Banks as Producers of Financial Services

Abstract

This paper documents that a rise in government debt is associated with a fall in shadow banking and a rise in traditional banking. This is explained in a model where banks are valued for the financial services they offer. Government debt does not compete directly with banks in providing financial services, but the demand for government debt by banks imparts a liquidity premium to government debt. A rise in government debt is estimated to disproportionately benefit traditional banks so they expand at the expense of shadow banks. An optimal debt policy leads both types of banks to become default free.

Keywords: Banking, Shadow Banking, Liquidity Premium, Optimal Debt Policy