Liquidity Backup from Commercial Banks to Shadow Banks

Abstract

During the Great Recession, liquidity did not flow out of the banking sector but transferred internally. Deposits increased, but the volumes of all other short-term debt financing instruments except for T-Bills decreased. Commercial banks, which have stable funding sources from deposits, did not render liquidity backup to shadow banks but held the increased deposits as cash on hand. This paper uses deposits and financial commercial paper outstanding as proxies for commercial and shadow banking financing instruments because they are unique liabilities of commercial and shadow banks, respectively. I provide evidence that when liquidity falls in shadow banks, commercial banks experience funding inflows. In normal times, commercial banks render liquidity backup to shadow banks in the following weeks using the increased deposits. However, the dynamic correlation breaks down in crisis times.