An economic model of shadow banking : double tranches and heterogeneous risk tolerance

• Main Authors: Hu, Zehui, Long, Zijie, Yang, Yi
• Other Authors: Wu Guiying Laura
• Format: Final Year Project
• Language: English
• Published: 2016
• Subjects: DRNTU::Social sciences::Economic theory::Macroeconomics
• Online Access: http://hdl.handle.net/10356/66914
• Institution: Nanyang Technological University

Faced with the expansion of accumulated non-performing loans (NPLs), commercial banks widely adopt a financial process of “securitization” to reduce NPLs and transfer credit risks to the debt market. However, repercussions of the subprime mortgage crisis have prompted regulators to contemplate broader perspectives on securitization to mitigate risk and ensure systemic stability. The GSV model (2013) has studied equilibrium interest rates in a debt market with profit maximizing shadow banks and infinitely risk-averse investors, but yet to include structured debt with heterogeneous risk tolerance of institutional investors. Our paper incorporated these two features to provide a more rigorous competitive bidding model for determination of Nash equilibria under different scenarios. Through further sensitivity analysis, we obtained results with manifest implications for market structure reforms and regulatory capital requirements for shadow banking. With a double-tranche structure, intermediaries utilize wealth more effectively; total profits of investors and shadow banks, representing the overall efficiency of the market, also increase due to enhanced liquidity. When tail risk is neglected, tranching entices intermediaries into more aggressive leverage with heightened financial vulnerability to aggregate disturbance.