Banks as Patient Fixed-Income Investors
We examine the business model of traditional commercial banks when they compete with shadow banks. While both types of intermediaries create safe “money-like” claims, they go about this in different ways. Traditional banks create safe claims by holding illiquid fixed-income assets to maturity, and they rely on deposit insurance and costly equity capital to support this strategy. This strategy allows bank depositors to remain “sleepy”: they do not have to pay attention to transient fluctuations in the market value of bank assets. In contrast, shadow banks create safe claims by giving their investors an early exit option requiring the rapid liquidation of assets. Thus traditional banks have a stable source of funding, while shadow banks are subject to runs and fire-sale losses. In equilibrium, traditional banks have a comparative advantage at holding fixed-income assets that have only modest fundamental risk, but are illiquid and have substantial transitory price volatility, whereas shadow banks tend to hold relatively liquid assets.