In the Shadow of Shadow Banking: A Liquidity Perspective

Abstract

Liquidity requirements for commercial banks improve risk-sharing for depositors. Nevertheless, shadow banks, issuing securities with lower liquidity, operate outside such regulatory constraints. In an economy featuring shadow banks and a fixed level of liquidity for shadow bank securities, higher liquidity requirements lead to a reduction in aggregate liquidity provision, owing to regulatory arbitrage incentives. Conversely, when the liquidity of shadow bank securities is endogenous, higher liquidity requirements could enhance aggregate liquidity provision, because the liquidity of shadow bank securities decreases with the market share of shadow banks, thus mitigating the incentive for regulatory arbitrage.

Keywords: Shadow Banking, Liquidity Requirements, Regulatory Arbitrage, Liquidity Shortage, Search and Matching

JEL Classification: E40, E50, G20