When shadows grow longer: shadow banking with endogenous entry

Why did the shadow banking sectors in the US and the euro area expand in the decade before the financial crisis and what are the implications for systemic risk and macro-prudential policy? This paper examines these issues with a model of the financial sector where the size of the shadow banking sector is endogenous. In the model, shadow banking is an alternative banking strategy which involves greater risk-taking at the expense of being exposed to "fundamental runs" on the funding side. When such runs occur, shadow banks liquidate their assets in a secondary market. Entry into shadow banking is profitable when traditional banks provide sufficient secondary market demand to prevent these liquidations from causing a fire-sale. During periods of stability, the shadow banking sector expands to an excessively large size that ferments systemic risk. Its collapse then triggers a fire-sale that renders traditional banks vulnerable to "liquidity runs". The prospect of liquidity runs undermines market discipline and increases the risk-taking incentives of traditional banks. Policy interventions aimed at alleviating the fire-sale fuel further expansion of the shadow banking sector. Financial stability is achieved with a Pigouvian tax on shadow bank profits. JEL Classification: E44, G01, G11, G21, G28