Busts after periods of prolonged prosperity have been found to be catastrophic. Financial institutions increase their leverage and shift their portfolios towards projects that were previously considered too risky. This results from institutions rationally updating their expectations and becoming more optimistic about the future prospects of the economy. Default is inevitably harsher when a bad shock occurs after periods of good news. Commonly used measures to forecast risk in the system, such as VIX, fail to capture this phenomenon, as they are also biased by optimistic expectations. Competition among financial institutions for better relative performance exacerbates the boom-bust cycle. We explore the relative advantages of alternative regulations in reducing financial fragility, and suggest a novel criterion for improvement of aggregate welfare.
