DP13248 | Markets, Banks, and Shadow Banks

Publication Date

10/16/2018

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Abstract

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.