Shadow banking and financial regulation: A small-scale DSGE perspective

This paper estimates a small-scale DSGE model of the US economy with interacting traditional and shadow banks. We find that shadow banks amplify the transmission of structural shocks by helping escape constraints from traditional intermediaries. We show how this leakage toward shadow entities reduces the ability of macro-prudential policies targeting traditional credit to reduce economic volatility. A counterfactual experiment suggests that a countercyclical capital buffer, if applied only to traditional banks, would have in fact amplified the boom-bust cycle associated with the financial crisis of 2007–2008. On the other hand, a broader regulation scheme targeting both traditional and shadow credit would have helped stabilize the economy.