01 February 2019

ECB working paper: Markets, banks, and shadow banks

Authors assume that screening is not observed by debtholders, and therefore there is a moral hazard problem. Intermediaries may be willing to use (more expensive) equity finance in order to ameliorate the moral hazard problem and reduce the cost of debt. One of the novelties in the paper is that they assume that for this channel to operate, the capital structure has to be certified by an external (public or private) agent. Public certification is done by a bank supervisor that verifies whether those intermediaries that choose to be regulated (called regulated banks) comply with the regulation. Intermediaries that do not comply with the regulation (called shadow banks) have to resort to more expensive private certification. Authors consider two different types of regulation, namely risk-insensitive (or at) and risk sensitive (Value-at-Risk based) capital requirements, which broadly correspond to, respectively, the Basel I and the Basel II and III Accords of the Basel Committee on Banking Supervision. They show that regardless of the risk-sensitivity of the capital requirements, different types of financing can coexist. In particular, safer projects are always funded by the market, while riskier projects are funded by intermediaries. Depending on the risk-sensitivity of the requirements two different market structures can emerge. With at requirements the equilibrium market structure is such that regulated banks always fund the riskiest projects, while if shadow banks operate they fund projects that are safer than those of the regulated banks. With Value-at-Risk requirements the equilibrium market structure is such that regulated banks always fund the intermediate risk projects, while if shadow banks operate they fund the riskiest projects.

They also examine an alternative to the certification model, in which the advantage of regulated banks relative to shadow banks comes from the existence of underpriced deposit insurance. Although the main results remain unchanged, there are some interesting differences. In particular, in the model with deposit insurance regulated banks never want to have capital buffers. Their results imply that reducing the gap between the costs of private and public certification, say by charging banks for the cost of bank supervision or by increasing deposit insurance premia, would lead to an expansion of the shadow banking system.

The paper also contains a characterization of optimal capital requirements, which are less risk-sensitive than the those based on a Value-at-Risk criterion  la Basel II and III. It also discusses what happens when there are exogenous changes in the safe rate or in the cost of bank capital, showing that the regulated banking sector will shrink and the unregulated sector will expand when the safe rate is low and the excess cost of bank capital is high.

Finally, it analyzes what happens when they endogenize the cost of capital, showing that in this case a tightening of capital requirements has a negative effect on the risk-taking behavior of (regulated and shadow) banks that are not directly constrained by the regulation, via the higher cost of bank capital. Authors would like to conclude with a few remarks. First, they have assumed that screening reduces the loans probability of default, but they could also consider other effects on the quality of the pool of loan applicants, say reducing the loss given default. Second, a thorough discussion of the financial stability implications of their results would require introducing a more realistic correlation structure of project returns within and across types of entrepreneurs. Third, although the model is set in terms of entrepreneurial finance it could also be interpreted in terms of household finance, with different types corresponding to borrowers with, for example, different loan-to-values.

Working paper

© ECB - European Central Bank