Working Paper Series no. 817: Welfare-Based Optimal Macroprudential Policy with Shadow Banks

The relevance of non-bank financial institutions (NBFIs) for financial stability has recently been addressed by financial regulators. For instance, imbalances in the non-bank financial sector have been identified as a main risk to financial stability in the euro area during the Covid-19 pandemic. Furthermore, the importance of NBFIs has been acknowledged in recent discussions on a “Capital Markets Union (CMU)” in Europe. However, designing a macroprudential framework for the non-bank financial sector similar to the approach applied to commercial banks is barely feasible. While traditional banks directly intermediate funds between borrowers and savers, a multitude of specialized financial corporations operating in complex intermediation chains are usually involved in non-bank credit intermediation.

Nevertheless, changes in macroprudential regulation for the commercial banking sector can shift credit intermediation towards less regulated parts of the financial system. For instance, higher capital requirements for traditional banks potentially lead to credit leakage towards unregulated NBFIs: As tighter banking regulation does not initially affect credit demand, higher regulation for commercial banks may incentivize borrowers to switch to NBFIs as commercial bank credit becomes relatively costly. Consequently, prudential authorities need to decide on an optimal level of regulation such that on the one side, banks' equity buffers are sufficiently high, but on the other side credit leakage to non-banks is limited.

In this paper, I study the optimal design of bank capital requirements and loan-to-value (LTV) ratios in the presence of a non-bank financial sector. I base the analysis on a New-Keynesian dynamic stochastic general equilibrium (DSGE) model featuring a heterogeneous financial sector calibrated to match economic and financial conditions in the euro area. The findings on optimal policy reveal that in the presence of NBFIs, the welfare-optimal level of static capital requirements is lower (13.5 percent) than in a counterfactual scenario where credit is intermediated only by traditional banks (16 percent). I highlight that the difference in optimal regulation can be attributed to an additional trade-off the regulator has to take into account, which relates to the composition of credit provided by commercial banks and NBFIs. Furthermore, NBFI presence affects the optimal dynamic response of macroprudential regulation to fluctuations in output and credit. Whenever macroeconomic disturbances imply credit leakage towards NBFIs, regulatory adjustments are more pronounced as in an economy without non-bank finance.

I then show that the additional policy trade-off is shaped by structural characteristics of financial institutions. For instance, empirical evidence suggests a significant degree of market power in the euro area commercial banking sector. In contrast, some studies find that non-bank finance can increase efficiency in financial markets by providing alternative financing sources and due to the involvement of highly specialized institutions in the intermediation process. However, NBFI intermediation can increase systemic risk, as structural characteristics, economic motivations, and regulatory constraints within the diverse non-bank financial sector can accelerate financial stress and macroeconomic disturbances, and finally pose a threat to financial stability.

In summary, the findings indicate that neglecting NBFIs potentially impairs the efficiency of macroprudential policies, as regulators do not internalize credit leakage and an additional trade-off related to the composition of credit. Thus, they should consider developments in the non-bank financial sector, even if their policies only apply to traditional banks. Furthermore, the lack of macroprudential tools for NBFIs raises potential gains from coordinating the implementation of different macroprudential policy measures. In addition, coordination with monetary policy can play a role, as NBFIs' activity is also related to the overall price of credit in the economy. Thus, credit leakage may be aggravated when the effective lower bound (ELB) on nominal interest rates is reached.