Heterogeneous Regulation of Financial Institutions

We consider a model of a financial sector in which two types of projects can be undertaken: standard projects that have low returns, and advanced projects that have potentially higher returns but are subject to an agency problem. Intermediaries specialize in projects but there is a common market where they can trade liquidity to deal with shocks. Optimal regulation is sector-interdependent in that tighter regulation in one sector allows for looser regulation in the other sector. In addition, regulation that is optimally set in both sectors is heterogeneous and implements higher leverage ratios in the sector carrying out standard projects. Regulatory arbitrage, where projects are sold from the highly to the less regulated sector, are part of the optimal outcome. The results have various implications for the current discussion on regulation of the non-bank financial system.