We consider two types of bank capital regulation: risk-insensitive (or flat) and risk-sensitive capital requirements. The former broadly match the 1988 Accord of the Basel Committee (Basel I), as the latter match the 2004 (Basel II) and 2010 (Basel III) Accords (although Basel III combines risk-sensitive capital requirements with a risk-insensitive leverage ratio). We highlight the various effects these regulations have on the equilibrium market structure, with especial focus on if they shift some types of lending from regulated banks into shadow banks or direct market finance, in addition to their impact on the entire risk of the economic climate.
Our analysis demonstrates tighter risk-insensitive (risk-sensitive) capital requirements can result in a shift of intermediate (high) risk entrepreneurs from regulated to unregulated resources of finance. Although the possibilities of default of loans to entrepreneurs that stay in the regulated banking sector decrease, the possibilities of default of loans to entrepreneurs that switch rise. The net effect could be a riskier economic climate. For this reason, the look of optimal bank capital regulation must look at the existence of unregulated finance, whose presence imposes a constraint leading to lessen capital requirements.
Financial sector structure
To analyse the links between capital requirements, financial market structure and financial stability, we concentrate on the role of competitive banks as intermediaries between entrepreneurs of different risk types, who need funds for his or her investment projects, and (uninsured) investors. Entrepreneurs are penniless and their risk types are observable. Banks can screen entrepreneurs’ projects at a price, which reduces their possibility of default. We assume that screening isn’t contractible, so there exists a moral hazard problem, which may be the key informational friction in the model.
In the current presence of these moral hazard problem, (inside) capital provides ‘skin in the game’, serving as a committed action device to screen borrowers. However, bank capital is costly so there exists a trade-off. For a few borrowers, banks could be willing to use more costly equity to be able to ameliorate the moral hazard problem and reduce the price of uninsured debt.
However, because of this channel to operate, the administrative centre structure needs to be observable to investors. Given the incentives of banks to save lots of on costly equity, we assume that capital needs to be certified by an external (private or public) agent. Public certification is performed by a bank supervisor that verifies whether banks that prefer to get regulated adhere to the regulation. The administrative centre of banks that choose never to be regulated isn’t certified by the supervisor, so they need to resort to private certification, which we assume to become more expensive. Thus, (cheaper) public certification is linked with complying with a regulation that could be very tough, at least for banks financing certain types of entrepreneurs. Because of this, intermediaries might prefer never to adhere to the regulation and resort to private certification, giving rise to shadow banks. Hence, in this setup the emergence of shadow banks is associated with a trade-off between your costs (when it comes to more expensive of capital) and benefits (when it comes to lower certification costs) to be at the mercy of capital regulation.
It ought to be highlighted that fundamentally the same results obtain whenever we replace the assumption of lower certification costs by the assumption of under-priced deposit insurance for the regulated banks.
We show that the equilibrium structure of an unregulated economic climate is one where safer entrepreneurs are directly funded by investors that usually do not screen them (in addition to what’s done by credit history agencies). Riskier entrepreneurs, alternatively, are funded by intermediaries that privately screen them, which we call banks. Importantly, we show that banks are always funded with some capital, and that the administrative centre ratio is increasing in the chance of the entrepreneurs.
The consequences of flat and risk-based regulation
To measure the implications of bank capital regulation on the structure and threat of the economic climate, we investigate the consequences of introducing (and tightening) risk-insensitive (or flat) and risk-sensitive capital requirements. We follow the Basel II and III approach of utilizing a value-at-risk (VaR) criterion to look for the risk-sensitive requirements.
Specifically, under both regulations, safer entrepreneurs borrow from the marketplace and riskier entrepreneurs borrow from banks. The difference between both regulations is that flat requirements are specially costly for relatively safe entrepreneurs which may be better off borrowing from shadow banks, while VaR requirements are specially costly for risky entrepreneurs which may be better off borrowing from shadow banks. Hence, with flat capital requirements the equilibrium market structure is in a way that regulated banks always fund the riskiest projects, while if shadow banks operate they fund projects that are safer than those of the regulated banks. With VaR capital requirements, the equilibrium market structure is in a way that regulated banks always fund the intermediate risk projects, while if shadow banks operate they fund the riskiest projects. Thus, the sort of capital requirements leads to completely different structures of the financial sector.
Our results illustrate the way the existence of unregulated finance affects the potency of the various types of regulation, with some interesting empirical implications. Specifically, tightening flat (VaR) capital requirements escalates the screening incentives of banks that the regulation is binding at the expense of driving some safer (riskier) entrepreneurs to the shadow bank operating system, where you will see lower screening and higher default risk. Hence, a tightening of capital requirements can result in a reduction in the chance of loans to entrepreneurs that stick with the regulated banks, but simultaneously increase the threat of loans to the ones that shift out from the regulated banks, which might result (if the next effect is large enough) within an increase in the entire threat of the economic climate.
These email address details are consistent with recent empirical studies showing that stricter capital requirements are associated with an expansion of the shadow bank operating system (see Buchak et al. 2017 on the mortgage market and Irani et al. 2018 on the syndicated corporate loan market).
An initial extension of our results shows the way the equilibrium structure and threat of the economic climate change with two key parameters of the model: the expected return required by investors (the safe rate) and the surplus cost of bank capital. We show that for both types of capital requirements, an increased safe rate and/or less cost of capital expand the number of entrepreneurs financed by regulated banks. According to these results, the shadow bank operating system will thrive when the safe rate is low (due, for instance, to a savings glut) and the expense of bank capital is high (due, for instance, to a member of family scarcity of bank capital).
Another extension analyses a variation of the model where the cost of capital is endogenously derived by the equating the demand to the way to obtain bank capital. In this instance, a tightening of capital requirements make a difference all banks throughout the market (and not simply those that the regulation is binding) via an upsurge in the equilibrium cost of capital. This may result in lower capital and higher threat of those (regulated and shadow) banks not constrained by regulation.
Optimal capital requirements
Our paper also characterises the second-best optimal capital requirements, that’s, the ones that maximise social welfare when the regulator is at the mercy of the same informational frictions as banks. We show that optimal capital requirements are risk-sensitive and higher generally compared to the capital that banks could have in the lack of regulation. However, they aren’t VaR requirements with a set confidence level as the ones in Basel II and III. While optimal capital requirements upsurge in the riskiness of the loans, they don’t increase up to in the typical Basel formula.
It ought to be noted that the current presence of direct market and shadow bank finance imposes a constraint on the regulator leading to lessen optimal capital requirements for low- and high-risk entrepreneurs, that’s, those entrepreneurs that are more susceptible to be funded by markets and shadow banks, respectively.
Summing up, our research addresses a challenging issue, namely, to describe how capital requirements shape the structure and threat of the economic climate. We construct a theoretical model where direct market finance, regulated banks, and shadow banks coexist. The model builds on the theory that financial intermediaries can decrease the possibility of default of their loans by screening their borrowers at a price. We assume that screening isn’t observed by investors, so you will find a moral hazard problem. Intermediaries could be ready to use (more costly) equity finance as a way to ameliorate the moral hazard problem and reduce the price of debt. Among the novelties inside our paper is that people assume that because of this channel to operate, the administrative centre structure needs to be certified by an external (public or private) agent. Public certification is performed by a bank supervisor that verifies whether those intermediaries that prefer to get regulated (called regulated banks) adhere to the regulation. Intermediaries that usually do not adhere to the regulation (called shadow banks) need to resort to more costly private certification.
We show that while tighter capital requirements bring about safer regulated banks, in addition they shift some lending to shadow banks, leading to an increase in the chance of the economic climate. We also show that flat and risk-based capital requirements have completely different effects on the structure and the chance of the economic climate. Finally, we show that optimal capital requirements are less risk-sensitive than those predicated on a VaR criterion à la Basel II and III.
Buchak, G, G Matvos, T Piskorski, and A Seru (2018), “Fintech, Regulatory Arbitrage, and the Rise of Shadow Banks,” Journal of Financial Economics, forthcoming.
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Irani, R, R Iyer, R Meisenzahl, and J-L Peydró (2018), “The Rise of Shadow Banking: Evidence from Capital Regulation,” CEPR Discussion Paper No. 12913.
Martinez-Miera, D and R Repullo (2018), “Markets, Banks and Shadow Banks,” CEPR Discussion Paper No. 13248.