Guillaume Plantin
Shadow banking and bank capital regulation
Review of Financial Studies | Volume 28, Issue 1 (Jan 2015), 146-175

The term “shadow banking system” refers to the institutions that do not hold a banking license, but perform the basic functions of banks by refinancing loans to the economy with the issuance of money-like liabilities. Roughly speaking, licensed banks refinance the loans that they hold on their balance sheets with deposits or interbank borrowing, whereas the shadow banking system refinances securities backed by loan portfolios with quasi-deposits such as money market funds shares.

Absent any prudential regulation, leverage—the fraction of total assets that is refinanced with such money-like liabilities—is much higher in the shadow banking system than in the licensed one. This higher leverage in turn makes the shadow banking system less stable. It is now well understood that the U.S. shadow banking system was the epicentre of the global financial crisis that erupted in 2008. An initial “run” on shadow institutions then propagated throughout the entire global banking system.

Perhaps surprisingly, the main response to the 2008 banking crisis consists thus far of a global trend towards increasing capital requirements for licensed banks, leaving many aspects of shadow banking unaddressed by regulatory reforms. 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.

The model

In “Shadow banking and bank capital regulation,” I offer a model of optimal banking regulation in the presence of regulatory arbitrage that can be used to assess this concern. The paper offers two mo delling contributions:

  1. It first builds a theory of bank capital regulation on the simple premise that the shareholders of banks, unlike those of other firms, internalize only a fraction of the total costs induced by a default on their liabilities. This in turn stems from the specific role of bank liabilities as money. Default by a given bank affects not only the depositors of this bank, but also other agents in the economy willing to trade with them using deposits as media of exchange. This implies that the optimal leverage of banks is lower than the one that bank shareholders would find privately optimal. In short, it is the difference in the nature of their liabilities that explains why the capital of banks is regulated while that of non-financial firms is not.
  2. The paper then introduces regulatory arbitrage by simply assuming that the regulator cannot monitor all the markets in which bank assets are refinanced with money-like liabilities. The small, but important, difference between the regulated and unregulated markets is that banks cannot commit not to use their material information about their assets in the latter because they are more opaque.
This modelling of shadow banking as unregulated banking captures parsimoniously the essence of regulatory arbitrage by banks. Regulatory arbitrage typically amounts to finding alternative legal and accounting classifications

for transactions that would be privately uneconomical given regulation under the standard classification, so that these transactions can be carried out outside the scope of regulation. For example, having money market funds with a fixed net asset value investing in commercial paper backed by asset-backed securities is economically close to the financing of loans by deposits, but legally, and therefore prudentially, quite different. In practice, these regulatory arbitrages exploit fine details and subtle loopholes in accounting rules and prudential regulations. These details vary over time, but the principle remains. Solving this model generates three main insights.

The insights

First, bank shareholders seek to bypass capital requirements and increase leverage on a loan portfolio in the shadow banking sector for two reasons. They may want to free up capital, or they may seek to exploit negative proprietary information about the portfolio. Heightened capital requirements for licensed banks make the former motive more likely than the latter, and thus alleviates informational frictions. As a result, tightening capital requirements spurs liquidity in the shadow banking sector.

Capital requirements should be lower with shadow banking

Second, the residual illiquidity premium in the shadow banking sector implies that a bank must transfer more risk per dollar raised in this sector than through its balance sheet. If capital requirements are tighter, banks substitute dollars raised through their balance sheets with dollars raised through the shadow banking sector. Because they transfer more risk per dollar raised by doing so, tightening capital requirements is overall counterproductive. It leads to an increase in the effective total leverage on loan portfolios. This implies that the optimal capital requirement for licensed banks is lower in the presence of a shadow banking system is typically lower than it would be if capital regulation was perfectly enforced.

Tightening Capital Requirements with shadow banking lowers the quality of collateral for unsecured creditors

Finally, if banks have more granular information than regulators about the riskiness of their assets, then tightening capital requirements in the presence of shadow banking also comes at the cost of an excessive encumbrance of their least risky assets. Banks find it preferable to refinance these safer assets in the shadow banking sector because their private information is less problematic for such assets that are therefore better collateral. Unsecured creditors, such as depositors (or deposit insurance funds), are then left with lower quality collateral.

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.