Financial Regulation in a Quantitative Model of the Modern Banking System

How does the shadow banking system respond to changes in the capital regulation of commercial banks? This paper builds a quantitative general equilibrium model with commercial banks and shadow banks to study the unintended consequences of capital requirements. A key feature of our model is defaultable bank liabilities that provide liquidity services to households. The quality of the liquidity services provided by bank liabilities depends on their safety in case of default. Commercial bank debt is fully insured and thus provides full liquidity. However, commercial banks do not internalize the social costs of higher leverage in the form of greater bankruptcy losses (moral hazard) and are subject to a regulatory capital requirement. In contrast, shadow bank liabilities are subject to runs and credit risk and thus typically less liquid compared to commercial banks. Shadow banks endogenously limit their leverage as they internalize the costs. Tightening the commercial banks' capital requirement from the status quo leads to safer commercial banks and more shadow banking activity in the economy. While the safety of the financial system increases, it provides less liquidity. Calibrating the model to data from the financial accounts of the U.S., the optimal capital requirement is around 20%.