Collateral constraints widely used in models of financial crises feature a pecuniary
externality: Agents do not internalize how borrowing decisions made in “good times” affect
collateral prices during a crisis. We show that under commitment the optimal financial
regulator's plans are time inconsistent and study time-consistent policy. Quantitatively, this
policy reduces sharply the frequency and magnitude of crises, removes fat tails from the
distribution of asset returns, and increases social welfare. In contrast, constant debt taxes …

Collateral constraints widely used in models of financial crises feature a pecuniary
externality, because agents do not internalize how collateral prices respond to collective
borrowing decisions, particularly when binding collateral constraints trigger a crisis. We
study a production economy in which physical assets serve as collateral for debt and
working capital loans, and show that agents in a competitive equilibrium borrow``too much"
during credit expansions compared with a financial regulator who internalizes this …