Implications of Shadow Bank Regulation for Monetary Policy at the Zero Lower Bounds

Abstract

Counter to the credit channel of monetary transmission, monetary policy tightening induces a rise in lending by two di erent types of non-bank nancial institutions (NBFI): shadow banks and investment funds. A monetary DSGE model is able to replicate the empirical facts when augmented with interme- diaries that allow for regulatory arbitrage on the one hand, and household portfolio rebalancing on the other. Therefore NBFI reduce the e ectiveness of the bank lending channel, which posits a decrease in bank lending following monetary tightening. Given the pending regulation of the nancial system, I study how regulation of the shadow banking sector may a ect the monetary transmission mechanism, especially during a zero lower bound (ZLB) episode. I nd that bringing shadow banks back onto the balance sheets of commercial banks is bene cial for consumption smoothing. Alternatively, regulating them like investment funds results in a milder recession during, and a quicker escape from, the ZLB. This is because a large demand shock that moves the economy to the ZLB acts in a similar way to a monetary tightening due to the inability to lower the policy rate to the unconstrained level. Consequently, the bank lending channel becomes operational and its e ectiveness can be reduced via less reliance on deposit funding.