Regulating Asset Price Risk

There has been a long debate about whether speculators are stabilizing or not.We consider a model where speculators have a stabilizing role in normal times,but may also provoke large risk panics. The very feature that makes arbitrageursliquidity providers in normal times, namely their tolerance of risk, enables a largeincrease in asset price risk during a nancial panic. We show that a policy thatdiscourages balance sheet risk reduces the magnitude of nancial panics, as wellas asset price risk in both normal and panic states.[...]