# **1. Introduction**

The literature on both macroeconomics with financial frictions and prudential policy reform has exploded in the wake of the recent global financial crisis.<sup>1</sup> However, as was the case of the discussion of these topics in the past, the connections between theory and policy remain ill established.<sup>2</sup> Impressive progress has been made in analyzing the linkages between real and financial volatility and identifying the channels of transmission and dynamics leading to financial crises. Yet limited progress has been made so far in conducting welfare analyses to identify in a precise manner the justification for various types of policies (regulatory and otherwise) and calibrate their use accordingly.

Linking theory to policy is inherently hard, not least because it is difficult to sort out market failures leading to a constrained efficient equilibrium from those leading to a constrained inefficient equilibrium. In the first case, the state can improve the equilibrium by supplying public goods that help relax the constraints. In the second case, through regulatory interventions, the state can directly improve the efficiency of the equilibrium, given the constraints. However, to implement a sensible regulatory agenda, the state also needs to identify the nature of the market failure lying behind the constrained inefficiencies—again not an easy task. Thus, the suitable policy response to a _principal-agent (agency)_ failure may be quite different from that applying to a _collective action_ failure, to the point of sometimes pulling in diametrically opposite directions. At the same time, there needs to be a differentiation between _policy_ failures (both of omission, where the state fails to improve the market equilibrium, and of commission, where the actions of the state worsen the equilibrium) and _market_ failures. Finally, even justified state interventions can have adverse unintended consequences. In particular, they can alter the structure of market incentives and induce _public moral hazard_ .

This paper contributes towards bridging some of the gap between theory and policy. By reviewing from a policy perspective the theoretical literature on financial frictions, starting from its early roots, the paper provides a roadmap that not only links more systematically theory with policy but also helps put in a proper perspective the different branches of the literature in relation to each other. It does so by using an extension of the basic conceptual framework developed in de la Torre and Ize (2010a and 2010b) that identifies three basic paradigms (or interpretative lenses), an agency paradigm, a collective action paradigm and a collective cognition paradigm.

Our method consists in introducing various types of frictions (participation, enforcement, asymmetric information gathering, asymmetric information processing, and collective bargaining) and sources of aggregate volatility (aggregate risk, irreducible uncertainty, overlapping generations, and behavioral finance-type biases) into the frictionless, atomistic world of Arrow-Debreu with infinitely-lived agents transacting under perfect competition. We

> 1 Brunnermeier, Eisenbach and Sannikov (2012) provide an excellent recent technical survey of the theoretical literature on the macroeconomic impact of financial frictions. Bank of England (2009), Borio (2011) or Galati and Moessner (2012) provide broad overviews of macroprudential policy proposals. A small but growing literature, such as Hanson, Kashyap and Stein (2011), Longworth (2011) or De Nicolo, Favara and Ratnovski (2012), attempts to connect the two strands of literature.

> 2 For a discussion of the difficulties of assessing the appropriateness of traditional prudential regulation based on micro foundations, see for example Allen and Gale (2007).

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