The Law and Economics of Shadow Banking

In our recent paper, we discuss the economic case for regulating shadow banking and ask three questions. First, what is shadow banking? Second, why should it be regulated? And third, what’s an efficient way to regulate it? We focus on systemic risk, defined as the likelihood of a financial system failure so serious that it impairs the financing of production and consumption. We argue that such a risk can never be measured precisely enough to predict financial crises.

Our paper examines shadow banking on the basis of its contribution to systemic risk. We argue that shadow banking should be regulated because it does not internalize the social cost of the systemic risk it generates. Moreover, because systemic risk cannot be accurately measured and priced, we argue that the externalities of shadow banking should be limited through quantity regulation — restrictions on the size of shadow banking – rather than  taxation.

Our conclusions are based on a macro perspective of the economics of banking. 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 immediate cash and, therefore, safety against long-term risky investments. Banks typically serve this function and, because they profit from transforming debts (long-term into short-term, risky into safe), are highly leveraged. But while leverage is restricted for banks, it is not for shadow banks to as great a degree. In order to make their promises credible, shadow banks must rely on liquidity supplied by ordinary banks or, alternatively, on collateral, which must be liquid. When this is no longer the case, a financial crisis occurs. Liquidity and leverage are thus the defining features of banking, both ordinary 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 lacks the regulation of liquidity and leverage imposed on banks for the purpose of financial stability.

Shadow banks cater to a global demand for safe assets, which cannot be met by ordinary banks. 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 doing so. The law and economics of shadow banking deals with correcting this negative externality. We focus on collateral because that makes independent shadow banking possible 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 margin of safety, a so-called “haircut,” on the market value of the securities before they are considered good collateral. When tail risk occurs, 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 restore the perception of safety. The central bank helps avoid a financial crisis by being willing to buy any quantity of the distressed assets at a given price, setting an upper limit on the  haircuts, and hence stabilizing the price of the assets being leveraged.

Unfortunately, the central bank’s actions also suspend market discipline leading to moral hazard exacerbating the negative externalities of shadow banking. To address this problem, some commentators have proposed to charge a premium for liquidity insurance from the central bank. To put this levy into effect, 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 as banks do for deposit insurance. Alternatively, to correct the negative externalities, a so-called “Pigovian tax” could be levied as a condition of allowing the collateral to the bankruptcy protections that make it attractive as security for shadow banking.

We don’t believe that charging for the liquidity insurance provided by a central bank would be an effective or efficient way to regulate shadow banking. First, because systemic risk cannot be measured precisely, such insurance could not be priced accurately. Second, the threat to withhold the insurance when the premium had not been paid would not be credible during 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 deal with the externalities of shadow banking, we advocate quantity regulation. Quantity regulation is more efficient than a Pigovian tax to correct negative externalities when the social cost of these externalities is difficult to estimate, as is the case with the contribution of shadow banks to systemic risk. Moreover, quantity regulation is relatively easy to implement through leverage restrictions. We argue that shadow banking should be regulated indirectly, by capping the permissible leverage on the assets that can be pledged as collateral.

We argue that a dual form of regulation is necessary to constrain shadow banking effectively. First, minimum haircuts should be established for the collateral backing cash-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 unconditional liquidity guarantee (so-called “liquidity put”) from official banks to their off-balance-sheet vehicles, which Basel III already requires.

Our approach to shadow banking has the advantage of covering all elements of the financial system requiring a backstop in the event of a crisis. Those elements are the assets being levered to create liquidity and the banks backing such liquidity. However, we acknowledge that designing an optimal regulation for shadow banking faces two important challenges. First, it is difficult to identify the right level of leverage for assets and institutions. Second, it is even more difficult to adapt these levels to changing circumstances. These challenges also apply to the regulation of banks in general.

This post comes to us from Hossein Nabilou, a postdoctoral researcher at the Faculty of Law, Economics, and Finance of the University of Luxembourg and a research scholar at Columbia Law School, and from Alessio M. Pacces, the professor of law and finance at the Erasmus School of Law, Erasmus University Rotterdam. The post is based on their recent paper, “The Law and Economics of Shadow Banking,” available here.

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