This paper traces the roots of collateral flow and its potential vulnerabilities in the shadow banking system to their regulatory capital treatment in the banking sector. As part of assessing the interaction of banking regulation and the shadow banking sector, it investigates the impact of bank regulatory capital reforms on the repo markets, and specifically the regulatory treatment of certain types of collateral widely used to secure repo transactions in Europe. As sovereign bonds constitute 80% of the financial collateral used in the European repo transactions, this paper details the preferential regulatory capital treatment of such assets within the Basel framework as well as the EU regime for bank regulatory capital, i.e., the CRD IV package comprising the CRD IV & CRR. The paper argues that the effects of capital reforms percolate to collateral used in repo transactions, which constitute a large part of the shadow banking operations and is the major source of short-term funding for banks and other financial institutions. It highlights the favorable regulatory risk-weights assigned to sovereign debt the exposure to which requires lower levels of capital or bears no capital at all. In addition, the regulation-induced perceived riskless nature of sovereign bonds leads to lower collateral haircuts for government collateral in the repo markets, which again boosts the demand for such collateral. The main finding of the paper is that there is a positive correlation between the preferential regulatory treatment of certain exposures for regulatory capital purposes and the surge of interest in such exposures (collateral) to be used in repo transactions. The preferential treatments of certain repo collateral (domestic government bonds) in terms of capital requirements and repo haircuts can also partly explain the home bias and bank-sovereign loop in the European banking and financial markets. This paper concludes that the preferential regulatory capital treatment of sovereign bonds, which drives a wedge between their real or fundamental riskiness and perceived riskiness, should be removed, as they tend to increase the distortions in risk pricing and are likely to contribute to systemic risk, the consequences of which can by far offset the potential benefits of such a preferential regulatory treatment.