The Shadow Disintermediation and Cost of Risk-sensitive Capital

Abstract

Exploiting an exogenous increase to capital charges from cross-border banking laws as a source of variation in loan retention, this paper shows that banks relax contractual restrictions and originate riskier loans. The probability of default increases by 7 percentage points (45% in relative terms) but higher risk is not ex ante priced. The vintage-maturity variation of loans during the regulatory transition supports a causal interpretation. The increase in risk is more pronounced on loans in which banks have private information and expertise, while shadow banks do not change their investment in riskier loans. Exploiting transactional data from trustee filings, I also show that shadow banks sold treated loans at lower prices ex post. These findings suggest that information asymmetry in decentralized credit markets limits the effectiveness of macroprudential regulation.

Keywords: Regulatory arbitrage, shadow banks, moral hazard

JEL Classification: G2