“Shadow Banking and Bank Capital Regulation” by Guillaume Plantin
Toulouse School of Economics and CEPR
This paper studies the prudential regulation of banks in the presence of a shadow banking system. If banks do not internalize all the costs that risks on deposits create for the economy, imposing capital requirements on banks is welfare improving in principle. We suppose that banks can use the shadow banking system to bypass such capital requirements, albeit at an informational cost. If it is not possible to regulate the shadow banking system at all, then relaxing capital requirements so as to shrink shadow activity may be more desirable than tightening them. Such a tightening creates a surge in shadow banking that may overall increase financial fragility, and reduce welfare. If it is possible to impose a haircut on refinancings in the shadow banking system, then overall welfare increases but the shareholders of traditional banks are much worse off. They would therefore strongly oppose any shadow-banking regulation.