Shadowy Banking: Theft by Safety Net

Abstract

Shadowy Banking is financial activity that is engineered to extract implicit subsidies from government safety nets. It substitutes innovative corporate entities and products for activities that could be performed more straightforwardly within a traditional banking firm. The shadows obscure organizational forms and transactions strategies that circumvent regulatory restraints and extract subsidies by regulation-induced innovation. Because government support kicks in when private equity is exhausted, safety nets are implicit contracts that offer loss-absorbing equity capital from taxpayers. Unlike lenders and insurers who assess and absorb risk, taxpayers accept unquantifiable Knightian uncertainty. As coerced equity investors whose liability is unlimited, taxpayers would be better served if information systems and corporate law were revised to give them at least the same safeguards and rights of disclosure that minority shareholders enjoy.

Keywords: shadow banking, regulatory arbitrage, financial reform, regulation-induced innovation

JEL Classification: G21, G28, G34, E58, L89