Has monetary policy fueled the rise in shadow banking?

Abstract

How does monetary policy affect the shadow banking sector? Studies exploring the effect of monetary conditions on financial institutions have predominantly focused on traditional banks and disregarded shadow banking. Compiling a novel dataset with disaggregated shadow banking components, we assess the link between ECB's monetary policy setting and the rise of the shadow banking sector in the euro area over the 1999–2019 period. Our empirical analysis robustly demonstrates that monetary policy actions have been associated with a move away from traditional banking to the much riskier shadow banking sector. The magnitude of this effect is three times greater than the regulatory arbitrage effect. We uncover two underlying drivers. First, tight monetary policy promotes shadow banking because financial actors attempt to reduce their funding costs. Second, loose monetary policy expands shadow banking because it intensifies the investors' search for yield. Implied policy recommendations are discussed.