Financial Regulation in a Quantitative Model of the Modern Banking System

Abstract

How does the shadow banking system respond to changes in capital regulation of commercial banks? We propose a quantitative general equilibrium model with regulated and unregulated banks to study the unintended consequences of regulation. Tighter capital requirements for regulated banks cause higher liquidity premia, leading to higher shadow bank leverage and a larger shadow banking sector. At the same time, tighter regulation eliminates implicit subsidies to regulated banks and improves the competitive position of shadow banks, reducing their incentives for risk taking. The net effect is a safer financial system with more shadow banking. Calibrating the model to data on financial institutions in the U.S., the optimal capital requirement is around 16%.

Keywords: Shadow Banks, Liquidity Demand, Capital Requirement, Bank Regulation

JEL Classification: E44, G21, G28