David Miles Imperial College, London April 2017 10/15/2017 Discussion of: Markets, Banks and Shadow Banks David Martinez-Miera and Rafael Repullo David Miles Imperial College, London April 2017

Paper addresses big issues in regulation Might capital regulation drive lending out of regulated banks to shadow banks? Which type of lending might go to the shadow sector? What type of capital regulation is most likely to drive lending away? What type of investment by non-financial firms is most likely financed by funding raised in capital markets rather than intermediated through banks?

Lots of insight from simple model Firms type is common knowledge – prob of failure p. But monitoring by lender can reduce chance of failure Monitoring by lender is costly and not observable by depositors – so moral hazard Inside equity of banks reduces moral hazard and so increase monitoring, but it is costly (δ > 0). Inside bank equity has to be credibly verified –either by system of bank supervision and regulation (for “banks”) or by some other means (auditors?) for shadow banks So double cost of equity, but I think it makes monitoring effectively observable. Lots of insight from simple model

Results Safe companies (low p) always prefer direct financing from capital market. Monitoring is worth little to safe companies so intermediation through banks who have advantage in monitoring is not efficient. Simple result obviously abstracts from other reasons investors might like banks: eg – very liquid claims linked to payments network; – banks offer cheap way of diversifying across many thousands of borrowers for risk averse, small scale investors.

Results Flat capital requirements can: Make shadow sector unviable if set at low level – because they are more efficient way of verifying capital than certification of capital for shadow banks But if set at high level can create emergence of shadow banks who make safer lending than do regulated banks. The flat rate capital requirement (unrelated to risk p) perversely drives safer companies to the shadow sector.

Results Value at Risk capital requirements can: Make shadow sector unviable if set at low level – because they are more efficient way of verifying capital than auditors for shadow banks But if set at high level can create emergence of shadow banks who make riskier lending than do regulated banks. The higher capital requirement on riskier lending drives risky lending to the shadows

Results: Optimal capital regulation: Very nice way of characterising optimal system – linked to utility of representative consumer. For parameterised version of model: Optimal K rule is risk sensitive but less so than VAR type No shadow banks in equilibrium (but depends on calibration?) Higher is required rate of return of risk neutral investors higher is capital requirement (since cost of equity falls relative to other claims, δ is fixed) Higher is cost of equity, lower is capital requirement.

Issues What makes shadow banks different? They have same funding – with same liability structure why aren’t they viewed as deposit takers like banks and regulated in same way? In the model they just chose their status – in practice if they have liabilities and assets exactly like banks they are banks. What are the costs of making credible the capital of shadow banks and why would such certification costs be proportionate to equity capital? Lump sum would costs would fundamentally change things – but aren’t they more realistic? Why is capital (equity) expensive anyway – why do risk neutral investors require an expected return on bank equity that is greater than on other claims (including direct claims on firms)?