When Shadows Grow Longer: Shadow Banking with Endogenous Entry

35 Pages Posted: 28 Aug 2016

See all articles by Anil Ari

Anil Ari

International Monetary Fund

Matthieu Darracq Paries

European Central Bank (ECB)

Christoffer Kok

European Central Bank (ECB)

Dawid Żochowski

European Central Bank

Date Written: August 26, 2016

Abstract

Why did the shadow banking sectors in the US and the euro area expand in the decade before the financial crisis and what are the implications for systemic risk and macro-prudential policy? This paper examines these issues with a model of the financial sector where the size of the shadow banking sector is endogenous. In the model, shadow banking is an alternative banking strategy which involves greater risk-taking at the expense of being exposed to “fundamental runs” on the funding side. When such runs occur, shadow banks liquidate their assets in a secondary market. Entry into shadow banking is profitable when traditional banks provide sufficient secondary market demand to prevent these liquidations from causing a fire-sale. During periods of stability, the shadow banking sector expands to an excessively large size that ferments systemic risk. Its collapse then triggers a fire-sale that renders traditional banks vulnerable to “liquidity runs”. The prospect of liquidity runs undermines market discipline and increases the risk-taking incentives of traditional banks. Policy interventions aimed at alleviating the fire-sale fuel further expansion of the shadow banking sector. Financial stability is achieved with a Pigouvian tax on shadow bank profits.

Keywords: Shadow Banking, Fire-Sales, Financial Crises, Macro-Prudential Regulation

JEL Classification: E44, G01, G11, G21, G28

Suggested Citation

Ari, Anil and Darracq Paries, Matthieu and Kok, Christoffer and Żochowski, Dawid, When Shadows Grow Longer: Shadow Banking with Endogenous Entry (August 26, 2016). ECB Working Paper No. 1943. Available at SSRN: https://ssrn.com/abstract=2830543

Anil Ari (Contact Author)

International Monetary Fund ( email )

700 19th Street NW
Washington, DC 20431
United States

HOME PAGE: http://https://sites.google.com/site/anlari/

Matthieu Darracq Paries

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany
+496913446631 (Phone)
+496913447604 (Fax)

Christoffer Kok

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

Dawid Żochowski

European Central Bank ( email )

Sonnemannstrasse 20
Frankfurt am Main, 60314
Germany

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