## Shadow Banking and Market Discipline on Traditional Banks

_IMF Working Papers, December 22, 2017_

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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

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### 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.

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## Content in this bundle

- **Shadow Banking and Market Discipline on Traditional Banks, WP/17/285, December 2017**
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_Source: https://www.imf.org/en/publications/wp/issues/2017/12/22/shadow-banking-and-market-discipline-on-traditional-banks-45518_