Shadow banking and optimal capital requirements

Abstract: This paper studies optimal time-varying capital requirements in a general equilibrium model with two types of financial intermediaries: regulated commercial banks (CBs) and unregulated shadow banks (SBs). Subject to capital regulation, each CB faces higher cost of funds and requires higher lending interest rate when it lends more to the borrower. The borrower internalizes this effect and chooses a lower leverage ratio when financing with a CB than when financing with an unregulated SB. Tightening the capital requirement reduces the credit supply within the CB sector but may stimulate total borrowings through an extensive-margin effect, as more borrowers choose high-leverage SB finance over low-leverage CB finance and the aggregate leverage ratio of all borrowers increases. If the extensive-margin effect outweighs the intensive-margin effect, tightening capital requirement will be expansionary and optimal capital requirements will become countercyclical.