Financial Regulation in a Quantitative Model of the Modern Banking System

Abstract

This paper builds a 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 commercial bank capital regulation changes. A key feature of our model are defaultable bank liabilities that provide liquidity services to households. While the debt of commercial banks is insured and therefore delivers the full value of liquidity services to households, shadow banks’ debt is uninsured. Its value depends on the expected default rate of shadow banks. 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. and commercial banks’ regulatory fillings, the optimal capital requirement is around 20%.