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This paper studies optimal financial policy in a world where the financial sector can become excessively optimistic. I decompose the welfare effects of bank capital regulation to demonstrate the effects of exuberance and its interaction with incentive problems in banking. The optimal policy depends not only on the extent, but also on the type of optimism. For example, it is markedly different when the exuberance of banks focuses on neglected downside risk, as opposed to overstated upside opportunities. A central normative conclusion is that "leaning against the wind", by tightening capital requirements in exuberant times, can be counterproductive. I show that two natural metrics, describing the distortion in perceived upside and downside risk, are sufficient statistics for the policy implications of exuberance. My results shed light on the diverse empirical evidence on the relationship between bank capital and risk-taking. Finally, I investigate the sensitivity of these insights under different assumptions about government rationality and paternalism.

This paper studies leverage regulation when equity investors and/or creditors have distorted beliefs relative to a planner. We characterize how the optimal regulation responds to arbitrary changes in investors'/creditors' beliefs, relating our results to practical scenarios. We show that the optimal regulation depends on the type and magnitude of such changes. Optimism by investors calls for looser leverage regulation, while optimism by creditors, or jointly by both investors/creditors, calls for tighter leverage regulation. Our results apply to environments with (i) planners with imperfect knowledge of investors'/creditors' beliefs, (ii) monetary policy, (iii) bailouts and pecuniary externalities, and (iv) endogenous beliefs. (JEL D62, D83, E52, G01, G21, G28, H81)

We document that the expectations of households, firms, and professional forecasters in standard surveys simultaneously extrapolate from recent events and underreact to new information. Existing models of expectation formation, whether behavioral or rational, cannot account for these observations. We develop a rational theory of extrapolation based on limited attention, which is consistent with this evidence. In particular, we show that limited, asymmetric attention to procyclical variables can explain the coexistence of extrapolation and underreactions. We illustrate these mechanisms in a microfounded macroeconomic model, which generates expectations consistent with the survey data, and show that asymmetric attention increases business cycle fluctuations. (JEL C53, D83, D84, E23, E27, E32)