DP13248 Markets, Banks, and Shadow Banks

Author(s): David Martinez-Miera, Rafael Repullo
Publication Date: October 2018
Keyword(s): Bank Regulation, bank supervision, Capital requirements, credit screening, credit spreads, loan defaults, market finance, optimal regulation, Shadow banks
JEL(s): G21, G23, G28
Programme Areas: Financial Economics
Link to this Page: www.cepr.org/active/publications/discussion_papers/dp.php?dpno=13248

We analyze the effect of bank capital requirements on the structure and risk of a financial system where markets, regulated banks, and shadow banks coexist. Banks face a moral hazard problem in screening entrepreneurs' projects, and they choose whether to be regulated or not. If regulated, a supervisor certifies their capital; if not, they have to rely on more expensive private certification. Under both risk-insensitive and risk-sensitive requirements, safer entrepreneurs borrow from the market and riskier entrepreneurs borrow from banks. But risk-insensitive (sensitive) requirements are especially costly for relatively safe (risky) entrepreneurs, which may shift from regulated to shadow banks.