Macroprudential Bank Capital Regulation in a Competitive Financial System
University of Chicago - Finance
Christian C. Opp
University of Pennsylvania - The Wharton School
Marcus M. Opp
University of California, Berkeley - Finance Group
October 9, 2014
We propose a general equilibrium model to examine the systemwide effects of bank capital requirements when firms can substitute between financing from public markets and banks. In our model banks can serve a socially beneficial role of monitoring firms that are credit rationed by public markets, but banks' access to deposit insurance creates socially undesirable risk-shifting incentives. Increased efficiency of public markets exacerbates these asset substitution incentives by reducing banks' rents from socially valuable investments. Equity capital ratio requirements reduce banks' risk taking incentives, but can also constrain banks' balance sheets. Our framework allows for full flexibility on the specification of the cross-sectional distribution of firm types, banks' monitoring advantages vis-a-vis public markets, and the distribution of signals available to regulators. Absent balance sheet effects, increases in equity-ratio requirements unambiguously improve welfare and the stability of the banking system. However, when bank capital is scarce, increased equity-ratio requirements may cause banks to substitute from socially valuable projects to high-risk investments. Our model provides conceptual guidance on how the effects of regulatory policies depend on the development of public markets, the cross-sectional distribution of firms, and the risk signals available to regulators.
Number of Pages in PDF File: 44
Keywords: capital requirements, macroprudential regulation, banks, competition, public capital markets
JEL Classification: G21, G28
Date posted: July 19, 2014 ; Last revised: September 22, 2015
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