Financial stability and macroprudential regulation under diagnostic expectations

In this article, we examine the joint implications of external financing frictions and cognitive misperceptions for the stability of the financial system and the appropriate conduct of macroprudential regulation.

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ECBECB
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https://www.ecb.europa.eu//pub/economic-research/resbull/2022/html/ecb.rb221123~26823e3ac9.en.htmlhttps://www.ecb.europa.eu//pub/economic-research/resbull/2022/html/ecb.rb221123~26823e3ac9.en.html
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Saturday, November 26, 2022
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Diamond, The Journal of Finance, Journal, DSGE, European Central Bank, University of Mannheim, S, Credit, Ricardian equivalence, Economics, Crash, Policy, Daniel Kahneman, Journal of Money, Credit and Banking, Judgement, American Economic Review, Disagreement, Investment, Element, Instability, Review, Political economy, Magazine, Arab Center for Consultancy & Economic Studies, Central bank, Decision-making, University, Hart O. Berg, Business, Journal of Political Economy, RESEARCH, Global, Ben Bernanke, Welfare, The Review of Economic Studies, Writing, McGraw Hill Education, Risk, George Selgin, Directorate, P, Nature, Rafael Bordalo Pinheiro, Frictional unemployment, Literature, McMillan, Private sector, History, Risk management, Bank, Security (finance), Bookkeeping, Machine tool, Real estate, Dybvig, Gertler, Maxted
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NEW YORK
Summary
Key Points: 
  • In this article, we examine the joint implications of external financing frictions and cognitive misperceptions for the stability of the financial system and the appropriate conduct of macroprudential regulation.
  • [2]
    Relative to the rational benchmark, diagnostic expectations and their interactions with financing frictions exacerbate instability in financial markets and economic activity.
  • Financial implications of financing frictions and diagnostic expectations (1/2)

    Notes: The chart illustrates interactions between fluctuations in financial net worth (i.e.

  • Blue ink indicates additional effects over a world with rational expectations that stem from diagnostic expectations.
  • First, diagnostic expectations intensify a positive interaction between fluctuations in financial net worth and fluctuations in asset prices (Chart 1).
  • Financial implications of financing frictions and diagnostic expectations (2/2)

    Notes: The chart reports stationary density functions of the aggregate capitalisation of financial intermediaries under rational and diagnostic expectations.

  • Relative to the rational framework, under diagnostic expectations, appropriate macroprudential restrictions on new credit to the nonfinancial sector are tighter, even when the regulator is subject to the same expectations as the private sector.
  • These results naturally reveal disagreements among potential regulators with differing degrees of diagnostic expectations about the appropriate regulation.
  • We examine the joint implications of external financing frictions and diagnostic cognitive misperceptions about economic fundamentals or asset prices for the stability of the financial system and the appropriate conduct of macroprudential regulation.
  • The key result is that diagnostic expectations exacerbate financial instability relative to the benchmark of rational expectations.
  • This finding calls for tighter macroprudential regulation even when the regulator is also subject to misperceptions.
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