Banking and Shadow Banking

Tightening financial regulation squeezes banking activities into the shadow banking sector, which may hurt financial stability and production (Plantin, 2014). Unlike Plantin’s work, we investigate regulations that reduce banks’ leverage and dampen financial amplification effects. Moreover, our paper studies the trade-off between economic growth and financial stability in light of shadow banking within a continuoustime, macro-finance framework. Shadow banking modeled as off-balance-sheet financing has an enforcement problem. We demonstrate that this problem leads to an endogenous leverage constraint for shadow banking and that the constraint tightens in economic downturns, which in turn forces shadow banks to conduct asset fire sales.