Abstract
I study the optimal regulation of a financial sector where individual banks
face self-enforcing constraints countering their default incentives. The
constrained-efficient social planner can improve over the unregulated
equilibrium in two dimensions. First, by internalizing the impact of banks'
portfolio decisions on the prices of assets and liabilities that affect the
enforcement constraints. Second, by redistributing future net worth from new
entrants to surviving banks, which increases the current forward-looking value
of all banks, relaxing their enforcement constraints and decreasing the
probability of banking crises. The latter can be accomplished with systemic
preemptive bailouts that are time consistent and unambiguously welfare
improving. Unregulated banks can be both overleveraged and underleveraged
depending on the state of the economy, thus macroprudential policy requires
both taxes and subsidies, while minimum bank capital requirements are generally
ineffective.