Welfare-Based Optimal Macroprudential Policy with Shadow Banks

Abstract

In this paper, I show that the existence of non-bank financial institutions (NBFIs) has implications for the optimal regulation of the traditional banking sector. I develop a New Keynesian DSGE model for the euro area featuring a heterogeneous financial sector allowing for potential credit leakage towards unregulated NBFIs. Introducing NBFIs raises the importance of credit stabilization relative to other policy objectives in the welfare-based loss function of the regulator. The resulting optimal policy rule indicates that regulators adjust dynamic capital requirements more strongly in response to macroeconomic shocks due to credit leakage. Furthermore, introducing non-bank finance not only alters the cyclicality of optimal regulation, but also has implications for the optimal steady-state level of capital requirements and loan-to-value ratios. Sector-specific characteristics such as bank market power and risk affect welfare gains from traditional and NBFI credit.