Regulation with Externalities and Misallocation in General Equilibrium

Abstract

We study allocative efficiency and optimal regulation in inefficient economies with misallocation and pecuniary externalities. We characterize the allocative value of a market based on its price, cross-sectional misallocation among participants, and pecuniary externalities. With both complete and incomplete regulation, a social planner equalizes prices faced by fully regulated agents with the allocative value of markets. With incomplete regulation, the planner uses regulation of fully regulated agents to trade off correcting externalities against misallocation from regulatory arbitrage by unregulated agents. The planner uses partial regulation of unregulated agents to reduce misallocation from regulatory arbitrage. We leverage our framework to answer relevant policy questions, including: (i) the social value of a new unregulated agent is its profits plus a simple measure of social value of its activities; (ii) the social value of new regulation is summarized by its reduction in misallocation. We apply our theory to shadow bank institution regulation and capital flow management in a small open economy. We extend our theory to environments with multiple regulators and common agency.

Keywords: Misallocation, regulatory arbitrage, unregulated finance, macroprudential regulation, capital flows, capital controls, pecuniary externalities

JEL Classification: F38, G28, D62