Traditional and Shadow Banks

We propose a theory of the coexistence of traditional and shadow banks. In our model, bankers can choose to set up a traditional or a shadow bank: shadow banks escape the costly regulation traditional banks must comply with, but forgo deposit insurance, which traditional banks can rely upon. Thus, in a crisis, shadow banks repay their creditors by selling assets at fire-sale prices to traditional banks, which fund these purchases with insured deposits. This creates a complementarity between traditional and shadow banks. We show that in equilibrium, the two bank types coexist. The analysis implies that an increase in deposit insurance leads to a decrease in the relative size of the traditional banking sector, and that in equilibrium, the shadow-banking sector is larger than socially optimal. Our model is consistent with several facts from the 2007 financial crisis: assets and (deposit-like) liabilities migrated in large amounts from shadow banks to traditional banks, and shadow bank assets were sold to traditional banks at fire sale prices.