Shadow Banking and Market Discipline on Traditional Banks

IMF Working Papers, December 22, 2017

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Shadow Banking and Market Discipline on Traditional Banks

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Bibliographic details

• Authors: Anil Ari, Matthieu Darracq-Paries, Christoffer Kok
• Published: December 22, 2017
• Series: IMF Working Papers
• DOI: https://doi.org/10.5089/9781484335376.001

Summary

• Presents a model in which shadow banking arises endogenously and undermines market discipline on traditional banks.
• Depositors' ability to re-optimize in response to crises imposes market discipline: traditional banks optimally commit to a safe portfolio strategy to prevent early withdrawals.
• With costly commitment, shadow banking emerges as an alternative banking strategy that combines high risk-taking with early liquidation in times of crisis.
• An equilibrium exists where the shadow banking sector expands to a size where its liquidation causes a fire-sale and exposes traditional banks to liquidity risk.
• Policy interventions that make traditional banks safer—liquidity support, bank regulation, and deposit insurance—fuel further expansion of shadow banking but have a net positive impact on financial stability.
• Financial stability can also be achieved with a tax on shadow bank profits.

Model and Mechanism

• Core mechanism: Depositors can re-optimize in crises, which disciplines traditional banks via the threat of early withdrawal.
• Costly commitment by banks undermines their ability to commit to safe portfolios, enabling a shadow banking strategy that:
  • Pursues higher risk-taking.
  • Engages in early liquidation when crises hit.
• Shadow bank liquidations can generate fire-sale discounts that transmit liquidity risk to traditional banks.

Application to the 2008 U.S. Financial Crisis

• The model is applied to the 2008 financial crisis in the United States.
• During the crisis, shadow banks experienced a sudden dry-up of funding and liquidated assets, consistent with the model’s mechanism of early liquidation and contagion via fire-sales.

Equilibrium Dynamics and Key Mechanisms

• Expansion channel: Shadow banking may expand until its collective liquidation causes a fire-sale that imposes liquidity risk on traditional banks.
• Interest-rate channel: Higher deposit rates that compensate depositors for liquidity risk:
  • Weaken the threat of early withdrawal.
  • Encourage traditional banks to pursue riskier portfolios, potentially leaving them in default.

Policy Implications and Recommendations

• Interventions aimed at making traditional banks safer:
  • Liquidity support.
  • Bank regulation.
  • Deposit insurance.
  • These measures can stimulate further shadow banking expansion but yield a net positive effect on financial stability.
• Alternative or complementary policy: A tax on shadow bank profits can also achieve financial stability.

Content in this bundle

• Shadow Banking and Market Discipline on Traditional Banks, WP/17/285, December 2017
  • Shadow Banking and Market Discipline on Traditional Banks, WP/17/285, December 2017 (Markdown version)
  • Shadow Banking and Market Discipline on Traditional Banks, WP/17/285, December 2017 (PDF)