Financial Regulation and Shadow Banking: A Small-Scale DSGE Perspective

By Patrick Fève and Olivier Pierrard

In this paper, we revisit the role of regulation in a small-scale dynamic stochastic general equilibrium (DSGE) model with interacting traditional and shadow banks. We estimate the model on US data and we show that shadow banking interferes with macro-prudential policies. More precisely, asymmetric regulation causes a leak towards shadow banking which weakens the expected stabilizing effect. A counterfactual experiment shows that a regulation of the whole banking sector would have reduced investment fluctuations by 10% between 2005 and 2015. Our results therefore suggest to base regulation on the economic functions of financial institutions rather than on their legal forms.

Regulators and banks play a cat and mouse game, and I wonder whether to adopt a rule like “if it looks like a bank, regulate as a bank” would work. But this is a good attempt at tackling the shadow banking sector, which is difficult to track properly both in real life and as a modeler.


One Response to Financial Regulation and Shadow Banking: A Small-Scale DSGE Perspective

  1. pierrard says:

    This is indeed a quite theoretical rule. For instance, the model assumes full information, i.e. the regulator knows perfectly the existence, the economic function, as well as the size of the shadow banking. In this case, it is easy to implement a “global” regulation. When the regulator is not aware of part of the shadow sector and/or that the shadow may easily switch to another economic function, a “believed as global” regulation would stimulate the development of shadow banking activity, which is probably not the purpose of the regulator. This might be an interesting extension.

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