The Law and Economics of Shadow Banking

In our recent ECGI-Law working paper, ‘The Law and Economics of Shadow Banking’, we discuss the economic case for regulating shadow banking. Our paper asks three questions. First, what is shadow banking? Second, why shadow banking should be regulated. Third, how to regulate shadow banking efficiently. We focus on systemic risk, defined as the likelihood of a financial system failure of such proportions as to impair the financing of production and consumption. We argue that such a risk can never be measured with a precision sufficient to predict financial crises. Our paper identifies shadow banking based on its contribution to systemic risk. It argues that shadow banking should be regulated because the social cost of systemic risk is not internalized by the actors generating it. Moreover, because systemic risk can only imperfectly be measured, and thus priced, our paper argues that shadow banking should be curbed by quantity regulation.

We take a macro perspective to the economics of banking and derive regulatory implications from there. Thus, our paper contributes to the literature that seeks to incorporate macroeconomics into the economic analysis of law, such as the legal theory of finance or law and macroeconomics.

Shadow banking contributes to systemic risk by promising cash immediacy, or safety, against long-term, risky investments. This is maturity transformation broadly intended, and is what banks typically do. Because banks profit from transforming debts (long-term into short-term, risky into safe), they are highly leveraged. Whereas leverage is restricted for official banking, it is less so for shadow banking. In order to make their promises credible, however, shadow banks need to rely on the liquidity put by official banks, or on collateral. The promise of immediacy requires that this collateral be liquid. When this is no longer the case, a financial crisis occurs. Liquidity and leverage are thus the defining features of banking, both official and shadow, and the source of its vulnerability. We define banking as the business of leveraging on collateral to support liquidity promises. This becomes shadow banking when it avoids the regulation of liquidly and leverage imposed on banks for the purpose of financial stability.

Shadow banking caters to a global demand for safe assets, which cannot be met by official banking. Therefore, a ban on shadow banking would be inefficient. However, shadow banks tend to overproduce safe assets because they do not bear the social cost of this production. The law and economics of shadow banking deals with correcting this negative externality. We focus on collateral because that enables independent shadow banking and is ultimately responsible for financial crises. The problem stems from the promise of liquidity backed by securities which are deemed safe according to a risk model. The latter commands a haircut on the market value of the securities to make them good collateral. Upon materialization of tail risk, however, a collateral crisis ensues, wherein lenders run on shadow banks by raising haircuts. Eventually, the securities may be no longer accepted as collateral for funding. Such runs can only be stopped by a central bank that can recreate the perception of safety. Showing willingness to buy any quantity of the distressed assets at a given price, this central bank sets an upper limit on haircuts and, by stabilizing the price of the assets being levered upon, stops a financial crisis.

Unfortunately, by stopping a collateral crisis, the central bank suspends market discipline, too. This could lead to moral hazard, which would exacerbate the negative externalities of shadow banking. To address this problem, some commentators have proposed to charge a premium for the liquidity insurance offered by the central bank. To operationalize this levy, access to collateral for short-term funding should be restricted. This could be done by restricting collateralized borrowing to a special class of financial institutions, which would be regulated, and pay for insurance, like banks do for deposit insurance. Alternatively, a Pigovian tax could be levied as a condition for collateral to enjoy the bankruptcy law privileges that make it attractive for backing the liabilities of shadow banking.

We believe that charging for the liquidity insurance by a central bank is not an effective and an efficient way to regulate shadow banking. First of all, because systemic risk can only be measured imperfectly, such insurance could not be priced accurately. Second, the threat to withhold the insurance when the premium has not been paid would not be credible in the presence of a systemic event. Both circumstances are conducive to moral hazard. Third, because the economic definition of collateral is broader than the legal definition, and evolves with time, moral hazard cannot be controlled ex-ante through bankruptcy law restrictions. To cope with the externalities of shadow banking, we instead advocate quantity regulation. Quantity regulation is more efficient than a Pigovian tax to cope with externalities when the social cost is difficult to estimate, as the contribution of shadow banks to systemic risk is. Moreover, quantity regulation is relatively easy to implement via a single policy variable, which is leverage. We argue that shadow banking should be regulated indirectly, by capping the admissible leverage on the assets that can be pledged as collateral.

We argue that a combination of instrument-based and entity-based regulation is necessary to constrain shadow banking effectively. First, minimum haircuts should be established on the collateral backing money-like liabilities. Second, because such liabilities could be accepted without collateral, leverage should be restricted also at the level of the entities making liquidity promises. In practice, this implies pricing the liquidity put from official banks to off-balance-sheet vehicles, which is already a consequence of the implementation of Basel III.  

Our approach to shadow banking has the key advantage of covering all parts of the financial system which will require a backstop in the event of a crisis. These are the assets being levered to promise liquidity and the banks that back such liquidity promises. Financial innovation must use one of these channels to create private money, which is likely to create systemic risk. However, we acknowledge that designing an optimal regulation of shadow banking faces two important challenges. First, it is difficult to identify the optimal levels of asset and institutional leverage. Second, it is even more difficult to adapt these levels to new circumstances. These challenges also apply to the regulation of banking in general.

Hossein Nabilou is a Postdoctoral researcher at the Faculty of Law, Economics, and Finance of the University of Luxembourg.

Alessio M. Pacces is the Professor of Law and Finance at the Erasmus School of Law, Erasmus University Rotterdam.