Are Traditional and Shadow Banks Symbiotic?

Abstract

This paper documents how traditional and shadow banks interacted with one another during the 2007 financial crisis, when both assets and liabilities flew from shadow to traditional banks. To rationalize their behavior, we propose a simple model which demonstrates the symbiotic coexistence and mutual reliance of traditional and shadow banks through their interaction in a crisis. In our model, shadow banks escape the costly regulation traditional banks must comply with, but give up deposit insurance, which traditional banks can rely upon. Without deposit insurance, shadow banks repay their creditors in a crisis by selling assets at fire-sale prices to traditional banks. By using deposit insurance to purchase these assets, traditional banks are able to generate enough profit to offset their regulatory costs. The model allows us to study the (unintended) consequences of regulations for traditional banks on the shadow banking sector.