Shadow Banking, Externality and Government Bonds

Abstract

We build an OLG model of depositors, traditional banks and shadow banks, in which traditional banking sector is inherently more efficient than shadow banking sector in resolving maturity mismatch between investments’ long-horizon and depositors’ short-livedness. Government optimally provides deposit insurance to protect traditional banks from aggregate risks and charges an insurance fee as a convex function of banks’ investment scale which reflects the corresponding distortion to the economy implied by emergency taxes in finance of possible bail-outs. Due to this convexity, traditional banking sector can only operate with decreasing return to scale, which gives rise to shadow banking intermediation-the Regulatory Arbitrage View. However, due to higher efficiency traditional banks themselves have motive to engage in shadow banking business and abuse the safety net to provide implicit guarantees for their shadow banking sectors, in which way negative externality from shadow banking business to the economy is presented. Given that the government cannot regulate shadow banking size and thus constrain this externality directly, government bonds outstanding can be social net wealth exactly because their existence constrains the size of shadow banking business and thus its externality to the economy.