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December 22, 2017

IMF published a working paper on shadow banking and market discipline on traditional banks. The paper proposes a framework in which depositors may withdraw their deposits early in reaction to crises.

The paper 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 on traditional banks: these 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.

The model focuses on the 2008 financial crisis in the United States, during which shadow banks experienced a sudden dry-up of funding and liquidated their assets. It derives an equilibrium in which the shadow banking sector expands to a size where its liquidation causes a fire-sale and exposes traditional banks to liquidity risk. Higher deposit rates in compensation for liquidity risk also weaken threats of early withdrawal and traditional banks pursue risky portfolios that may leave them in default. Policy interventions—such as liquidity support, bank regulation, and deposit insurance—which are aimed at making traditional banks safer, fuel further expansion of shadow banking but have a net positive impact on financial stability. The paper argues that financial stability can also be achieved with a tax on shadow bank profits.

 

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Keywords: International, Banking, Shadow Banking, Fire Sales, IMF

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