The results from the ECB’s stress tests are in and, while no one’s happy that 25 out of 130 banks failed, finding out that Italy, Greece, and Cyprus haven’t finished fixing their financial sectors is hardly a shock. But Guillaume Plantin, Professor of Finance at the Toulouse School of Economics, all these prudential measures meant to stave off the next big crash might be doing more harm than good by redirecting business to the shadow banking system. But instead of trying to regulate shadow banks, he thinks regulators should simply take a step back.

“The main response to the 2008 banking crisis consists thus far of a global trend towards increasing capital requirements for licensed banks, leaving many aspects of shadow banking unaddressed by regulatory reforms,” Plantin writes. “These heightened capital requirements for licensed banks may trigger even more regulatory arbitrage than was observed in the recent past, thereby inducing a large migration of banking activities towards the shadow banking system.”

Figure. Bank balance sheet after initial cash transfers are made

Prudential Regulations shadow banking

Shadow banking: Plantin assumes that regulatory arbitrage can’t be prevented

Plantin’s argument, which he gives in more detail in an upcoming paper in the Review of Financial Studies, is that the optimum amount of leverage is higher from a bank’s perspective than it is from society’s perspective because banks don’t internalize all of their costs, which he says is why banks need capital requirements and non-financial companies don’t. Since capital requirements are typically binding, banks actively seek out regulatory arbitrage: new financial products or tactics that get around regulations and allow the banks to increase their effective leverage anyways.

Plantin’s big assumption, which really informs the rest of the paper, is that regulators aren’t able to clamp down on regulatory arbitrage because banks will always be able to throw more resources at the problem (both money and expertise) leaving regulators a step behind. His basic argument is that loosening regulations shifts leverage back into the traditional arena where at least we can see it, instead of pushing it into the opaque shadow banking system.

Figure . Surplus in Proposition 3 case c

Prudential Regulations shadow banking

Shadow banking: Plantin is too quick to accept risky practices

Plantin says his motivation for the paper is that not enough researchers are seriously grappling with ‘imperfect enforcement’. Aside from this approach being incredibly tough to sell politically, but it’s strange that he never considers other regulatory answers. In reality, stringent capital requirements exist because some banks are ‘too big to fail’ and taxpayers will be on the hook for another bailout if something goes wrong. If it’s true that regulators can’t possibly keep up with financial innovation meant to get around the law (already not something we should accept at face value), surely the answer would be to break up the banks so that they don’t have to be bailed out in the first place. Plantin seems very quick to conclude that we have no choice but to accept an over-leveraged banking sector.

Full PDF here ShadowBankingAndBankCapital