Aggregate Investment Externalities and Macroprudential Regulation


  • We would like to thank the editor Paul Evans, two referees, Claudio Borio, Elena Carletti, Russ Cooper, Giancarlo Corsetti, Jordi Gali, Thomas Gehrig, Piero Gottardi, Bob King, David Levine, Ennisse Kharroubi, Bruno Parigi, Javier Suarez, Jean Tirole, and especially John Moore for helpful discussions, and Ethem Güney and Kamali Wickramage for wonderful research assistance. We are also grateful to seminar participants at the BIS, the University of Chicago, the European University Institute, Toulouse School of Economics, Studienzentrum Gerzensee, the University of Vienna, and the University of Zürich for useful comments. The research leading to these results has received funding from the European Research Council under the European Community’s Seventh Framework Programme (FP7/2007-2013) grant agreement 249415-RMAC and NCCR FinRisk (project Banking and Regulation).


Evidence suggests that banks tend to lend a lot during booms and very little during recessions. We propose a simple explanation for this phenomenon. We show that instead of dampening productivity shocks, the banking sector tends to exacerbate them, leading to excessive fluctuations of bank credit, output, and asset prices. Our explanation relies on three ingredients that are characteristic of modern banks’ activities: moral hazard, high exposure to aggregate shocks, and the ease with which capital can be reallocated to its most productive use. At the competitive equilibrium, banks offer privately optimal contracts to their investors, but these contracts are not socially optimal: banks reallocate capital excessively upon aggregate shocks. This is because banks do not internalize the impact of their decisions on asset prices. We examine the efficacy of possible policy responses to these properties of credit markets, and derive a rationale for macroprudential regulation in the spirit of a Net Stable Funding Ratio.