Sustainable Shadow Banking

Commercial banks are subject to regulation that restricts their investments. When banks are concerned for their reputation, however, they could self-regulate and invest more efficiently. Hence, a shadow banking that arises to avoid regulation has the potential to improve welfare. Still, reputation concerns depend on future economic prospects and may suddenly disappear, generating a collapse of shadow banking and a return to traditional banking, with a decline in welfare. I discuss how a combination of traditional regulation and cross reputation subsidization may enhance shadow banking and make it more sustainable.