{
  "title": "Shadow Banking and Market Discipline on Traditional Banks",
  "publication": "IMF Working Papers, December 22, 2017",
  "sourceUrl": "https://www.imf.org/en/publications/wp/issues/2017/12/22/shadow-banking-and-market-discipline-on-traditional-banks-45518",
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  "summary": "We present 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 on traditional banks: these banks optimally commit to a safe portfolio strategy to prevent early wi",
  "sections": [
    {
      "heading": "Summary",
      "content": "- Presents a model in which shadow banking arises endogenously and undermines market discipline on traditional banks.\n- 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.\n- With costly commitment, shadow banking emerges as an alternative banking strategy that combines high risk-taking with early liquidation in times of crisis.\n- 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.\n- 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.\n- Financial stability can also be achieved with a tax on shadow bank profits."
    },
    {
      "heading": "Model and Mechanism",
      "content": "- Core mechanism: Depositors can re-optimize in crises, which disciplines traditional banks via the threat of early withdrawal.\n- Costly commitment by banks undermines their ability to commit to safe portfolios, enabling a shadow banking strategy that:\n  - Pursues higher risk-taking.\n  - Engages in early liquidation when crises hit.\n- Shadow bank liquidations can generate fire-sale discounts that transmit liquidity risk to traditional banks."
    },
    {
      "heading": "Application to the 2008 U.S. Financial Crisis",
      "content": "- The model is applied to the 2008 financial crisis in the United States.\n- 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."
    },
    {
      "heading": "Equilibrium Dynamics and Key Mechanisms",
      "content": "- Expansion channel: Shadow banking may expand until its collective liquidation causes a fire-sale that imposes liquidity risk on traditional banks.\n- Interest-rate channel: Higher deposit rates that compensate depositors for liquidity risk:\n  - Weaken the threat of early withdrawal.\n  - Encourage traditional banks to pursue riskier portfolios, potentially leaving them in default."
    },
    {
      "heading": "Policy Implications and Recommendations",
      "content": "- Interventions aimed at making traditional banks safer:\n  - Liquidity support.\n  - Bank regulation.\n  - Deposit insurance.\n  - These measures can stimulate further shadow banking expansion but yield a net positive effect on financial stability.\n- Alternative or complementary policy: A tax on shadow bank profits can also achieve financial stability.\n\n---\n\n Content in this bundle\n\n- Shadow Banking and Market Discipline on Traditional Banks, WP/17/285, December 2017\n  - Shadow Banking and Market Discipline on Traditional Banks, WP/17/285, December 2017 (Markdown version){rel=\"alternate\" type=\"text/markdown\"}\n  - Shadow Banking and Market Discipline on Traditional Banks, WP/17/285, December 2017 (PDF){rel=\"external\" type=\"application/pdf\"}\n\n---\n\nSource: https://www.imf.org/en/publications/wp/issues/2017/12/22/shadow-banking-and-market-discipline-on-traditional-banks-45518"
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    "Authors: Anil Ari, Matthieu Darracq-Paries, Christoffer Kok",
    "Published: December 22, 2017",
    "Series: IMF Working Papers",
    "DOI: https://doi.org/10.5089/9781484335376.001",
    "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.",
    "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:",
    "Shadow bank liquidations can generate fire-sale discounts that transmit liquidity risk to traditional banks.",
    "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.",
    "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:",
    "Interventions aimed at making traditional banks safer:",
    "Alternative or complementary policy: A tax on shadow bank profits can also achieve financial stability.",
    "**Shadow Banking and Market Discipline on Traditional Banks, WP/17/285, December 2017**"
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