ECB: how central banks can absorb liquidity risk from shadow banking

ECB Working Paper Series
Unconventional monetary policy and funding liquidity risk
No 2350 / January 2020

This paper investigates the efficiency of various monetary policy instruments to sta- bilize asset prices in a liquidity crisis. We propose a macro-finance model featuring both traditional and shadow banks subject to funding risk. When banks are well cap- italized, they have access to money markets and efficiently mitigate funding shocks. When aggregate bank capital is low, a vicious cycle arises between declining asset prices and funding risks. The central bank can partially counter these dynamics. Increasing the supply of reserves reduces liquidity risk in the traditional banking sector, but fails to reach the shadow banking sector. When the shadow banking sec- tor is large, as in the US in 2008, the central bank can further stabilize asset prices by directly purchasing illiquid securities.

The full paper is available at https://www.ecb.europa.eu//pub/pdf/scpwps/ecb.wp2350~32855510af.en.pdf

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