ABSTRACT
Shadow banking emerged into the light in the wake of the financial crisis that broke out in 2007, when banking regulators woke up to the realisation that their vassals had unreported or under-reported commitments to unregulated institutions whose claims could make regulated banks insolvent. This chapter argues that a different kind of balance sheet regulation is responsible for creating the shadow banking system in the financially advanced economies. In such financially complex economies, the policy of setting high capital requirements for banks plays a particular part in creating and sustaining the shadow banking system. Capital adequacy requirements are supposed to work by inducing banks to hold capital that matches the 'riskiness' of their assets. It is no coincidence that the countries that most actively pursued the overcapitalisation of their banking systems were also the countries in which shadow banking has proliferated.
