On Shadow Banking and Financial Frictions in DSGE Modeling

Abstract

At the forefront of macroeconomic research on the causes of the Great Financial Crisis (GFC) was and still is the usage of dynamic stochastic general equilibrium (DSGE) models. To capture the nonlinearities of the GFC, these models were enriched with a variety of financial frictions. This paper focuses on a special subset of these frictions, the shadow banking system. We provide a structured review of the strand of literature that considers shadow banking in DSGE setups and draw particular attention to the modeling approach as well as impact of shadow banking. Our analysis allows the following conclusions: firstly, models featuring shadow banking are better able to simulate realistic movements in the business cycle that are of comparable magnitude to the GFC. Secondly, the models consider amplification channels between the financial sector and the real economy that proved to be of importance during the crisis. Thirdly, the models display a good explanatory power of financial stability measures in the light of shadow banking.

Exploring Systemic Risk Measurement Issues in Shadow Banks: A Case of an Emerging Economy

“…They tend to concentrate on aggregate imbalances and serve as a warning signal tracker of unsustainable pressures that build up in the financial system exogenously (Bisias et al, 2012). These measures focus on the multiple factors like business fluctuations and credit cycle, unemployment, inflation and growth those add to the macroeconomic vulnerability and capture the system’s sensitivity to economic shocks (Ferrante, 2018; Kirchner, 2020). Since top-down approach, ignore the risk that develops from the individual institution, are less effective (Arnold et al, 2012), is the limitation.…”

“…Paul McCulley coined the term SB in 2007 and described it as a group of organizations highly levered up without any access to the public backstop, but in 2011 the Financial Stability Board recognized it as a set of activities and entities engaged in credit intermediation outside the purview of the regulation (FSB, 2011)These SBs are also known as non-bank financial intermediaries (NBFIs) or non-banking financial companies (NBFCs), have an essential impact on monetary policy and financial stability (Kirchner, 2020).…”

“…Further, they also avail cheap credit during the boom that aggravates instability during the crisis (Adrian & Shin, 2010; Helgadóttir, 2016). Comprehensively, it is worth mentioning that their activities add vulnerability resulting in system-wide failure (Kirchner, 2020).…”