Externalities as Arbitrage

Externalities as Arbitrage

December 29,2017Working Paper No. 3632

Regulations on financial intermediaries can create apparent arbitrage opportunities. Intermediaries are unable to fully exploit these opportunities due to regulation, and other agents are unable to exploit them at all due to limited participation. Does the existence of arbitrage opportunities imply that regulations are sub-optimal? No. I develop of general equilibrium model, with financial intermediaries and limited participation by other agents, in which a constrained-efficient allocation can be implemented with asset prices featuring arbitrage opportunities. Absent regulation, there would be no arbitrage; however, allocations would be constrained-inefficient, due to pecuniary externalities and limited market participation. Optimal policy creates arbitrage opportunities whose pattern across states of the world reflects these externalities. From financial data alone, we can construct perceived externalities that would rationalize the pattern of arbitrage observed in the data. By examining these perceived externalities, and comparing them to the stated goals of regulators, as embodied in the scenarios of the stress tests, we can ask whether regulations are having their intended effect. The answer, in recent data, is no.