The Prudential Toolkit with Shadow Banking

Kinda Hachem and Martin Kuncl

Staff Working Papers from Bank of Canada

Abstract: Several countries now require banks or money market funds to impose state-contingent costs on short-term creditors to absorb financial stress. We study these requirements as part of the broader prudential toolkit using a model with five key ingredients: banks may face an aggregate stress state with high withdrawals; a fire-sale externality motivates a mix of non-contingent and state-contingent regulation; banks may use shadow technologies to circumvent regulation; parameters of the shadow technologies may be private information; and bailouts may occur. We characterize the optimal policy for various combinations of these ingredients and demonstrate that the threat of shadow activities constrains state-contingent regulation more than non-contingent regulation, especially when imperfect information and limited commitment coexist. The planner triggers shadow activities with positive probability under imperfect information, and shadow activities that deplete resources in the stress state elicit larger bailouts under limited commitment, rendering the requirement of state-contingent costs a weak instrument.

Keywords: Financial institutions; Financial stability; Financial system regulation and policies (search for similar items in EconPapers)
JEL-codes: D62 E61 G01 G21 G28 (search for similar items in EconPapers)
Pages: 90 pages
Date: 2025-03
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Working Paper: The Prudential Toolkit with Shadow Banking (2025)
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Persistent link: https://EconPapers.repec.org/RePEc:bca:bocawp:25-9

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