“Banking and Shadow Banking” by Ji Huang
National University of Singapore
Does stringent financial regulation always secure financial stability? No, not when shadow banking plays a role. This paper incorporates shadow banking modeled as off-balance-sheet financing in a standard continuous-time macro-finance model. In this model, regular banks pursue regulatory arbitrage by extending their businesses outside the regulatory perimeter via shadow banking. The absence of regulatory authorities in the shadow banking sector creates an enforcement problem. We show that the enforcement problem gives rise to an endogenous constraint on leverage for shadow banking. Shadow banking adds to financial instability because tightening market discipline in economic downturns forces shadow banks to sell assets at fire-sale prices to regular banks. Overall, financial instability as a function of financial regulation is U-shaped rather than monotonically decreasing as conventional wisdom predicts. This paper proposes a framework that can comprehensively evaluate the impact of different regulatory regimes on both the regulated and unregulated banking sectors.