Corrective Regulation with Imperfect Instruments

Abstract

This paper studies the optimal design of second-best corrective regulation, when some agents or activities cannot be perfectly regulated. We show that policy elasticities and Pigouvian wedges are sufficient statistics to characterize the marginal welfare impact of regulatory policies in a large class of environments. We show that the optimal second-best policy is determined by a subset of policy elasticities: leakage elasticities, and characterize the marginal value of relaxing regulatory constraints. We apply our results to scenarios with unregulated agents/activities and with uniform regulation across agents/activities. We illustrate our results in applications to shadow banking, scale-invariant regulation, asset substitution, and fire sales.

Too Levered for Pigou: Carbon Pricing, Financial Constraints, and Leverage Regulation

“…This result mirrors insights inDávila and Walther (2022) that, with constraints on the regulation of some externality-generating activity (here abatement), the optimal second-best regulation of other choices (here leverage) depends on Pigouvian wedges in the constrained regulation and on how the perfectly regulated choices affect the imperfectly regulated activity.…”

“…Instead, the motive for implementing an equity mandate ē comes from the interaction between environmental externalities and financial frictions because binding financial constraints imply that the optimal emissions tax is below the total social cost of emissions. The results in Proposition 7 thus contribute to the debate on whether environmental externalities should be included in the mandate of financial regulatory frameworks (also see Dávila and Walther, 2022;Oehmke and Opp, 2022).…”

“…Another related contribution by Oehmke and Opp (2022) analyzes capital requirements as a tool to incentivize bank lending to green firms when emissions taxes are not available. Dávila and Walther (2022) more generally study optimal regulation when policy instruments are imperfect, with an application to risk-weighted capital requirements that take environmental externalities into account. We complement these results by comparing the efficiency under different environmental policy tools, and ask under what conditions it may be beneficial to combine environmental policy with leverage regulation in a setting in which there is no motive for financial regulation absent environmental externalities.…”

Too Levered for Pigou: Carbon Pricing, Financial Constraints, and Leverage Regulation

“…By studying financial policy in this context we also relate to recent contributions by Oehmke and Opp (2022) and Dávila and Walther (2022), who consider risk-weighted capital regulation as a tool for tackling environmental externalities. We follow a different approach in that we take optimal emissions taxes as a starting point and show under what conditions leverage regulation can be valuable as a complementary policy tool.…”

Prudential Policy with Distorted Beliefs

“…We assume continuous and strictly positive densities to simplify the exposition of our analysis of belief perturbations (see Section 2.3). Our results go through, with some additional technical conditions, if we impose weaker assumptions, such as absolute continuity of the relevant distributions.12 In Section E.3 of the Online Appendix, we describe the form of the first-best policy, in which the planner can also control investment directly Dávila and Walther (2021). provide a systematic study of second-best regulation in general environments.…”