Financial Regulation in a Quantitative Model of the Modern Banking System

By Tim Landvoigt and Juliane Begenau

This paper builds a quantitative general equilibrium model with commercial banks and shadow banks to study the unintended consequences of capital requirements. In particular, we investigate how the shadow banking system responds to capital regulation changes for traditional banks. A key feature of our model are defaultable bank liabilities that provide liquidity services to households. In case of default, commercial bank debt is fully insured and thus provides full liquidity services. In contrast, shadow banks are only randomly bailed out. Thus, shadow banks’ liquidity services also depend on their default rate. Commercial banks are subject to a capital requirement. Tightening the requirement from the status quo, leads households to substitute shadow bank liquidity for commercial bank liquidity and therefore to more shadow banking activity in the economy. But this relationship is non-monotonic due to an endogenous leverage constraint on shadow banks that limits their ability to deliver liquidity services. The basic trade-off of a higher requirement is between bank liquidity provision and stability. Calibrating the model to data from the Financial Accounts of the U.S., the optimal capital requirement is around 20%.

The more you regulate the banks, the more assets will leak into the shadow banking system that is muc more difficult to regulate. It is therefore impossible to have a completely safe banking system and there is an optimum level of regulation, which may actually depend on a lot of things, including some that vary with economic conditions. It is going to be difficult to find regulators and politicians with that kind of flexibility.


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