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Macroprudential capital requirements with non-bank finance

Kyle P. Dempsey

No 2415, Working Paper Series from European Central Bank

Abstract: I analyze the impact of raising capital requirements on the quantity, composition, and riskiness of aggregate investment in a model in which firms borrow from both bank and non-bank lenders. The bank funds loans with insured deposits and costly equity, monitors borrowers, and must maintain a minimum capital to asset ratio. Non-banks have deep pockets and competitively price loans. A tight capital requirement on the bank reduces risk-shifting and decreases bank leverage, reducing the risk of costly bank failure. In response, though, the bank can change both price and non-price contract terms. This may induce firms to substitute out of bank finance, leading to a theoretically ambiguous effect on the profile of aggregate investment. Quantitatively, I find that the bank's incentive to insure itself against issuing costly equity and competition from the non-bank sector mutes the long run impact of raising capital requirements. Increasing the capital requirement from 8% to 26% eliminates bank failures with effectively no change in the quantity or riskiness of aggregate investment. JEL Classification: G2, E5, E6, E32, E44

Keywords: banking; business cycles; capital requirements (search for similar items in EconPapers)
Date: 2020-05
New Economics Papers: this item is included in nep-cba, nep-dge, nep-fdg, nep-mac and nep-rmg
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