Shadow Banking and Financial Regulation

Abstract

The so-called “shadow banking” system arose over recent decades and achieved full bloom just prior to the recent financial crisis. That system proved unstable. And the shadow banking system was the central focus of the government’s emergency policy response to the crisis. Drawing on existing theory, this article argues that maturity transformation - the financing of longer-term financial assets with short-term (money-market) liabilities - is inherently unstable, and that this instability generates externalities. Consequently, government intervention may be warranted on grounds of economic efficiency. The article examines the efficiency characteristics of three potential approaches to policy intervention, which may be used alone or in combination: (i) ex ante risk constraints; (ii) ex post liquidity support; and (iii) insurance for short-term creditors. It shows that, under plausible assumptions, an insurance regime (supplemented with ex ante risk constraints to counteract the effects of moral hazard) is efficiency-maximizing. The proposed insurance regime would (i) make short-term liability insurance available to financial firms whose assets fall beneath a specified risk (volatility) threshold; and (ii) disallow financial firms whose assets exceed that threshold (and firms that are eligible for, but decline to participate in, the insurance regime) from funding themselves in the money markets. The article proposes functional criteria for establishing the efficiency-maximizing risk threshold.

Keywords: Shadow Banking, Financial Stability, Deposit Insurance