Bagehot was a Shadow Banker: Shadow Banking, Central Banking, and the Future of Global Finance

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Bagehot was a Shadow Banker: Shadow Banking, Central Banking, and the Future of Global Finance

Bagehot was a Shadow Banker: Shadow Banking, Central Banking, and the Future of Global Finance

Perry Mehrling
>Columbia University, Graduate School of Arts and Sciences, Department of Economics

Zoltan Pozsar
International Monetary Fund (IMF)

James Sweeney
Credit Suisse

Daniel H. Neilson
Institute for New Economic Thinking (INET); Bard College at Simon’s Rock

November 5, 2013

Abstract:

At the heart of both the modern shadow banking system and the 19th century banking system described by Walter Bagehot is the wholesale money market, with the central bank providing a liquidity backstop. We characterize shadow banking as “money market funding of capital market lending” and construct a model of such a system with dealers making markets and setting prices for funding and risk. Using this model, we describe the secular expansion of the market-based credit system and its rapid collapse during the global financial crisis. The model also clarifies the economic functions of the market-based credit system, the role of the central bank in such a system, and the global character of US dollar funding markets.

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