Optimal Regulation of Financial Intermediaries

I characterize the optimal financial regulation policy in an economy where financial intermediaries trade capital assets on behalf of households, but must retain an equity stake for incentive reasons. Financial regulation is necessary because intermediaries cannot be excluded from privately trading in capital markets. They don’t internalize that high asset prices force everyone to bear more risk. The socially optimal allocation can be implemented with a tax on asset holdings, or equivalently, reserve requirements. I derive a simple formula for the externality/optimal policy in terms of observable variables, valid for heterogenous intermediaries and asset classes, and arbitrary aggregate shocks. I use market data on leverage and volatility of intermediaries’ equity to measure the externality, which co-moves with the business cycle.