Optimal Financial Regulation and the Concentration of Aggregate Risk

Abstract

Excessive concentration of aggregate risk can lead to financial fragility and may create the need for financial regulation. This paper studies the optimal financial regulation policy in a standard model where financial frictions are derived from a moral hazard problem, with a focus on the allocation of aggregate risk. First, I study the competitive equilibrium where agents can write complete long-term contracts, and I derive a simple formula for the allocation of aggregate risk. I then consider the optimal allocation that can be achieved by a social planner who faces the same informational asymmetries as the market, and show the competitive equilibrium is not constrained efficient. I identify a “moral hazard externality” that appears in a wide class of models, and show how it can create incentives for an inefficient allocation of aggregate risk. Finally, I show that although the competitive equilibrium may feature excessive concentration of aggregate risk, the optimal allocation can be implemented with a tax on capital.