Confidence Banking ∗

Recently, a large unregulated ”shadow banking”, based on counterparty relations, flourished and then suddenly collapsed. In the absence of regulation, its existence hinges on confidence about counterparties’ good behavior, and such confidence hinges on counterparties’ reputation concerns. Even when reputation allows for a cheaper alternative to traditional banking – by saving on regulatory costs – its effects are fragile – its value depends on expected economic conditions and its formation depends on beliefs about other agents’ behavior. Financial regulation can enhance confidence and stabilize shadow banking by taxing low reputation firms and by subsidizing high reputation firms. ∗I thank V.V. Chari, Gary Gorton, Hanno Lustig, Motohiro Yogo and seminar participants at Minneapolis Fed, UCLA, Yale and the 2010 SED Meetings in Montreal for their comments. The usual waiver of liability applies. †Department of Economics. Yale University.