David Andolfatto and Ed Nosal
Working Paper 2020-14
August 2020

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Abstract: Short-term debt is commonly used to fund illiquid assets. A conventional view asserts that such arrangements are run-prone in part because redemptions must be processed on a first-come, first-served basis. This sequential service protocol, however, appears absent in the wholesale banking sector—and yet, shadow banks appear vulnerable to runs. We explain how banking arrangements that fund fixed-cost operations using short-term debt can be run-prone even in the absence of sequential service. Interventions designed to eliminate run risk may or may not improve depositor welfare. We describe how optimal policies vary under different conditions and compare these to recent policy interventions by the Securities and Exchange Commission and the Federal Reserve. We conclude that the conventional view concerning the societal benefits of liquidity transformation and its recommendations for prudential policy extend far beyond their application to depository institutions.

JEL classification: G01, G21, G28

Key words: shadow banks, bank runs, short-term debt

https://doi.org/10.29338/wp2020-14Off-site link

The authors thank conference participants at the second annual Missouri Macro Workshop; the 2017 Summer Workshop on Money, Banking, Payments, and Finance, at the Bank of Canada; the 2017 Canadian Macro Study Group in Ottawa; the 36th anniversary of the Diamond-Dybvig model held at Washington University in 2019; as well as seminar participants at the Federal Reserve Banks of Atlanta, Chicago, Cleveland and St. Louis, the National University of Singapore, Arizona State University, the University of Hawaii, Indiana University, Simon Fraser University, and the London School of Economics. The authors owe special thanks to Todd Keister, whose comments on a prior draft led to a number of substantial improvements. The views expressed here are those of the authors and not necessarily those of the Federal Reserve Bank of Atlanta, the Federal Reserve Bank of St. Louis, or the Federal Reserve System. Any remaining errors are the authors' responsibility.

Please address questions regarding content to David Andolfatto, Federal Reserve Bank of St. Louis, Federal Reserve Bank Plaza, St. Louis, MO 63102, or Ed Nosal, Research Department, Federal Reserve Bank of Atlanta, 1000 Peachtree Street NE, Atlanta, GA 30309.

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