optimal regulation of financial networks with debt interdependencies between financial firms. We first show that firms often have an incentive to choose excessively risky portfolios and overly correlate their portfolios with those of their counterparties. We then characterize how optimal regulation depends on a firm's financial centrality and its available investment opportunities. In standard core-periphery networks, optimal regulation depends non-monotonically on the correlation of banks' investments, with maximal restrictions for intermediate levels of correlation. Moreover, it can be uniquely optimal to treat banks asymmetrically: restricting the investments of one core bank while allowing an otherwise identical core bank (in all aspects, including network centrality) to invest freely.