Financial regulation and shadow banking: A small-scale DSGE perspective

In this paper, we revisit the role of regulation in a small-scale dynamic stochastic general equilibrium (DSGE) model with interacting traditional and shadow banks. We estimate the model on US data and we show that shadow banking interferes with macro-prudential policies. More precisely, asymmetric regulation causes a leak towards shadow banking which weakens the expected stabilizing effect. A counterfactual experiment shows that a regulation of the whole banking sector would have reduced investment fluctuations by 10% between 2005 and 2015. Our results therefore suggest to base  regulation on the economic functions of financial institutions rather than on their legal forms.

KEYWORDS: Shadow Banking, DSGE models, Macro-prudential Policy.
JEL CLASS.: C32, E32.