Higher Capital Requirements, Safer Banks? Macroprudential Regulation in a Competitive Financial System
38 Pages Posted: 27 Nov 2012 Last revised: 10 May 2017
Date Written: March 11, 2014
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: Suggested Citation