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I develop a theoretical model to examine the effect of capital requirements on risk taking and market structure of banks. Within a portfolio choice model I allow for heterogeneous productivity among banks and consider the simultaneous capital regulation with a leverage ratio and a risk-weighted ratio. Regulators face a trade-off between the efficient allocation of resources and financial stability. In an oligopolistic market risk-weighted requirements incentivise banks with high productivity to lend to low-risk firms. When a leverage ratio is introduced these banks lose market shares to less productive competitors and react with risk-shifting into high-risk loans. While average productivity in the low-risk market falls market shares in the high-risk market are dispersed across new entrants with high as well as low productivity. |
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