Does Financial Tranquility Call for More Stringent Regulation?

Consistent with the Minsky hypothesis and the “volatility paradox” (Brunnermeier and Sannikov, 2014), recent empirical evidence suggests that financial crises tend to follow prolonged periods of financial stability and investor optimism. But does financial tranquility always call for more stringent regulation? We examine this question using a simple portfolio choice model that features the interaction between learning and externality. We evaluate the potential of a macroprudential policy in the form of a capital income tax to restore efficiency, and highlight a key challenge faced by regulators: whether the stringency of prudential policy should rise or fall over time depends on the resilience of the financial system, which is difficult to know and thus may lead to inefficient regulation. Our paper provides a simple framework to shed light on the current regulation debates, such as the ongoing debates on the financial deregulation initiatives in the U.S. (as evident in the August 2017 Jackson Hole meeting), and the discussions on how to regulate the rapidly-developing online finance industry in China.