Is Private Leverage Excessive?

I examine whether a benevolent government can improve on the free market allocation by setting capital requirements for private borrowers in a stochastic model with collateral constraints. Previous theoretical studies have found that when asset prices enter into bor- rowing constraints, pecuniary externalities between atomistic agents can make the laissez faire equilibrium constrained ine¢ cient. For reasonable parameter values, I find that, quan- titatively, the answer is 'no', private and government leverage choices coincide. Limiting private leverage by imposing capital requirements has the beneficial e¤ect of dampening the effects of the collateral amplification mechanism. This reduces fire sales in recessions and limits the negative externality that individual asset sales have on other credit constrained borrowers. However, we find that capital requirements are a blunt tool. They tax the activities of highly productive entrepreneurs and reduce the amount they produce in equilibrium. This reduces total factor productivity and steady state consumption. In the end, society faces a choice between high but unstable consumption in the free borrowing world and low but stable consumption in the regulated world. The government chooses the former.