ECB published a working paper that analyzes the effect of bank capital requirements on the structure and risk of a financial system where markets, regulated banks, and shadow banks coexist. The issues addressed in the paper include the difference between regulated and shadow banks in the context of direct market finance; the type of borrowers funded by these institutions; the ways in which bank capital regulation affects lending through these channels; and the impact of the existence of shadow banks on the effectiveness of Basel III.
The paper presents the model of bank lending under moral hazard in which banks are not regulated and have to pay a cost to certify their capital. The paper analyzes the effects of flat and Value-at-Risk (VaR) requirements on the structure and risk of the financial system. It also characterizes optimal capital requirements and considers the effect of changes in funding costs and of endogenizing the cost of capital. Appendix A shows that the qualitative results remain unchanged when the advantage of regulated banks relative to shadow banks comes from the existence of underpriced deposit insurance. Appendix B contains the proofs of the analytical results.
The analysis shows how tighter risk-insensitive (sensitive) capital requirements can lead to a shift of intermediate (high) risk entrepreneurs from regulated to unregulated finance. This results in an increase in the default probability of entrepreneurs that shift and, therefore, in an unintended consequence of capital regulation that can lead to a riskier financial system. The analysis also reveals the ways in which optimal capital regulation must consider the existence of unregulated finance, whose presence imposes a constraint on the regulator, which leads to lower optimal capital requirements.
Related Link: ECB Working Paper (PDF)
Keywords: Europe, EU, Banking, Basel III, Shadow Banking, Capital Requirements, Credit Risk, ECB
A well-recognized researcher in the field; offers many years of experience in the real estate ﬁnance industry, and leads research efforts in expanding credit risk analytics to commercial real estate.
Previous ArticleIFRS Foundation Consults on Q&A on Application of Its SMEs Standard
The European Commission (EC) published a report summarizing responses to the targeted consultation on the supervisory convergence and the single rulebook in the European Union (EU).
The Office of the Superintendent of Financial Institutions (OSFI) published an update on the discussion paper that intended to engage federally regulated financial institutions and other interested stakeholders in a dialog with OSFI, to proactively enhance and align assurance expectations over key regulatory returns.
The European Central Bank (ECB) published its opinion on a proposal for a regulation on European green bonds, following a request from the European Parliament.
The Advisory Scientific Committee (ASC) of the European Systemic Risk Board (ESRB) published a report that explores the expected impact of digitalization on provision of financial and banking services, and proposes policy measures to address the risks stemming from digitalization.
The European Banking Authority (EBA) announced that the guidelines on the reporting and disclosure of exposures subject to measures COVID-relief measures shall continue to apply until further notice.
The Swedish Financial Supervisory Authority (FI) announced that the capital adequacy reporting as at December 31, 2021 must be done by February 11, 2022.
The Central Bank of the Philippines (BSP) issued communications covering developments related to online lending platforms, open finance framework and roadmap, and on the expected regulations in the area sustainable finance.
The Board of Governors of the Federal Reserve System (FED) published the final rule that amends Regulation I to reduce the quarterly reporting burden for member banks by automating the application process for adjusting their subscriptions to the Federal Reserve Bank capital stock, except in the context of mergers.
The European Banking Authority (EBA) published its assessment of risks through the quarterly Risk Dashboard and the results of the Autumn edition of the Risk Assessment Questionnaire (RAQ).
The Malta Financial Services Authority (MFSA) updated the guidelines on supervisory reporting requirements under the reporting framework 3.0.