By Ken Chow, Queen’s University
On May 8th, 2018, the Queen’s Economics Department hosted the second annual workshop on Financial Intermediation and Regulation, jointly hosted by the Bank of Canada and the John Deutsch Institute. The conference brought together some of the world’s leading experts in finance and industrial organization to present and discuss their latest research. The conference covered interesting topics relating to finance and regulations including the impact of shadow banking on monetary policy , the strategic use of trade credit in retail supply chains , the dealers’ and investors’ bidding behaviour in Canadian treasury bills auctions , and how the current selection process of arbitrators in the US favours the repeat selection of industry-friendly arbitrators. 
A key feature of this conference is the emphasis put on the policy implications of academic research. In particular, the rise of the shadow banking sector in the last few decades have attracted the attention of academic researchers, central bankers and policymakers worldwide, making Kairong Xiao’s paper titled “Monetary Transmission through Shadow Banks” a very timely inclusion to the conference. To illustrate the importance of the shadow banking system, note that in the United States just prior to the onset of the great recession, the total shadow banking liabilities exceeded $20 trillion USD compare to $10 trillion USD liabilities in the traditional banking system. 
To understand the shadow banking system, it’s helpful to look at what traditional banking entails. We can think of a bank as a bridge between depositors and borrowers. Depositors put spare cash into the bank, who then lends it to borrowers like small businesses or home buyers. In return for the deposits, the bank pays depositors a fraction of its income from interest on loans. In the traditional banking system, the government often explicitly or implicitly guarantees both deposits (e.g. FDIC, CDIC) and loans (e.g. Fannie Mae, Freddie Mac). In the shadow banking system, the intermediation between depositors and borrowers involves not just one entity but a whole array of financial intermediaries covering each step of the process of converting a deposit into a loan. A borrower could obtain their mortgage from a non-bank mortgage company. This company then sells it securitizer, who packages the loans into tradable financial products. These products are then bought by hedge funds or market money funds who sell them to investors. Unlike in the traditional banking system, these shadow banking products are not guaranteed by the government. They are, therefore, often backed and insured by third-party private companies instead (e.g. AIG). Even from the simplified illustration, it is evident that the shadow banking system poses a challenge to regulators and policymakers since it involves players from the entire spectrum of the financial market. To make informed policy recommendations, we need academic research that studies all the different players and moving parts in the shadow banking sector, and their implications for the wider economy. This brings us back to Kairong Xiao’s research on shadow banks and monetary policy transmission.
Xiao described a new channel in which monetary policy (specifically, interest rate setting) is transmitted through the shadow banks to the wider economy. To understand his work, let’s simplify the shadow banking system into a single entity we called a shadow bank. The shadow bank takes deposits from investors and lends them to borrowers like a traditional bank. There are two main differences between a traditional bank and a shadow bank in this setting. The first is that traditional banks provide depositors with more banking services (like ATMs, bill payments for examples) while a shadow bank does not. The second is that a shadow bank provides a higher savings rates to depositors in order to distinguish itself from the traditional banks to attract deposits.
In this model, which is also backed by empirical analysis, we see that in a high-interest rate world the majority of depositors choose shadow banks over tradition banks. This primarily occurs because depositors value higher savings rates more than other banking services provided by traditional banks. In a low-interest rate world, depositors pull their money out of the shadow banks and put it into the traditional banks. This is because in a low-interest world, both shadow banks and traditional banks offer equally low rates and so the traditional banks are preferred because of the additional banking services they offer.
This implies that when the central bank raises interest rates, it is driving deposits into shadow banks. Since shadow bank deposits are not guaranteed, it increases systemic risk in the financial market. Note that central banks raise interest rates as a contractionary policy to decrease money-like liabilities in the banking sector. However, this research suggests that the existence of shadow bank dampen this effect as depositors can now put their money into the shadow bank instead. Indeed, Xiao’s paper shows that shadow banks create 34 cents of deposits for every dollar taken out of the traditional banking system.
In a 2015 speech “Financial Stability and Shadow Banks: What We Don’t Know Could Hurt Us“, former Federal Reserve Chairman Stanley Fischer emphasized that there is a lack of research on the interconnectedness between shadow banks, the traditional banking system, and financial markets.  As the shadow banking sector continues to expand, there is an urgent need for more research into shadow banking. Xiao and other researchers have already provided some insights into the shadow banking sector. However, we are still very far away from understanding it in order to ensure that it can function smoothly together with the rest of the economy.
 “Monetary Transmission through Shadow Banks”, Kairong Xiao, Columbia Business School
 “Cheap Trade Credit and Competition in Downstream Markets”, Mariassunta Giannetti, Stockholm School of Economics
 “Identifying Dependencies in Demand for Government Securities”, Jakub Kastl, Princeton University
 “Uninformed Plaintiffs and Biased Arbitration”, Mark Egan, HBS
 Pozsar, Zoltan, Tobias Adrian, Adam B Ashcraft, and Haley Boesky (2010), “Shadow bank-
ing.” Working Paper.
 “Financial Stability and Shadow Banks: What We Don’t Know Could Hurt Us”, Vice Chairman Stanley Fischer, 2015 Financial Stability Conference.