Shadow banking: policy challenges for central banks

Central banks responded with exceptional liquidity support during the financial crisis to prevent a systemic meltdown. They broadened their tool kit and extended liquidity support to nonbanks and key financial markets. Many want central banks to embrace this expanded role as “market maker of last resort” going forward. This would provide a liquidity backstop for systemically important markets and the shadow banking system that is deeply integrated with these markets. But how much liquidity support should central banks provide to the shadow banking system without risking their balance sheets? And would not an accommodative market-making role send the wrong signals to market participants? I discuss the expanding role of the shadow banking sector and the key drivers behind its growing importance. There are close parallels between the growth of shadow banking before the recent financial crisis and earlier financial crises, with rapid growth in near monies as a common feature. This endogenous ebb and flow of shadow banking-type liabilities is indeed an ingrained part of our advanced financial system. We should think twice before we let central banks backstop the liquidity needs of private shadow banking markets, at least not before there has been substantial market reform. It would indeed be ironic if central banks were to declare victory in the fight against too-big-to-fail institutions, just to end up bankrolling too-big-to-fail financial markets.