The Role of Shadow Banking in the Monetary Transmission Mechanism and the Business Cycle

Abstract

This paper investigates the heterogeneous impact of monetary policy shocks on financial in- termediaries. I distinguish between banks and shadow banks based on their funding constraints. Because credit creation by banks responds to economy-wide productivity endogenously, bank reaction to shocks corresponds to the balance sheet channel. Shadow banks are constrained by their available funding and their behavior is better explained by the lending channel. In line with empirical observations, shadow bank lending moves in the opposite direction to bank lending following monetary policy shocks, which mitigates aggregate credit responses. The propagation of real and financial shocks is likewise altered when shadow banks are identified as a distinct sector among financial intermediaries. Following estimation of the model using Bayesian methods, a historical shock decomposition highlights the roles of banks and shadow banks in the run-up to the 2007 - 08 financial crisis.