Uncertainty and the Shadow Banking Crisis: Estimates from a Dynamic Model

Shadow banks play an important role in the modern financial system and are arguably the source of key vulnerabilities that led to the 2007–2009 financial crisis. I develop a quantitative framework with uncertainty fluctuations and endogenous bank default to study the dynamics of shadow banking. I argue that the increase in asset return uncertainty during the crisis results in a spread spike, making it more costly for shadow banks to roll over their debt in the short-term debt market. As a result, these financial institutions are forced to deleverage, leading to a decrease in credit intermediation. The model is estimated using a bank-level data set of shadow banks in the United States. The parameter estimates imply that uncertainty shocks can explain 72% of asset contraction and 70% of deleveraging in the shadow banking sector. Maturity mismatch and asset fire-sales amplify the impact of the uncertainty shocks. First-moment shocks to bank asset return, financial shocks, or fire-sale cost shocks alone cannot reproduce the large interbank spread spike, dramatic deleveraging, or contraction in the U.S. shadow banking sector during the crisis. The model also allows for policy experiments. I analyze how unconventional monetary policies can help to counter the rise in the interbank spread, thus stabilizing the credit supply. Taking bank moral hazard into consideration, I find that government bailout might be counterproductive as it might result in more aggressive risk-taking among shadow banks, especially when bailout decisions are based on bank characteristics.