The intended and unintended consequences of financial-market regulations: A general-equilibrium analysis

Abstract

Financial markets have historically been regulated. This regulation is motivated by the desire to rule out anti-competitive behavior, to prevent agency problems that arise in the presence of asymmetric information, and to limit negative externalities, where the behavior of an individual investor or institution can affect the entire financial system. The recent financial crisis, which has highlighted the negative feedback from financial markets to the real sector, has intensified the debate about the ability of financial-market regulations to stabilize these markets and improve macroeconomic outcomes. We study the intended and unintended consequences of various regulatory measures used to reduce fluctuations in financial and real markets and to improve welfare. The measures we study are the ones that have been proposed by regulators in response to the financial crisis: the Tobin financial-transactions tax, portfolio (short-sale) constraints, and borrowing (leverage) constraints.For example, on 1 August 2012, France introduced a financial transaction tax of 0.20%; on 25 July 2012, Spain's Comision Nacional del Mercado de Valores (CNMV) imposed a three-month ban on short-selling stocks, while Italy's Consob prohibited short-selling of stocks of 29 banks and insurance companies; and, tighter leverage constraints have been proposed following the subprime crisis: for instance, on 17 October 2008 the European Commissioner, Joaquin Almunia, said: "Regulation is going to have to be thoroughly anti-cyclical, which is going to reduce leverage levels from what we've seen up to now."Our objective is to evaluate these three regulatory measures within the same dynamic, stochastic general equilibrium model of a production economy, and to compare within a single economic setting, both the intended and unintended effects of these different measures on the financial and real sectors. The kind of questions we address are the following: Of the three regulatory measures we consider, which is most effective in stabilizing financial markets? What exactly is the channel through which each measure works? What will be the impact, intended or unintended, of this measure on other financial variables and the spillover effects on real variables? Would more tightly regulated markets be more stable and increase productivity and welfare?We have undertaken a general-equilibrium analysis of a production economy with investors who are uncertain about the current state of the economy and disagree in a time-varying way about its expected growth rate. Trading in financial markets allows investors to share laborincome risks. But, financial markets also provide an arena for speculative trading amongst investors who disagree. This speculative trading increases volatility of bond and stock returns and also the volatility of investment growth, increases the equity risk premium, and reduces welfare.The main finding of our paper is that all three regulatory measures we consider have similar effects on financial and macroeconomic variables: they reduce stock ...

Asset pricing with heterogeneous beliefs and illiquidity

“…For these linear state dynamics, the parabolic partial differential equation (PDE) system describing the equilibrium price can be reduced to a system of linear ordinary differential equations (ODEs) by a suitable ansatz, and in turn compared to the explicit formulas that obtain for our small‐cost asymptotics in this case. In this example, we find that the introduction of small transaction costs increases volatility, in line with the asymmetric information model of Danilova and Julliard (2019); the risk‐sharing model studied in Herdegen, Muhle‐Karbe, and Possamaï (2019); numerical results of Adam, Beutel, Marcet, and Merkel (2015) and Buss, Dumas, Uppal, and Vilkov (2016); and empirical studies such as Hau (2006), Jones and Seguin (1997), and Umlauf (1993). By contrast, the introduction of small holding costs decreases the equilibrium volatility.…”

“…(2015); Buss et al. (2016), and empirical studies such as Hau (2006), Jones and Seguin (1997), and Umlauf (1993).…”

The Dynamic Properties of Financial‐Market Equilibrium with Trading Fees

“…Buss et al. () study the impact of a transaction tax in a production economy and Buss, Uppal, and Vilkov () focus on the interplay between illiquidity and recursive utility.…”

Preventing Controversial Catastrophes

“…Recent examples focused on endowment economies include Brunnermeier, Simsek and Xiong (2014), Gilboa, Samuelson and Schmeidler (2014), and Blume, Cogley, Easley, Sargent and Tsyrennikov (2014). Buss, Dumas, Uppal and Vilkov (2016) study welfare gains or losses from financial market regulation in a general equilibrium production economy, by computing the expected utility of potentially irrational agents under the measure of a rational econometrician. Heyerdahl-Larsen and Walden (2016) introduce an efficiency measure for dynamic production economies, and highlight distinctions that arise between efficiency measures in this more general setting.…”

“…1 Our policy experiments maintain the assumption of complete financial markets. Related theoretical models with incomplete financial markets are studied in Dieckmann (2011) and Buss, Dumas, Uppal and Vilkov (2016). Davila (2016) characterizes an optimal linear financial transaction tax in a static economy in which investors disagree.…”