Shadow Banking and Financial Innovation: Regulators in Search of a Theory Post-2008?

The 2007-09 crisis posed an intellectual challenge to finance and economics, and to the practice of financial regulation. The financial crisis exposed the field of academic economics as apparently not tuned into diagnosing and anticipating the nature or the scale of the credit crunch. The diagnoses of this problem vary. On the one hand, it is clear to many that financial regulation at national and international levels had been informed by a wrong set of theoretical assumptions. Post-2009, there is a consensus in regulatory and academic circles that the neoclassical derived micro-prudential approach to financial regulation at national and international levels had become inadequate in the age of deepening connections and systemic risks in the financial system. On the other, some scholars have argued that financial regulators, rather than being guided by a firm theoretical framework, simply acted as ‘market makers’ to the private financial institutions, and thus became ‘captured’ in the spiral of regulatory arbitrage, or financial innovation.

Perhaps no other element of the financial cycle encapsulates these dilemmas better than the phenomenon of shadow banking. Having first come to light in 2007, the role of the shadow banking system in the financial crisis of 2007-09 underscored the so far under-examined role of endogenous financial process,  ‘inside liquidity’ mechanisms in generating financial cycles and systemic risks in finance. Yet paradoxically, while systemic risk has become central in post-crisis regulatory moves to regulate the shadow banking system, it remains a rather ambiguous notion in financial regulation. This paper inquiries into what, if anything, has shifted in the regulatory maps, in light of the lessons about the shadow banking system. Revisiting key policy reforms aimed at regulating the shadow banking system, I ask what are the areas of conceptual ambiguity in the post-2009 financial reforms; to what extent the reforms are driven by the objective to resolve the problem of regulatory capture; and to what extent the post-crisis architecture is informed by a new set of theoretical assumptions.