Aggregate investment externalities and macroprudential regulation

Empirical evidence shows that banks tend to lend too much during booms, and too littleduring recessions. Thus, instead of dampening productivity shocks, the banking sectortends to exacerbate them, leading to excessive fluctuations of credit, output and assetprices. We propose a simple explanation for this dysfunctionality of credit markets. Thisexplanation relies on three ingredients that are characteristic of modern banks’ activities.The first ingredient is moral hazard: banks are supposed to monitor the small and mediumsized enterprises that borrow from them, but they may shirk on their monitoring activities,unless they are given sufficient informational rents. These rents limit the amount thatinvestors are ready to lend them, to a multiple of the banks’ own capital. The secondingredient is the banks’ high exposure to aggregate shocks: banks’ assets have positivelycorrelated returns. Finally the third ingredient is the ease with which modern banks canreallocate capital between different lines of business. At the competitive equilibrium ofthe financial sector, banks offer privately optimal contracts to their investors but thesecontracts are not socially optimal: banks’ decisions of reallocating capital react too stronglyto aggregate shocks. This is because banks do not internalize the impact of their decisionson asset prices. This generates excessive fluctuations of credit, output and asset prices. Weexamine the efficacy of several possible policy responses to this dysfunctionality of creditmarkets, and show that it can provide a rationale for macroprudential regulation.Keywords: Bank Credit Fluctuations, Macro-prudential Regulation, Investment Externalities.JEL: G21, G28, D8