Business Management Dynamics

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ISSN: 2047-7031

bmd Business and Management Dynamics bmd
ISSN: 2047-7031  
Volume  6   Issue 5  2016  
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Article Abstract
Competing Banks in the Presence of an Unregulated Fringe
Keywords:  financial regulation; shadow banking; Montecarlo simulation
Pedro Hemsley and Rafael Morais
Banking activities are subject to some of the most stringent regulatory frameworks in any country. However, imposing any type of regulation creates an incentive to shadow banking, as some transactions will take place in unregulated firms that are de facto banks. If the regulator does not take this possibility into account, regulation will by myopic. We consider a setting in which two types of firm produce a similar financial product, which has a negative externality - for example, unregulated firms may sell subprime mortgages without proper risk evaluation. The first type of firm is subject to complying with regulation or should pay any fines levied by the government, but the second type is not. The regulator wants to impose a tax or fine to decrease consumption due to the negative externality. We compute the optimal regulatory structure and show that when the government is myopic - i.e., it only considers the impact of taxes and fines on the regulated sector -, the tax is higher than if the demand that trickles down into the unregulated sector is taken into account, and the shadow banking sector grows larger. We run a Montecarlo simulation to show that, in a particular linear demand setting, the myopic tax is twice as high as the optimal one, and causes shadow banking to increase by more than 70%.
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