Bank holding companies invest in risky projects through bank entities or sell projects for a fee, thus engaging in shadow banking. To increase the fee income, BHCs guarantee sold projects with bank proceeds. For high capital requirements and for high demand for financial assets, BHCs expand their bank investments to increase the value of guarantees and to raise demand for off-balance intermediation. The amount of credit in the economy increases, bank defaults are more frequent, and costs of deposit insurance increase. For high social costs of interventions, the welfare-maximizing minimum capital requirement lies below the level optimal in absence of shadow banking.

Discussant: Robin Doettling (University of Amsterdam)