How Does Macroprudential Regulation Change Bank Credit Supply?
Anil K. Kashyap
University of Chicago, Booth School of Business; National Bureau of Economic Research (NBER); Federal Reserve Bank of Chicago
Dimitrios P. Tsomocos
University of Oxford - Said Business School and St. Edmund Hall; University of Oxford - Said Business School
Board of Governors of the Federal Reserve System
May 1, 2014
Chicago Booth Research Paper No. 14-18
Saïd Business School WP 2014-6
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.
Number of Pages in PDF File: 51
Keywords: Risk taking, Limited Liability, Bank Runs, Regulation, Capital, Liquidity
JEL Classification: E44, G01, G21, G28
Date posted: July 1, 2014 ; Last revised: June 18, 2015