Banking, In and Out of the Shadows

"This gives rise to a natural impetus to regulation," says Grochulski. "But one limit to regulation is that it has not been achieved in a globally unified framework, and there is competition among jurisdictions for regulating more lightly. Take the Cayman Islands, for example. Our article explores the limits placed on U.S. regulators by the lack of international regulatory coordination."

The article builds on the Diamond-Dybvig maturity-mismatch model — a framework that is a long-standing staple among economists for analyzing bank runs and liquidity regulation. A key feature of the framework is that banks desire the liquidity associated with short-term investments but also want the higher returns associated with longer-term, relatively illiquid investments. In the model's initial period, a bank must choose how to allocate its portfolio between short-term and long-term investments with the knowledge that, in a later period, it may be hit with a "liquidity shock" that forces it to sell its longer-term investments in a secondary securities market. Another key feature of the model is a lack of full transparency: Only a bank itself knows whether it has been hit by a liquidity shock, and secondary-market trading is anonymous.

In Grochulski's model economy, banks' ability to trade anonymously in the secondary market creates a "pecuniary externality." An individual bank does not bear the cost of the effect of its trading on other banks. The external­ity drives a wedge between the market (or laissez faire) equilibrium and the socially optimal outcome. This inefficiency gives rise to a role for regulation.

In the absence of shadow banking, one optimal liquidity regulation consists of a tax on the illiquid asset and a subsidy on the liquid asset. (The latter can be thought of as interest on bank reserves.) This tax-subsidy combination tilts the asset allocation trade-off faced by banks in favor of more liquid assets. That, in turn, decreases the supply of illiquid assets in the secondary market and thereby increases their price.

Grochulski models shadow banking as an arbitrage-seeking activity. The shadow banking sector gives banks an alternative to the regulated banking sector. By shifting to the shadow sector, a bank escapes regulation but loses the benefits associated with the government safety net. In this setting, a regulated bank's incentive to shift activity to the shadow sector increases steeply with the secondary-market price of the illiquid asset. As a consequence, optimal liquidity policy changes with the introduction of shadow banking. In particular, Grochulski and Zhang found, the optimal tax and subsidy rates need to be reduced in order to reduce the secondary-market price of liquid assets and thereby limit the incentive for regulated banks to shift activity to the shadow banking sector.

For the researchers, this finding strongly suggests that bank regulators need to take shadow banking into account when designing optimal liquidity policy. In their words, "the option to move assets from regulated banks into shadow banks can potentially render bank liquidity regulations ineffective."