What SH3 does, is to just blur the shadows in 2D before applying them to the scene. That, as people have noticed, creates some nasty artifacts.
Firstly the blur filter they use is not particularly sophisticated. It's probably just a down-sample to a lower resolution, followed by using the standard bilinear texture filter to expand up again. That makes it look a little blocky. You can do nicer filtering operations with jittering and variable sized sampling, but it's a bit more expensive...
The other problem (and for me it's a more serious one) is that you get odd "halo" effects around the shadows. The problem is that the stencil shadow is essentially in 2D once you've drawn it. If you just blur that, you get a nice soft edge to the shadows, but not all of them should look like that.
On a flat plane, like the floor, any blurring looks good because you are blending stuff together which is physically adjacent. However if (for example) the character is in front of that shadow, and the character itself is not shadowed (perhaps the light is behind the camera and the character itself is *casting* the shadow), then the shadow pixels on the floor will be blended with the non-shadowed pixels on the character, and so there will be a strange blurred area of light around the character.