Dynamic Bank Capital Regulation in the Presence of Shadow Banks

Abstract

I embed shadow banks, i.e. financial intermediaries without regulatory oversight, in a quantitative general equilibrium model in which both regulated banks and shadow banks finance firms that have production technologies with different riskiness. In the model, shadow banks 1) do not have deposit insurance, 2) do not face capital regulation, and 3) have a relatively lower price of taking risk compared with regulated banks. Limited liability and deposit insurance can lead regulated banks to provide socially inefficient risky loans; this excessive risk-taking can be activated by economic shocks that reduce the return on safer loans and can be prevented by higher bank capital requirements at the cost of lower liquidity provision. I propose a novel channel that additionally boosts excessive risk-taking incentives associated with migration of credit from shadow banks toward regulated banks when the returns to safer projects are depressed. The failure to account for the interaction between regulated banks and shadow banks does not only underestimate the impact of business cycle shocks on Ramsey optimal capital requirements in a range from 10 basis points to 1 percentage point in the U.S., but may also lead to calling for increases in capital requirements when a decrease would otherwise be warranted. I show that capital requirements should also react to shocks that originate in the shadow banking sector even if these shocks do not influence regulated banks directly. The results stress the importance of considering the interactions of regulated banks and shadow banks for designing macroeconomic policies.

Keywords: Shadow Banks, Capital Requirements, Macroprudential Policies, Risk-taking

JEL Classification: E44, E58, G21, G28, C51