Shadow Banks and Systemic Risks

55 Pages Posted: 31 Jan 2016

See all articles by Rui Gong

Rui Gong

Indiana University

Frank H. Page

Systemic Risk Centre, LSE; Indiana University, Bloomington - Department of Economics

Date Written: July 23, 2015

Abstract

We answer the following question: Does regulating the banking network increase systemic risk in the entire financial network in the presence of unregulated shadow banks? In order to answer this question, we introduce a formal definition of systemic risk based on the equilibrium state dynamics generated by a dynamic, stochastic game of network formation with banks, shadow banks, and the real economy as players. Based on the equilibrium dynamics, we discuss the properties of equilibrium financial networks. The predictions of the model are consistent with empirical evidence in the literature. Our analysis makes clear the systemic importance of connections between commercial banks and shadow banks in determining the health of the entire financial network. Lastly, but most importantly, we give a definition of systemic risk based on equilibrium dynamics, and therefore, a definition which takes into account the strategic interactions of financial institutions when facing different regulatory policies. Given our definition of systemic risk, we discuss various policies for regulating the financial system. Then, specializing our dynamic stochastic game model to a more basic model in which banks and shadow banks form a network including connections to the real economy, we show, via numerical simulations of our stochastic game model under various regulatory regimes, that imposing bank regulations not faced by shadow banks does indeed increase systemic risk throughout the financial network.

Keywords: Systemic Risk, Shadow Banking Regulation, Discounted Stochastic Games, Endogenous Network Formation, Multi-layered Financial Networks

JEL Classification: D85, G32

Suggested Citation

Gong, Rui and Page, Frank H., Shadow Banks and Systemic Risks (July 23, 2015). Available at SSRN: https://ssrn.com/abstract=2724314 or http://dx.doi.org/10.2139/ssrn.2724314

Rui Gong

Indiana University ( email )

Bloomington, IN
United States

Frank H. Page (Contact Author)

Systemic Risk Centre, LSE ( email )

Houghton St
London, WC2A 2AE
United Kingdom

HOME PAGE: http://www.systemicrisk.ac.uk/

Indiana University, Bloomington - Department of Economics ( email )

Wylie Hall
Bloomington, IN 47405-6620
United States

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