The Leverage of Financial Intermediaries, Market Failure, and Regulation

37 Pages Posted: 16 Feb 2010

See all articles by Tianxi Wang

Tianxi Wang

University of Essex - Department of Economics

Date Written: October 13, 2009

Abstract

This paper first presents a new approach to examine the leverage of financial intermediaries. It is driven by differing risk preferences and captures two features: Debt serves to boost the return of equity, and equity to safe net debt. Then the paper shows, for the first time, that if unregulated, financial intermediaries are leveraged over the social best level, whereas the leverage of real sectors is not subject to the market failure. The market failure is expounded for the first time. It is fixed by proper capital adequacy regulation. The regulation raises the profit of the finance sector as a whole, but individual financial intermediaries have incentive to circumvent the regulation.

Keywords: Risk, Differing Risk Preferences, Leverage, Financial Intermediaries, Overleveraged, Externality, Capital Adequacy Regulation

JEL Classification: D52, D62, G, G01

Suggested Citation

Wang, Tianxi, The Leverage of Financial Intermediaries, Market Failure, and Regulation (October 13, 2009). Available at SSRN: https://ssrn.com/abstract=1551895 or http://dx.doi.org/10.2139/ssrn.1551895

Tianxi Wang (Contact Author)

University of Essex - Department of Economics ( email )

Wivenhoe Park
Colchester CO4 3SQ
United Kingdom

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