Shadow Banking

Shadow banking is often defined by reference to what is not, namely official banking. This essay takes a different approach. Focusing on the purpose of shadow banking regulation, namely minimizing systemic risk, shadow banking is defined as leveraging on collateral to support liquidity promises.

This essay discusses the economic case for regulating shadow banking by asking three questions. First, what is shadow banking? Second, why regulate shadow banking? Third, how to regulate shadow banking efficiently? It is argued that shadow banking should be regulated because the social cost of systemic risk is not internalized by the players generating it. Moreover, because systemic risk cannot be accurately measured and priced, this essay argues that the negative externalities of shadow banking should be limited through quantity regulation – restrictions on the size of shadow banking – rather than corrective taxation.