The rule of law is important in policymaking because it ensures all actors are subject to the same rules. If regulations are applied inconsistently across actors in a regulated industry, this creates distortions that reduce the effectiveness of a given regulation (for better or worse, depending on the quality of the regulation).
In finance, the “shadow banking” sector, made up of institutions that engage in financial intermediation without access to traditional deposits, is so named because it is not subject to many of the regulations imposed on depository institutions. This leads to a natural question: if a regulation can’t be applied to a substantial portion of an industry, will inconsistent enforcement make the regulation a net loss?
In a new paper by Julien Bengui and Javier Bianchi, the authors find that in the case of a macroprudential tax on debt, it is still welfare maximizing to implement such a regulation even if a portion of the sector remains unregulated:
The outreach of macroprudential policies is likely limited in practice by imperfect regulation enforcement, whether due to shadow banking, regulatory arbitrage, or other regulation circumvention schemes. We study how such concerns affect the design of optimal regulatory policy in a workhorse model in which pecuniary externalities call for macroprudential taxes on debt, but with the addition of a novel constraint that financial regulators lack the ability to enforce taxes on a subset of agents. While regulated agents reduce risk taking in response to debt taxes, unregulated agents react to the safer environment by taking on more risk. These leakages undermine the effectiveness of macroprudential taxes but do not necessarily call for weaker interventions. A quantitative analysis of the model suggests that aggregate welfare gains and reductions in the severity and frequency of financial crises remain, on average, largely unaffected by even significant leakages.
While the lack of uniform enforcement increases the risk of financial crises, the effects “are not powerful enough to overturn” the overall benefits to the financial system compared to weaker or no regulations.
Regulating (or even defining, in some cases) “shadow banks” is a tricky task that nonetheless has an important influence on overall financial stability. Nevertheless, the paper’s results show that, even if implemented imperfectly, well-designed regulations (particularly the market-friendly debt tax used in the paper) can still improve financial stability.