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Optimal regulation and investment incentives in financial networks

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  • Jackson, Matthew O.
  • Pernoud, Agathe

Abstract

We examine the optimal regulation of financial networks with debt interdependencies between financial firms. We first show that firms often have incentives to choose excessively risky portfolios and to 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 at 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 (identical in all aspects, including network centrality) to invest freely.

Suggested Citation

  • Jackson, Matthew O. & Pernoud, Agathe, 2025. "Optimal regulation and investment incentives in financial networks," Journal of Public Economics, Elsevier, vol. 252(C).
    • Handle: RePEc:eee:pubeco:v:252:y:2025:i:c:s0047272725002154
    DOI: 10.1016/j.jpubeco.2025.105516
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    Keywords

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    JEL classification:

    • D85 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Network Formation
    • F15 - International Economics - - Trade - - - Economic Integration
    • F34 - International Economics - - International Finance - - - International Lending and Debt Problems
    • F36 - International Economics - - International Finance - - - Financial Aspects of Economic Integration
    • F65 - International Economics - - Economic Impacts of Globalization - - - Finance
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
    • G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation
    • G38 - Financial Economics - - Corporate Finance and Governance - - - Government Policy and Regulation

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