Liquidity channels and stability of shadow banking

Using financial networks modeling, I ask whether severe liquidity conditions of shadow banks during a crisis can be improved with support from regulated banks. The research is motivated by the sudden lack of liquidity available to shadow banks during the 2007-2009 financial crisis and the selective liquidity support that regulated banks provided to rescue shadow banks. In this paper, I build a three-period network model with strategic interactions between regulated banks, shadow banks, and money-market investors. I show that financial market endogenously develop a core-periphery network structure generating heterogeneity in size, interconnectedness, and riskiness of banks. Core regulated banks, defined as the largest and most interconnected banks, form long-term relationships with core shadow banks by channeling liquidity to them from periphery banks. These long-term relationships are accompanied by implicit liquidity guarantees during a crisis. Although the initial model characteristics of all banks are identical, the core regulated banks make larger profits than periphery regulated banks while the market is stable, but are exposed to higher default risk following a severe asset shock. Similarly, supported (core) shadow banks promise a higher rate to their money market investors and grow to a larger size than the non-supported (periphery) shadow banks. I provide intuition for why financial markets develop these heterogeneities and examine policies to control systemic risk, which include quality control of shadow banks' assets, minimum cash reserves requirements, redemption gates and liquidity withdrawal fees. I also find the optimal rate of support that the central bank should impose when setting the indirect liquidity channels. Finally, I provide a discussion about the “too-big-to-fail” considerations in the context of liquidity channels between regulated and shadow banks.