Interest Rate Policy and Financial Regulation: How to Control Excessive Risk Taking?

This paper characterizes the optimal combination of monetary policy and financial regulation in a quantitative infinite horizon model with a risk taking channel of monetary policy. The model economy is rich enough to match main characteristics of the U.S. economy and its financial sector, yet tractable enough to deliver clear prescriptions regarding the optimal policy mix. The optimal policy mix has a simple state contingent leverage regulation and a small financial contribution tax on profits of financial intermediaries. Revenue derived from this tax helps to secure equity financing to solvent financial institutions during economic downturns. Leverage regulation and monetary policy act as complements when policy deviates from the optimum. Standard capital-adequacy regulation is welfare decreasing though effective at reducing risk taking.