Shadow Banking and Bank Capital Regulation

Banks are subject to capital requirements because their privately optimal leverage is higher than the socially optimal one. This is in turn because banks fail to internalize all costs that their insolvency creates for agents who use their money-like liabilities to settle transactions. If banks can bypass capital regulation in an opaque shadow banking sector, it may be optimal to relax capital requirements so that liquidity dries up in the shadow banking sector. Tightening capital requirements may spur a surge in shadow banking activity that leads to an overall larger risk on the money-like liabilities of the formal and shadow banking institutions. (JEL G01, G21, G28) The U.S. banking system now features two components of equal importance, traditional banks and the so-called “shadow banking system. ” This term refers to the nexus of financial institutions that perform the function of traditional banks by financing loans with the issuance of money-like liabilities while not being subject to the prudential regulation of banks. Pozsar et al. (2010) offer an excellent detailed description of the shadow banking system, and show that its total liabilities have the same order of magnitude as that of the traditiona