Excessive concentration of aggregate risk can lead to financial fragility and may create the need for financial regulation. This paper studies the optimal financial regulation policy in a standard model where financial frictions are derived from a moral hazard problem, with a focus on the allocation of aggregate risk. First, I study the competitive equilibrium where agents can write complete long-term contracts, and I derive a simple formula for the allocation of aggregate risk. I then consider the optimal allocation that can be achieved by a social planner who faces the same informational asymmetries as the market, and show the competitive equilibrium is not constrained efficient. I identify a “moral hazard externality” that appears in a wide class of models, and show how it can create incentives for an inefficient allocation of aggregate risk. Finally, I show that although the competitive equilibrium may feature excessive concentration of aggregate risk, the optimal allocation can be implemented with a tax on capital. 

Paper: Optimal Financial Regulation and the Concentration of Aggregate Risk

Last Updated: Oct 15, 2014