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.
A fresh policy framework
Under this framework, monetary policy and the regulation of banks aim at stabilizing both inflation and the true economy. Stabilisation of the true economy consists in stabilising output fluctuations due to macroeconomic shocks and by financial instability. In the latter case, stabilisation of output fluctuations is attained by avoiding or reducing financial instability itself.
The central bank could have two instruments at its disposal:
(a) the short-term interest and