Regulating the Shadow Banking System

Yale authors show us how it could be done.

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905290_throwing_a_shadowA new paper by Gary B. Gorton and Andrew Metrick, both from the Yale School of Management and the National Bureau of Economic Research (NBER), proposes a model for regulating the shadow banking system. Their main focus is the use of collateral for securitization and repo – the authors believe it should be tightly regulated and show us how they think that ought to happen. The abstract is below. The paper can be downloaded for free at SSRN.

Abstract:

The “shadow” banking system played a major role in the financial crisis, but was not a central focus of the recent Dodd-Frank Law and thus remains largely unregulated. This paper proposes principles for the regulation of shadow banking and describes a specific proposal to implement those principles. We first document the rise of shadow banking over the last three decades, helped by regulatory and legal changes that gave advantages to the main institutions of shadow banking: money-market mutual funds to capture retail deposits from traditional banks, securitization to move assets of traditional banks off their balance sheets, and repurchase agreements (“repo”) that facilitated the use of securitized bonds in financial transactions as a form of money. All of these features rely on an evolution of the bankruptcy code that allows securitized bonds to be used as a form of privately created money in large financial transactions, a usage that can have significant efficiency gains and would be costly to eliminate. History has demonstrated two successful methods for the regulation of privately created money: strict guidelines on collateral (used to stabilize national bank notes in the 19th century), and government-guaranteed insurance (used to stabilize demand deposits in the 20th century). We propose the use of strict rules on collateral for both securitization and repo as the best approach for shadow banking, with compliance required in order to enjoy the safe-harbor from bankruptcy.

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