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α: calibrated so average coauthorship-adjusted count equals average raw count
We examine the optimal regulation of financial networks with debt interdependencies between financial firms. We first show that firms often have incentives to choose excessively risky portfolios and to overly correlate their portfolios with those of their counterparties. We then characterize how optimal regulation depends on a firm’s financial centrality and its available investment opportunities. In standard core–periphery networks, optimal regulation depends non-monotonically on the correlation of banks’ investments, with maximal restrictions at intermediate levels of correlation. Moreover, it can be uniquely optimal to treat banks asymmetrically—restricting the investments of one core bank while allowing an otherwise identical core bank (identical in all aspects, including network centrality) to invest freely.