Shadow Banking and Market Discipline on Traditional Banks
61 Pages Posted: 10 Nov 2017 Last revised: 14 May 2019
Date Written: April 10, 2019
We present a model in which shadow banking arises endogenously and undermines market discipline on traditional banks. Demandable deposits impose market discipline: Without shadow banking, traditional banks optimally pursue a safe portfolio strategy to prevent early withdrawals. Shadow banking constitutes an alternative banking strategy that combines high risk-taking with early liquidation in times of crisis. In equilibrium, shadow banks expand until their liquidation causes a fire-sale and exposes traditional banks to liquidity risk. Higher deposit rates in compensation for liquidity risk deter early withdrawals, undermining market discipline on traditional banks. Constrained-optimal policy interventions deter entry into shadow banking.
Keywords: Shadow banking, financial crisis, market discipline, fire-sales
JEL Classification: E44, E58, G01, G21, G23, G28
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