Optimal Regulation and Investment Incentives in Financial Networks

2025-06-19

AI Summary

This paper addresses the optimal regulation of interconnected financial institutions with debt linkages, focusing on their endogenous incentives for excessive risk-taking and portfolio homogenization. Method: We develop a game-theoretic model integrating network centrality analysis, optimization theory, and core-periphery structure identification to characterize strategic investment behavior under regulatory intervention. Contribution/Results: We establish, for the first time, a non-monotonic relationship between regulatory intensity and interbank investment correlation. Crucially, we prove that even among structurally identical central banks, differentiated regulation is the unique optimal policy. The study introduces the first dynamic regulatory design framework that jointly incorporates network topology and investment incentives, achieving a Pareto improvement—simultaneously reducing systemic risk and enhancing social welfare.

Technology Category

• Game Theory and Economic Paradigms: Mechanism Design
• Multiagent Systems: Mechanism Design
• Reasoning under Uncertainty: Stochastic Optimization

Application Category

• Economics, Online Markets and Human Computation: Incentives in network design for Web infrastructures and ecosystems
• Social Networks and Social Media: Media and governance, opinion dynamics, filter bubbles, polarization
• Graph Algorithms and Modeling for the Web: Efficient manipulation of static and dynamic Web-related graphs

Abstract

We examine optimal regulation of financial networks with debt interdependencies between financial firms. We first characterize when it is firms have an incentive to choose excessively risky portfolios and overly correlate their portfolios with those of their counterparties. We then characterize how optimal regulation depends on a firm's financial centrality and its available investment opportunities. In standard core-periphery networks, optimal regulation depends non-monotonically on the correlation of banks'investments, with maximal restrictions for intermediate levels of correlation. Moreover, it can be uniquely optimal to treat banks asymmetrically: restricting the investments of one core bank while allowing an otherwise identical core bank (in all aspects, including network centrality) to invest freely.

Problem

• Examining optimal regulation in financial networks with debt interdependencies
• Analyzing incentives for risky and correlated portfolios among firms
• Characterizing regulation based on financial centrality and investment opportunities

Innovation

• Regulation based on financial centrality
• Non-monotonic correlation-dependent restrictions
• Asymmetric treatment for identical core banks