Shadow banking changes macro-prudential trade-offs – BdF paper

The shadow banking sector has a major impact on macro-prudential policy, a working paper published by the Banque de France finds.

In Welfare-based optimal macro-prudential policy with shadow banks, Stefan Gebauer presents a dynamic stochastic general equilibrium model for the eurozone. The model simulates a financial sector where credit can leak towards unregulated non-bank financial institutions.  

The presence of NBFIs, or “shadow banks”, raises the importance of credit stabilisation for financial regulators, Gebauer finds. Where macroeconomic shocks can lead to credit leakages from banks to NBFIs, regulators need to adjust dynamic capital requirements for financial institutions more strongly.

A “shadow banking sector” means regulators should impose lower static capital requirements on traditional banks than when they are not, he finds. Credit leakage to NBFIs may increase when nominal interest rates reach their effective lower bound.

The presence of NBFIs may increase financial market efficiency by reducing banks’ market power, he finds, but they can also increase systemic risk. A combination of NBFIs’ characteristics and the restraints on regulators “can accelerate financial stress and macroeconomic disturbances, and finally pose a threat to financial stability”.

Financial regulators cannot ignore the shadow banking sector, Gebauer says, without potentially weakening the effectiveness of their macro-prudential policies. Central banks also need to consider monetary policy’s impact on the sector, he says, given the possible effect of nominal interest rates on credit leakage.