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Financial stability and macroprudential regulation under diagnostic expectations

Author

Listed:
  • Camous, Antoine
  • Van der Ghote, Alejandro

Abstract

Recent empirical findings (Bordalo et al., 2018, 2019; Greenwood et al., 2022) have vindicated the view thatsystemic risk in financial markets is also influenced by cognitive misperceptions about future economicdevelopments in addition to being influenced by financial frictions. Most of the literature on macroprudentialregulation, nonetheless, has omitted those misperceptions and instead has derived policy implicationsassuming rational expectations. In this article (which is based on Camous and Van der Ghote, 2021), weexamine the joint implications of external financing frictions and extrapolative expectations for the stability ofthe financial system and the appropriate conduct of macroprudential regulation. We find that interactionsbetween those two elements exacerbate financial instability relative to the rational benchmark. This calls fortighter macroprudential regulation, even when the regulator is also subject to cognitive misperceptions.Disagreement about the appropriate macroprudential regulation among potential regulators with differingdegrees of misperception is stronger during booms, when risk-taking in financial markets and in realinvestments is more aggressive. JEL Classification: E32, E44, E71

Suggested Citation

  • Camous, Antoine & Van der Ghote, Alejandro, 2022. "Financial stability and macroprudential regulation under diagnostic expectations," Research Bulletin, European Central Bank, vol. 101.
    • Handle: RePEc:ecb:ecbrbu:2022:0101:
    Note: 2828013
    as

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    References listed on IDEAS

    as
    1. Bernanke, Ben S. & Gertler, Mark & Gilchrist, Simon, 1999. "The financial accelerator in a quantitative business cycle framework," Handbook of Macroeconomics, in: J. B. Taylor & M. Woodford (ed.), Handbook of Macroeconomics, edition 1, volume 1, chapter 21, pages 1341-1393, Elsevier.
    2. Hart, Oliver & Moore, John, 1990. "Property Rights and the Nature of the Firm," Journal of Political Economy, University of Chicago Press, vol. 98(6), pages 1119-1158, December.
    3. Mark Gertler & Nobuhiro Kiyotaki & Andrea Prestipino, 2020. "A Macroeconomic Model with Financial Panics," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 87(1), pages 240-288.
    4. Pedro Bordalo & Nicola Gennaioli & Andrei Shleifer, 2018. "Diagnostic Expectations and Credit Cycles," Journal of Finance, American Finance Association, vol. 73(1), pages 199-227, February.
    5. Giovanni Dell’Ariccia & Deniz Igan & Luc Laeven, 2012. "Credit Booms and Lending Standards: Evidence from the Subprime Mortgage Market," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 44(2‐3), pages 367-384, March.
    6. Pedro Bordalo & Nicola Gennaioli & Rafael La Porta & Andrei Shleifer, 2019. "Diagnostic Expectations and Stock Returns," Journal of Finance, American Finance Association, vol. 74(6), pages 2839-2874, December.
    7. Robin Greenwood & Samuel G. Hanson & Andrei Shleifer & Jakob Ahm Sørensen, 2022. "Predictable Financial Crises," Journal of Finance, American Finance Association, vol. 77(2), pages 863-921, April.
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    More about this item

    Keywords

    diagnostic expectations; financial cycles; macroprudential regulation;
    All these keywords.

    JEL classification:

    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • E71 - Macroeconomics and Monetary Economics - - Macro-Based Behavioral Economics - - - Role and Effects of Psychological, Emotional, Social, and Cognitive Factors on the Macro Economy

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