Shadow Banking and Regulation: A Quantitative Assessment Césaire A. Meh Kevin Moran Bank of Canada Université Laval Journées du CIRPÉE 2013, Lac Beauport 26 septembre 2013 The views expressed are those of the authors and not those of the Bank of Canada.
INTRODUCTION : SHADOW BANKING Shadow banking, or market-based financing : credit intermediation involving entities and activities outside the regular banking system. credit is provided directly or through a chain that transforms maturity or liquidity. SBs rely on short-term market-funding (repos, ABCP) leverage is built up, as in the regular banking system
SB and Regulated Banking Systems: Similar Size Chart A: MBF liabilities vs. traditional bank liabilities Canada United States Can$ billions 1600 0 1995 1997 1999 2001 2003 2005 2007 2009 2011 Source: Bank of Canada Market-based financing liabilities Traditional bank liabilities 1400 1200 1000 800 600 400 200 0 1995 1997 1999 2001 2003 2005 2007 2009 2011 Last observation: 2011Q1 Source: U.S. Federal Reserve Market-based financing liabilities Traditional bank liabilities US$ billions 25000 20000 15000 10000 5000 Last observation: 2011Q1
REGULATION MIGHT BE KEY Shadow banking system is lightly regulated An important driving force of growth in SB might be regulatory arbitrage Aim to bypass capital requirements and achieve higher effective leverage than permitted by prudential regulation.
GOALS Contribute to the debate and literature on shadow banking Explore quantitatively the interaction between shadow banking and the traditional, regulated banking sector Discuss several proposals to potentially regulate shadow banking system
THIS PAPER Build dynamic general equilibrium model in which shadow and traditional banking systems coexist. Banks may offload assets, performing or nonperforming, to SBs. may lower screening standards at origination. provides banks with needed flexibility to recycle capital when facing shocks requiring funding. Impact of SB on banking sector risk and macroeconomy depends on the trade-off between lower screening incentives and increased flexibility. Use the model to study the macroeconomic effects of SB and its interplay with capital requirement on traditional banks.
FINDINGS At Given Regulatory Requirements the presence of shadow banks can reduce screening incentives and increase banking sector risk but may help enhance overall credit intermediation Tightening Regulatory Requirements can increase bank screening intensity and lower banking sector risk but may lead to a migration of credit towards shadow banking sector Easier access to funds by SB can increase banking sector risk
BRIEF LITERATURE REVIEW Banking: Holmstom & Tirole (1997), Meh & Moran (2010), Christensen, Meh & Moran (2011) Adverse selection in loan sale: Parlour & Plantin (2008) & Plantin (2011) Bank capital channel: Chen (2001), Aikman & Paustian (2004), Gerali et al. (2010), Gertler & Karadi (2010), Gertler & Kiyotaki (2010), Brunnermeier and Sannikov (2011) Shadow banking: Goodhart et al. (2012), Gorton (2011), Poltzar (2010), Plantin (2011), Acharya et al. (2011), Gennaioli, Shleifer & Vishny (2011)
OUTLINE 1. Sketch of the model a. Real-side similar to Gertler and Kiyotaki (2010) b. Banking and bank capital (HT, MM) c. Shadow banking and adverse selection (PP) 2. Preliminary findings 3. Conclusion
MODEL Final Good Sector competitive firms use labor and capital with a CRS technology to produce the final goods (numeraire) may experience persistent aggregate productivity shocks Capital Good Sector competitive firms use final good and existing stock of capital to produce new capital in the presence of adjustment costs
BANKING SECTOR Bankers are endowed with a screening technology and have access to investment projects Banks finance investment projects requiring q t kt units of funds with own capital (a t ) and deposits (d b t ) Projects produce k t+1 = ω k t of installed capital in period t +1, idiosyncratic shock ω {0,R} Probability that a loan performs (ω = R) is p t if the bank screens and zero otherwise, Revenue generated by performing project: ν t+1 R k t, where ν t+1 = r k t+1 +(1 δ)q t+1
BANKING SECTOR (cont.) Screening Screening projects at the beginning of period t increases probability of success: p t = p(υ t ) Screening is costly and not publicly observable Screening gives banks private information about project s success: good (ω = R) or bad (ω = 0) New attractive investment opportunities After screening and before project comes to fruition, bank may receive a new productive investment opportunity Return is λ > 1 per unit of funds, where λ is sufficiently large New investment opportunities arrive with probability l To undertake new investment opportunities, a banks needs funding at hand Banks can offload assets (good or bad) to the SB
SHADOW BANKING SYSTEM SB buy assets sold (or securitized loan) by bank Use short-term debt from deep pocketed households (wholesale market) to purchase loans, cost of funds is r sb t Good bank cannot signal its type; trade between bank and SB is not publicly observable: adverse selection Market pooling price is given by r t : [ p t l ][ r t = p t l +1 p t 1 1+r sb t ] p t l : Good banks that receive a liquidity shock that sold 1 p t : Bad banks that sold (bad banks always sell) When the adverse selection is severe r t is low.
HOUSEHOLDS Households derive utility from consumption and leisure Households are distributed on unit interval i [0,1] Cost to access outlet for savings, increases with distance (Dotsey & Ireland 1995) Banks located at 0, shadow banks at 1. Endogenous market segmentation: households closer to 0 use banks and other households use SB Threshold household i determined in equilibrium
Less Liquid SBs Can Increase Screening and Bank Stability...but may reduce economic activity The Economy s Steady State Variables More Liquid SB Less Liquid SB Bank Leverage (κ) 10.0 10.0 Screening (Υ) 0.10 0.23 Success Prob. (p(υ)) 0.957 0.962 Price of Loans (r) 0.90 0.85 Threshold (i ) 0.90 0.91 Capital Stock 14.6 11.37 Consumption 1.79 1.30 GDP 2.17 1.68
Impact of Tighter Leverage Regulation Variables Less Liquid SB More Liquid SB High Reg. Low Reg. High Reg. Low Reg. Lev. Ratio Lev. Ratio Lev. Ratio Lev. Ratio Screening 0.23 0.343 0.10 0.152 Success Prob. 0.962 0.966 0.957 0.958 Price of loans 0.85 0.863 0.90 0.908 Threshold (i ) 0.91 0.85 0.90 0.84 Capital 11.37 9.26 14.6 12.79 Tighter capital regulation can increase bank screening standards and banking stability, but such effect may be weaker when the SB is more liquid
Easier funding access for SB may increase bank risk-taking Dev. from s.s. (%) Dev. from s.s. (%) Dev. from s.s. (%) 1 0.5 GDP 0 0 10 20 Quarters 0.02 0.04 Probability of Success 0 0.06 0 10 20 Quarters 1.5 1 0.5 Bank Net Worth 0 0 10 20 Quarters Dev. from s.s. (%) Dev. from s.s. (%) Dev. from s.s. (%) 3 2 1 Investment 0 0 10 20 Quarters 0.8 0.6 0.4 Price of loans (r) 0.2 0 10 20 Quarters 0.1 Banks Access to Funds (i * ) 0 0.2 0 10 20 Quarters Dev. from s.s. (%) Dev. from s.s. (%) Dev. from s.s. (%) 1.5 1 0.5 Price of Capital (q) 0 0 10 20 Quarters Bank Screening Intensity 2 4 6 0 10 20 Quarters Funding Costs for Shadow Banks 0.2 0.4 0.6 0 10 20 Quarters
CONCLUSION Build a DGE model in order to quantitatively assess the interactions between banks, shadow banks, and regulation The presence of shadow banks can allow banks to redeploy capital profitably, but may reduce screening incentives and banking sector stability Tightening regulatory requirements on banks can raise screening standards and lower bank risk, but may lead to credit migration towards the shadow banking sector
NEXT STEP ON THIS PAPER Use the model to examine examples of proposal to regulate shadow banks tighter capital requirements on both shadow banks and banks limits on amounts that can be sold to shadow banks
PRELIMINARY PARAMETERIZATION Key Parameter Values Household Preferences b β ψ η χ b χ sb 0.7 0.99 4.0 1.0 0.0006 0.005 Final Good and Capital Good Production θ k θ h θ b φ ( )/φ ( ) δ 0.36 0.6399 0.0001 0.5 0.02 Banking and Shadow Banking Sectors p t = 1/(1+ζexp( Υ)) c l α b ζ 0.05 0.5 1.5 0.05
FINANCIAL CONTRACT: SOLUTION Payments: R b t = cυ t q t p(υ t )(1 l)(1 r t )ν e t+1 ; R h t = R cυ t q t p(υ t )(1 l)(1 r t )ν e t+1 Deposited attracted: d b t / k t = p(υ t)ν e t+1 1+r b t ( R Bank leverage for given screening: κ b t = Screening intensity: 1 ( 1+cΥ t p(υt)νe t+1 q t(1+rt b) R cυ t q t p(υ t )(1 l)(1 r t )ν e t+1 ). ), cυ tq t p(υ t)(1 l)(1 r t)νt+1 e p(υ t ) Υ t p (Υ t ) = q t(1+rt b ) Rνt+1 e,
Aggregate Capital and Net Worth Evolution of capital stock K t = φ(i t /K t )K t +(1 δ)k t,with K t+1 = p t R K t Evolution of aggregate bank net worth A t = τ b[ ] p t 1 (1 l)+r t 1 (lλ+(1 p t 1 )) ν t Rt 1 K b t 1 +wt b