Shadow Banking and Market Discipline on Traditional Banks

We present a model in which shadow banking arises endogenously and undermines marketdiscipline on traditional banks. Depositors' ability to re-optimize in response to crisesimposes market discipline on traditional banks: these banks optimally commit to a safeportfolio strategy to prevent early withdrawals. With costly commitment, shadow bankingemerges as an alternative banking strategy that combines high risk-taking with earlyliquidation in times of crisis. We bring the model to bear on the 2008 financial crisis in theUnited States, during which shadow banks experienced a sudden dry-up of funding andliquidated their assets. We derive an equilibrium in which the shadow banking sectorexpands to a size where its liquidation causes a fire-sale and exposes traditional banks toliquidity risk. Higher deposit rates in compensation for liquidity risk also weaken threats ofearly withdrawal and traditional banks pursue risky portfolios that may leave them in default.Policy interventions aimed at making traditional banks safer such as liquidity support, bankregulation and deposit insurance fuel further expansion of shadow banking but have a netpositive impact on financial stability. Financial stability can also be achieved with a tax onshadow bank profits