Shadow Interconnectedness: The Political Economy of (European) Shadow Banking

Abstract

Political economy approaches to shadow banking should take into account interconnectedness. Rather than tracing institutions crossing porous regulatory perimeters, analytical efforts would be better placed to theorize collateral networks, the institutions that act as key nodes in those networks, and the common exposure they generate. The paper argues that the collateral intensive nature of shadow banking generates two mechanisms of interconnectedness: the risk management framework and the re-use/re-hypothecation channel. Both have systemic implications, together generating an important political conflict for the management of shadow banking because private leverage is born in, and can destabilize, government debt markets. Collateral-intensive finance thus confronts central banks and governments with a deeply political question: what governance arrangement is best suited to manage the systemic risks generated through shadow activities that blur the lines between financial stability policy and fiscal policy? Institutional innovations that ensure coordination between the central bank and government work best to manage ‘shadow’ interconnectedness.

Keywords: shadow banking, interconnectedness, repo markets, collateral networks, government debt market, European banking, European Central Bank, safe assets

JEL Classification: E58, E63, F36, G15, G18, G21, H10