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Higher Capital Requirements, Safer Banks? Macroprudential Regulation in a Competitive Financial System

38 Pages Posted: 27 Nov 2012 Last revised: 10 May 2017

Milton Harris

University of Chicago - Finance

Christian C. Opp

University of Pennsylvania - The Wharton School

Marcus M. Opp

Stockholm School of Economics - Department of Finance

Date Written: March 11, 2014

Abstract

We propose a tractable general equilibrium framework to analyze the effectiveness of bank capital regulations when banks face competition from other investors, such as institutions in the shadow-banking system. Our analysis shows that increased competition can not only render previously optimal bank capital regulations ineffective but also imply that, over some ranges, increases in capital requirements cause more banks in the economy to engage in value-destroying risk-shifting. To avoid this perverse outcome, the regulator has to set capital requirements high enough, so that risk-shifting activities become less profitable from a banker's perspective than socially valuable banking activities. Our model generates a set of novel implications that highlight the intricate dependencies between optimal bank capital regulation and the comparative advantages of various institutions in the financial system.

Keywords: Bank Capital Regulation, Shadow Banking System, Risk-shifting, Government Bailouts

JEL Classification: G28, G21, G12

Suggested Citation

Harris, Milton and Opp, Christian C. and Opp, Marcus M., Higher Capital Requirements, Safer Banks? Macroprudential Regulation in a Competitive Financial System (March 11, 2014). Available at SSRN: https://ssrn.com/abstract=2181436 or http://dx.doi.org/10.2139/ssrn.2181436

Milton Harris

University of Chicago - Finance ( email )

5807 S. Woodlawn Avenue
Chicago, IL 60637
United States
(773) 702-2549 (Phone)
(773) 753-8310 (Fax)

HOME PAGE: http://faculty.chicagobooth.edu/milton.harris/

Christian C. Opp (Contact Author)

University of Pennsylvania - The Wharton School ( email )

3641 Locust Walk
Philadelphia, PA 19104-6365
United States
215-573-3186 (Phone)

Marcus M. Opp

Stockholm School of Economics - Department of Finance ( email )

SE-113 83 Stockholm
Sweden

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