Abstract
Bank holding companies invest in risky projects through regulated bank entities and sell projects for a fee, thus engaging in shadow banking. To increase the fee income, BHCs guarantee sold projects with bank proceeds. When demand for financial assets is high, BHCs expand their own bank investments to increase the value of guarantees and to boost the income from off-balance intermediation. The banking sector and the shadow banking sector both expand, bank defaults are more frequent, and guarantees effectively provide recourse to government guarantees enjoyed by regulated banks. By adjusting the minimum capital requirement for banks the regulator can eliminate some of the negative effects of the guarantees.
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