52 Pages Posted: 1 Jul 2014 Last revised: 18 Feb 2017
Date Written: May 1, 2014
We analyze a variant of the Diamond-Dybvig (1983) model of banking in which savers can use a bank to invest in a risky project operated by an entrepreneur. The savers can buy equity in the bank and save via deposits. The bank chooses to invest in a safe asset or to fund the entrepreneur. The bank and the entrepreneur face limited liability and there is a probability of a run which is governed by the bank’s leverage and its mix of safe and risky assets. The possibility of the run reduces the incentive to lend and take risk, while limited liability pushes for excessive lending and risk-taking. We explore how capital regulation, liquidity regulation, deposit insurance, loan to value limits, and dividend taxes interact to offset these frictions. We compare agents welfare in the decentralized equilibrium absent regulation with welfare in equilibria that prevail with various regulations that are optimally chosen. In general, regulation can lead to Pareto improvements but fully correcting both distortions requires more than one regulation.
Keywords: Risk taking, Limited Liability, Bank Runs, Regulation, Capital, Liquidity
JEL Classification: E44, G01, G21, G28
Suggested Citation: Suggested Citation
Kashyap, Anil K. and Tsomocos, Dimitrios P. and Vardoulakis, Alexandros, How Does Macroprudential Regulation Change Bank Credit Supply? (May 1, 2014). Chicago Booth Research Paper No. 14-18; Saïd Business School WP 2014-6. Available at SSRN: https://ssrn.com/abstract=2460900 or http://dx.doi.org/10.2139/ssrn.2460900
By Anat Admati