Regulating the Shadow Banking System

Abstract

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.

Keywords: Shadow Banking, Financial Crisis, Bank Regulation

JEL Classification: G1, G2