Traditional and Shadow Banks

Abstract

This paper shows that traditional and shadow banks interacted in similar ways in the 2007 and 2020 financial crises, when both assets and liabilities flew from shadow to traditional banks. We explain this finding by modeling the symbiotic relationship between traditional and shadow banks. Traditional banks are subject to costly regulation in exchange for deposit insurance, while shadow banks avoid regulation but cannot rely on deposit insurance. During crises, shadow banks repay their creditors by selling assets at fire sale prices which are purchased by traditional banks using deposit insurance. Regulations for traditional banks have (unintended) effects on shadow banks.