Financial Regulation in a Quantitative Model of the Modern Banking System

Financial Regulation in a Quantitative Model of the Modern Banking System

By Juliane Begenau, Tim Landvoigt
September 2018Working Paper No. 3558

WFA Award for Best Paper on Financial Institutions

How does the shadow banking system respond to changes in capital regulation of commercial banks? We propose a tractable quantitative general equilibrium model with regulated and unregulated banks to study the unintended consequences of capital requirements. Tightening the capital requirement from the status quo leads to a safer banking system despite riskier shadow banking activity. A reduction in aggregate liquidity provision decreases the funding costs of all banks, raising profits and investment. Calibrating the model to data on financial institutions in the U.S., the optimal capital requirement is around 17%.

Keywords
shadow banks, liquidity demand, capital requirement, bank regulation