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Procedia Computer Science 00 (2021) 000–000 www.elsevier.com/locate/procedia
www.elsevier.com/locate/procedia

The 8th International Conference on Information Technology and Quantitative Management

The 8th International Conference on Information Technology and Quantitative Management
(ITQM 2020 & 2021)
(ITQM 2020 & 2021)
Shadow Banking Under Capital Regulation and The Internal
Shadow Banking Under Capital Regulation and The Internal
Ratings-Based Approach
Ratings-Based Approach
Maria Ermolova aa*
Maria Ermolova *
a
National Research University Higher School of Economics, International Centre of Decision Choice and Analysis, 11 Pokrovsky Bulvar,
a
National Research University Higher School Pokrovka Complex,
of Economics, Moscow,Centre
International 109028, Russia Choice and Analysis, 11 Pokrovsky Bulvar,
of Decision
Pokrovka Complex, Moscow, 109028, Russia
Abstract
Abstract
The article discusses the mechanism of risk-shifting in the presence of information asymmetry. Due to the asymmetry of
The article discusses
information, the mechanism
the regulator of risk-shifting
cannot differentiate in the by
bank assets presence
the risk of level,
information asymmetry.
and therefore cannotDueguarantee
to the asymmetry of
the banking
information, the regulator
system's solvency. cannot policy
This restrictive differentiate bank the
encourages assets by to
banks thework
risk outside
level, and therefore cannot
of regulation, guarantee
using credit the banking
intermediation or
system's
other solvency.
schemes that This restrictive
are not imposedpolicy encouragesThe
by regulation. the paper
banks suggests
to work outside
the IRBofapproach,
regulation,
asusing
a toolcredit intermediation
to reduce or
information
other schemes
asymmetry thatthat are not
affects imposed
shadow by regulation.
banking The paper suggests
size. The modification the IRB
of the model approach,
Ordoñez as ais tool
(2018) to reduce
proposed. information
It presented the
asymmetry
critical that
levels of affects shadow
the capital banking size.
requirements The banks
at which modification
choose toof stay
the model
in shadowOrdoñez (2018) is proposed. It presented the
banking.
critical levels of the capital requirements at which banks choose to stay in shadow banking.
© 2021 The Authors. Published by Elsevier B.V.
© 2021 The Authors. Published by Elsevier B.V.
This is an open access article under the CC BY-NC-ND license (https://creativecommons.org/licenses/by-nc-nd/4.0)
© 2021 The
Selection Authors.
and/or Published
peer-review by Elsevier
under B.V. of the organizers of ITQM 2020&2021
Peer-review under responsibility of responsibility
the scientific committee of the The 8th International Conference on Information Technology
Selection and/or peer-review under responsibility
and Quantitative Management (ITQM 2020 & 2021) of the organizers of ITQM 2020&2021
Keywords: shadow banking; information asymmetry; capital regulation; internal ratings-based approach (IRB)l; risk-shifting;
Keywords: shadow banking; information asymmetry; capital regulation; internal ratings-based approach (IRB)l; risk-shifting;

1. Introduction
1. Introduction
A bank can reduce the risk level by transferring it to another party involved. However, it does not reduce the
A banksystem's
financial can reduce
riskthe risk It
level. level
onlybyredistributes
transferring the
it torisk
another
fromparty
the involved. However,
bank to market it does notAreduce
participants. the
bank can
financialassets
transfer system's
to a risk level.sheet
balance It only
of a redistributes
company thatthe is risk
a partfrom
of athe bank to
financial market
group but participants.
is not subjectAtobank can
banking
transfer assets
regulation. to a balance
Participants havesheet of a company
different levels ofthat is a partabout
awareness of a financial
the risk ofgroup butbeing
assets is notpassed
subjecton.
to banking
A bank
regulation.
knows Participants
its assets' have better
risk level different
thanlevels of awareness
investors (to whomabout the risk
the risk of assets being
is transferred) passed
and the on. A (who
regulator bank
knows itstheassets'
controls banks'risk levelto better
ability cover than
lossesinvestors (to whom
in distress). the of
The result riskinformation
is transferred) and theis regulator
asymmetry (who
not an optimal
controls the
decision banks' participants.
of market ability to coverThelosses in distress).
investor assigns an The result ofinterest
excessive information
rate dueasymmetry
to the lackis not an optimal
of information
decision
about theof market
bank participants.
portfolio's Theregulator
risk. The investorprohibits
assigns an excessive
holding riskyinterest rate to
assets, due due
histoinability
the lacktoofidentify
information
high-
about the bank portfolio's risk. The regulator prohibits holding risky assets, due to his inability to identify high-

* Corresponding author. Tel.: +7-915-108-1942.

address: m.d.ermolova@gmail.com;
* Corresponding
E-mail mermolova@hse.ru.
author. Tel.: +7-915-108-1942.
E-mail address: m.d.ermolova@gmail.com; mermolova@hse.ru.

1877-0509 © 2021 The Authors. Published by Elsevier B.V.

This is an open access article under the CC BY-NC-ND license (https://creativecommons.org/licenses/by-nc-nd/4.0)
Peer-review under responsibility of the scientific committee of the The 8th International Conference on Information Technology and
Quantitative Management (ITQM 2020 & 2021)
10.1016/j.procs.2022.01.053
440 Maria Ermolova et al. / Procedia Computer Science 199 (2022) 439–447
Maria Ermolova / Procedia Computer Science 00 (2021) 000–000

risk assets among them. The latter encourages banks to transfer their assets outside the regulator's control
(using non-bank financial companies).
G. Ordoñez considers the problem [11]. He applied the term «shadow banking», provided by the Financial
Stability Board, to define credit intermediation outside the regulated banking system. According to [11], bank
investments in "classic" debt securities (safe assets) serve a signal of the bank's actions in a regulated area. In
contrast, the investment in securitised assets (risky assets: superior and inferior assets) shows that a bank is a
part of shadow banking. The paper [11] shows that society's welfare is lower without financial intermediaries
(shadow banking), so banks’ and other financial intermediaries' co-existence is advantageous. However, the
first best solution is still not achieved when a bank invests in both safe and superior assets. He proposes to
increase wealth by taxing the shadow banking and subsidising the traditional (regulated) banking system, by
allowing banks to choose which part of the financial system to be located in. However, the author, himself,
recognises the complexity of implementing such a mechanism.
In this paper, another solution, such as an internal rating-based (IRB) approach is proposed, to reduce
information asymmetry and shadow banking size. The IRB approach is a well-known regime in Russia and
around the world, when, in 2019, more than 2000 banks in the world used this method. IRB is an approach in
which banks assess risk, based on their internal models. Simultaneously, the current paper shows that one of the
crucial parameters that affect the shadow banking size is the regulator's capital requirements. [11] omitted the
capital requirements, but the current work implements it.
Thus, the purpose of this article is to propose the IRB approach as the method to reduce information
asymmetry and shadow banking by adjusting the Ordoñez theoretical model. It will show the impact of capital
requirements on shadow banking size.
The work is organised as follows. Section 2 discusses the IRB approach. Section 3 presents other works that
study the topic of shadow banking formation. Section 4 suggests the Ordoñez model adjustment. Section 5
shows the findings of the study.

2. Literature and the state of the market

This section presents arguments that show that some of the prerequisites factored in the Ordoñez model [11]
are not realistic. They do not accurately describe reality, both today and ten years ago. The model [11]
supposes that the regulator and investor do not have enough information to understand asset risk correctly. In
this regard, the investor asks for an increased risk premium on all assets that come from shadow banking. The
regulator conducts a strongly restrictive policy and prohibits investing in any risk assets. In other words, one
can be faced with information asymmetry, due to which, suboptimal decisions of the regulator and investors
arise. The result is a shadow banking example. Ordoñez concludes that shadow banking is effective [11]. It
allows increasing the level of well-being of the society.
Let us discuss two issues. The first issue concerns how significant the information asymmetry is between a
bank, the regulator, and investors. The second issue concerns whether the regulator chose the path towards
restrictive policies, prohibiting investments in any risk assets, under information asymmetry.
Answering the first issue, we recognise that information asymmetry is significant. [2] cited by [1] consider
the agency problem throughout the securitisation process. Investors without information about the assets'
quality perceive assets as less risky than they were. Creditworthiness and liquidity guarantees created a greater
illusion among investors about risk. It increases the risk insensitivity of investors. However, after the crisis of
2007, the regulator has worked on a disclosure policy to reduce information asymmetry. The SEC has
introduced new mandatory disclosure requirements [1].
Answering the second issue, we object that the regulator has followed the path of banning banks from
investing in risky assets. The regulator introduced a requirement for the bank to keep at least 5% of the risk of a
securitisation transaction and postpone super-revenue on reserves for the first losses; increases the
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Maria Ermolova / Procedia Computer Science 00 (2021) 000–000

independence of rating agencies and transparency of their methodologies; excludes regulatory arbitrage
between trading and banking books; implements stricter disclosure requirements for assets, including their
ratings, based on internal bank models; improves the competence of the regulator in terms of risk assessment
[11].
This paper shows that one of the critical steps to reduce information asymmetry is developing advanced risk
assessment, namely the internal risk-based approach (IRB). Let us discuss how information asymmetry changes
when banks switch to the IRB and how much the IRB makes a transparent risk assessment for the regulator.
Firstly, the IRB implementation is possible after a favourable decision by the regulator. To conduct validation,
the regulator analyses all banking methods and credit risk models and its integration in a bank’s processes for at
least three years before the date of submission of a request for IRB. The regulator asesses adequacy of the
prerequisites, evaluation method, depth, completeness, and representativeness of the data, model accuracy. The
regulator checked whether a bank considers all defaults and correctly calculates the losses. In the EU, the
regulators constantly refine the risk assessment methodology and analyse where banks underestimate these
risks.
After obtaining permission, the regulator collects reports, in great detail, every month, as part of subsequent
supervision. The standards of the EU are given in [7]. In Russia, Directive of the Bank of Russia No. 4927-U
presents reporting forms 0409113 and 0409114. Therefore, after the IRB introduction, the regulator and the
bank's asymmetry does not disappear but decreases.
The introduction of advanced risk assessment models does not directly guarantee a reduction in information
asymmetry. Without creating a full-fledged environment, it is possible to move from opacity concerning the
risk itself to ambiguity for its assessment's correctness. However, the above facts show that the current process
excludes the opacity of the evaluation method. The constant validation of the assessment's adequacy is carried
out due to the bank's built-up internal protection system and the regulator's active participation. Moreover,
validation by the regulator affected not only banks but also rating agencies [1].
[9] consider that one of the critical solutions that can lead to increased financial stability is developing the
regulator's competence in risk assessment with advanced approaches. Therefore, society should invest in the
regulator's training since its role in ensuring financial stability is significant. The combination of regulatory and
supervisory measures improves financial stability. As [5] note, capital regulation addresses moral risk by
reducing the size of market losses, while supervision reduces the problem of adverse selection, that is, the
likelihood of losses.
Therefore, to say that the regulator prohibits investing in risky assets is incorrect. It is true to say that the
regulator creates such capital requirements that stimulate banks to take less risk. The development of the
competence of the regulator is encouraged in this model. Therefore, the Ordoñez’s prerequisite for a limited
policy is not relevant. Instead of restrictive policies, the regulator encourages banks to keep less risk through
capital requirements. It is essential to build a correct risk assessment, including developing competencies
among banks and the regulator.
We decided to modify the Ordoñez model and use its example to show a different way of how the system
can develop. Based on the above arguments, we have excluded the restrictive policy of the regulator. As a
result, the regulator should ensure sufficient financial services penetration, cover investor demand [8] and
ensure financial stability.
While Ordoñez concludes that shadow banking increases society's well-being, compared to its absence, there
are other opinions on shadow banking's effect. [6] note that regulation affects banks' strategy (the volume of
assets and their risk level) and their decision to enter shadow banking with off-balance-sheet lending. [6] found
out that the higher a bank capital level, the higher the probability that it would go to shadow banking. On the
contrary, [10] shows that stricter capital requirements help to struggle with excessive risk-taking. However,
according to his model, society's welfare increases not fixed capital requirements but dynamic (endogenous)
ones.
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Maria Ermolova / Procedia Computer Science 00 (2021) 000–000

3. Model

In the Ordoñez model [11], there are three types of assets (safe, superior, and inferior) and three agents
(investors, the regulator, and banks). The level of awareness of the asset's risk is growing from investor to bank.
Banks can distinguish between all three types of assets. The regulator can only determine whether the asset is
safe or risky (there is no division into superior and inferior assets). The investor cannot assess the asset risk at
all. Ordoñez refers shadow banking to a banks' investments in risky assets, contrary to the regulator's policy.
Investors are aware of shadow banking, so they differentiate the interest rate between traditional and shadow
banking, for which they provide funds to banks. A bank decides which type of banking to stay in by comparing
profits in traditional and shadow banking, taking into account the availability of access to superior assets (their
number is limited). Since the return on superior assets is high, banks with access to them will always go into
shadow banking. The remaining banks that have access only to inferior assets will partially go into shadow
banking and partially remain in traditional banking.

3.1 Assets distribution in banking

Under the IRB regime, a regulator can monitor the asset risk level and distinguish between superior and
inferior assets. It allows maintaining a less restrictive policy. The regulator still prohibits investing in inferior
assets but lifts the ban on investing in superior assets within the traditional banking. Simultaneously, the
regulator requires that a bank’s capital must be at least the minimum capital adequacy ratio (which is not taken
into account in the Ordoñez model). On the one hand, it expands the range of investment opportunities by
removing the ban on investments in superior assets. On the other hand, it restricts investments through the
capital requirement.
Table 1 shows the access of assets in the markets and their distribution in the Ordoñez model and after its
adjustment. We keep the assumption the same as in the Ordoñez model, that the volume of superior assets is
limited. Only α % of banks have access to superior assets. Accordingly, the remaining 1-α % can be invested in
either inferior or safe assets. The letters A, B, C, D, E, and F denote the shares of banks that are invested in
asset i in market j, where
• A + B = 1, where A is the share of α % of banks, who invest in superior assets in shadow banking, B is
the share of α % of banks, who invest in inferior assets in shadow banking.
• C + D + E + F = 1, where C is the share of 1-α % of banks, who invest in inferior assets in shadow
banking, the logic for D, E and F is similar.
• The share of banks who go into shadow banking is A ∗ α + (C + E) ∗ (1 − α).

Table 1. Assets distributions on the banking

Shadow Traditional
Asset (i) Total
Banking (SB) Banking (TB)
Superior (sup) A B α
Risky
Inferior (inf) C D
1-α
Safe Safe (saf) E F

For both the Ordoñez model and its modifications, E = D = 0. It means that the safe assets are located
only in traditional banking, and inferior assets are located only in shadow banking. However, on the contrary to
Ordoñez, it became possible to invest in superior assets in the traditional market, if the bank implemented the
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Maria Ermolova / Procedia Computer Science 00 (2021) 000–000

IRB approach. Then, B > 0 in the adjusted model. We assume that there are no additional expenses in
traditional banking than the shadow one (for example, for IRB implementation, taxes).

3.2 Assets properties

There are no adjustments in the asset properties of the Ordoñez model.

Safe assets pay ys per unit of investment with probability ps at the end of the period, and 0 otherwise. The
probability to get a payoff is the same for both safe and superior assets but higher than for the inferior assets
(psup = psaf = ps > pr ), but the payoff of superior assets is higher and equals the payoff of inferior assets
(ysup = yinf = yr > ys ). The expected payoff for superior assets is more than for safe assets, which, in turn, is
more than inferior, risky assets (ps yr > ps ys > pr yr ).

3.3 Profit

Profit is computed as the following.

𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑡𝑡𝑖𝑖𝑚𝑚 = 𝑅𝑅𝑅𝑅𝑣𝑣𝑖𝑖𝑚𝑚 − 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝑛𝑛𝑖𝑖𝑚𝑚 = 𝑝𝑝𝑖𝑖𝑚𝑚 ∗ 𝑦𝑦𝑖𝑖𝑚𝑚 ∗ 𝑔𝑔𝑖𝑖 ∗ (𝐼𝐼𝐼𝐼𝐼𝐼 + 𝑘𝑘) − 𝑔𝑔𝑖𝑖 ∗ (𝑝𝑝𝑖𝑖𝑚𝑚 ∗ 𝐼𝐼𝐼𝐼𝐼𝐼 ∗ 𝑅𝑅𝑚𝑚 + 𝑘𝑘)  ሺͳሻ

where i is an asset type (i = {s, r}), m is a type of banking (m = {TB, SB}), Inv is an investment, k is the
bank capital, g i is the restrictions of investments (see section «Capital regulation» below) (g i = 1 for shadow
banking), R m is an interest rate.

3.4 Interest rate

Banks who invest in superior assets in traditional banking are easily recognised because only IRB banks are
allowed to invest in superior assets in traditional banking. IRB can be applied after official permission of the
regulator to use IRB to calculate the capital adequacy ratio. The permission is provided after regulatory
validation of IRB models and processes. The theoretical model may be sophisticated by choice (incentive),
whether to switch to IRB or not. However, this issue is outside the scope of this study. Thus, the rates in
traditional and shadow banking will be the following.

1
𝑅𝑅𝑇𝑇𝑇𝑇 =
𝑝𝑝𝑠𝑠
           ሺʹሻ

1
𝑅𝑅𝑆𝑆𝑆𝑆 =
𝑥𝑥𝑠𝑠 ∗𝑝𝑝𝑠𝑠 +(1–𝑥𝑥𝑠𝑠 )∗𝑝𝑝𝑟𝑟
         ሺ͵ሻ

where xs is a share of banks who invest in superior assets in SB, relative to all banks in shadow banking:

𝐴𝐴∗𝛼𝛼
𝑥𝑥𝑠𝑠 =
𝐴𝐴∗𝛼𝛼+𝐶𝐶∗(1−𝛼𝛼)
          ሺͶሻ

The derivation process of interest rate is presented in more details in [11].

3.5 Capital regulation

Banks must have sufficient capital to be able to cover unexpected losses. To do this, the regulator defines the
minimum value of the capital adequacy ratio (CAR). For example, in Basel II [3] and Basel III [4] CAR equals
444 Maria Ermolova et al. / Procedia Computer Science 199 (2022) 439–447
Maria Ermolova / Procedia Computer Science 00 (2021) 000–000

8%. Violation from 8% means that a bank has assumed a risk higher than a sufficient level to cover losses
caused by stress. As a rule, in case of violation of the standard, the regulator charges a fine to a bank, and then,
if it is unable to provide the minimum level of capital for a long time, revokes the licence.
In the Ordoñez model there is no capital requirement, but we introduce it into the model. The capital
adequacy ratio is calculated as follows.

𝑘𝑘
𝐴𝐴𝑖𝑖 = 𝑔𝑔𝑖𝑖 ∗ (𝐼𝐼𝐼𝐼𝐼𝐼 + 𝑘𝑘) =         ሺͷሻ
𝐶𝐶𝐶𝐶𝐶𝐶∗𝑅𝑅𝑊𝑊𝑖𝑖

𝑘𝑘
𝑔𝑔𝑖𝑖 = 𝑚𝑚𝑚𝑚𝑚𝑚 (1; )        ሺ͸ሻ
𝐶𝐶𝐶𝐶𝐶𝐶∗𝑅𝑅𝑊𝑊𝑖𝑖 ∗(𝐼𝐼𝐼𝐼𝐼𝐼+𝑘𝑘)

where CAR is a capital adequacy ratio, RWi is a risk weight (RWi = 1 – pi ), Ai is the volume that can be
invested in asset i.

3.6 The choice of banking and assets for the adjusted model

There are six options that a bank examines before a final decision about the asset and type of banking.

Table 2. Options comparison

TB TB SB SB
sup saf sup inf
TB sup
TB saf O1
SB sup O2 O3
SB inf O4 O5 O6

The banks who have access to superior assets (α % of banks) will examine all the alternatives, other banks
(1 – α % of banks) analyse only option O5. A bank will choose the type of banking and assets, comparing the
profit. All options are analysed and discussed later.

3.6.1 Option O1 (superior assets in TB vs safe assets in TB)

The banks who have access to superior assets (α banks) can also invest in safe assets, but the banks do not
choose the safe investments, because in traditional banking, all other things being equal, the profit for superior
assets is always higher than for safer ones, due to a higher return (ps yr > ps ys ) (the costs are the same).

3.6.2 Option O3 (superior assets in SB vs safe assets in TB)

As was mentioned above, a bank will prefer superior assets to safe assets in TB. If a bank goes into shadow
banking, then a profit of superior assets in TB is lower than in SB. The profit in TB, with safe assets is much
lower than with superior assets in SB. Thus, the final choice is superior assets in SB.

3.6.3 Option O4 (inferior assets in SB vs superior assets in TB)

First, a bank with access to superior assets will choose between superior assets in TB and SB. If superior
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Maria Ermolova / Procedia Computer Science 00 (2021) 000–000

assets are more profitable in TB, then it is more profitable than with inferior assets in SB too. Thus, the final
choice is superior assets in TB.

3.6.4 Option O6 (superior assets in SB vs inferior assets in SB)

The banks who have access to superior assets (α banks) can also invest in inferior assets, but the banks do
not choose this option, because, in shadow banking, all other things being equal, the profit for superior assets is
always higher than for inferior ones due to a higher return (ps yr > pr yr ) (the costs are the same).

3.6.5 Options O2 and O5

The options O2 and O5 require a more complex solution that will be presented below.

Table 3. Type of solution

Notes: A and C in terms of Table 1, where A is the share of α % of banks, who invest in superior assets in shadow banking, C is the share
of 1-α % of banks, who invest in inferior assets in shadow banking.

1-α banks
to be in TB to be in SB
α banks A\C C=0 C=1
to be in TB A=0 1 3
to be in SB A=1 2 4

3.6.6 Option O2 (superior assets in TB vs superior assets in SB)

The banks who have access to superior assets (α banks) should choose between investing in traditional
banking or shadow banking. Traditional banking assumes capital regulation. Thus, profit is subjected to CAR.

3.6.7 Option O2 (Table 4.)- Case 1 and 2 (Table 5.)

In cases № 1 and 2, one can analyse the banking choice for superior assets, provided that there are no
investments in inferior assets in shadow banking (С = 0). If there is no capital regulation, the revenue is the
same in both types of banking; otherwise, traditional banking revenue can be less than in shadow banking, due
to a reduced asset volume caused by capital regulation and a necessity to hold sufficient capital requirement.

𝑅𝑅𝑅𝑅𝑣𝑣𝑆𝑆𝑆𝑆−𝑠𝑠𝑠𝑠𝑠𝑠 = 𝑝𝑝𝑠𝑠 𝑦𝑦𝑟𝑟 (𝐼𝐼𝐼𝐼𝐼𝐼 + 𝑘𝑘)        ሺ͹ሻ

𝑅𝑅𝑅𝑅𝑣𝑣𝑇𝑇𝑇𝑇−𝑠𝑠𝑠𝑠𝑠𝑠 = 𝑝𝑝𝑠𝑠 𝑦𝑦𝑟𝑟 𝑔𝑔𝑠𝑠 ∗ (𝐼𝐼𝐼𝐼𝐼𝐼 + 𝑘𝑘)        ሺͺሻ

If g s < 1 then revenue in traditional banking is reduced compared to shadow banking. It corresponds to

𝑘𝑘
𝐶𝐶𝐶𝐶𝐶𝐶 > = 𝐶𝐶𝐶𝐶𝑅𝑅1         ሺͻሻ
(1−𝑝𝑝_𝑠𝑠)(𝐼𝐼𝐼𝐼𝐼𝐼+𝑘𝑘)

Costs on both types of banking are the same (due to xs = 1) and equal to
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/ Procedia / Procedia
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00 (2021) 199 (2022) 439–447
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1
𝑅𝑅𝑇𝑇𝑇𝑇 = 𝑅𝑅𝑆𝑆𝑆𝑆 =
𝑝𝑝𝑠𝑠
         ሺͳͲሻ

To sum up, if (9) is true, then a bank who has access to superior assets will choose shadow banking,
otherwise traditional banking.

3.6.8 Option O5 (safe assets in TB vs inferior assets in SB)

Banks with no access to superior assets (1 - α banks) should choose between investing in safe assets in
traditional banking or inferior assets in shadow banking. Traditional banking assumes capital regulation, then
the profit of safe assets is subjected to CAR.

3.6.9 Option O2 (Table 4.)- Case 3 and 4 (Table 5.)

If CAR is more than CAR1 , then all investments in superior assets are made in shadow banking. Thus, A =
1. Discussing the choice between safe and inferior assets, one can mention the following. On the one hand, the
return of safe assets is higher than the return of inferior assets, but the profit of safe assets is restricted by
capital requirement. On the other hand, the interest rate in shadow banking is higher than in traditional banking.
Thus, the CAR value at which the gain of traditional banking at a lower interest rate still covers the reduction in
profit caused by capital requirements. There are no investments in inferior assets in shadow banking. Thus,
C = 0. One can find the threshold of CAR under which C = 0.

1
𝜋𝜋 𝑇𝑇𝑇𝑇−𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 = 𝑔𝑔𝑠𝑠 (𝑝𝑝𝑠𝑠 𝑦𝑦𝑠𝑠 (𝐼𝐼𝐼𝐼𝐼𝐼 + 𝑘𝑘)– 𝑝𝑝𝑠𝑠 𝐼𝐼𝐼𝐼𝐼𝐼 – 𝑘𝑘)     ሺͳͳሻ
𝑝𝑝𝑠𝑠

1
𝜋𝜋𝑆𝑆𝑆𝑆−𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖 = 𝑝𝑝𝑟𝑟 𝑦𝑦𝑟𝑟 (𝐼𝐼𝐼𝐼𝐼𝐼 + 𝑘𝑘)– 𝑝𝑝𝑟𝑟 𝐼𝐼𝐼𝐼𝐼𝐼 – 𝑘𝑘     ሺͳʹሻ
𝑝𝑝𝑠𝑠

Equate the two profits and get the following:

−𝑘𝑘𝑝𝑝𝑠𝑠 +𝑝𝑝𝑟𝑟 (−𝐼𝐼𝐼𝐼𝐼𝐼+(𝐼𝐼𝐼𝐼𝐼𝐼+𝑘𝑘)𝑝𝑝𝑠𝑠 𝑦𝑦𝑟𝑟 )

𝑔𝑔𝑠𝑠 = (𝐼𝐼𝐼𝐼𝐼𝐼+𝑘𝑘)𝑝𝑝𝑠𝑠 (−1+𝑝𝑝𝑠𝑠 𝑦𝑦𝑠𝑠 )
       ሺͳ͵ሻ

Then, there are no investments in inferior assets in shadow banking (i.e. all (1-α% banks) will invest in safe
assets in traditional banking) if

𝑘𝑘𝑝𝑝𝑠𝑠 (1−𝑝𝑝𝑠𝑠 𝑦𝑦𝑠𝑠 )

𝐶𝐶𝐶𝐶𝐶𝐶 ≤ (−1+𝑝𝑝 = 𝐶𝐶𝐶𝐶𝑅𝑅2      ሺͳͶሻ
𝑠𝑠 )(−𝑘𝑘𝑝𝑝𝑠𝑠 +𝑝𝑝𝑟𝑟 (−𝐼𝐼𝐼𝐼𝐼𝐼+(𝐼𝐼𝐼𝐼𝐼𝐼+𝑘𝑘)𝑝𝑝𝑠𝑠 𝑦𝑦𝑟𝑟 ))

4. Conclusion

The article discusses the mechanism of risk-shifting in the presence of information asymmetry. The model is
based on the Ordoñez model. Due to the asymmetry of information, the regulator cannot differentiate bank
assets by the risk level. Therefore, it cannot guarantee (in particular, to investors) an adequate risk level of
banks that is sufficient to cover losses by capital in the event of stress. As a result, the regulator designs a
policy that prohibits investments in any risky assets. It leads to the fact that banks transfer their activities
outside the control of the regulator. It is defined as shadow banking. If investors buy "classic" debt securities,
they work with a bank in a regulated market. Investing in securitisation deals involves using schemes outside of
banking regulation, which encourages investors to raise the interest rate.
 Maria Ermolova et al. / Procedia Computer Science 199 (2022) 439–447 447
Maria Ermolova / Procedia Computer Science 00 (2021) 000–000

Information asymmetry leads to less than optimal decisions. Banks cannot invest in superior assets, even
though they generally have an acceptable risk level. Ordoñez proposed reducing the problem of asymmetry by
maintaining subsidies, in which banks in shadow banking must pay fees for their choice.
This article suggests another method for reducing the volume of shadow banking. This method involves
introducing the IRB approach, namely a differentiated calculation of the risk level for each asset, individually,
based on internal models of banks which meet the requirements of the regulator. Due to a more differentiated
risk assessment and constant validation of models and detailed reporting (by class, segment, rating scale
category, accounting, transition matrix, including the reasons for withdrawing credit from the portfolio, the
actual level of losses), the regulator will be able to control investments in superior assets and thereby reduce a
banks' entry into shadow banking.
The paper notes the impact of the capital requirements on the size of shadow banking. The modification of
the Ordoñez model, by adding IRB mode, and introducing a banks' calculation and compliance with capital
requirements, allowed us to find the boundary levels of the capital adequacy ratio, at which banks can change
their strategy in favour of shadow banking. The conclusion about the negative impact of high capital
requirements coincides with the conclusion of [6], and does not confirm the conclusion of [10].

Acknowledgements

This work/article is an output of a research project implemented as part of the Basic Research Program at the National
Research University Higher School of Economics (HSE University). The author acknowledges Henry Penikas for
introducing to the article [11] and discussing throughout all stages of the work. Author is grateful to Fuad Aleskerov and
Dmitry Veselov for the useful comments received at the Workshop by the International Centre of Decision Choice and
Analysis on May 17, 2020. Author acknowledges all reviewers for valuable comments.

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