Banking and Shadow Banking: Sciencedirect

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Journal of Economic Theory 178 (2018) 124–152
www.elsevier.com/locate/jet
Banking and shadow banking

Ji Huang 1
The Chinese University of Hong Kong, China
Received 25 January 2017; final version received 3 September 2018; accepted 11 September 2018
Available online 13 September 2018
Abstract
This paper incorporates shadow banking modeled as off-balance-sheet financing in a continuous-time
macro-finance framework. Regular banks pursue regulatory arbitrage via shadow banking, and they support
their shadow banks with implicit guarantees. We show that an enforcement problem with implicit guarantees
gives rise to an endogenous constraint on leverage for shadow banking. Our model captures that shadow
banking is pro-cyclical and that shadow banking increases endogenous risk. Tightening bank regulation in
our model increases the borrowing capacity of shadow banking and financial instability. Furthermore, we
show that a limited degree of aggregate risk sharing does not improve financial stability in the presence of
shadow banking.
© 2018 Elsevier Inc. All rights reserved.
JEL classification: E44; G21; G24; G38
Keywords: Shadow banking; Implicit guarantee; Bank regulation; Endogenous risk
E-mail address: [email protected].

1 I am deeply grateful to Markus Brunnermeier, Yuliy Sannikov, and Mark Aguiar for their guidance and
encouragement. I also thank Filippo De Marco (discussant), Sebastian Di Tella, Mikhail Golosov, Nobu Kiyotaki,
Valentin Haddad, Ben Hebert (discussant), Zongbo Huang, John Kim, Michael King, Xuyang Ma, Matteo Maggiori,
Hyun Song Shin, Eric Stephens (discussant), Wei Xiong, Yu Zhang, and all seminar participants at the Princeton Finance
Student Workshop, National University of Singapore, Chinese University of Hong Kong, Richmond Fed, Hong Kong
University, MFM Meeting May 2013 and May 2014, 2015 Shanghai Macroeconomics Workshop, 11th World Congress
of the Econometric Society, 2016 AEA annual meeting, and Stanford GSB Junior Workshop on Financial Regulation
and Banking. Comments from the editor, the associate editor, and two referees have improved the paper substantially.
Contact details: 9/F, Esther Lee Building, The Chinese University of Hong Kong, Shatin, N.T., Hong Kong, China.
https://doi.org/10.1016/j.jet.2018.09.003
0022-0531/© 2018 Elsevier Inc. All rights reserved.
J. Huang / Journal of Economic Theory 178 (2018) 124–152 125
0. Introduction
The 2007-09 global financial crisis underlined the significance of shadow banking for both
financial stability and bank regulation. Although shadow banking is not a well-defined concept,
many experts agree that regulatory arbitrage is one of its main drivers (Acharya et al., 2012;
Gorton and Metrick, 2010; Pozsar et al., 2010). Following this idea, we regard shadow banking in
this paper as off-balance-sheet financing that banks use for economizing their regulatory capital.
Regulatory arbitrage offered by shadow banking is not free as it brings with it an enforcement
problem. As credit enhancement, banks promise that they will protect their off-balance-sheet
entities in trouble. These promises, typically referred to as implicit guarantees, have been widely
used in various segments of the shadow banking sector such as asset-backed commercial paper
(ABCP), money market mutual funds (MMF), and securitization.2 The enforcement problem
with implicit guarantees exists because these promises cannot be incorporated into any contract
that a third party would enforce. If such promises were explicit, the arbitrage opportunity would
disappear because regulatory authorities would consider off-balance-sheet debt in the same way
as banks’ on-balance-sheet obligations like deposits.
In this paper, we explore the implications of shadow banking for both financial stability and
bank regulation within the continuous-time macro-finance framework proposed by Brunnermeier
and Sannikov (2014). The framework offers an ideal setup for three reasons. First, it allows us
to characterize the full dynamics of an economy with an enforcement problem. Second, the
financial amplification effect, i.e., endogenous risk, emphasized in this framework is suitable
for the analysis of financial instability caused by the amplification effect. As shadow banking
activities affect financial amplification, the framework captures the link between shadow banking
and financial stability. Third, the financial amplification effect leads to a market inefficiency that
calls for bank regulation.
On the empirical side, our model captures two facts of shadow banking that we observed in the
run-up to and during the 2007-09 financial crisis. First, shadow banking is pro-cyclical. Acharya
et al. (2012) and McCabe (2010) document the boom and bust of ABCP and MMF markets
respectively. According to the author’s own calculations, the ratio of securitization undertaken by
private issuers in the U.S. rose from 13% in early 2003 to 22% in the middle of 2007.3 However,
this rising trend completely reversed in the 2007-09 financial crisis with the ratio dropping to 17%
by the end of 2009. The second fact is the reintermediation process that shadow banks conducted
fire sales of assets to traditional banks during the crisis. He et al. (2010) estimate that hedge
funds and broker-dealers reduced their holdings of securitized assets by $800 billion, while the
traditional banking sector raised its holding of securitized assets by $500 billion. Acharya et al.
(2012) document that most losses on assets financed by ABCP remained with sponsoring banks
because they absorbed the bulk of these assets when ABCP investors exited the market in 2007.
2 Gorton and Souleles (2007) have an extensive discussion on the institutional details of securitization and off-balance-
sheet financing, and emphasize the enforceability problem of implicit guarantees for such financing. In practice, a large
number of financial instruments or their investors have enjoyed implicit supports from sponsoring financial firms. For in-
stance, HSBC spent $35 billion in order to bring assets of its off-balance-sheet structured investment vehicles (SIVs) onto
its balance sheet in late 2007 (Goldstein, 2007); Citigroup moved $37 billion assets in SIVs back to its balance sheet
(Moyer, 2007). In the money market, Securities and Exchange Commission reported that at least 44 MMFs received
support from their sponsors to avoid breaking the buck during the 2007-09 financial crisis (McCabe, 2010).
3 The data source is “Financial Accounts of the United States.” See the online appendix for the details of how we
construct the ratio of securitization one by private asset-backed security issuers.
126 J. Huang / Journal of Economic Theory 178 (2018) 124–152
Our paper makes a number of theoretical contributions. We show that the enforcement prob-
lem with implicit guarantees gives rise to an endogenous leverage constraint on shadow banking.
By exploring the dynamics of shadow banking, we highlight two key results: i) the pro-cyclicality
of shadow banking increases endogenous risk, i.e., financial instability, and ii) strengthening
regulation of regular banking raises the borrowing capacity of shadow banking, which in turn in-
creases endogenous risk. In addition, we show that a certain degree of aggregate risk sharing does
not necessarily improve financial stability in the presence of shadow banking. We next illustrate
the main mechanisms driving these results.
In this paper, we model regular banking as a regular bank’s on-balance-sheet financing and
shadow banking as the regular bank’s collateralized off-balance-sheet financing. Regular banking
is subject to bank regulation that does not apply to shadow banking. In contrast with Brunner-
meier and Sannikov (2014), aggregate risk in our model is driven by a jump process, which gives
rise to credit risk as shadow banks may default. To enhance the safety of shadow bank debt,
regular banks extend implicit guarantees, which in turn are subject to the enforcement problem.
Tightening regulation of regular banking raises the maximum leverage of shadow banking.
As in the limited enforcement literature, we assume that a regular bank loses the opportunity
of accessing shadow banking if it defaults on its shadow bank debt. Thus, the opportunity cost
for the regular bank to default amounts to the present value of future benefits that shadow bank-
ing offers. Since more stringent regulation implies greater opportunities of regulatory arbitrage
offered by shadow banking, the opportunity cost of default is larger in economies with tighter
regulation, and thus the leverage of shadow banking is higher in such economies.
Since the leverage of shadow banking is endogenous, there exists an interesting feedback loop
between the opportunity cost of default and the leverage of shadow banking. For instance, if the
opportunity cost declines due to a loosening of bank regulation, the incentive to default rises
and the borrowing capacity of shadow banking declines. Thus, shadow banking offers fewer
benefits to regular banks, which leads to an even lower opportunity cost of default. Because of
this feedback loop, shadow banking could be unsustainable if the regulation of regular banking
is sufficiently lenient. Furthermore, we show that if there is no such feedback loop in a model,
tightening bank regulation does not necessarily lead to the expansion of the shadow banking
system.
The dynamics of shadow banking are driven by the leverage constraint. In economic booms,
high asset prices and the corresponding low return from holding assets lower the profitability
of banking. Hence, regular banks are not inclined to leverage up via shadow banking and plan
to default in the event of a negative shock. As a result, the leverage constraint is less tight in
economic upturns, which permits the high borrowing capacity of shadow banking. In addition,
the feedback loop emphasized above accelerates the expansion of the shadow banking sector in
economic booms.
Shadow banking increases endogenous risk as a general equilibrium effect in our model. Since
their borrowing capacity is pro-cyclical, shadow banks accumulate substantial amounts of assets
in upturns. However, when the economy faces a recession, the borrowing capacity of shadow
banks shrinks, which forces them to sell a large scale of assets to regular banks (i.e., reinter-
mediation). Shadow banks have to sell these assets at fire-sale prices because bank regulation
restrains regular banks from acquiring too many assets. Hence, asset prices have to drop a lot
so that regular banks are willing to purchase the assets. Endogenous risk rises due to the asset
fire-sale.
The relationship between bank regulation and financial instability is U-shaped. When regula-
tion is loose enough, shadow banking is unsustainable. In such a situation, tightening regulation
leads at first to lower instability. But when regulation becomes sufficiently tight, the borrowing
capacity of shadow banking expands and a considerable number of banking activities shift to the
shadow banking sector. Hence, more stringent regulation, in this circumstance, eventually gives
rise to a larger shadow banking system and higher financial instability.
In addition, we find that in the presence of shadow banking financial stability does not improve
substantially when a limited degree of aggregate risk sharing becomes possible in an economy.
This is in contrast with the conventional wisdom that aggregate risk sharing yields better financial
stability. The intuition for our result is that better risk sharing lowers a sponsor’s incentive to
default on its shadow bank debt. Thus, better risk sharing makes the leverage constraint less
tight and the borrowing capacity of shadow banking higher. Since shadow banking increases
endogenous risk, the expansion of the shadow banking sector dampens the positive effect of
aggregate risk sharing.
Related Literature. The literature on shadow banking is swiftly growing and diverse. Differ-
ent papers model shadow banking in drastically different ways, and Adrian and Ashcraft (2016)
provide a thorough survey of this growing literature. In this paper, we attempt to categorize a few
models of shadow banking along two dimensions: the motive for shadow banking and the type
of negative externalities that shadow banking causes.
The existence of shadow banking can be demand/preference driven. For example, in Gennaioli
et al. (2013), infinitely risk-averse households only value securities’ worst scenario payoffs, and
shadow banking can increase such payoffs by pooling different assets together. Meanwhile, in
Moreira and Savov (2017), the preference specification of households leads directly to a demand
for the liquid securities that shadow banking generates.
The second motive for shadow banking is regulatory arbitrage, as we discuss in this paper.
Luck and Schempp (2014), Ordonez (2013), and Plantin (2014) are papers that fall into this
category.
Models of shadow banking differ with respect to the type of the externalities that shadow bank-
ing causes. The first category includes non-pecuniary externalities. In Plantin (2014), shadow
banking exposes the real sector to counter-productive uncertainty. In both Luck and Schempp
(2014) and Gennaioli et al. (2013), creditors of shadow banks suffer from unexpected default
that bank runs or crises cause. Generally, investments financed by shadow banking in these mod-
els have worse or more volatile fundamentals than investments financed by regular banking.
Unlike papers discussed in the previous paragraph, we do not assume that shadow banking
involves any investments of inferior quality as in Moreira and Savov (2017). Instead, we focus
on the pecuniary externality; that is, the leverage choices of individual shadow banks cause ex-
cessive endogenous risk because they do not internalize the price impact of their actions in the
competitive equilibrium.
Although Plantin (2014) also touches upon the idea that tight regulation may have negative
unintended consequences, our paper differs from his work in three critical aspects. First, we focus
on the class of bank regulations that restricts the use of bank leverage; in contrast, Plantin (2014)
examines regulation that prohibits banks from issuing outside equity. Second, we recognize fi-
nancial instability as the endogenous risk that the financial market generates; for Plantin (2014),
however, the riskiness of outside equity reflects the instability that is counterproductive for the
real sector. Last, the dynamic general equilibrium setting of our framework allows us to char-
acterize dynamic properties of shadow banking and to discuss the trade-off between economic
growth and financial stability, for which the static setting in Plantin (2014) is not suitable.
This paper is also related to the literature on pecuniary externalities. One closely related paper
is Bianchi (2011), whose quantitative examination of the pecuniary externality in a dynamic gen-
eral equilibrium model highlights that raising borrowing costs can prevent excessive borrowing
and improve welfare.
For our methodology in this paper, we follow the emerging literature (Brunnermeier and
Sannikov, 2014; He and Krishnamurthy, 2012b, 2013) that considers economies with financial
frictions in a continuous-time setting. The methodology allows a full characterization of the en-
tire dynamics of an economy. As a departure from this literature, we consider aggregate jump
risks in our framework. The jump process makes it easy to model the insolvency risk of a shadow
bank. Along with the insolvency risk, the tractability of the continuous-time method allows us
to endogenize the leverage constraint on shadow banking and to explicitly solve for its debt
capacity. Our contribution to this literature is to demonstrate how to solve a continuous-time
macro-finance model with an enforcement problem.
The paper is structured as follows. We first establish our baseline model in Section 1. In
Section 2, we then characterize the equilibrium of this baseline model and illustrate the main
results with numerical examples. We explore the welfare implication of the baseline model in
Section 3. Section 4 considers an extension of the model, in which debt issued by shadow banks
is risky. Section 5 concludes.
1. The baseline model
In the baseline model, we introduce shadow banking into the macro-finance framework de-
veloped by Brunnermeier and Sannikov (2014), in which an economy is populated by productive
bankers and less productive households. Unlike Brunnermeier and Sannikov (2014) that allows a
single type of debt financing, bankers in our model can raise funds in two forms: regulated regu-
lar banking, modeled as on-balance-sheet financing, and unregulated shadow banking, modeled
as off-balance-sheet financing.
1.1. Technology and preferences
Time t ∈ [0, ∞) is continuous. Let Kt be the aggregate “efficiency units” of physical capital
in the economy and kt the holding of a banker. A banker holding physical capital kt produces
consumption goods yt at rate yt = akt over a short period of time dt, where a is a constant. We
assume that bankers produce ιt kt units of new physical capital over dt with inputs ιt kt and capital
adjustment costs 0.5φ(ιt − δ)2 kt , both of which are paid in consumption goods. Parameter δ is
the depreciation rate of physical capital and φ a positive constant.4 Physical capital held by a
banker evolves according to
dkt = kt (ιt − δ) dt − kt xdNt ,
where x is a positive constant and {Nt }∞ 5

t=0 is a Poisson process with the arrival rate λ. The
Poisson shock is the only source of aggregate risk that the economy faces.
4 We assume that capital adjustment cost to be quadratic in net investment, as consistent with Christiano et al. (2005),
He and Krishnamurthy (2012a), and many other quantitative macroeconomic models.
5 Poisson shocks adjust the “efficiency units” of physical capital held by a banker. In this setup, where capital quality
shocks are proportional, the economy is scale-invariant with the aggregate “efficiency units” of physical capital. The
scale-invariance property is useful for equilibrium characterization. See Gertler and Karadi (2011) and Gertler et al.
(2012) for the same setting in discrete-time models.
To have compact expressions, we let yt denote the left limit of a stochastic process {ys }∞ s=0 at
time t and ŷt denote the right limit. For instance, the amount of physical capital held by a banker
will jump from kt to k̂t if the Poisson shock arrives, where k̂t = kt (1 − x).
Households are less productive. Physical capital kth held by a household generates consump-
tion goods yth = a h kth , where a h < a. The capital adjustment costs 0.5φ(ιht − δ)2 kth apply to
households’ production of new physical capital. The law of motion for physical capital held by
households is

dkth = kth ιht − δ dt − kth xdNt .
Households are risk neutral with a time discount factor ρ. Although households may have
negative consumption in the baseline model, main results that we will derive later still hold in
the setup where households have Epstein–Zin preferences (see the online appendix).
Bankers have logarithmic preferences with the same time discount factor ρ. We assume that
bankers retire and exit the economy with independent Poisson arrival rate χ and new bankers ar-
rive at the same rate. When new bankers enter the economy, they inherit a positive σ proportion of
retiring bankers’ wealth. These assumptions limit the possibility that bankers take over all wealth
in the economy and undo effects of financial frictions that Section 1.3 will cover. We
assume that

if a banker retires with wealth Wt , she will earn lifetime utility J r (Wt ) = ρ1 ln ρ(1 − σ )Wt .
Hence, the expected lifetime utility of a banker is
⎡ T ⎤

E0 ⎣ e−ρt u (ct ) dt + e−ρT J r (WT )⎦ , (1)
0
where T denotes the stochastic retirement time that occurs at rate χ and

ln (c) , if c > 0,
u (c) =
−∞, otherwise.
1.2. Return from holding physical capital
The market for physical capital is frictionless. The price of physical capital is in units of con-
sumption goods, denoted by qt . The law of motion for qt , which we will solve for in equilibrium,
is
q
dqt = qt μt dt − (qt − q̂t )dNt ,
q
where μt is the growth rate of the price of physical capital. If a Poisson shock hits the economy
at time t , the price of physical capital qt jumps to q̂t .
At time t , in the absence of a negative shock, the return from holding a unit of physical capital
includes the net output a − ιt − 0.5φ(ιt − δ)2 , the accumulation of physical capital (ιt − δ)qt ,
q
and the rise in the price of physical capital μt qt . In the presence of the Poisson shock, a unit of
physical capital drops to 1 − x units and the price of physical capital jumps to q̂t . Hence, the total
loss is qt − (1 − x)q̂t . In summary, the rate of return for bankers from holding physical capital is
q
Rt dt − xt dNt , where (2)
a − ιt − 0.5φ(ιt − δ)2 q q qt − (1 − x)q̂t
Rt ≡ + ιt − δ + μt and xt ≡ .
qt qt
q
We label xt as endogenous risk. Similarly, the rate of return for households holding physical
capital is
q a h − ιht − 0.5φ(ιht − δ)2 q

Rth dt − xt dNt , where Rth ≡ + ιht − δ + μt
qt
1.3. Equity issuance friction, bank regulation, and shadow banks
In this section, we introduce three sets of frictions with respect to bankers’ external financing.
Firstly, bankers face a constraint on equity issuance, which leads to a market inefficiency when
they cannot trade contracts written on the aggregate state of the economy. Secondly, bank regula-
tion is introduced to improve market efficiency. As a response to the regulation, bankers establish
shadow banks to pursue regulatory arbitrage. The third friction is an enforcement problem that
shadow banking is subject to.
The constraint on equity issuance is common in models with financial frictions. We could
justify the constraint with agency problems between bankers and households as in He and Krish-
namurthy (2012b) and Di Tella (2017). In the baseline model, we assume that bankers must retain
100 percent equity of their regular banks and the only channel for them to raise external funds
is to issue short-term risk-free debt.6 In Section 4, we relax the constraint and allow bankers to
issue a limited amount of outside equity.
Given that financial markets are incomplete, the constraint on equity financing leads to the
lack of aggregate risk sharing and market inefficiency. Since bankers can only raise external
funds by using leverage, their exposure to aggregate risks is disproportionately high when con-
tingent securities are unavailable (Di Tella, 2017). Small shocks could have large effects on the
economy due to the amplification through bankers’ balance sheets. Moreover, individual bankers
do not internalize these effects into their leverage decisions, which is a source of inefficiency
(Lorenzoni, 2008; Stein, 2012). Thus, bank regulation is necessary for improving market effi-
ciency.
Bank regulation in the model is a tax on regular banks’ debt. We interpret the tax as the
shadow cost of all bank regulations that banks face.7 The rate is τt = min{τ, τ st }, where τ is a
positive constant and st is the debt to equity ratio of the regular banking sector. We set the tax
rate as min{τ, τ st } instead of a constant τ for two reasons. First, if τt = τ , the solution of the
baseline model would have a kink at st = 0, and this kink would jeopardize our numerical algo-
rithm.8 Second, setting τt = min{τ, τ st } simplifies the characterization of the leverage constraint
on shadow banking. In Section 2.3, we argue that assuming τt = τ would not change the quali-
tative predictions of the baseline model. To counterbalance the wealth effect of bank regulation
on bankers, we assume that tax revenues are repaid back to regular banks instantly as lump-sum
subsidies, and the ratio of subsidy to bank equity is πt .
To circumvent the bank regulation, a banker sponsors a shadow bank and earns its residual
value by charging a management fee in each period. In practice, this activity is referred to as
6 We can decompose any risky debt in our model into the risk-free component and the equity component. Since bankers
cannot issue outside equity, households only hold risk-free debt in equilibrium.
7 Kisin and Manela (2016) estimate the shadow cost of capital ratio requirement imposed on U.S. major banks. In
Drechler et al. (2017), the opportunity cost of reserve requirement is equivalent to the tax on regular bank debt in our
model.
8 We define the solution of the baseline model in Section 2.2. The online appendix contains the detailed discussion of
the numerical problem that arises if τt = τ .
Fig. 1. This figure shows the balance sheets of the regular and shadow banks managed by a banker.
off-balance-sheet financing. Similar to regular banks, shadow banks are subject to the constraint
on equity issuance. In the baseline model, households only accept risk-free debt issued by shadow
banks. In Section 4, we allow shadow bank debt to be risky.
In contrast to regular banks, we assume that bankers cannot retain any equity of their shadow
banks. The rationale of this assumption is that if they hold equity of their shadow banks, the
regulatory authority will treat these shadow banks as regular ones. Given this assumption, shadow
bank debt is backed by physical capital with no equity buffer. Investors of a shadow bank would
bear any loss that occurs to the shadow bank unless its sponsor bails it out and absorbs the loss
with her own wealth.
To enhance the safety of shadow bank debt, bankers extend implicit guarantees of bailing out
their shadow banks in trouble. Offering explicit guarantees is not feasible as the regulatory au-
thority will consider any debt with explicit guarantees as its sponsoring bank’s on-balance-sheet
debt. Since no third party would enforce implicit guarantees, shadow banking is subject to an
enforcement problem. The enforcement problem does not apply to regular banking because the
debt of a regular bank is senior to its equity.
To ensure that shadow bank debt is risk-free, households impose a leverage constraint on
shadow banking: a shadow bank can borrow up to s̄t∗ times the wealth of its sponsor at time t .
If a banker defaults on her shadow bank debt, we assume that she can re-enter the shadow bank
debt market only if a random event occurs. This event arrives at a Poisson rate ξ . Based on
this punishment scheme, households will fix s̄t∗ such that the continuation value of planning
to default for a banker is the same as the continuation of not doing so. We will solve for s̄t∗ in
Sections 2.1.3 and 2.1.4. To simplify the characterization of s̄t∗ , we assume that when households
lend to a shadow bank, they do not observe the leverage of its sponsor’s regular bank.
1.4. Problems for bankers and households
Suppose a banker has wealth Wt (Fig. 1). Denote the value of her regular bank debt by St . The
excess return from holding physical capital funded by regular banking is St (Rt − rt − τt ) dt −
q
St xt dNt , where rt is the risk-free rate. Rt − rt − τt is the excess return earned by the bank in the
q
absence of Poisson shocks. If a Poisson shock hits the economy, the bank loses St xt . The banker
also manages a shadow bank. We denote the value of the shadow bank debt by St∗ . The leverage
constraint on shadow banking implies
St∗ ≤ s̄t∗ Wt . (3)
The banker earns the difference between the asset return Rt St∗
and the interest expense rt St∗ .
Let
Dt denote the strategic decision. Like {St , St∗ }∞ 0 , the process {D }
t 0
∞ is predictable with respect
to the filtration generated by {Nt }∞ ∗ q

0 . If Dt = 0, the banker will bear the loss St xt for creditors of
her shadow bank when the Poisson shock hits the economy; if Dt = 1, the banker will not take
the loss. Hence, the banker’s dynamic budget constraint is

dWt = Wt Rt + St (Rt − rt − τt ) + St∗ (Rt − rt ) + Wt πt − ct dt
q
− Wt + St + (1 − Dt ) St∗ xt dNt , (4)
∞
where ct is the banker’s consumption. In summary, the banker takes qt , rt , τt , πt , s̄t∗ t=0 as
∞
given and chooses ct , St , St∗ , ιt , Dt t=0 to maximize her expected lifetime utility (1) subject to
the leverage constraint on shadow banking (3), the solvency constraint Wt ≥ 0, and the dynamic
budget constraint (4).
If a banker cannot issue shadow bank debt due to his previous default on shadow bank debt,
his dynamic budget constraint becomes
q
dWt = (Wt Rt + St (Rt − rt − τt ) + Wt πt − ct ) dt − (Wt + St ) xt dNt .
The banker chooses {ct , St , ιt }∞
t=0 to maximize his expected lifetime utility subject to solvency
and dynamic budget constraints.
In addition to risk-free debt, households hold physical capital. Denote by Sth the value of
physical capital that household h manages. The wealth Wth of the household evolves according
to

q
dWth = Wth rt + Sth Rth − rt − cth dt − Sth xt dNt , (5)
where cth is the household’s consumption. The household takes {qt , rt }∞

t=0 as given and chooses
h h ∞
ct , St t=0 to maximize
⎡∞ ⎤

U0h = E0 ⎣ e−ρt cth dt ⎦
0
subject to the solvency constraint Wth ≥ 0 and the dynamic budget constraint (5).
1.5. Equilibrium
Let I = [0, 1] and H = (1, 2] be sets of bankers and households, respectively. Individual
bankers and households are indexed by i ∈ I and h ∈ H .

Definition 1. Given the initial endowments of physical capital k0i , k0h ; i ∈ I , h ∈ H to bankers
and households such that
1 2
k0i di + k0h dh = K0 ,
0 1
an equilibrium is defined by a set of stochastic processes adapted to the filtration generated by

{Nt , t ≥ 0}: the price of physical capital {qt }, the risk-free rate {rt }, the tax rate process {τt },
the maximum leverage of shadow banking s̄t∗ , the ratio of subsidy to bank equity {πt },

wealth Wti , Wth , financing decisions Sti , Sti,∗ , Sth , investment decisions ιit , ιht , default de-
i i h
cisions Dt , and consumption ct , ct of banker i ∈ I and household h ∈ H ; such that

1. W0i , W0h satisfy W0i = q0 k0i and W0h = q0 k0h , for i ∈ I and h ∈ H ;
2. households fix the maximum leverage of shadow banking {s̄t∗ } to ensure that shadow bank
debt is risk-free, and they solve their problems given {qt , rt };
3. bankers solve their problems given qt , rt , τt , πt , s̄t∗ ;
4. the budget of the regulatory authority is balanced
1 1
τt Sti di = πt Wti di; (6)
0 0
5. markets for both consumption goods and physical capital clear
1 2 1 2
cii di + cth dh = a − g ιt kt di +
i i
a h − g ιht kth dh, (7)
0 1 0 1
1 2
kti di + kth dh = Kt , (8)
0 1
⎛ 1 ⎞ ⎛ 2 ⎞

where dKt = ⎝ ιit − δ kti di ⎠ dt + ⎝ ιht − δ kth dh⎠ dt − xKt dNt ,
0 1
qt kti = Wti + Sti + Sti,∗ , qt kth = Sth .
Given the definition, the market for risk-free debt clears by Walras’ Law.
2. Bank regulation and financial instability
In this section, we use numerical examples to characterize equilibria of the baseline model.
With the model characterization, we will present our main result that the relationship between
endogenous risk and bank regulation displays a U shape.
2.1. Equilibrium characterization
Economic dynamics of the baseline model mainly depend on how the shadow banking sector
evolves. In this section, we will characterize optimality conditions of households and bankers
and then derive the maximum leverage of shadow banking.
2.1.1. Production of physical capital

Households choose the investment rate ι to maximize the rate of return from holding physical
capital Rth ; that is, the optimal ι solves
−ι − 0.5φ (ι − δ)2
max + ι.
ι qt
The first-order condition implies that the optimal investment rate ιht is a function of the price of
capital qt ; that is, ιht = δ + (qt − 1) φ. Since bankers have the same investment technology as
households do, in equilibrium
qt − 1
ιt = ιht = δ + . (9)
φ
2.1.2. Households’ optimal choices

Since households are risk-neutral and not financially constrained, the expected return they
earn from holding any asset in equilibrium must equal their time discount factor ρ. Therefore,
we have the following equilibrium conditions:
rt = ρ, (10)
q
Rth − λxt ≤ rt , with equality if Sth > 0. (11)
Equation (11) indicates that if households hold physical capital in equilibrium, the expected rate
of return equals the risk-free rate.
2.1.3. Bankers’ optimal choices

Logarithmic bankers’ consumption and portfolio decisions are “myopic,” which simplifies
the characterization of their strategic default decisions. In particular, we use two properties of the
logarithmic preference: i) a banker’s consumption ct is ρ proportion of her wealth Wt ; that is,
ct = ρWt , (12)
and ii) a banker’s expected lifetime utility (i.e., continuation value) Jt satisfies
⎡ T ⎤

ln(Wt )
Jt ≡ Et ⎣ e−ρ(u−t) ln(cu )du + e−ρ(T −t) J r (WT )⎦ = + ht ,
ρ
t
where T denotes the random time that the banker retires, and ht captures future investment
opportunities and evolves endogenously according to dht = ht μht dt − (ht − ĥt )dNt . If a banker
defaults, her expected investment opportunities will become worse and her continuation value
becomes Jtd = ln(Wt ) ρ + hdt , where hdt follows dhdt = hdt μh,d
t dt − (ht − ĥt )dNt . In the next
d d
d
section, we will characterize ht and ht .
We next illustrate the intuition of optimality conditions for bankers’ portfolio and strate-
gic default decisions. The formal derivation of these conditions can be found in Appendix A.
Intuitively, a banker would like to maximize the expected growth rate of her continuation
value E[dJt]. Given the law of motion for Wt (equation (4)), if we apply Ito’s Lemma to
Jt = ln(Wt ) ρ + ht , then
1
Et [dJt ] = Rt + st (Rt − rt − τt ) + st∗ (Rt − rt )
ρ

+ λ ln 1 − (1 + st + (1 − Dt ) st∗ )xt dt
q

+ λ (1 − Dt )ĥt + Dt ĥdt dt + O,

where st = St Wt , st∗ = St∗ Wt , and O denotes the sum of all other terms that are independent
of st , st∗ , ĥt , and ĥdt . We label st and st∗ as the leverage of her regular bank and shadow bank,
respectively.
A banker’s optimal portfolio choice depends on whether she plans to default on her shadow
bank Dt . Next, we will derive optimality conditions of (st , st∗ ) in both cases (i.e., Dt = 0 and
Dt = 1). Given the optimal (st , st∗ ), we solve for the optimality condition of Dt = 0; that is, the
enforcement constraint for the banker.
No Intention of Default. Given that Dt = 0, Et [dJt ] reduces to
1
Rt + st (Rt − rt − τt ) + st∗ (Rt − rt ) + λ ln 1 − (1 + st + st∗ )xt dt
q
Et [dJt ] =
ρ
+ λĥt dt + O,
which shows that the banker is exposed to risks of her regular and shadow banks. First-order
conditions with respect to (st , st∗ ) are
q
λxt
Rt − rt − τt ≤ q , with equality if st > 0, (13)
1 − 1 + st + st∗ xt
q
λxt
Rt − rt ≥ q , with equality if st∗ < s̄t∗ . (14)
1 − 1 + st + st∗ xt
Intuitively, the excess returns of regular banking Rt − rt − τt and shadow banking Rt − rt must
cover the risk premium of holding physical capital, which is on the right side of inequalities
(13) and (14). The banker takes the tax rate τt as given because τt only depends on the debt to
equity ratio of the regular banking sector rather the leverage of an individual bank. In addition,
the portfolio choice (st , st∗ ) must be time consistent in the sense that if a Poisson shock indeed
arrives, the banker still finds it optimal to honor her shadow bank debt. In Appendix A, we
confirm the time-consistency of (st , st∗ ).
Intention of Default. If Dt = 1, the banker does not bear any risk from shadow banking.
Thus, she would borrow via shadow banking up to the limit (i.e., st∗ = s̄t∗ ) if Rt > rt . Recall
that creditors of a shadow bank do not observe the leverage of its sponsor’s regular bank. This
assumption implies that investors of shadow bank debt cannot infer the banker’s intention of
default on shadow bank debt ex ante. Hence, the banker can freely choose the leverage of her
regular bank s̃t to maximize
1
Rt + s̃t (Rt − rt − τt ) + s̄t∗ (Rt − rt )dt + λ ln 1 − (1 + s̃t )xt
q
Et dJt =
ρ
+ λĥdt dt + O.
The first-order condition of s̃t is
q
λxt
Rt − rt − τt = q. (15)
1 − (1 + s̃t ) xt
Since the banker assumes no risk from her shadow bank, the optimal leverage of her regular bank
is relatively high (s̃t > st ).
Strategic Default. The enforcement constraint for the banker is to ensure that the expected
growth rate of her continuation value Et [dJt ] with no intention of default is not less than Et [dJt ]
with the intention of default; that is,
1 q
st (Rt − rt − τt ) + st∗ (Rt − rt ) + λ ln 1 − 1 + st + st∗ xt + λĥt
ρ
1 q

≥ s̃t (Rt − rt − τt ) + s̄t∗ (Rt − rt ) + λ ln 1 − (1 + s̃t ) xt + λĥdt . (16)
ρ
The opportunity cost of strategic default is that the banker cannot access shadow banking for a
certain period and her future investment opportunities deteriorate (ĥdt < ĥt ). Hereafter, we let
Ht denote ht − hdt . The benefit of strategic default is that the banker can take higher leverage
(s̃t + s̄t∗ > st + st∗ ).
2.1.4. The maximum leverage of shadow banking

In this section, we characterize the maximum leverage of shadow banking s̄t∗ . Recall that
households only accept debt that is risk-free in equilibrium. Thus, the maximum leverage of
shadow banking s̄t∗ ought to be such that the enforcement constraint (16) holds as long as st∗ ≤ s̄t∗ .
To find s̄t∗ , we simplify the enforcement constraint (16) so that the leverage of shadow banking
becomes a banker’s only choice variable that enters the enforcement constraint. Since st ≥ 0 and
st∗ ≤ s̄t∗ , four scenarios may occur in equilibrium: i) st > 0 and st∗ = s̄t∗ ; ii) st = 0 and st∗ < s̄t∗ ;
iii) st = 0 and st∗ = s̄t∗ ; and iv) st > 0 and st∗ < s̄t∗ . Scenario iv is inconsistent with a banker’s
optimality conditions (13) and (14). The assumption τt = min{τ, τ st } excludes scenario iii.9
Scenario i is close to what happens in reality; that is, regular banking is active (st > 0) and the
leverage constraint on shadow banking is binding (st∗ = s̄t∗ ). In scenario i, first-order conditions
(13) and (15) imply that st + st∗ = s̃t , and thus the enforcement constraint reduces to

(s̃t − st ) Rt − rt − τt = st∗ Rt − rt − τt ≤ ρλĤt .
If a banker plans to default on her shadow
bank debt, she will take higher leverage and obtain an
additional return (s̃t − st ) Rt − rt − τt . The simplified enforcement constraint shows that if the
opportunity cost of default Ĥt is large enough, the banker would not plan to default.
In scenario ii, the enforcement constraint (16) has the same simplified form.10 Thus, to ensure
that the enforcement constraint (16) holds, the maximum leverage of shadow banking s̄t∗ satisfies
ρλĤt
s̄t∗ = . (17)
Rt − rt − τt
The maximum leverage of shadow banking depends on the opportunity cost of default on
shadow bank debt Ĥt and the profitability of banking Rt − rt − τt . Notice that bankers’ portfolio
choice determines the price of physical capital qt , which in turn affects their return from holding
9 s = 0 implies that τ = min{τ, 0} = 0. Thus, a banker is indifferent between shadow banking and regular banking.
t t
The binding leverage constraint on shadow banking st∗ = s̄t∗ implies that a banker strictly prefers raising credit via regular
banking, which contradicts with st = 0.
10 The second scenario is not realistic and only exists for a small set of parameter values. If s = 0, then τ = 0.
t t
First-order equations (14) and (15) imply that st∗ = s̃t . To plug τt = 0 and st∗ = s̃t into the enforcement constraint (16),
we have the same simplified form.
physical capital Rt and the maximum leverage of shadow banking s̄t∗ . However, bankers do not
internalize this general equilibrium effect, which gives rise to a source of inefficiency.
Next, we characterize Ht to fully understand what affects the maximum leverage of shadow
banking s̄t∗ . The following proposition indicates that we can represent the opportunity cost of
default Ht as the present value of future tax benefits su∗ τu , u > t . The discount factor of future
tax benefits is the banker’s time discount factor plus the “re-enter” rate ξ and the retirement
rate χ . Once bankers re-enter the shadow bank debt market or retire, the opportunity cost of
being prohibited from using shadow banking disappears.
Proposition 1 (Opportunity Cost of Default). Probabilistic Representation of Ht :

⎡∞ ⎤
∗τ
s
Ht ≡ ht − ht = Et ⎣ exp (− (ρ + ξ + χ) (u − t)) du⎦ .
d u u
(18)
ρ
t
Proof. See the online appendix. 2
There exists a crucial feedback loop between the maximum leverage of shadow banking {s̄t∗ }
and the opportunity cost of default {Ht }. First, equation (17) implies that the maximum leverage
of shadow banking increases with bankers’ opportunity cost of default. Second, the probabilistic
representation (18) indicates that the higher the maximum leverage of shadow banking is, the
more costly it is for bankers to default on their shadow bank debt.
This feedback loop gives rise to an equilibrium where shadow banking does not exist. Let us
conjecture that {s̄t∗ = 0, t ≥ 0}. The probabilistic representation (18) implies {Ht = 0, t ≥ 0}, and
equation (17) verifies the conjecture. Thus, we have the following proposition:
Proposition 2 (No Shadow Banking). In the baseline model, there always exists an equilibrium
where shadow banking does not exist; that is, {s̄t∗ = 0, Ht = 0, t ≥ 0}.
In this degenerate equilibrium, productive bankers are unable to leverage up via shadow bank-
ing. By contrast, there may exist a non-degenerate equilibrium, where shadow banking exists. In
this paper, we will focus on the non-degenerate equilibrium, given the importance of shadow
banking.11
2.1.5. Market clearing and wealth distribution

Since households are risk-neutral and they can have negative consumption, the market for
consumption goods clears automatically as long as the risk-free rate equals households’ time
discount factor, rt = ρ. The market for physical capital clears if the fractions of physical capital
held by bankers and households sum to 1. Let ψt be the fraction of physical capital held by
bankers. The budget of the regulatory authority is balanced if it transfers all tax revenues back to
bankers; that is, πt = st τt .
Like other continuous-time macro-finance models, the wealth distribution matters for the
dynamics of the economy. Later, we will capture the dynamics of an equilibrium with a state vari-
1 i
able, the bankers’ wealth share ωt ≡ 0 Wt di qt Kt . Lemma 1 characterizes how ωt evolves.
11 There exists a continuum of sunspot equilibria, in which the economy may suddenly switch to the degenerate equi-
librium where shadow banking disappears. Equilibrium selection is beyond the scope of this paper.
Lemma 1. The law of motion for ωt is

dωt = ωt μωt dt − ωt − ω̂t dNt , (19)
= Rt + st (Rt − rt ) + st∗ (Rt − rt ) − μt − μK
q
where μωt t − ρ − χ(1 − σ ), (20)
(1 + st + st∗ )(1 − x)q̂t − (st + st∗ )qt
and ω̂t = ωt . (21)
(1 − x)q̂t
Proof. See Appendix A. 2
In the absence of Poisson shocks, the state variable ωt grows at rate μωt . If a Poisson shock
hits the economy, the state variable jumps from ωt to ω̂t .
2.2. Markov equilibrium
Although we can characterize an equilibrium with equations (3)-(18), it is still challenging

to solve for an equilibrium. Fortunately, our economy has the property of scale invariance. This
means that the baseline model permits a Markov equilibrium with state variable ωt , and the
dynamics of all endogenous variables in the Markov equilibrium can be characterized by the
law of motion for ωt and functions q(·) and H (·). Hence, solving for the Markov equilibrium is
equivalent to solving for q(·) and H (·). With Ito’s Lemma, we can find a differential equation
that defines q(·),
q q (ωt )
μt = ωt μωt , (22)
q(ωt )
q̂t = q(ω̂t ). (23)
Given the probabilistic representation of Ht , we know
t
su∗ τu
exp (− (ρ + ξ + χ) u) du + exp(− (ρ + ξ + χ) t)Ht
ρ
0
is a martingale. To apply Ito’s Lemma, we have
min{τ, τ st } ∗
(ρ + ξ + χ) H (ωt ) = st + ωt μωt H (ωt ) + λ H (ω̂t ) − H (ωt ) . (24)
ρ
Equations (22) and (24) indicate differential equations that q(·) and H (·) satisfy, respectively.
It is easy to see that equation (24) is not an Ordinary Differential Equation as H (ω) depends
on the value of H (·) in state ω̂t , where the economy will move to given a Poisson shock. Since
ω̂t < ωt (i.e., Poisson shocks lower bankers’ wealth share), equations (22) and (24) are Delay
Differential Equations. In the following subsection, we will detail how to calculate q (ω) and
H (ω) given the values of q(·) and H (·) over (0, ω) and also highlight boundary conditions for
q(·) and H (·).
2.2.1. Numerical calculation

Given {ω, q(ω̃), H (ω̃), 0 < ω̃ ≤ ω}, we will compute q (ω) and H (ω) using the following
procedure. First of all, we postulate that households also hold physical capital and find s + s ∗
such that
a − ah λx q
− min{τ, τ max{0, s + s ∗ − s̄ ∗ }} = − λx q , (25)
q 1 − (1 + s + s ∗ )x q
equations (13), (14), (17), (21) and (23) hold. Equation (25) is the difference of the two Eu-
ler equations (11) and (13) with τt = min{τ, τ st }. While solving for s + s ∗ , we also derive
ω̂, q̂, x q , s, s ∗ , and s̄ ∗ . Next, we compute ψ = (1 + s + s ∗ )ω and check if our conjecture is
true, i.e., ψ < 1. If it is true, we calculate μq based on equation (13) and μω according to equa-
tion (20). If ψ < 1 does not hold, then we set ψ = 1 and s + s ∗ = 1/ω − 1. Given s + s ∗ , we derive
ω̂, q̂, x q , s, s ∗ , s̄ ∗ , μq , and μω based on equations (13), (14), (17), (20), (21), and (23). Given μq
and μω , we compute q (ω) according to equation (22). Finally, we derive H (ω) according to
equation (24).
Boundary conditions are i) μq (ω̄) = μH (ω̄) = 0 at ω̄, where μω (ω̄) = 0; and ii) q(0) = q
2
and H (0) = 0, where q satisfies a h − δ + q−1 /2φ − ρq = λxq. The state ω̄ is a movable
singular point such that μω (ω̄) = 0. Ito’s Lemma implies boundary conditions μq (ω̄) = 0 and
μH (ω̄) = 0. The state ω = 0 is a limit state where only households exist in the economy. We
derive the asymptotic properties of q(ω) and H (ω) at ω = 0 in Appendix B.
2.2.2. Equilibrium uniqueness

Within the class of Markov equilibria, we can identify the condition under which the degen-
erate equilibrium is the unique equilibrium. To prove this result, we define a mapping which
takes the cost of default function H (·) as the input,
⎡ ∞ ⎤

min{τ, τ s }
H (ω) = Et ⎣ exp(− (ρ + ξ + χ) (u − t)) su du ωt = ω⎦
u ∗
ρ
t
where
ρλH (ω̂t )
st∗ ≤ ,
R(ωt ) − r − τ (ωt )
and (su , su∗ ) are portfolio weights of a banker in the equilibrium of a hypothetical economy with
exogenous H (·). To solve for H (·), we follow the procedure illustrated in Section 2.2.1 and
use the given H (·) to compute s̄ ∗ . The last step of the procedure yields H (·).
The fixed point of the mapping is H (·) that characterizes the Markov equilibrium. As we
have noted in Section 2.1.4, the mapping may have two fixed points: one corresponds to the
non-degenerate equilibrium, and the other yields the degenerate equilibrium. The following the-
orem provides a sufficient condition that justifies the uniqueness of the degenerate equilibrium:
Theorem 1 (Uniqueness). If τ < (ρ + ξ + χ) x, the mapping is a contraction mapping with

the fixed point H (ω) = 0 for all ω ∈ (0, ω̄].
Proof. See the online appendix. 2
To prove that is a contraction mapping, we show that satisfies Blackwell’s sufficient con-
ditions if τ < (ρ + ξ + χ)x. The feedback loop illustrated in Section 2.1.4 explains why could
be a contraction mapping. Suppose the tax on regular bank debt τ decreases. The probabilistic
representation (18) implies that the opportunity cost of default drops. The enforcement constraint
implies that the maximum leverage of shadow banking {s̄t∗} declines accordingly (equation (17)).
The decline in the leverage of shadow banking {s̄t∗ } reduces the opportunity cost of default {Ht }
further (the probabilistic representation (18)). This cycle makes shadow banking unsustainable
in equilibrium if τ is small enough.
Fig. 2. Economic Dynamics. This figure presents the fraction of physical capital held by bankers ψ , the price of physical
capital q, the leverage of shadow banking s ∗ (solid line), a banker’s overall leverage s + s ∗ (dashed line), the endogenous
risk x q , the profitability of banking R − r − τ , and the opportunity cost of default H as functions of the state variable ω
(i.e., bankers’ wealth share). For parameter values, see Section 2.3.
2.3. Economic dynamics
In this section, we present main dynamic properties of the baseline model with a numerical
example. Parameter values are a = 22.5%, a h = 10%, δ = 10%, λ = 1, x = 4%, φ = 3, ρ = 3%,
χ = 15%, σ = 10−5 , τ = 3%, and ξ = 6%. The calibration of parameter values is detailed in the
online appendix.
With the continuous-time method, we can characterize full dynamics of the economy. First,
we express all endogenous variables as functions of the state variable, bankers’ wealth share ωt .
Second, we use the law of motion for ωt (equation (19)) and Ito’s formula to derive the law of
motion for all endogenous variables. The stationary distribution of the state variable shown in
the online appendix has a single peak where bankers hold around 38% of wealth in the econ-
omy.
Our model inherits most dynamic features of Brunnermeier and Sannikov (2014). After a
series of negative shocks, the economy enters downturns and bankers’ wealth share diminishes
due to their disproportionately high exposure to aggregate risks. As a result, bankers hold a
declining fraction of physical capital and aggregate productivity deteriorates (Panel a of Fig. 2).
Hence, the price of physical capital declines (Panel b of Fig. 2) and the endogenous risk x q
increases (Panel d of Fig. 2). The endogenous risk reaches its highest level as bankers start
asset fire sales and less productive households begin to hold physical capital. The profitability of
banking Rt − r − τt rises in downturns due to the low price of physical capital (Panel e of Fig. 2),
which explains why the overall leverage of a banker s + s ∗ is counter-cyclical (the dashed line
of Panel c of Fig. 2).
Fig. 3. Financial Instability and Reintermediation. This figure presents the price of physical capital (solid line), the
endogenous risk (solid line), the size of the regular banking sector, and the size of the shadow banking sector as functions
of the state variable ω (i.e., bankers’ wealth share) in an economy with shadow banking. For comparison, upper panels
also show the price of physical capital (dashed line) and the endogenous risk (dashed line) for the same economy without
shadow banking. For parameter values, see Section 2.3.
Pro-cyclical Leverage of Shadow Banking. The leverage of shadow banking is pro-cyclical

(Panel c of Fig. 2). As the price of physical capital increases in economic upturns (Panel b of
Fig. 2), the profitability of regular banking Rt − rt − τt declines (Panel e of Fig. 2). Thus, the
profitability of shadow banking and the opportunity cost of default are relatively high in up-
turns, which makes the enforcement constraint less tight (equation (17)). Since the enforcement
constraint is more lax in upturns, bankers can take on higher leverage in the shadow banking
sector.
The feedback loop that we highlight in Section 2.1.4 also contributes to the pro-cyclicality of
shadow banking. Since the leverage of shadow banking is relatively high in upturns, the access
to shadow banking helps bankers save a large amount of tax. Therefore, the opportunity cost
of default on shadow bank debt is high in economic upturns (equation (18)) as default would
deprive bankers of the benefit of tax saving. The higher opportunity cost of default, in turn,
makes the enforcement constraint more lax, and thus increases the leverage of shadow banking
further (equation (17)).
The dynamic properties of shadow banking and regular banking indicate that we do not
lose the generality of our results by assuming that the tax rate on regular bank debt τt equals
min{τ, τ st } instead of the constant τ . If regular banks’ leverage is sufficiently high (i.e., st > 1)
in downturns, the two setups yield the same result since min{τ, τ st } = τ . In upturns, if the maxi-
mum leverage of shadow banking is so high that bankers only use shadow banking (i.e., st = 0),
the two setups also give the same result as the τt does not enter the first-order condition asso-
ciated with shadow banking. The only difference between the two setups is in the intermediate
case where 0 < st < 1.
Financial Instability. Shadow banking increases financial instability. Upper panels of Fig. 3
compare the baseline model (solid lines) with its simplified version without shadow banking.
Shadow banking provides relatively cheap credit as it is not subject to regulation. Hence, bankers
can hold more physical capital in an economy with shadow banking and the price of physical
capital is also higher (Panel a of Fig. 3). However, the benefit of shadow banking is not free. The
endogenous risk is higher in the economy with shadow banking (Panel b of Fig. 3).
Reintermediation. Shadow banking increases financial instability through the reintermedi-
ation process. The lower panels of Fig. 3 illustrate the reintermediation process; that is, if the
economy experiences a series of negative shocks, a large amount of assets migrate from the
shadow banking sector to the regular banking sector. The reintermediation process raises en-
dogenous risk for the following reason: shadow banks accumulate a large number of assets in
economic upturns. The scale of this asset accumulation is larger than what the regular banking
sector would pursue given its relatively high funding cost caused by bank regulation. If adverse
shocks hit the economy, shadow banks have to divest large amounts of assets as their leverage
constraints tighten, and regular banks are reluctant to acquire these assets because it is expensive
to expand their balance sheets. As a result, the price of physical capital declines more than it
would if there were no shadow banking.
Inefficiency. Shadow banking causes inefficiency through its general equilibrium effects.
First of all, we notice that the operation of a single shadow bank neither lowers the quality of
physical capital nor increases endogenous risk. In fact, shadow banking improves the welfare of
a banker by providing cheap credit. Hence, it is the general equilibrium effects of shadow bank-
ing that cause economic inefficiency. The fundamental cause of the inefficiency is that in upturns
when individual bankers accumulate large amounts of assets financed via shadow banking they
do not internalize negative effects of reintermediation that occurs in recessions.
2.4. Regulatory implications
In this section, we emphasize that the regulation of regular banking has nonlinear effects on
financial instability in the presence of shadow banking. In addition, we show that the borrowing
capacity of shadow banking being endogenous is crucial for our model to capture the nonlinear
effects.
2.4.1. Regulatory paradox

We present comparative-statics analyses to highlight that bank regulation may have unin-
tended consequences when shadow banking plays a critical role. In particular, we vary the tax
on regular bank debt τ , and stress the U-shaped relationship between financial instability and the
regulation of the regular banking sector.
The conventional wisdom that tough regulation secures financial stability may not hold when
shadow banking plays a role. In economies without shadow banking, if the regulatory authority
tightens regulation by raising τ , banks’ leverage and endogenous risk will decline (Panel a of
Fig. 4). However, in economies with shadow banking, it is those with tighter regulation that
experience higher endogenous risk (Panel b of Fig. 4). The intuition follows. Regular banks will
face higher tax burdens if regulation becomes tighter. Since if a banker defaults on her shadow
bank debt, she can only use regular banking, tighter regulation gives rise to a larger opportunity
cost of default (Panel c of Fig. 4). Furthermore, the enforcement constraint implies that the
larger opportunity cost of default leads to the higher leverage of shadow banking (equation (17)).
Hence, the shadow banking sector is larger in economies with more stringent regulation (Panel d
of Fig. 4). Since shadow banking adds to financial instability, tough regulation imposed on regular
banks can deteriorate financial stability, as Panel b of Fig. 4 presents.
Fig. 4. Regulatory Paradox. This figure shows endogenous risks in economies without shadow banking, endogenous
risks in economies with shadow banking, the opportunity cost of default, and the leverage of shadow banking. Solid
lines are for the economy with loose bank regulation (τ = 2.9%); dashed lines for the economy with modest regula-
tion (τ = 3.6%); dash-dotted lines for the economy with tight regulation (τ = 4.3%). For other parameter values, see
Section 2.3.
Regulatory Smile. The regulatory paradox result holds only when the regulatory restriction
is so tight that the shadow banking sector becomes sizable. Recall the feedback loop discussed
in Section 2.1.4. If the regulatory authority lowers the tax rate τ , the opportunity cost of default
on shadow bank debt declines. This, in turn, lowers the maximum leverage of shadow banking
and further reduces the opportunity cost of default. The feedback loop is very effective. The solid
line in the lower panel of Fig. 5 shows that as τ declines from 2.5% to 2.3%, the shadow banking
system disappears. In the regime where the shadow banking system is absent, the conventional
wisdom is still true; that is, tightening regulation secures financial stability (the solid line in the
upper panel of Fig. 5). In summary, our model stresses that regulatory restrictions on regular
banks have nonlinear effects on financial instability in an economy where the scale of shadow
banking varies endogenously.
2.4.2. Exogenous leverage constraint on shadow banking

The endogenous leverage constraint on shadow banking is essential for the “regulatory para-
dox” result. To illustrate this point, we modify the baseline model by replacing the endogenous
cost of default {Ht , t ≥ 0} with a constant H̄ .
The “regulatory paradox” result does not hold in the modified model (the dashed line of the
upper panel of Fig. 5), although it preserves many other dynamic features of the baseline model.12
The intuition follows. If the opportunity cost of default on shadow bank debt is an exogenous
constant, the borrowing capacity of shadow banking will be unrelated to the degree of bank
regulation. Hence, the size of the shadow banking sector will not change much as the degree of
12 We characterize the dynamic properties of the modified model in the online appendix.
Fig. 5. Financial Instability and Bank Regulation. This figure shows how the change in the tax rate influences the endoge-
nous risk x q and the leverage of shadow banking at the stochastic steady states in the baseline model (solid lines) and
in the modified model with an exogenous leverage constraint for shadow banking (dashed lines). The stochastic steady
state is the state where ωμω − λ(ω − ω̂) = 0. The exogenous cost of default H equals 2.1818, which is the average cost
of default in the calibrated model in Section 2.3. For other parameter values, see Section 2.3.
regulatory restriction varies (the dashed line in the lower panel of Fig. 5). If regulatory authorities
raise the tax on regular banking, not many banking activities will migrate to the shadow banking
sector. As a result, the scale of the reintermediation does not change as significantly as it does in
the baseline model. Hence, financial instability does not rise as the tax rate increases.
The comparison between the baseline model and its variant underlines two points. First, if
the leverage constraint on shadow banking is exogenously given in a model, the model may not
capture the U-shaped relationship between financial instability and bank regulation. Second, it
is not true that tightening regulation always squeezes a large amount of banking activities into
the shadow banking sector. This is because shadow banking faces more frictions than regular
banking does. The enforcement problem is one example. Due to these frictions, creditors must
impose some leverage constraints on shadow banking. These constraints would restrain shadow
banks from acquiring too many assets that regular banks have to unload due to tight regulation.
3. Welfare analysis
In this section, we highlight that tightening bank regulation can decrease bankers’ welfare
because it leads to the expansion of the shadow banking sector and the deterioration of finan-
cial stability. This channel is in contrast to the traditional view that stringent bank regulation
depresses economic growth, which in turn may lower social welfare.
To simplify welfare aggregation, we assume that all bankers have the same level of initial
wealth. Without loss of generality, we normalize the aggregate amount of physical capital at
time 0 to be 1. Note that bankers’ wealth share ω0 is exactly the fraction of physical capital
that they own. Thus,
a banker’s initial wealth is ω0 q0 , and the initial wealth of the household
sector is 1 − ω0 q0 . The welfare pair of a representative household and a banker in period 0
Fig. 6. Welfare and Dynamics of Banker’s Wealth. This figure shows how the change in tax rate affects the welfare of a
banker and a household in period 0, the average growth rate of bankers’ wealth, and the average volatility of bankers’
wealth in an economy without shadow banking (dashed lines) and in an economy with shadow banking (solid lines). For
agents’ welfare, we focus on state ω0 = 0.38. We use the stationary distribution to calculate moments. For parameter
values other than τ , see Section 2.3.

is (1 − ω0 )q0 , ln(ω0 q0 ) ρ + h0 . It is straightforward to see that a household’s welfare only
depends on the price of physical capital since it is risk-neutral. Upper panels of Fig. 6 display
the welfare of a banker and a household in the state ω0 = 0.38 across economies with different
degrees of bank regulation.13 Solid lines correspond to economies with shadow banking and
dashed lines to those without shadow banking.
When there is no shadow banking, implementing bank regulation improves bankers’ welfare
(the dashed line in Panel a of Fig. 6) but lowers households’ welfare (the dashed line in Panel b
of Fig. 6). As the tax rate τ increases from zero, both the volatility and the growth rate of bankers’
wealth decline (dashed lines in Panel c and d of Fig. 6). The benefit of the low wealth volatility
dominates if the tax rate is not too high. From a banker’s perspective, the unregulated competitive
equilibrium (τ = 0) is suboptimal because she does not internalize the negative impact of her
q
leverage choice on endogenous risk xt . If the tax rate is too high, tightening regulation lowers the
welfare of the banker because the negative effect of the low wealth growth dominates (the dashed
line in Panel a of Fig. 6). Households’ welfare always worsens as bank regulation tightens.
This is because tight regulatory restriction prevents productive bankers from raising credit for
financing their holdings of physical capital, which lowers the aggregate productivity and the
price of physical capital.
Lower panels of Fig. 6 show that as shadow banking emerges, tightening bank regulation in-
creases both the growth rate and the volatility of bankers’ wealth. This is in contrast with how the
change in regulatory restriction affects the two terms when shadow banking is absent. Strength-
13 The economy mostly stays around the state ω = 0.38.

0
ening bank regulation increases the size of the shadow banking sector. On the one hand, bankers
can access more cheap credit as there is no tax on shadow bank debt. This benefits the growth
of their wealth. On the other hand, a large shadow banking sector leads to high endogenous risk,
which makes bankers’ wealth more volatile.
When shadow banking exists, bank regulation has nonlinear effects on bankers’ welfare. If
bank regulation is not too stringent, tightening regulation leads to the growth of shadow banking,
which benefits bankers’ welfare (the solid line in Panel a of Fig. 6). However, if regulation is too
strict, the negative effect of high volatility dominates, and tightening regulation hurts bankers’
welfare. Even though tightening bank regulation eventually lowers bankers’ welfare in both types
of economies, the underlying mechanisms are different: in the economy without shadow banking,
it is the low wealth growth that causes the low welfare; in the economy with shadow banking, it
is the high volatility of bankers’ wealth that drives the result.
As the shadow banking sector expands, productive bankers can raise more cheap credit to
fund their holdings of physical capital. Hence, the aggregate productivity increases and the price
of physical capital appreciates. Therefore, tightening bank regulation benefits households in the
presence of shadow banking (the solid line in Panel b of Fig. 6).
4. Robustness
We have done three types of robustness checks for the “regulatory paradox” result. In this
section, we only concentrate on the first one, in which we allow both regular and shadow banks
to issue outside equity up to a certain proportion. The first robustness check also shows that better
aggregate risk sharing does not necessarily improve financial stability in the presence of shadow
banking.
The detailed discussion of the other two robustness exercises is in the online appendix. In
the second one, we assume that households have Epstein–Zin preferences instead of risk-neutral
ones. In the third robustness check, we model bank regulation as a capital adequacy constraint.
In the third exercise, the dynamic features of both shadow banking and regular banking are
inconsistent with facts observed during the 2007-09 financial crisis.
4.1. Risky shadow bank debt
We relax the restriction on equity issuance such that bankers must retain ε proportion of a
bank’s outstanding equity. For shadow banking, the equity issuance means that investors of a
shadow bank expect its sponsor to bear only ε fraction of the total loss to the shadow bank.
Given the relaxed restriction on equity issuance, a banker’s dynamic budget constraint be-
comes

1−ε
dWt = Wt Rt + Wt (Rt − rt ) + St (Rt − rt − τt ) + St∗ (Rt − rt )
ε

Wt ∗ q
− (1 − ε) + St + St λxt dt
ε

Wt ∗ q
+ (Wt πt − ct )dt − ε + St + (1 − Dt )St xt dNt .
ε
We only explain two terms related to outside equity since other terms have the same interpretation
as they do in the economy model (see equation (4)). A banker with wealth Wt can obtain external
Fig. 7. Economic Dynamics. This figure presents the fraction of physical capital held by bankers ψ , the price of physical
capital q, the leverage of shadow banking s ∗ , the endogenous risk x q , the profitability of banking R − r − τ − (1 − ε)λx q ,
and the opportunity cost of default H as functions of the state variable ω (i.e., bankers’ wealth share) in two different
models. Solid lines correspond to the extended model where bankers only need to retain 95% of their banks’ equity
shares. For a shadow bank, retaining 95% of their equity shares means investors only expect sponsoring banks to bear
95% of the loss that occurs to the shadow bank. Dashed lines correspond to the baseline model. For parameter values,
see Section 2.3.
equity financing (1−ε)Wt/ε . In addition to paying the opportunity cost rt , the banker must pay
external shareholders a premium for their exposure to the potential loss (1 −ε) Wt/ε +St +St∗ xt ,
q
∗ q
of which investors of the shadow bank bear (1 − ε)St xt q. Since households are risk-neutral, the
premium is the expected loss (1 − ε) Wt/ε + St + St∗ λxt .
Relaxing the equity issuance restriction also makes the enforcement constraint less binding.
This is because investors of shadow banks share risks with their sponsors, which lowers sponsors’
incentives to default. In particular, the maximum leverage of shadow banking (17) becomes
ρλĤt
s̄t∗ = .
Rt − r − τt − (1 − ε)λx q
We next focus on key properties of the model (readers can find other equilibrium conditions
in the online appendix). First of all, outside equity financing improves the risk sharing between
bankers and households as well as the efficiency of capital allocation (Panel a and b of Fig. 7).
However, due to the expansion of shadow banking (Panel c of Fig. 7), endogenous risk does not
change much compared to the baseline model (Panel d of Fig. 7). Since bankers share profits with
external shareholders, the profitability of banking declines (Panel e of Fig. 7), which explains the
decline in bankers’ incentives to default on their shadow bank debt.
The “regulatory paradox” result still holds. If the tax on regular banks’ liability is sufficiently
low, shadow banking is unsustainable. Since the enforcement problem is less severe in economies
with better risk sharing, shadow banking is more likely to emerge in such economies. The lower
Fig. 8. Financial Instability, Bank Regulation, and Outside Equity. This figure shows how the change in the tax rate
influences the endogenous risk x q and the leverage of shadow banking at the stochastic steady states in the baseline
model (dashed lines) and in two extended models where bankers must retain 95% (dash-dotted lines) or 90% (solid
lines) of their banks’ equity shares. For a shadow bank, retaining ε proportion of their equity shares means investors only
expect its sponsor to bear ε proportion of the loss that occurs to the shadow bank. The stochastic steady state is the state
where ωμω − λ(ω − ω̂) = 0. For other parameter values, see Section 2.3.
panel of Fig. 8 shows that shadow banking emerges if the tax rate τ is larger than 0.2 in the
economy where bankers must retain 90% of equity. However, this threshold is around 0.25 in the
baseline model. If shadow banking is relatively small, financial instability is significantly lower
in economies where bankers can share more aggregate risks with households (the upper panel
of Fig. 8). If the regulation of regular banks is so stringent that the shadow banking sector is
relatively large, tightening bank regulation raises financial instability as in the baseline model.
The striking result presented by Fig. 8 is that the expansion of shadow banking can neutralize
positive effects of aggregate risk sharing. The lower panel of Fig. 8 shows that the size of the
shadow banking sector is larger in an economy where bankers can share a larger proportion
of aggregate risk with households. Since shadow banking increases endogenous risk, economies
with different degrees of aggregate risk sharing have almost the same level of financial instability
as the economy without aggregate risk sharing has (the upper panel of Fig. 8).
5. Conclusions
In this paper, we emphasize the enforcement problem with shadow banking and endogenize
the borrowing capacity of shadow banking based on this friction. By modeling shadow banking
in a continuous-time macro-finance framework, our paper captures dynamics of shadow banking
and uncovers the general equilibrium mechanism through which shadow banking adds to finan-
cial instability. Since the borrowing capacity of shadow banking is endogenous in our framework,
our paper highlights that tightening regulation of regular banking actually helps shadow banks
increase their debt capacity. The general equilibrium framework that we use is suitable for wel-
fare and policy discussions in the modern economy where the unregulated shadow banking sector
plays a critical role.
Appendix A. Proofs
1
Proof of Lemma 1. Let Wta denote 0 Wti di. In a Markov equilibrium, bankers’ dynamic budget
constraint (4), the optimal portfolio choice of bankers, and the balanced budget of the regulatory
authority imply that

dWta = Wta Rt + st (Rt − rt ) + st∗ (Rt − rt ) − ρ − χ(1 − σ ) dt

q̂t
− Wta − (1 + st + st∗ )(1 − x) Wta − (st + st∗ )Wta dNt ,
qt
where (1 + st + st∗ )(1 − x) q̂qtt Wta is the asset values of all physical capital that bankers hold and
(st + st∗ )Wta is the value of liabilities that bankers have. Note bankers retire at the intensity χ .
Given

q
d (qt Kt ) = qt Kt μt + μK t dt − qt Kt − (1 − x)Kt q̂t dNt ,

the scaling factor 1 (qt Kt ) evolves according to

1 1 q 1 1
d =− μt + μK t dt − − dNt .
qt Kt qt Kt qt Kt (1 − x)Kt q̂t
Then, Ito’s lemma implies that
dωt = ωt μωt dt − (ωt − ω̂t )dNt
where μωt = Rt + st (Rt − rt ) + st∗ (Rt − rt ) − μt − μK
q
t − ρ − χ(1 − σ )
(1 + st + st∗ )(1 − x)q̂t − (st + st∗ )qt
and ω̂t = ωt . 2
(1 − x)q̂t
Lemma 2. The optimal choice of a banker {st , st∗ , Dt } characterized in Section 2 is time consis-
tent.
Proof. The Hamilton–Jacobi–Bellman (HJB) equation for the banker’s optimal control problem
0= max {(1 − Dt )HJBN + Dt HJBD } , where (26)
ct ,St ,St∗ ≤s̄t∗ Wt ,Dt

ln(ct ) − ρJt + μρW + ht μht + χ Jtr (Wt ) − Jt
HJBN ≡ max q ,
∗
ct ,St ,St∗ ≤st∗ Wt +λ ρ ln Wt − Wt + St + St xt + ĥt − Jt
1

ln(ct ) − ρJt + μρW + ht μht + χ Jtr (Wt ) − Jt

HJBD ≡ max q ,
ct ,St ,St∗ ≤st∗ Wt +λ ρ1 ln Wt − (Wt + St ) xt + ĥdt − Jt
1
μW ≡ Wt (Rt + πt ) + St (Rt − rt − τt ) + St∗ (Rt − rt ) − ct .
Wt
While choosing her portfolio and consumption at time t , the banker also decides whether she
would default on her shadow bank obligations (HJBD ) in the event of an adverse shock or not
(HJBN ). Because of the time-consistency problem, a banker’s portfolio choice (St , St∗ ) with
respect to both HJBN and HJBD must satisfy their time-consistency constraints:
q q
ln Wt − Wt + St + St∗ xt ln Wt − (Wt + St ) xt
+ ĥt ≥ + ĥdt (27)
ρ ρ
for HJBN and

q q
ln Wt − Wt + St + St∗ xt ln Wt − (Wt + St ) xt
+ ĥt ≤ + ĥdt (28)
ρ ρ
for HJBD . First-order conditions with respect to portfolio choices are given by (13) and (14)
for HJBN , and (15) for HJBD . The banker finds it optimal to honor her shadow bank debt if
HJBN ≥ HJBD .
Next, we will show that if the leverage constraint on shadow banking is satisfied bankers’ HJB
equation can reduce to 0 = HJBN with the time-consistency constraint (27) being satisfied. First,
we know that the optimal choice of HJBD is dominated by that of HJBN by how we define the
maximum leverage of shadow banking in equation (17). Thus, what we need to verify is that if
the portfolio choice (st , st∗ ) satisfies the leverage constraint for shadow banking, it also satisfies
the time-consistency constraint (27). Given the leverage constraint st∗ ≤ s̄t∗ and the first-order
condition with respect to (st , st∗ ), we have
1 − (1 + st + st∗ )xtq
st∗ ≤ρ ĥt − ĥdt ) q .
xt
Since x > ln(1 + x) for x > 0 and (1 + st + st∗ )xt < 1 by the solvency constraint,
q

st∗ xt st∗ xt
q q
ln 1 + ∗ q < ∗ q ≤ ρ ĥt − ĥt .
d
1 − (1 + st + st )xt 1 − (1 + st + st )xt
Hence, we show that the time-consistency constraint (27) is satisfied. 2
Appendix B. Algorithm
The formal delay differential equations that characterize the Markov equilibrium are
μq (ω, q0ω , H0ω ) μH (ω, q0ω , H0ω )
q (ω) = ω ω q(ω), and H (ω) = H (ω),
ω
ωμ (ω, q0 , H0 ) ωμω (ω, q0ω , H0ω )
where q0ω ≡ {q(v), 0 ≤ v ≤ ω}, H0ω ≡ {H (v), 0 ≤ v ≤ ω} and μq , μH , and μω are functional
operators that we illustrate in Section 2.2.1.
As ω approaches zero, q(ω̂) is close to q(ω) and the expression of the endogenous risk (2)
implies that x q converges to x. As the marginal buyer of physical capital, households’ first-order
condition (11) fixes q(0) = q, which satisfies
a h − δ (q − 1)
2
+ − ρ = λx.
q 2φq
As ω converges to zero, H (ω̂) becomes close to H (ω). The differential equation (24) for H (ω)
implies that H (ω) converges to τ s ∗/ρ(ρ+ξ +χ). Given the expression for the maximum leverage of
shadow banking (17), we can see that H (ω) converges to zero as ω becomes arbitrarily close to
zero.
The critical difference between delay differential equations and ordinary differential equations
is that q (ω) and H (ω) not only depend on q(ω) and H (ω) but also rely on values of the two
functions on [0, ω]. Therefore, to numerically solve for q(ω) and H (ω) initial conditions that
we need are q(ω) = q + q and H (ω) = H ωω0 on an interval [0, ω0 ], where q , H , and ω0 are
small constants.
Numerical Procedure
We set positive constants ql = 0, qh = 0.4, Hl = 0, Hh = 0.4, ω0 = 2 × 10−5 , and de-
fine q = 0.5(ql + qh ) and H = 0.5(Hl + Hh ). We discretize the state space [0, 1] such that
ω(1) = 0, ω(2), ..., ω(m) = ω0 , ..., ω(N) = 1. We follow the following steps to solve the differ-
ential equations for ω(n), n = m, m + 1, ....
(i) For each n ≥ m, we need to identify ω̂, where ω moves to if a Poisson shock arrives. For
any candidate ω̂ within the interval (0, ω(n)), we find q̂ = q(ω̂) and Ĥ = H (ω̂). Next, we solve
for s + s ∗ based on equation (21) and s̄ ∗ based on equations (13) and (17). Hence, we also fix s.
To test if the candidate ω̂ is correct, we check if equation (25) holds. If we find such ω̂, then
proceed to step (ii)
(ii) If s + s ∗ satisfies ω(1 + s + s ∗ ) ≤ 1, then proceed to step (iii); otherwise, we search for
smaller ω̂ such that ω(1 + s + s ∗ ) = 1 holds and proceed to step (iii)
(iii) Given ω̂ as well as x q , s, and s ∗ , we use equation (20) to compute μω and use equation
(13) to compute μq . Given μω and μq , equation (22) yields dq/dω. Hence, we compute q(n + 1)
dq
q(n + 1) = q(n) + (ω(n + 1) − ω(n)),
dω
and proceed to step (iv)
(iv) To update H (n +1), we first compute Ĥ = H (ω̂) and use equation (24) to compute dH/dω.
Then, we compute H (n + 1) according to
dH
H (n + 1) = H (n) + (ω(n + 1) − ω(n))
dω
and proceed to step (v).
(v) Check five conditions: 1) both μq and μω are negative; 2) μq is negative and μω is positive;
3) μω is negative and μq is positive; 4) ψ(n) < ψ(n − 1) while ψ(n − 1) = 1; 5) μq (n) >
μq (n − 1) while ψ(n − 1) = 1.
If condition 1 holds, proceed to step (vi); if condition 2 holds, we lower q by setting qh = q
and restart step (i) from n = m without changing ql , Hh , or Hl ; if either of conditions 3–5 holds,
then we raise q by setting ql = q and restart step (i) from n = m without changing qh , Hh ,
or Hl .
If none of the five conditions hold, we proceed to step (i) from n + 1.
(vi) Check 4 conditions: 1.1) |μH (n)| < 10−3 ; 1.2) μH > 10−3 ; 1.3) μH < −10−3 ; 1.4) there
exists k ≤ n such that μH (k) < 0 and the maximum absolute value of μH (k) − μH (k − 1) for
all k ≤ n is higher than 1.5.
If condition 1.1 holds, we exit the whole procedure; if condition 1.2 holds, we lower H by
setting Hh = H and restart step (i) from n = m with ql = 0, qh = 0.4, and not changing Hl ;
if either conditions 1.3 or 1.4 holds, we raise H by setting Hl = H and restart step (i) from
n = m with ql = 0, qh = 0.4, and not changing Hh .
We identify conditions 4, 5, and 1.4 from experimenting a number of numerical procedures
and initial conditions. Higher-order methods, such as Runge–Kutta, can replace the Euler method
used steps (iii) and (iv).
Appendix C. Supplementary material
Supplementary material related to this article can be found online at https://doi.org/10.1016/

j.jet.2018.09.003.
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Banking and shadow banking

JEL classification: E44; G21; G24; G38

Keywords: Shadow banking; Implicit guarantee; Bank regulation; Endogenous risk

E-mail address: [email protected].

1. The baseline model

1.1. Technology and preferences

dkt = kt (ιt − δ) dt − kt xdNt ,

where x is a positive constant and {Nt }∞ 5

1.2. Return from holding physical capital

q a h − ιht − 0.5φ(ιht − δ)2 q

1.3. Equity issuance friction, bank regulation, and shadow banks

1.4. Problems for bankers and households

to the filtration generated by {Nt }∞ ∗ q

where cth is the household’s consumption. The household takes {qt , rt }∞

an equilibrium is defined by a set of stochastic processes adapted to the filtration generated by

5. markets for both consumption goods and physical capital clear

qt kti = Wti + Sti + Sti,∗ , qt kth = Sth .

2. Bank regulation and financial instability

2.1. Equilibrium characterization

2.1.1. Production of physical capital

2.1.2. Households’ optimal choices

2.1.3. Bankers’ optimal choices

2.1.4. The maximum leverage of shadow banking

Proposition 1 (Opportunity Cost of Default). Probabilistic Representation of Ht :

Proof. See the online appendix. 2

2.1.5. Market clearing and wealth distribution

Lemma 1. The law of motion for ωt is

Proof. See Appendix A. 2

2.2. Markov equilibrium

Although we can characterize an equilibrium with equations (3)-(18), it is still challenging

2.2.1. Numerical calculation

2.2.2. Equilibrium uniqueness

Theorem 1 (Uniqueness). If τ < (ρ + ξ + χ) x, the mapping  is a contraction mapping with

Proof. See the online appendix. 2

2.3. Economic dynamics

Pro-cyclical Leverage of Shadow Banking. The leverage of shadow banking is pro-cyclical

2.4. Regulatory implications

2.4.1. Regulatory paradox

2.4.2. Exogenous leverage constraint on shadow banking

13 The economy mostly stays around the state ω = 0.38.

4.1. Risky shadow bank debt

for HJBN and

Appendix C. Supplementary material

Supplementary material related to this article can be found online at https://doi.org/10.1016/

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Theorem 1 (Uniqueness). If τ < (ρ + ξ + χ) x, the mapping is a contraction mapping with