Portfolio Regulation of Financial Institutions with Market Power

Abstract

We examine how portfolio regulations affect risk sharing between financial institutions with market power. Unconstrained access to complete markets permits flexible exploitation of market power and induces inefficient risk sharing. Appropriate portfolio restrictions counteract this, improving liquidity and risk sharing by bundling securities with offsetting strategic incentives. However, excessive regulation can be counterproductive, destroying gains from trade. An application of our theory shows that cross-asset spillovers are critical for policy evaluation: in general equilibrium, risk sharing can improve even if certain asset-specific liquidity measures deteriorate. We also discuss the effects of asymmetric regulation for different institutions.