08 December 2018

VoxEU: Markets, banks, and shadow banks

The current financial system is characterised by the coexistence of direct market finance, regulated banks, and shadow banks. This column looks at what gives rise to each of these sources of finance as well as the effect of bank capital regulation on the financing that flows through them.

High 'flat' (or risk-insensitive) capital requirements shift intermediate-risk entrepreneurs from regulated banks to shadow banks, while high risk-based requirements do the same for high-risk entrepreneurs, increasing the risk of the corresponding loans. This result highlights the need to take into account the existence of shadow banks when designing bank capital regulation.

Authors‘ research addresses a challenging issue, namely, to explain how capital requirements shape the structure and risk of the financial system. They construct a theoretical model in which direct market finance, regulated banks, and shadow banks coexist. The model builds on the idea that financial intermediaries can reduce the probability of default of their loans by screening their borrowers at a cost.

They assume that screening is not observed by investors, so there is a moral hazard problem. Intermediaries may be willing to use (more expensive) equity finance in order to ameliorate the moral hazard problem and reduce the cost of debt. One of the novelties in their paper is that they assume that for this channel to operate, the capital structure has to be certified by an external (public or private) agent. Public certification is done by a bank supervisor that verifies whether those intermediaries that choose to be regulated (called regulated banks) comply with the regulation. Intermediaries that do not comply with the regulation (called shadow banks) have to resort to more expensive private certification.

Authors show that while tighter capital requirements result in safer regulated banks, they also shift some lending to shadow banks, resulting in an increase in the risk of the financial system. They also show that flat and risk-based capital requirements have very different effects on the structure and the risk of the financial system. Finally, they show that optimal capital requirements are less risk-sensitive than those based on a VaR criterion à la Basel II and III.

Full article

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