Alessio M. Pacces

Hossein Nabilou

Erasmus University Rotterdam, School of Law

University of Luxembourg, Faculty of Law, Economics, and Finance

The Law and Economics of Shadow Banking

18/03/2020

This essay discusses the economic case for regulating shadow banking. Focusing on systemic risk, shadow banking is defined as leveraging on collateral to support liquidity promises. Regulating shadow banking is efficient because of the negative externality stemming from systemic risk. However, because uncertainty undermines the precise measurement of systemic risk, quantity regulation is preferable to a Pigovian tax to cope with this externality. This paper argues that regulation should limit the leverage of shadow banking mainly by imposing a minimum haircut regulation on the assets being used as collateral for funding.

I. INTRODUCTION

This paper deals with the economic rationale for regulating shadow banking. It discusses whether the regulatory initiatives proposed by academics and policymakers are consistent with this rationale. We posit that the ultimate goal of financial regulation is to promote financial stability. Therefore, we evaluate shadow banking regulation based on its ability to reduce financial instability efficiently.

 

Regulating shadow banking is challenging because shadow banking is often defined by reference to what it is not, namely licensed or official banking. However, such an approach does not capture the essence of the shadow banking problem. The official banking system has implicitly or explicitly supported a significant part of what is known today as shadow banking. For instance, the Asset Backed Commercial Paper (ABCP) conduits or the Structured Investment Vehicles (SIV), which were exposed to the U.S. housing market during the Global Financial Crisis (GFC), all enjoyed guarantees by banks – so-called ‘put options’ – by way of contract or reputation. The remainder of shadow banking was still problematic for financial stability because of the contracts in which shadow banks were counterparty to banks. American International Group (AIG), for instance, was counterparty to a significant part of the banking system relying on Credit Default Swaps (CDS) to insure against the default of Mortgage Backed Securities (MBS).

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