I examine whether a benevolent government can improve on the free market allocation
by setting capital requirements for private borrowers in a stochastic model with collateral
constraints. Previous theoretical studies have found that when asset prices enter into bor-
rowing constraints, pecuniary externalities between atomistic agents can make the laissez
faire equilibrium constrained ine¢ cient. For reasonable parameter values, I find that, quan-
titatively, the answer is 'no', private and government leverage choices coincide. Limiting
private leverage by imposing capital requirements has the beneficial e¤ect of dampening the
effects of the collateral amplification mechanism. This reduces fire sales in recessions and
limits the negative externality that individual asset sales have on other credit constrained
borrowers.
However, we find that capital requirements are a blunt tool. They tax the activities of
highly productive entrepreneurs and reduce the amount they produce in equilibrium. This
reduces total factor productivity and steady state consumption. In the end, society faces
a choice between high but unstable consumption in the free borrowing world and low but
stable consumption in the regulated world. The government chooses the former