Shadow Banking and Bank Capital Regulation
Hong Kong Institute for Monetary and Financial Research (HKIMR) Research Paper WP No. 32/2014
Review of Financial Studies, Volume 28, Issue 1, January 2015, Pages 146-175
39 Pages Posted: 2 Jan 2015 Last revised: 1 Aug 2022
Date Written: December 31, 2014
Abstract
This working paper was written by Guillaume Plantin (Sciences Po Paris, Centre for Economic Policy Research and Hong Kong Institute for Monetary Research).
Banks are subject to capital requirements because their privately optimal leverage is higher than the socially optimal one. This is in turn because banks fail to internalize all the costs that their insolvency creates for the non-financial agents using their money-like liabilities to settle transactions. If banks can bypass capital regulation in an opaque shadow-banking system, it may be optimal to relax capital requirements so that liquidity dries up in the shadow-banking system. Tightening capital requirements may spur a surge in shadow-banking activity that leads to an overall larger risk on the money-like liabilities of the formal and shadow banking institutions.
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