The Law and Economics of Shadow Banking

This essay discusses the economic case for regulating shadow banking. It asks three questions. First, what is shadow banking? Second, why shadow banking should be regulated. Third, how to regulate shadow banking efficiently.
Although shadow banking is, like banking, based on maturity transformation, no definition of shadow banking is ideal for regulatory purposes. Focusing on systemic risk, we take an instrument-based approach and define banking as leveraging on collateral to support liquidity promises. For regulation to be effective, however, this definition must be combined with other entity-based approaches.
The economic rationale for regulating shadow banking is the negative externality stemming from systemic risk. Because uncertainty makes any measure of systemic risk imprecise, quantity regulation is preferable to a Pigovian tax to cope with this externality. Regulation should limit the leverage of shadow banking by imposing a minimum haircut regulation on the assets being used as collateral for funding.
In theory, minimum haircuts regulation is an efficient way to constrain shadow banking. However, the practical difficulties of monitoring leverage at the assets level call for an indirect regulation of institutional leverage, too. This is effectively achieved through the regulation of bank leverage, which increases the cost of liquidity puts to shadow banking. Such risk-insensitive restrictions, however, undermine the efficiency of banking, whether official or shadow.