Capital Regulation with Two Banking Sectors: Cyclicality and Implementation

• Published date: 01 March 2019
• Author: TAEJIN KIM,VISHAL MANGLA
• Date: 01 March 2019
• DOI: http://doi.org/10.1111/jmcb.12596

DOI: 10.1111/jmcb.12596

TAEJIN KIM

VISHAL MANGLA

Capital Regulation with Two Banking Sectors:

Cyclicality and Implementation

Wepresent a capital regulation policy in a model in which banks can choose

to be unregulated, by operating in the shadow banking sector, when the

cost of being regulated (restriction on portfolio risk) exceeds the benefit

(cheaper funding/insurance). We show that the welfaremaximizing capital

requirement policy can be procyclical: lowerrequirement during booms and

higherrequirement during recessions. Our policy specifies the level of capital

requirement as a function of the observed relativesize of the unregulated and

regulated banking sectors. This specification achievesthe optimal aggregate

risk exposure by obtaining the right mix of the two sectors.

JEL codes: E32, G21, G28

Keywords: capital regulation, shadow banking, regulatoryarbitrage,

optimal debt contract.

FROM THE FINANCIAL CRISIS OF 2007–09, we have learnt

(painfully) two lessons about banks: (i) there exists a “shadow” banking sector inter-

mediating credit in parallel to the traditional regulated banking sector, and (ii) there is

flow of capital across the two sectors.1Figure 1 illustrates that the size of the shadow

banking sector doubled from $10 trillion in the year 2000 to $20 trillion at its peak in

We are deeply grateful to Arvind Krishnamurthy for his support and comments. We thank Mirza

Afrasiab (discussant), Snehal Banerjee, Alexander Bleck (discussant), Michael Fishman, Craig Furfine,

Pedro Gete, Kathleen Hagerty, Guido Lorenzoni, Robert McDonald and Zhenyu Wang(discussant), and

seminar participants at WFA 2012, Econometrics Society NASM 2012, EFA 2012, Fed Cleveland, Fed

Philadelphia, Northwestern University, Indiana University, Cheung Kong Graduate School of Business,

Bank of Canada, KAIST,Hanyang University, The Chinese University of Hong Kong, and The University

of Hong Kong.We are also grateful to two anonymous referees and the editor (Pok-sang Lam) for numerous

valuable comments.

TAEJIN KIM is an Assistant Professor, Department of Finance, CUHK Business School, Chinese Uni-

versity of Hong Kong (E-mail: taejinkim@baf.cuhk.edu.hk). VISHAL MANGLA is an Associate Director,

Quantitative Research, Moody’s Analytics (E-mail: vishal.mangla@moodys.com).

Received September 27, 2016; and accepted in revised form February 27, 2018.

1. The shadow banking sector entities that are the focus of this paper are SIVs and SPVs that

intermediate credit through securitization and secured funding techniques such as asset-backed commercial

paper (ABCP), asset-backed securities (ABS), and collateralized debt obligations (CDOs). However,

Journal of Money, Credit and Banking, Vol.51, Nos. 2–3 (March–April 2019)

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2019 The Ohio State University

486 :MONEY,CREDIT AND BANKING

FIG. 1. Shadow Bank Liabilities versus Traditional Bank Liabilities, $ trillion.

NOTE: Shadow bank liabilities correspond to securitization activity and short-term money market transactions that are not

backstopped by deposit insurance. The details behind the construction of this plot are provided in Pozsar et al. (2010).

SOURCE: Flow of Funds Accounts of the United States as of 2012:Q3 (FRB) and FRBNY.

March 2008. An important component of this growth was the widespread adoption of

off-balance sheet investment vehicles such as structured investment vehicles (SIVs)

and special purpose vehicles (SPVs) by means of which large commercial banks

shifted their investments out of the regulatory purview (Gorton and Metrick 2010,

Acharya, Schnabl, and Suarez 2013). On the flip side, during the crisis, Goldman

Sachs and Morgan Stanley partially shifted their capital into the regulatory purview

by acquiring the status of bank holding company (Wall Street Journal 2008). More

generally, a number of hitherto unregulated entities of the intermediary sector ac-

cepted the government support. Figure 2 roughly captures the cyclical behavior of

the growth of the relative size of the unregulated banking sector.

In this paper, we take the view that financial intermediaries allocate their capital

between the regulated and unregulated banking sectors depending upon the business

cycle and the level/severity of the regulation.2Inmaking this decision, they compare

finance companies, credit hedge funds, moneymarket mutual funds, securities lenders, and the government-

sponsored enterprises (GSEs) are also examples of shadow banks (see Pozsar et al. 2010).

2. Thus, the key aspect of the shadow banking sector in this paper is that the shadow banking

sector provides a channel for regulatory arbitrage for banks. In the last crisis, the shadow banking sector

specialized in specific forms of business such as securitization, but we take more general view to shadow

TAEJINKIM AND VISHAL MANGLA :487

FIG. 2. Cyclical Behavior of Asset Backed Securities (ABS) Plus Unenhanced Commercial Paper (CP).

NOTE: We plot the ratio of the liabilities of the ABS issuers (line 11 of Table L.124 in Flowof Funds) plus CP without

explicit official guarantees (sum of lines 6, 10, 12, and 13 of Table L.208) and the liabilities of the traditional banking

sector (line 19 of TableL.109).

SOURCE: Flow of Funds Accounts of the United States as of 2012:Q3 (FRB) and NBER.

the benefit of being regulated—access to cheaper funding due to the government

guarantees—with the cost—restriction on risk-adjusted leverage. During booms with

better investment opportunities, the benefit of being regulated shrinks because the

funding becomes easier, whereas the cost of being regulated grows due to the higher

shadow value of the portfolio constraint. Therefore, if the level of the regulation is

held fixed, financial intermediaries are attracted toward the unregulated sector during

booms. These forces reverse during recessions.

We present a simple model to capture this strategic behavior of banks and find the

welfare maximizing capital regulation policy. We first show that the level of regu-

latory capital requirements necessary to ensure that the expected profit of regulated

banks equals that of unregulated banks is procyclical: relaxed capital requirements

during booms and tight during recessions. Next, we show that the relative size of the

banking in this work. Also, securitization is availableto both sectors, not exclusively to the shadow banking

sector.