Economics of Banking

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H.Keiding: Economics of Banking (Prel.version:September 2013) Chapter 18, page 1 Chapter 18 Capital Regulation and The Basel Accords 1. Introduction: why capital regulation? 2. Effects of capital regulation 2.2. A model where banks have equity in excess of regulatory demand. There is some empirical evidence that banks choose a composition of funding where the share of equity is larger than what is demanded by regulators. Below we consider a simple model of largely competitive financial markets, due to Allen, Carletti and Marquez (2011), where this is the case. We consider a one-period economy with firms having access to a risky investment and in need of financing, and banks that lend to the investors and monitor them. An investment…show more content…
If this is a result of market forces, it must be a market where all bargaining power is left with the borrowers, none with the banks. Therefore, it may be questioned whether the result can be seen as a decision by banks to hold more than the minimal capital required. If instead we introduce a regulator, determining k so as to maximize a social welfare function defined as we get that rL ≥ 2 − k, and inserting this into (1) we get that k ≥ 1 1 B + Π = q(y − rL ) + q(rL − (1 − k)rD ) − krE − q2 = q(y − (1 − k)rD ) − krE − q2 , 2 2 while otherwise everything is as before, then for large enough y (namely y ≥ 2, the capital ratio k may be chosen as 0, since the banks’ gain with rE = 2 is large enough to give incentives for q = 1. If y < 2, the capital ratio must be positive, whereas q may be less than 1. H.Keiding: Economics of Banking (Prel.version:September 2013) Chapter 18, page 3 2.3. A model where capital regulation may increase risk. To see that capital regulation may work in ways that run counter to intuition, we look at a simple model proposed by Hakenes and Schnabel (2010). It is in many respects close to the one which we used in the discussion of competition and risk (Chapter 11). We assume that there are N banks which are financed either by deposits D j or by equity E j , j = 1, . . . , N. The banks compete for depositors and for loans. Borrowers are entrepreneurs, who may choose risky projects, all of equal size 1, characterized
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