Optimal Bank Interest Margin Under Capital Regulation: Regret Aversion and Shadow Banking

Abstract

This paper takes a contingent claim approach to the market valuation of a banking firm’s equity. A model is presented that explicitly takes into account the following: (i) the bank is regret-averse; (ii) the earning-asset portfolio of the bank includes regular banking loans, default-free liquid assets, and shadow banking wealth management products; and (iii) imposing heightened capital requirements on the bank emerges. We argue that it may not be regretful for the bank to conduct the WMPs, implying that these activities have been increasing over time. Increases in WMPs or capital requirements decrease the bank interest margin, which makes the bank more prone to loan risk-taking, thereby adversely affecting banking stability.