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Bank, Shadow Banking, and Fragility

Date: 
Tuesday 16th December 2014 - 16:15 to 17:00
Venue: 
INI Seminar Room 1
Abstract: 
Co-author: Paul Schempp (University of Bonn and Max Planck Insitute for Research on Collective Goods)

This paper studies a banking model of maturity transformation in which regulatory arbitrage induces the existence of shadow banking next to regulated commercial 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, the parameter space in which a run on shadow banks may occur is reduced. 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.

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University of Cambridge Research Councils UK
    Clay Mathematics Institute London Mathematical Society NM Rothschild and Sons