Thomas S. Y. Ho and Sang Bin Lee
This paper provides a structural macro-financial model that can be used for the cost and benefit analysis of alternative financial regulatory regimes. The model solves for the optimal financial sector size to the real aggregate asset (household leverage) and to the aggregate capital (financial leverage) that maximize the expected real output. This paper suggests that macro-risk management is necessary and managing the aggregate capital in the financial sector is important.
We illustrate the impact of some regulatory policies on the real outputs with some numerical examples. Our model shows that holding 2.39% in excess of the optimal capital ratio would lower theGDPgrowth rate by 0.61%. Since the model shows that higher financial leverage would result in higher expected growth rate and volatility of real outputs, we suggest that macro-risk management also needs to determine a risk and return tradeoff of real output.