Wednesday, October 29, 2014

Shadow Banking: Less is More.

Is Deregulation the Most Effective Way to Deal with Shadow Banking?

These heightened capital requirements for licensed banks may trigger even more regulatory arbitrage than was observed in the recent past, thereby inducing a large migration of banking activities towards the shadow banking system. The higher solvency of the licensed banking system may then be more than offset by such growth in shadow banking, ultimately increasing the aggregate exposure of the money-like liabilities issued by both the formal and shadow banking sectors to shocks on loans.



It has generally been acknowledged that shadow banking was the “epicenter for the global financial crisis." High leverage made the shadow banking system fragile, and an initial run on shadow institutions was then transmitted throughout an interconnected global banking system. Despite this bit of now seemingly conventional wisdom, the primary response from regulators to the financial crisis has been to increase the capital requirements for chartered banks.  A new paper by Guillaume Plantin of the Toulouse School of Economics and CEPR posits that this seemingly misplaced focus not only leaves many aspects of shadow banking unaddressed by regulators, but also may foster more regulatory arbitrage and drive more banking activities to the shadow banking system.


In his paper, “Shadow Banking and Bank Capital Regulation,” Plantin bases his entire premise on one major assumption. He assumes that regulatory arbitrage can never be eliminated fully because of the diversity of regulators and the creativity and resourcefulness of banks. Based on this assumption, Plantin then proposes that by relaxing rather than tightening banking regulations, we drive financing and leverage activities away from the shadow banking sector back into the traditional banking sector where regulators can monitor it.  

According to Plantin’s abstract:







Banks are subject to capital requirements because their privately optimal leverage is higher than the socially optimal one.  This is in turn because banks fail to internalize all costs that their insolvency creates for agent who use their money-like liabilities to settle transactions. If banks can bypass capital regulation in a an opaque shadow banking sector, it may be optimal to relax capital requirements so that liquidity dries up in the shadow banking sector.  Tightening capital requirements may spur a surge in shadow banking activity that leads to an overall larger risk on the money-like liabilities of the formal and shadow banking institutions.


Plantin’s controversial premise, that it is impossible to regulate the shadow banking system effectively, leads him to the even more controversial conclusion that the only way to reduce reliance on shadow banking by traditional banks is to relax capital requirements.  








This paper is an attempt at taking the possibility of imperfect enforcement seriously in a model of bank regulation. The motivation is that the banking industry devotes important resources to regulatory arbitrage, and that it is difficult for supervisory authorities to match these resources. This was particularly obvious in the years leading to the 2008 crisis. There is little evidence that enforcement and supervision have been much strengthened by financial reforms since then. Regulatory arbitrage is thus likely to remain an important dimension of banking, and realistic economic models of financial regulation should take this dimension into account.