Abstract
I find that shadow bank money creation significantly expands during monetary tightening cycles. This “shadow banking channel” offsets reductions in commercial bank deposits and dampens the impact of monetary policy. Using a structural model of bank competition, I show that the difference in depositor clienteles between commercial and shadow banks quantitatively explains their different responses to monetary policy. Facing a more yield-sensitive clientele, shadow banks pass through more rate hikes to depositors, thereby attracting more deposits when the Federal Reserve raises rates. My results suggest that monetary tightening could unintentionally increase financial fragility by driving deposits into the uninsured shadow banking sector.
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