Capturing macroprudential regulation effectiveness: a DSGE approach with shadow intermediaries

Abstract

We develop a New Keynesian DSGE model with heterogeneous agents to investigate how the shadow financial system affects macroeconomic activity and financial stability. In the adopted framework, regulated commercial banks finance small firms through traditional business loans and exert costly effort to screen the projects they finance. Shadow financial intermediaries finance large firms, provide short-term lending to commercial banks, and are engaged in the secondary market for loans. In this market, commercial banks originate asset-backed securities under moral hazard to exploit regulatory arbitrage. Shadow intermediaries purchase these loans from commercial banks under adverse selection. In general equilibrium, this set of externalities is not internalized by the financial system. We show that a macroprudential authority may successfully mitigate the externalities by activating caps to both the leverage ratio and the securitization ratio in the traditional banking sector. Such policy actions are effective in safeguarding financial stability, dampening aggregate volatility and improving welfare.