Abstract:
This paper develops a theory of optimal bank contracting under deposit insurance and risk-weighted capital requirements. Capital requirements are computed exposure by exposure, while the deposit guarantee covers the bank's net shortfall across the entire balance sheet. This regulatory asymmetry creates scope for financial contracts to increase the implicit government subsidy: by structuring the payoff of a specific loan portfolio to concentrate losses in states where the rest of the balance sheet also performs poorly, a bank can shift expected losses onto the deposit insurer even though each risk weight remains a fair measure of the risk of the asset it applies to. The analysis delivers two results that challenge the conventional interpretation of credit risk transfer. First, contracts that transfer risk outside the banking sector need not reduce the implicit subsidy and can increase it, because the change in the joint distribution of cashflows across the balance sheet is not captured by exposure-based regulation. Second, the optimal contract can increase credit supply, but this expansion reflects rent extraction from the deposit guarantee rather than an improvement in the social value of lending. The results suggest that simplifying prudential regulation should move towards a single balance-sheet-based requirement rather than additional exposure-based rules.
Non-technical summary (UCL Econ Brief)
Abstract: Models of the banking sector often assume that banks compete à la Cournot, choosing loan quantities rather than rates. This paper asks when that assumption is microfounded. As in Schliephake and Kirstein (2013), banks first choose capital, which caps their lending through regulatory capital requirements, and then compete in loan rates. Extending their analysis to risky loans and asymmetric information, I derive sufficient conditions under which the unique equilibrium of this game is the Cournot outcome. The key condition is that a bank’s default risk depends only on its own rate. The competitor’s rate then affects how much the bank lends but not the quality of its borrowers. The condition holds under moral hazard and, if capacity-constrained banks ration borrowers randomly rather than by willingness to pay, under adverse or favorable selection. It fails under screening and relationship banking, where the competitor’s rate reshapes the quality of a bank’s borrower pool. The results identify environments in which Cournot is a microfounded description of bank competition.
Abstract: Macroprudential regulation is often viewed as a trade-off between banking system stability and aggregate credit supply. In this paper, we provide a comprehensive analysis of how changes in capital requirements affect bank lending. We use a theoretical framework to assess and nuance the trade-off. We show that imperfect competition, general equilibrium effects, and asset heterogeneity among banks result in lending responses that are complex and difficult to estimate. Armed with these theoretical insights, we assess existing strategies in the empirical literature and provide guidance for future research.