A Model of Bank Credit Cycles

This paper develops a model of financial intermediation in which the dynamic interaction between regulator supervision and banks’ loophole innovation generates credit cycles. In the model, banks’ leverages are constrained due to a risk-shifting problem. The regulator supervises the banks to ease this moral hazard problem, and its expertise in supervision improves gradually through learning-by-doing. At the same time, banks can engage in loophole innovation to circumvent supervision, which acts as an endogenous opposing force diminishing the value of the regulator’s accumulated expertise. In equilibrium, banks’ leverage and loophole innovation move together with the regulator’s supervision ability. Our model generates pro-cyclical bank leverage and asymmetric credit cycles. We show that a crisis is more likely to occur and the consequences are more severe after a longer boom. In addition, we investigate the welfare implications of a maximum leverage ratio in the environment of loophole innovation.