Macroprudential Capital Requirements with Non-Bank Finance

69 Pages Posted: 26 May 2020

Date Written: May, 2020

Abstract

I analyze the impact of raising capital requirements on the quantity, composition, and riskiness of aggregate investment in a model in which firms borrow from both bank and non-bank lenders. The bank funds loans with insured deposits and costly equity, monitors borrowers, and must maintain a minimum capital to asset ratio. Non-banks have deep pockets and competitively price loans. A tight capital requirement on the bank reduces risk-shifting and decreases bank leverage, reducing the risk of costly bank failure. In response, though, the bank can change both price and non-price contract terms. This may induce firms to substitute out of bank finance, leading to a theoretically ambiguous effect on the profile of aggregate investment. Quantitatively, I find that the bank's incentive to insure itself against issuing costly equity and competition from the non-bank sector mutes the long run impact of raising capital requirements. Increasing the capital requirement from 8% to 26% eliminates bank failures with effectively no change in the quantity or riskiness of aggregate investment.

Keywords: banking, business cycles, capital requirements

JEL Classification: G2, E5, E6, E32, E44

Suggested Citation

Dempsey, Kyle, Macroprudential Capital Requirements with Non-Bank Finance (May, 2020). ECB Working Paper No. 20202415, Available at SSRN: https://ssrn.com/abstract=3610733 or http://dx.doi.org/10.2139/ssrn.3610733

Kyle Dempsey (Contact Author)

Ohio State University ( email )

United States

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