We set up a model where asset price bubbles due to risk shifting can be moderated by capital requirements. However, imperfect information about the ratio of required capital, or, in the context of the sub-prime crisis, the extent of regulatory arbitrage, introduces uncertainty about the risk exposure of intermediaries. Underestimation of regulatory arbitrage may induce households to infer that higher asset prices are due to a decline of risk. First, this mechanism can explain why the risk premia paid by US financial intermediaries did not increase between 2000 and 2007 in spite of its increasing leverage. Second, we provide a theory of the risk taking channel of monetary policy: in the model, the underestimation of risk is larger the lower the level of the risk free interest rate.
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Paper provided by Banque de France in its series Documents de Travail with number
254.
Find related papers by JEL classification: E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit G12 - Financial Economics - - General Financial Markets - - - Asset Pricing G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Capital and Ownership Structure
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