Prudential Policy with Distorted Beliefs

This paper studies financial and monetary policy in environments in which equity investors and creditors may have distorted beliefs. We characterize conditions under which it is optimal to tighten or relax leverage caps in response to arbitrary changes in beliefs. The optimal policy response to belief distortions depends on the type as well as the extent of exuberance, and it is not generally true that regulators should lean against the wind by tightening leverage caps in response to optimism. We show that increased optimism by investors is associated with relaxing the optimal leverage cap, while increased optimism by creditors, or jointly by both investors and creditors is associated with a tighter optimal leverage cap. In the presence of government bailouts, increased optimism by equity investors may call for a tighter optimal leverage cap too, depending on whether equity optimism is concentrated on upside or downside risk. Increased optimism by either equity investors or creditors is associated with higher incentives to raise interest rates, so monetary tightening can act as a useful substitute for financial regulation.