The Economics of Shadow Banking

Coined under the rubric of “shadow banking,” the nonbank/bank nexus is largely seen as a form of regulatory arbitrage. However this is an incomplete view since there is genuine economic demand for such services. This paper attempts to explain the economics that supports the demand/supply for this market, the systemic risks that can arise, and regulatory and broader policy implications. Current regulatory approaches are actively pushing banks away from shortterm, secured, wholesale funding markets and incentivizing them to issue more deposits and term funding. The likely result would be that riskier activities move outside the banking system. Thus, understanding and correctly mapping the shadow banking system will become even more important for policymakers.