Shadow Banking and Market Discipline on Traditional Banks

65 Pages Posted: 18 Jan 2018

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

Multiple version iconThere are 2 versions of this paper

Date Written: December 2017

Abstract

We present a model in which shadow banking arises endogenously and undermines marketdiscipline on traditional banks. Depositors' ability to re-optimize in response to crisesimposes market discipline on traditional banks: these banks optimally commit to a safeportfolio strategy to prevent early withdrawals. With costly commitment, shadow bankingemerges as an alternative banking strategy that combines high risk-taking with earlyliquidation in times of crisis. We bring the model to bear on the 2008 financial crisis in theUnited States, during which shadow banks experienced a sudden dry-up of funding andliquidated their assets. We derive an equilibrium in which the shadow banking sectorexpands to a size where its liquidation causes a fire-sale and exposes traditional banks toliquidity risk. Higher deposit rates in compensation for liquidity risk also weaken threats ofearly 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, bankregulation and deposit insurance fuel further expansion of shadow banking but have a netpositive impact on financial stability. Financial stability can also be achieved with a tax onshadow bank profits.

Keywords: Financial crisis, United States, Western Hemisphere, Financial crises, Shadow banking, Central banks and their policies, Market discipline, Fire-sales, Financial Markets and the Macroeconomy, Government Policy and Regulation

JEL Classification: E44, E58, G01, G21, G23, G28

Suggested Citation

Ari, Anil and Darracq Paries, Matthieu and Kok, Christoffer and Żochowski, Dawid, Shadow Banking and Market Discipline on Traditional Banks (December 2017). IMF Working Paper No. 17/285. Available at SSRN: https://ssrn.com/abstract=3104558

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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