Handbook of the Economics of Finance

Sovereign Default, Domestic Banks, and Financial Institutions

Banking and Shadow Banking

We study a banking model in which regulatory arbitrage induces the existence of shadow banking next to regulated banks. We show that the size of the shadow banking sector determines its stability. Panic-based runs become possible only if this sector is large. Moreover, if regulated banks conduct shadow banking, a relatively larger shadow banking sector is sustainable. However, crises become contagious and spread to the regulated banking sector. We argue that deposit insurance may fail to eliminate adverse run equilibria in the presence of regulatory arbitrage. It may become tested in equilibrium if regulated banking and shadow banking are intertwined.

https://www.econstor.eu/bitstream/10419/113204/1/VfS_2015_pid_210.pdf

Banks, shadow banking, and fragility

​The paper sheds light on the interplay between monetary policy, the commercial banking sector and the shadow banking sector in mainland China by means of a nonlinear stochastic general equilibrium (DSGE) model with occasionally binding constraints. In particular, we analyze the impacts of interest rate liberalization on monetary policy transmission as well as the dynamics of the parallel shadow banking sector. Comparison of various interest rate liberalization scenarios reveals that monetary policy results in increased feed-through to the lending and investment under complete liberalization. Furthermore, tighter regulation of interest rates in the commercial banking sector in China leads to an increase in loans provided by the shadow banking sector.

/pdf/monetary-policy-transmission-in-china-a-dsge-model-with-2xgrt41xzo.pdf

Monetary Policy Transmission in China: A DSGE Model with Parallel Shadow Banking and Interest Rate Control

Banks, Shadow Banking, and Fragility

We provide a model that unifies the notion of self-fulfilling banking crises and sovereign debt crises. In this model, a bank run can be contagious by triggering a sovereign default, and vice versa. A deposit insurance scheme can eliminate the adverse equilibrium only if the government can repay its debt and credibly insure deposits irrespective of the performance of the financial sector. Moreover, we analyze how banking crises and sovereign defaults can be contagious across countries. We give conditions under which the implementation of a banking union is effective and costless. Finally, we discuss the current proposals for a banking union in the euro area and argue that it should be extended by a supranational Deposit Guarantee Scheme.

/pdf/sovereign-defaults-bank-runs-and-contagion-hawmuw7cml.pdf

Sovereign Defaults, Bank Runs, and Contagion

This paper discusses whether financial intermediaries can optimally provide liquidity, or whether the government has a role in creating liquidity by supplying government securities. We discuss a model in which intermediaries optimally manage liquidity with outside rather than inside liquidity: instead of holding liquid real assets that can be used at will, banks sell claims on long-term projects to investors. While increasing efficiency, liquidity management with private outside liquidity is associated with a rollover risk. This rollover risk either keeps intermediaries from providing liquidity optimally, or it makes the economy inherently fragile. In contrast to privately produced claims, government bonds are not associated with coordination problems unless there is the prospect that the government may default. Therefore, efficiency and stability can be enhanced if liquidity management relies on public outside liquidity.

/pdf/outside-liquidity-rollover-risk-and-government-bonds-527p70z54s.pdf

Outside Liquidity, Rollover Risk, and Government Bonds

This paper studies a banking model of maturity transformation in which regulatory arbitrage induces the coexistence of regulated commercial banks and unregulated shadow banks. We derive three main results: First, the relative size of the shadow banking sector determines the stability of the financial system. If the shadow banking sector is small relative to the capacity of secondary markets for shadow banks' assets, shadow banking is stable. In turn, if the sector grows too large, it becomes fragile: an additional equilibrium emerges that is characterized by a panic-based run in the shadow banking sector. Second, if regulated commercial banks themselves operate shadow banks, a larger shadow banking sector is sustainable. However, once the threat of a crisis reappears, a crisis in the shadow banking sector spreads to the commercial banking sector. Third, in the presence of regulatory arbitrage, a safety net for banks may fail to prevent a banking crisis. Moreover, the safety net may be tested and may eventually become costly for the regulator. JEL Classification: G21, G23, G28

Paul Schempp

Papers

Banks, shadow banking, and fragility

Banks, Shadow Banking, and Fragility

Sovereign Defaults, Bank Runs, and Contagion

Outside Liquidity, Rollover Risk, and Government Bonds

Banks, shadow banking, and fragility