Financial Innovation, Macro-prudential Policies and Leverage Cycles

Abstract In the wake of the 2008 global financial crisis, the Federal Reserve has initiated various macro-prudential policies to stabilize asset prices and stimulate the real economy. These policies achieved the targets during the recession in 2011, but failed in this task during the recovery in 2014. This paper rationalizes these observations on the effectiveness of macro-prudential policies in a three-period general-equilibrium model with incomplete markets, heterogeneous agents and endogenous leverage. The crucial insight is the interaction between belief heterogeneity and financial innovation at equilibrium. Financial innovation, as an additional macro-prudential tool, alongside collateral requirements on borrowing, takes the form of collateral protection insurance (CPI) contracts. The results show that macro-prudential policies which stabilize asset prices, may not improve social welfare. Specifically, policies that regulate higher collateral requirements stabilize asset prices, smooth the leverage cycle, but reduce social welfare, when belief heterogeneity is small. In contrast, the introduction of CPI contracts increases the dispersion of asset prices across date events, exacerbating the leverage cycle, but improves social welfare, when belief heterogeneity is large.