The Unintended Consequences of Banking Regulations: Shadow Banking

May 26, 2022

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Shadow banks are not subject to the stringent regulation that traditional banks are and can pose great risks to the financial system. Since the financial crisis, banking regulations have been tightened to reduce the fragility of the financial system. However, an unintended consequence is that tighter regulations, such as higher bank capital requirements, can cause an expansion of shadow banking activity. This effect, if large enough, may offset the intended impact of regulation. The overall impact of recent regulatory changes on systemic risk of the financial system is therefore less clear. In this Regulatory Insight, I discuss the interaction between regulation of traditional banks and shadow banking by reviewing a few recent papers modeling bank capital requirements and shadow banking. These studies suggest important implications for optimal regulatory policy. Although tightening capital requirements may lead to an increase in a larger shadow banking sector, it can still have an aggregate welfare-improving effect. However, the presence of shadow banking indeed poses more uncertainty and challenges to the supervision of financial institutions.