A Model of Shadow Banking
Journal of Finance, Forthcoming
65 Pages Posted: 8 May 2012
Date Written: April 16, 2012
We present a model of shadow banking in which banks originate and trade loans, assemble them into diversified portfolios, and finance these portfolios externally with riskless debt. In this model: outside investor wealth drives the demand for riskless debt and indirectly for securitization, bank assets and leverage move together, banks become interconnected through markets, and banks increase their exposure to systematic risk as they reduce idiosyncratic risk through diversification. The shadow banking system is stable and welfare improving under rational expectations, but vulnerable to crises and liquidity dry-ups when investors ignore tail risks.
JEL Classification: E44, G01, G21
Suggested Citation: Suggested Citation