2010b_bpea_gorton - 261 GARY GORTON Yale University ANDREW...

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Unformatted text preview: 261 GARY GORTON Yale University ANDREW METRICK Yale University Regulating the Shadow Banking System ABSTRACT The shadow banking system played a major role in the recent financial crisis but remains largely unregulated. We propose principles for its regulation and describe a specific proposal to implement those principles. We document how the rise of shadow banking was helped by regulatory and legal changes that gave advantages to three main institutions: money-market mutual funds (MMMFs) to capture retail deposits from traditional banks, securitization to move assets of traditional banks off their balance sheets, and repurchase agreements (repos) that facilitated the use of securitized bonds as money. The evolution of a bankruptcy safe harbor for repos was crucial to the growth and efficiency of shadow banking; regulators can use access to this safe harbor as the lever to enforce new rules. History has demonstrated two successful methods for regulating privately created money: strict guidelines on collateral, and government-guaranteed insurance. We propose the use of insurance for MMMFs, combined with strict guidelines on collateral for both securitization and repos, with regulatory control established by chartering new forms of narrow banks for MMMFs and securitization, and using the bankruptcy safe harbor to incentivize compliance on repos. A fter the Great Depression, by some combination of luck and genius, the United States created a bank regulatory system that oversaw a period of about 75 years free of financial panics, considerably longer than any such period since the founding of the republic. When this quiet period finally ended in 2007, the ensuing panic did not begin in the traditional sys- tem of banks and depositors, but instead was centered in a new “shadow” banking system. This system performs the same functions as traditional banking, but the names of the players are different, and the regulatory structure is light or nonexistent. In its broadest definition, shadow banking includes such familiar institutions as investment banks, money-market mutual funds (MMMFs), and mortgage brokers; some rather old contractual forms, such as sale-and-repurchase agreements (repos); and more esoteric instruments such as asset-backed securities (ABSs), collateralized debt obligations (CDOs), and asset-backed commercial paper (ABCP). 1 Following the panic of 2007–09, Congress passed major regulatory reform of the financial sector in the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. Dodd-Frank includes many provisions relevant to shadow banking; for example, hedge funds must now register with the Securities and Exchange Commission (SEC), much over-the- counter derivatives trading will be moved to exchanges and clearinghouses, and all systemically important institutions will be regulated by the Federal Reserve. Retail lenders will now be subject to consistent, federal-level regulation through the new Consumer Financial Protection Bureau housed...
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This note was uploaded on 03/10/2012 for the course ECON 122 taught by Professor Nordhaus during the Fall '10 term at Yale.

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2010b_bpea_gorton - 261 GARY GORTON Yale University ANDREW...

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