Christian C. Opp

Higher Capital Requirements, Safer Banks? Macroprudential Regulation in a Competitive Financial System

In this paper we propose a general equilibrium framework to analyze the effectiveness of bank capital regulations when the banking sector faces competition from unregulated investors. In our model an implicit bail-out guarantee for banks may generate excessive incentives to invest in high risk, negative NPV projects. When competition from unregulated investors is low, the banking sector has a natural incentive to first fund positive NPV projects and to only engage in risk-shifting when the banking sector’s funding capacity exceeds the supply of positive NPV projects. This “natural pecking order” of bank investment allows regulation in the form of simple equity-capital ratio requirements to be effective. However, when banks face sufficiently strong competition from unregulated investors, they weakly prefer to focus on the funding of high-risk issuers, since government-insured banks have a natural comparative advantage in that market. This “reverse pecking order” of bank investment renders simple capital regulation to be ineffective and may even cause equity injections to be locally counterproductive. However, we show that contingency of capital regulation on credit ratings can restore the natural pecking order of bank investment and thereby increase the efficiency of capital requirements. ∗Previous versions of this paper circulated under the titles ”Optimal Rating-Contingent Regulation” and ”Regulating Banks’ Risk Taking with External Risk Assessments.” We are grateful to Sam Lee for a thoughtful discussion of an earlier draft of this paper. In addition, we thank seminar participants at the Federal Reserve Bank of New York and at the Federal Reserve Board of Governors. †University of Chicago, Booth School of Business, e-mail: milt@chicagobooth.edu. Professor Harris thanks the Center for Research in Security Prices at the University of Chicago Booth School of Business for financial support. ‡University of Pennsylvania, The Wharton School, email: opp@wharton.upenn.edu. Research support from the Rodney White Center for Financial Research and the Wharton School Dean’s Research Fund is gratefully acknowledged. §University of California, Berkeley (Haas), email: mopp@haas.berkeley.edu.

The System-Wide Effects of Bank Capital Regulation on Credit Supply and Risk-Taking

We propose a tractable general equilibrium framework to analyze the eectiveness of bank capital regulations when banks face competition from public markets. Our analysis shows that increased competition can not only render previously optimal bank capital regulations ineective but also imply that, over some ranges, increases in capital requirements cause more banks to engage in value-destroying risk-shifting. Our model generates a set of novel implications that highlight the dependencies between optimal bank capital regulation and the comparative advantages of various players in the nancial system.

Intertemporal Information Acquisition and Investment Dynamics

This paper studies intertemporal information acquisition by agents that are rational Bayesian learners and that dynamically optimize over consumption, investment in capital, and investment in information. The model predicts that investors acquire more information in times when future capital productivity is expected to be high, the cost of capital is low, new technologies are expected to have a persistent impact on productivity, and the scalability of investments is expected to be high. My results shed light on the economic mechanisms behind various dynamic aspects of information production by the financial sector, such as the sources of variation in returns on information acquisition for investment banks or private equity funds.

Bank Capital and the Composition of Credit

We propose a tractable general equilibrium framework to analyze the eectiveness of bank capital regulations when banks face competition from public markets. Our analysis shows that increased competition can not only render previously optimal bank capital regulations ineective but also imply that, over some ranges, increases in capital requirements cause more banks to engage in value-destroying risk-shifting. Our model generates a set of novel implications that highlight the dependencies between optimal bank capital regulation and the comparative advantages of various players in the nancial system.

Bank Capital, Risk-Taking, and the Composition of Credit

We propose a tractable general equilibrium framework to analyze the eectiveness of bank capital regulations when banks face competition from public markets. Our analysis shows that increased competition can not only render previously optimal bank capital regulations ineective but also imply that, over some ranges, increases in capital requirements cause more banks to engage in value-destroying risk-shifting. Our model generates a set of novel implications that highlight the dependencies between optimal bank capital regulation and the comparative advantages of various players in the nancial system.

Over-the-Counter vs. Limit-Order Markets: The Role of Traders' Expertise

Decentralized markets attract large amounts of trade volume, even though they exhibit frictions absent in centralized exchanges. We develop a model with asymmetric information and expertise acquisition where some traders try to exploit any market structure to inefficiently screen their counterparties. In this environment, frictions characteristic of decentralized markets, such as time-consuming search, can promote higher efficiency. First, screening behavior may be less aggressive when traders reach fewer counterparties. Second, for asset classes where information improves allocative efficiency, decentralized markets with predictable trading encounters may dominate by encouraging expertise acquisition. In contrast, when information causes adverse selection, centralized markets dominate.We propose a parsimonious model to evaluate the relative merits of centralized and decentralized trade when agents are asymmetrically informed about the value of an asset. In a centralized market, the seller posts one price and buyers simultaneously decide whether to pay this price for the asset. In a decentralized market, the seller sequentially contacts buyers and quotes them potentially different prices. We compare the social efficiency of trade in these two types of market when traders’ information sets are independent of the market structure as well as when the acquisition of information by traders is endogenous.

To Pool or not to Pool? Security Design in OTC Markets

This paper studies the optimality of pooling and tranching for a privately informed originator who offers securities in an over-the-counter (OTC) market in which buyers have market power. Such a market scenario is particularly relevant when many of the natural counterparties face binding regulatory constraints. Contrary to the standard result that pooling and tranching are optimal practices, we find that selling assets separately may be optimal for originators, as doing so weakens buyers’ incentives to inefficiently screen them. Our results shed light on recently observed time-variation in the prevalence of pooling and tranching in financial markets. ∗The authors thank Barney Hartman-Glaser, Rich Kihlstrom, Marius Zoican, Pavel Zryumov, and audiences at BI-Oslo, EIEF, Illinois, INSEAD, UT-Dallas, Wharton, the NFA Meetings, and the SFS Cavalcade for helpful comments that significantly improved the paper. All authors are from the Wharton School at the University of Pennsylvania and can be reached at vglode@wharton.upenn.edu, opp@wharton.upenn.edu, and ruslans@wharton.upenn.edu, respectively.