Shadow Banking and Market Discipline on Traditional Banks

By Anil Ari, Matthieu Darracq-Paries, Christoffer Kok, Dawid Żochowski

December 22, 2017

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Anil Ari, Matthieu Darracq-Paries, Christoffer Kok, and Dawid Żochowski. Shadow Banking and Market Discipline on Traditional Banks, (USA: International Monetary Fund, 2017) accessed December 21, 2024

Disclaimer: IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.

Summary

We present a model in which shadow banking arises endogenously and undermines market discipline on traditional banks. Depositors' ability to re-optimize in response to crises imposes market discipline on traditional banks: these banks optimally commit to a safe portfolio strategy to prevent early withdrawals. With costly commitment, shadow banking emerges as an alternative banking strategy that combines high risk-taking with early liquidation in times of crisis. We bring the model to bear on the 2008 financial crisis in the United States, during which shadow banks experienced a sudden dry-up of funding and liquidated their assets. We derive an equilibrium in which the shadow banking sector expands to a size where its liquidation causes a fire-sale and exposes traditional banks to liquidity risk. Higher deposit rates in compensation for liquidity risk also weaken threats of early withdrawal and traditional banks pursue risky portfolios that may leave them in default. Policy interventions aimed at making traditional banks safer such as liquidity support, bank regulation and deposit insurance fuel further expansion of shadow banking but have a net positive impact on financial stability. Financial stability can also be achieved with a tax on shadow bank profits.

Subject: Asset and liability management, Asset liquidity, Bank deposits, Banking, Commercial banks, Financial institutions, Financial regulation and supervision, Financial services, Liquidity risk, Shadow banking

Keywords: Asset liquidity, Bank assets, Bank deposits, Bank profit, Bank run, Banking sector, Central bank, Commercial banks, Demand curve, Excess supply, Expected payoff, Financial crisis, Fire-sale discount, Fire-sales, Global, Liquidity risk, Market discipline, Secondary market, Shadow banking, Traditional bank, WP

Publication Details

Pages:

64
Volume:

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DOI:

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Issue:

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Series:

Working Paper No. 2017/285
Stock No:

WPIEA2017285
ISBN:

9781484335376
ISSN:

1018-5941

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