Finance Seminar: David Martinez
Markets, Banks and Shadow Banks
We analyse the effect of bank capital regulation on the structure and risk of the financial system. Banks intermediate between entrepreneurs and investors, and can monitor entrepreneurs’ projects. Monitoring is not observed by investors, so there is a moral hazard problem. Banks choose whether to be subject to the regulation, in which case a supervisor certi.es their capital, or not be subject to it, in which case they have to resort to more expensive private certification. Market finance, regulated banks, and shadow banks can coexist in equilibrium. Under both .at and risk-based capital requirements, safer entrepreneurs borrow from the market and riskier entrepreneurs borrow from intermediaries. The difference is that flat (risk-based) requirements are especially costly for relatively safe (risky) entrepreneurs which may be better off borrowing from shadow banks. We compare these regulations in terms of welfare, and characterise the optimal requirements taking into account the existence of both market and shadow bank finance.