Capital Requirements and Shadow Banking
Lucyna Górnicka (University of Amsterdam)

We construct a simple theoretical model explaining banks’ incentives to pursue investments in unregulated (off-balance) projects. We show that even if the off-balance project yields returns lower than the regulated project in all states of nature, the bank might still find it profitable to pass a fraction of its funds off balance. This happens as higher capital-to-assets ratio on the bank’s balance sheet reduces the interest rate demanded by investors in the off-balance project. A necessary condition for this result is that the bank can credibly provide off-balance investors with credit guarantees through an implicit recourse to its on-balance returns. By considering a theoretical model of regulatory arbitrage we attempt to explain key motives behind banks’ decisions to set up and sponsor off-balance vehicles and argue that any proposals of raising capital requirements – such as envisioned under Basel III – can fulfill their role of stabilizing the financial sector only if no regulatory arbitrage is possible. Otherwise, the benefit of  lower fluctuation of credit supply over the business cycle has to be weighted against the disadvantage related to passing higher fraction of funds off balance, when increasing minimum capital requirements.

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A Field Experiment on Audit Rules with an Application to Long-Term Care
Sandra Vriend (VU University Amsterdam)

We provide evidence on the performance of various audit rules from a large-scale field experiment, with almost 500 participating care providers, in the Dutch market for long-term care. The field experiment allows us to investigate the effect of various types of incentives, relating to the adopted audit rate, the possibilities for imposing sanctions in case of noncompliance, and the incorporation of trust in audit rules. More specifically: firstly, we assess the effect of both exogenous and performance-related variation in the audit rate on the fraction of audits that is approved and the number of applications that is filed. Secondly, we look at the effect of differences in the timing of audit, either exogenous or based on previous performance, and thus the opportunities for punishment, on these same outcome variables.