A new ECB paper explains key risk factors of shadow banking. First, if unregulated finance outgrows market size, tightening liquidity can escalate into runs and fire sales. Second, if shadow banks are operated by regulated banks they become a source of contagion. Third, and most importantly, if shadow banking focuses on regulatory arbitrage it erodes classical financial system safety nets.

Luck, Stephan and Paul Schempp, “Banks, Shadow Banks, and Fragility”, ECB Working Paper series, No. 1726, August 2014.

For the basic mechanics of shadow banking view post here.

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 paper. Emphasis and cursive text have been added

A review of shadow banking basics

“Shadow banks are financial institutions that operate outside the regulatory perimeter and conduct credit, maturity, and liquidity transformation without direct and explicit access to public sources of liquidity or credit backstops.…A key ingredient to the 2007-2009 financial crisis was the maturity mismatch in the shadow banking sector.”

“This paper contributes to the theoretical understanding of how shadow banking activities can set the stage for a financial crisis.”

A model analysis

“We discuss a simple banking model of maturity transformation…In our model, commercial banks are covered by a safety net. They are therefore also subject to regulation, which induces regulatory costs for the banks. The shadow banking sector competes with commercial banks by also offering maturity transformation services. In contrast to commercial banks, shadow banking activities are neither covered by the safety net nor subject to regulatory costs.”

Main propositions

“The relative size of the shadow banking sector may determine its stability. If the shadow banking sector is small relative to arbitrage capital, it appears to be stable. However, if it grows too large, fragility may arise. Fragility in our context is defined as the possibility that panic-based runs may occur. The underlying mechanism is as follows: If the short-term financing of shadow banks breaks down, they are forced to sell their securitized assets on a secondary market. If the size of the shadow banking sector is small relative to the capacity of this secondary market, shadow banks can sell their assets at face value in case of a run. Because they can raise a sufficient amount of liquidity, a run does not…[occur]. However, if the shadow banking sector is too large, the arbitrageurs’ budget not suffice to buy all assets at face value…Therefore, if the shadow banking sector is too large relative to available arbitrage capital, fire-sale prices are depressed due to cash-in-the-market pricing, and self-fulfilling runs become possible.”

“If commercial banks themselves engage in shadow banking activities, a larger shadow banking sector is sustainable. In this case, shadow banking indirectly benefits from the safety net for commercial banks. Banks being covered by the safety net implies that bank depositors never panic and banks thus have additional liquid funds to support their shadow banks. However, if this sustainable level is exceeded, the threat of a crisis may reappear. Moreover, a crisis in the shadow banking sector now also harms the sector of regulated commercial banking.”

Shadow banking that exists due to regulatory arbitrage may pose a severe risk for financial stability… A safety net for banks may not only be unable to prevent a banking crisis in the presence of regulatory arbitrage, but it may also be costly for the regulator (or taxpayer). If banks and shadow banking are separated, runs can only occur in the shadow banking sector and the regulated commercial banking sector is unaffected. If they are intertwined, a crisis in the shadow banking sector translates into a system-wide crisis, and ultimately the safety net becomes costly for the regulator. Regulatory arbitrage thus undermines the efficacy of the safety net while making it costly for the regulator.”

“The main contribution of our paper is to show how regulatory-arbitrage-induced shadow banking can contribute to the evolution of financial crises. We illustrate how shadow banking activities undermine the effectiveness of a safety net that is installed to prevent self-fulfilling bank runs. Moreover, we show how shadow banking may make the safety net costly for the regulator in case of a crisis…Under the premise that regulatory arbitrage cannot be prevented at all, our model indicates that financial stability may not always be reached by providing a safety net and regulating banks. One may consider a richer set of policy interventions that go beyond safety nets and regulation. E.g., the government or the central bank may have the ability to intervene on the secondary market in case of a crisis.”