Bank Capital Regulation and Structured Finance


  • We would like to thank two referees for their stimulating suggestions and Tobias Adrian, Adam Ashcraft, Nicola Cetorelli, Jean-Charles Rochet, Til Schuermann, and Javier Suarez as well as various seminar audiences, for useful comments. Remaining errors are our own. The views expressed in this paper are those of the authors and do not necessarily reflect the views of the Federal Reserve Bank of New York or the Federal Reserve System.


We model the interaction between bank capital regulation and financial innovation. Innovation takes the form of structured finance, namely, pooling and tranching of assets and the creation of separate structures with different seniority, different risk, and different capital charges. Structured finance can improve welfare by manufacturing safer securities, saving on the capital that the structures with different seniority need to satisfy incentive constraints. The divergence between private and social interests in future profits motivates regulation. Regulation lowers profits and may induce banks to innovate to evade the regulation itself, even if this decreases welfare.