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Prudential Policy with Distorted Beliefs
Eduardo Dávila and Ansgar Walther
American Economic Review. Jul 2023, Vol. 113, No. 7: Pages 1967-2006

Prudential Policy with Distorted Beliefs

Eduardo Dávila1 and Ansgar Walther2

1Yale University and NBER (email: )

2Imperial College London and CEPR (email: )

Abstract

This paper studies leverage regulation when equity investors and/or creditors have distorted beliefs relative to a planner. We characterize how the optimal regulation responds to arbitrary changes in investors’/creditors’ beliefs, relating our results to practical scenarios. We show that the optimal regulation depends on the type and magnitude of such changes. Optimism by investors calls for looser leverage regulation, while optimism by creditors, or jointly by both investors/creditors, calls for tighter leverage regulation. Our results apply to environments with (i) planners with imperfect knowledge of investors’/creditors’ beliefs, (ii) monetary policy, (iii) bailouts and pecuniary externalities, and (iv) endogenous beliefs. (JEL D62, D83, E52, G01, G21, G28, H81)