Commercial Banking and Shadow Banking: The Accelerating Integration of Banks and Markets and Its Implications for Regulation

Abstract

In this chapter we examine the implications of the increasing integration of banks and financial markets for the evolution of each as well the design of prudential regulation. The growth of the use of depository-banking-originated mortgage-backed securities sold in the market and used as collateral to back short-term funding transactions in the shadow banking sector illustrates this intertwining of banks and markets, and the potential systemic risk dangers of this, as is apparent from the recent crisis. An important implication of this integration is that it is becoming more and more difficult to isolate banking risks from financial market risks. Building on contemporary theories of financial intermediation, relationship banking and securitization, we show how these theories inform us about the underlying causes of the seismic shifts that have occurred in financial markets in recent years, and what they suggest about the kinds of regulatory reforms that may be most fruitful. We end with a list of open research questions suggested by our analysis.

Keywords: Relationship banking, financial markets, integration, shadow banking, regulation