LFE Research Seminar by Dimitrios Tsomocos (University of Oxford): «How does capital and liquidity regulation change bank credit supply?»

On Tuesday,  September 24 at 4.40pm  International College of Economics and Finance and International Laboratory of Financial Economics held a research seminar.

Speaker:  Dimitrios Tsomocos (University of Oxford)
Theme:    «How does capital and liquidity regulation change bank credit supply?»
Venue: Shabolovka st., 26, room 3209

Abstract: In this paper we explore the role of financial regulation in controlling excessive risk-taking that is induced by limited liability for borrowers and financial intermediaries that lend to them. The analysis is conducted in a two period endowment economy in which a saver and an entrepreneur can opt for direct lending or can have credit intermediated by a bank. The bank improves risksharing for the saver by offering the chance to put some savings into deposits which are lent onto the entrepreneur but are less risky than a direct loan. The better risk sharing leads to higher overall credit extension, which can exacerbate the distortion associated with limited liability. The focus of the paper is on understanding whether regulation can constrain the gambling and if so, does the form of regulation matter? We consider both traditional capital regulation that forces the bank to raise more equity than it would otherwise, as well as liquidity regulation that forces the bank to invest in a safe asset that maintains its value even if the entrepreneur defaults on his loan. We find a sharp difference between these two types of regulation. Capital regulation lessens the impact of a loan default on deposits, but hardly reduces the amount of overall risk-taking by the bank and the entrepreneur. Liquidity regulation forces the bank to hold some safe assets and in equilibrium this reduces overall risk-taking.