We analyze the effect of bank capital requirements on the structure and risk of a
financial system where markets, regulated banks, and shadow banks coexist. Banks face
a moral hazard problem in screening entrepreneurs projects, and they choose whether
to be regulated or not. If regulated, a supervisor certifies their capital; if not, they
have to rely on more expensive private certification. Under both risk-insensitive and
risk-sensitive requirements, safer entrepreneurs borrow from the market and riskier
entrepreneurs borrow from banks. But risk-insensitive (sensitive) requirements are
especially costly for relatively safe (risky) entrepreneurs, which may shift from regulated
to shadow banks.

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