Shadow Banking, Sovereign Risk and Collective Moral Hazard

The paper shows that the time-consistent policy of public bailout affects the private liquidity choice of banks in several ways. First, banks anticipate public support in a liquidity crisis and seek large and socially inefficient exposures to shadow banking, defined as a privately costly technology that allows banks to liquefy their balance sheet. In this way, banks reduce their liquidity need in terms of expensive sovereign debt securities and boost leverage. Second, the liquidity choice becomes risky even with respect to the sovereign debt securities portfolio allocation: banks protected by guarantees from a healthy risk-free government load with cheaper non-domestic risky sovereign debt as they expect to extract public support even in the presence of some sovereign default. Finally, the propensity to expose to shadow banking is procyclical. These insights have important implications in terms of regulation. Global reforms that curb banks' ability to extract free insurance from the public bailout would promote efficiency. Policymakers should resort to a full-blown ban on shadow banking only if the previous goal is unattainable.