Financial markets have historically been regulated. This regulation is motivated by the desire to rule out anti-competitive behavior, to prevent agency problems that arise in the presence of asymmetric information, and to limit negative externalities, where the behavior of an individual investor or institution can affect the entire financial system. The recent financial crisis, which has highlighted the negative feedback from financial markets to the real sector, has intensified the debate about the ability of financial-market regulations to stabilize these markets and improve macroeconomic outcomes. We study the intended and unintended consequences of various regulatory measures used to reduce fluctuations in financial and real markets and to improve welfare. The measures we study are the ones that have been proposed by regulators in response to the financial crisis: the Tobin financial-transactions tax, portfolio (short-sale) constraints, and borrowing (leverage) constraints.
For example, on 1 August 2012, France introduced a financial transaction tax of 0.20%; on 25 July 2012, Spain’s Comision Nacional del Mercado de Valores (CNMV) imposed a three-month ban on short-selling stocks, while Italy’s Consob prohibited shortselling of stocks of 29 banks and insurance companies; and, tighter leverage constraints have been proposed following the subprime crisis: for instance, on 17 October 2008 the European Commissioner, Joaquin Almunia, said: “Regulation is going to have to be thoroughly anti-cyclical, which is going to reduce leverage levels from what we’ve seen up to now.”
We evaluate these three regulatory measures within the same dynamic, stochastic general equilibrium model of a production economy, and compare within a single economic setting, both the intended and unintended effects of these different measures on the financial and real sectors. The kind of questions we address are the following: Of the three regulatory measures we consider, which is most effective in stabilizing financial markets? What exactly is the channel through which each measure works? What will be the impact, intended or unintended, of this measure on other financial variables and the spillover effects on real variables? Would more tightly regulated markets be more stable and increase productivity and welfare?
We have undertaken a general-equilibrium analysis of a production economy with investors who are uncertain about the current state of the economy and disagree in a time-varying way about its expected growth rate. Trading in financial markets allows investors to share labor-income risks. But, financial markets also provide an arena for speculative trading amongst investors who disagree. This speculative trading increases volatility of bond and stock returns and also the volatility of investment growth, increases the equity risk premium, and reduces welfare.
The main finding of our paper is that all three regulatory measures we consider have similar effects on financial and macroeconomic variables: they reduce stock and bond turnovers, reduce the risk-free rate, increase the equity risk premium and stock-return volatility, while changing capital investment and output growth. However, because the importance of the bond and stock markets for risk sharing and speculation is different, only those regulatory measures that are able to reduce speculation without hurting risk sharing substantially improve welfare. For example, the borrowing constraint improves welfare because it limits speculation by restricting access to funds needed to implement speculative trading strategies, but has only a marginal effect on risk sharing because borrowing plays a minor role for risk sharing. Similarly, a transaction tax improves welfare because, while it allows for small frequent trades to hedge labor-income risks, it makes large and erratic speculative trades less profitable. In contrast, a limit on stock holdings, such as a short-sale ban, leads to a decrease in welfare because it limits risk sharing severely, while reducing only partially speculative trading.