A Model of Shadow Banking: Crises, Central Banks and Regulation

28 Pages Posted: 26 May 2015  

Giovanni di Iasio

Bank of Italy

Zoltan Pozsar

Credit Suisse; Shadow Banking Colloquium (INET)

Date Written: May 18, 2015

Abstract

We build a two-period model à la Holmstrom and Tirole (1998) in which bankers have access to a shadow banking technology which allows to liquefy partially illiquid investment projects (e.g. mortgages) and to manufacture shadow collateral (e.g. MBS). We study the bankers' security design of shadow collateral. By seeking "simple shadow banking", bankers design shadow collateral which is liquid in all states of nature; in this case, the technology also provides liquidity insurance against aggregate shocks (crises). Conversely, with "complex shadow banking", shadow collateral is designed to be extremely liquid in states without aggregate shocks, thereby boosting bankers' leverage, but illiquid in a crisis. We frame this leverage-insurance choice into the modern financial ecosystem bankers inhabit, characterized by two structural developments. First, the rise of institutional cash pools which manage large cash balances. Their demand for parking space is accommodated by sovereign bonds and shadow collateral. Second, the proliferation of balance sheets with asset-liability mismatches (ALMs), like those of insurance companies and pension funds; these entities have liabilities in fixed nominal amount and, in a low yield environment, seek to allocate funds to bankers which deliver leverage-enhanced returns. We show that when the demand for parking space from cash pools - as compared to the supply of sovereign bonds - and the demand for returns from entities with ALMs are high, complex shadow banking is the competitive equilibrium outcome and the economy is prone to massive deleveraging in the case of aggregate shocks. The paper has several implications in terms of central banks' policy (e.g. Reverse Repo Programs), regulation (capital and liquidity) and, more generally, policies aimed at tackling the two structural developments.

Keywords: G01, G23, G28.

JEL Classification: Shadow banking, Financial crisis, Leverage, Liquidity.

Suggested Citation

di Iasio, Giovanni and Pozsar, Zoltan, A Model of Shadow Banking: Crises, Central Banks and Regulation (May 18, 2015). Available at SSRN: https://ssrn.com/abstract=2610093 or http://dx.doi.org/10.2139/ssrn.2610093

Giovanni Di Iasio (Contact Author)

Bank of Italy ( email )

Via Nazionale 91
00184 Roma
Italy

Zoltan Pozsar

Credit Suisse ( email )

Eleven Madison Avenue
New York, E14 4QJ
United States

Shadow Banking Colloquium (INET) ( email )

300 Park Avenue South, 5th Floor
New York, NY 10010
United States

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