Banks, Shadow Banking, and Fragility

39 Pages Posted: 23 Aug 2014

See all articles by Stephan Luck

Stephan Luck

Federal Reserve Bank of New York

Paul Schempp

University of Cologne - Center for Macroeconomic Research (CMR); Max Planck Institute for Research on Collective Goods

Date Written: August 13, 2014

Abstract

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.

Keywords: shadow banking, regulatory arbitrage, financial crisis, bank runs, maturity transformation

JEL Classification: G21, G23, G28

Suggested Citation

Luck, Stephan and Schempp, Paul, Banks, Shadow Banking, and Fragility (August 13, 2014). ECB Working Paper No. 1726, Available at SSRN: https://ssrn.com/abstract=2479948 or http://dx.doi.org/10.2139/ssrn.2479948

Stephan Luck (Contact Author)

Federal Reserve Bank of New York ( email )

33 Liberty Street
New York, NY 10045
United States

Paul Schempp

University of Cologne - Center for Macroeconomic Research (CMR) ( email )

Cologne
Germany

Max Planck Institute for Research on Collective Goods ( email )

Kurt-Schumacher-Str. 10
D-53113 Bonn, 53113
Germany

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