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Regulating the Shadow Banking System

Gary B. Gorton

Yale School of Management; National Bureau of Economic Research (NBER)

Andrew Metrick

Yale School of Management; National Bureau of Economic Research (NBER)

October 18, 2010

The “shadow” banking system played a major role in the financial crisis, but was not a central focus of the recent Dodd-Frank Law and thus remains largely unregulated. This paper proposes principles for the regulation of shadow banking and describes a specific proposal to implement those principles. We first document the rise of shadow banking over the last three decades, helped by regulatory and legal changes that gave advantages to three main institutions of shadow banking: money-market mutual funds (MMMFs) to capture retail deposits from traditional banks, securitization to move assets of traditional banks off their balance sheets, and repurchase agreements (“repo”) that facilitated the use of securitized bonds in financial transactions as a form of money. A central idea of this paper is that the evolution of a bankruptcy “safe harbor” for repo has been a crucial feature in the growth and efficiency of shadow banking, and so regulators can use access to this safe harbor as the lever to enforce new rules. As for the rules themselves, history has demonstrated two successful methods for the regulation of privately created money: strict guidelines on collateral (used to stabilize national bank notes in the 19th century), and government-guaranteed insurance (used to stabilize demand deposits in the 20th century). We propose the use of insurance for MMMFs combined with strict guidelines on collateral for both securitization and repo as the best approach for shadow banking, with regulatory control established by chartering new forms of narrow banks for MMMFs and securitization and using the bankruptcy safe harbor to incent compliance on repo.

Number of Pages in PDF File: 41

Keywords: Shadow Banking, Financial Crisis, Bank Regulation

JEL Classification: G1, G2

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Date posted: September 15, 2010 ; Last revised: November 12, 2010

Suggested Citation

Gorton, Gary B. and Metrick, Andrew, Regulating the Shadow Banking System (October 18, 2010). Available at SSRN: http://ssrn.com/abstract=1676947 or http://dx.doi.org/10.2139/ssrn.1676947

Contact Information

Gary B. Gorton (Contact Author)
Yale School of Management ( email )
135 Prospect Street
P.O. Box 208200
New Haven, CT 06520-8200
United States
203 432-8931 (Fax)
HOME PAGE: http://mba.yale.edu/faculty/profiles/gorton.shtml
National Bureau of Economic Research (NBER)
1050 Massachusetts Avenue
Cambridge, MA 02138
United States
Andrew Metrick
Yale School of Management ( email )
165 Whitney Avenue
New Haven, CT 06511
United States
(203)-432-3069 (Phone)
HOME PAGE: http://faculty.som.yale.edu/andrewmetrick/

National Bureau of Economic Research (NBER) ( email )
1050 Massachusetts Avenue
Cambridge, MA 02138
United States
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