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    ECB Paper Analyzes Effect of Capital Requirements on Financial System

    February 01, 2019

    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

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