Traditional and Shadow Banks During the Crisis

Abstract

We present a model of the interactions between traditional and shadow banks that explains their coexistence. In the 2007 financial crisis, some of shadow banks’ assets and liabilities moved to traditional banks, and assets were sold at fire sale prices. Our model is able to accommodate these stylized facts. The difference between traditional and shadow banks is twofold. First, traditional banks have access to a guarantee fund that enables them to issue claims to households in a crisis. Second, traditional banks have to comply with costly regulation. We show that in a crisis, shadow banks liquidate assets to repay their creditors, while traditional banks purchase these assets at fire-sale prices. This exchange of assets in a crisis generates a complementarity between traditional and shadow banks, where each type of intermediary benefits from the presence of the other. We find two competing effects from a decrease in traditional banks’ support in a crisis, which we dub a substitution effect and an income effect. The latter effect dominates the former, so that lower anticipated support to traditional banks in a crisis increases entry in the traditional banking sector ex-ante.