Shadow-banking entrusted loan management, deposit insurance premium, and capital regulation

- We take a capped contingent claim approach to value equity and liability of a bank.
- We study bank interest margin under capital regulation when the bank additionally conduct entrusted lending activities.
- Entrusted loans produce superior return but less safety for the bank and more liability for the deposit insurer.
- Relaxing regulatory capital requirements enhances return and safety for the bank.

This paper studies bank interest margin, i.e., the spread between the loan rate and the deposit rate of a bank, when the bank conducts regular lending and shadow-banking entrusted lending activities under capital regulation. We show that an increase in the entrusted loans increases the bank's interest margin, equity risk, and the liability of deposit insurer. Entrusted loans can help spur bank equity return, but there is a trade-off in terms of reduced banking stability. We also find that the reduced margin and the increased equity risk by capital regulation are reinforced when the bank additionally conducts entrusted lending activities. Relaxing regulatory capital requirements may produce superior return performance and greater safety for the bank carrying on shadow-banking entrusted loans.