Private credit creation in the modern financial market

The recent financial crisis started with subprime loan losses in the U.S. shadow banking sector, but why did this lead to a credit contraction by traditional banks? I study the macroeconomic implications of these aspects of the modern financial market. I provide a dynamic general equilibrium model with heterogeneous banking sectors and multiple mortgage loans. I highlight a novel contagion channel even without any direct ownership relationships between banks. A subprime loan shock causes shadow banks to fire sale mortgage loans. This depresses housing prices, inducing prime loans to default. The unexpected prime loan loss endogenously triggers a regime change in traditional banks’ value at risk constraints, thereby generating a market-wide lending freeze. This channel explains why traditional banks didn’t fill the gap created by the shrinking shadow banking sector during the crisis, but instead cut lending. Banks’ unwillingness to lend also accounts for the observed rise of excess reserves. An ex-ante tighter capital requirement on traditional banks has ambiguous effects on financial stability, by shifting lending to shadow banks. A combination of sector-specific capital requirements can mitigate the dilemma.