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Stephan Luck

22 August 2014
This paper studies a banking model of maturity transformation in which regulatory arbitrage induces the coexistence of regulated commercial banks and unregulated shadow banks. We derive three main results: First, the relative size of the shadow banking sector determines the stability of the financial system. If the shadow banking sector is small relative to the capacity of secondary markets for shadow banks' assets, shadow banking is stable. In turn, if the sector grows too large, it becomes fragile: an additional equilibrium emerges that is characterized by a panic-based run in the shadow banking sector. Second, if regulated commercial banks themselves operate shadow banks, a larger shadow banking sector is sustainable. However, once the threat of a crisis reappears, a crisis in the shadow banking sector spreads to the commercial banking sector. Third, in the presence of regulatory arbitrage, a safety net for banks may fail to prevent a banking crisis. Moreover, the safety net may be tested and may eventually become costly for the regulator.
JEL Code
G21 : Financial Economics→Financial Institutions and Services→Banks, Depository Institutions, Micro Finance Institutions, Mortgages
G23 : Financial Economics→Financial Institutions and Services→Non-bank Financial Institutions, Financial Instruments, Institutional Investors
G28 : Financial Economics→Financial Institutions and Services→Government Policy and Regulation