Shadow banking creates liquidity outside the regulated banking system. Unlike traditional money, shadow money is constrained by the value of assets that serve as collateral. Therefore, shadow banking is vulnerable to market price declines. As shown in a new paper by Moreira and Savov, pro-cyclicality is compounded by collateral values falling more than asset prices when uncertainty is rising. This makes modern financial systems prone to collateral runs and liquidity crises.

“The Macroeconomics of Shadow Banking”, Alan Moreira and Alexi Savov
http://www.newyorkfed.org/research/conference/2014/wholesalefunding/TheMacroeconomicsofShadowBanking_Moreira.pdf 

For an institutional summary of shadow banking view post here and for the related “backstop problem” view post here

The below are excerpts from the (largely technical) paper. Emphasis and cursive text have been added.

Definitions

We interpret shadow banking as liquidity transformation: issuing safe liquid liabilities against risky illiquid assets…Liquidity provision is constrained by the supply of collateral as all promises must be backed by assets. The efficient use of collateral…leads to the rise of shadow banking…Intermediaries maximize liquidity creation by issuing securities that are money-like in normal times but become illiquid in a crash.”

“We model the liquidity of a security as a function of its information sensitivity [i.e. the less sensitive the value of a security to new or private information, the more liquid it is].”

We refer to the crash-proof liquid security as money (e.g. deposits or Treasury-backed repos) and the normal-times liquid security as shadow money (e.g. asset-backed commercial paper or private-label repos)… shadow money becomes increasingly likely to cease to be liquid when a liquidity event arrives. This sets up a tradeoff between the quantity and fragility of the liquidity supply. “

A model of shadow banking

“We build a dynamic macro finance model that puts [shadow banking] at the center. In doing so, it joins the macroeconomic cycle to the liquidity transformation cycle in the financial sector.”

“At the heart of our model lies the distinction between liquidity and wealth. Securities are liquid only to the extent that they are backed by sufficient collateral to make their payoffs insensitive to private information. We show that intermediaries can provide liquidity efficiently by tranching the economy’s capital assets. This is the source of their economic value”

“Here is how [a shadow banking cycle] works. Households demand liquidity to insure against shocks. Intermediaries supply liquidity by tranching illiquid assets, subject to a collateral constraint due to crash risk…

  • In quiet times, intermediaries lever up the collateral value of their assets, expanding the quantity but also the fragility of liquidity, a shadow banking boom. Over time, investment in risky capital creates an economic boom, but it also builds up economic fragility.
  • A rise in uncertainty causes households to demand crash-proof, fully-collateralized liquid securities. Intermediaries de-lever to meet this demand. Shadow banking shuts down, contracting the liquidity supply and driving up discount rates. Asset prices fall, amplified by endogenous collateral runs (rising haircuts reinforce falling prices). Investment and economic growth also fall. A flight to quality effect pushes up the prices of safe assets, causing intermediaries to shift investment to storage-like capital.”

“Crash risk drives a wedge between the current value of an asset and its collateral value.”

The implications for systemic risk

“When uncertainty is low as in a prolonged quiet period, households are willing to hold shadow money at only a small spread over money. This allows intermediaries to expand liquidity provision, crowding out money which makes the liquidity supply more fragile…Low uncertainty thus leads to shadow banking-driven booms in liquidity transformation that spur economic booms while also building up economic fragility. In this way shadow banking increases the economy’s exposure to uncertainty shocks.”

When…a shock arrives, household flight to crash-proof liquidity causes the spread between shadow money and money to open up. The supply of liquidity contracts sharply as intermediaries strive to meet the demand for money…Shadow banking shuts down. Discount rates and collateral premia rise, asset prices and investment fall, growth turns negative. Intermediaries turn to investing only in the safest storage-like assets (like government debt or prime mortgages).”

“Collateral runs are a side effect of shadow banking and the fragility it generates. At times of high liquidity transformation, an uncertainty shock not only contracts liquidity provision, increasing discount rates and reducing prices, it also increases the volatility of liquidity provision going forward. The heightened exposure to future uncertainty shocks makes discount rates more sensitive to crashes. As a result, collateral values drop faster than prices (haircuts rise), further amplifying the contraction in the supply of liquidity.”