Essays on Financial Intermediation and Macroeconomic Policy

Abstract

This dissertation studies the role of capital requirements in combating excessive risk-taking incentives of banks in two settings.

In the first chapter, we build a quantitatively relevant DSGE model with endogenous risk-taking in which deposit insurance and limited liability can lead banks to make socially inefficient risky loans. This excessive risk-taking can be triggered by aggregate or sectoral shocks that reduce the return on safer loans. Excessive risk-taking can be avoided by raising bank capital requirements, but unnecessarily tight requirements lower welfare by limiting liquidity producing bank deposits. Consequently, optimal capital requirements are dynamic (or state contingent). We provide examples in which a Ramsey planner would raise capital requirements: (1) during a downturn caused by a TFP shock; (2) during an expansion caused by an investment specific shock; and (3) during an increase in volatility that has little effect on the business cycle. In practice, the economy is driven by a constellation of shocks, and the Ramsey policy is probably beyond the policymaker's ken; so, we also consider implementable policy rules. Some rules can mimic the optimal policy rather well but are not robust to all the calibrations we consider. Basel III guidance calls for increasing capital requirements when the credit to GDP ratio rises, and relaxing them when it falls; this rule does not perform well. In fact, slightly elevated static capital requirements generally do about as well as any implementable rule.

In the second chapter, we incorporate shadow banks into a quantitative general equilibrium model to study the impact of non-bank financial intermediation on capital regulation policies. Shadow banks do not have deposit insurance and have a relatively lower price of taking risk compared to regulated banks. We find that when the returns to safer projects are depressed, migration of credit from shadow banks toward traditional banks boosts excessive risk-taking incentives of regulated banks. Shadow banks magnify the impact of business cycle shocks on capital requirements that prevent excessive risk-taking. Moreover, the failure to account for the interaction between regulated banks and shadow banks does not only blunt policy prescriptions, but may also lead to calling for increases in capital requirements when a decrease would be warranted. We show that capital requirements should also react to shocks that originate in the shadow banking sector without having a direct influence on regulated banks. The Ramsey planner, equipped with capital requirements and a tax on shadow bank debt, implements the welfare-maximizing optimal policy by moving both instruments significantly to stabilize the effect of a TFP shock on the loans of regulated banks. Our results stress the importance of considering the interactions of banks and shadow banks for designing macroeconomic policies.