Manor Road Seminar Room C
We study banking competition in the presence of shadow money. Investors can choose between insured deposits and uninsured off-balance sheet shadow money. Banks compete for investors by setting corresponding interest rates and default endogenously. We calibrate our model to Chinese banking sector data using wealth management products (WMPs) as proxies for shadow money. Implicit guarantees inherent in WMPs incentivize banks to issue more shadow money. The resulting supply of credit boosts economic growth but also builds up financial fragility that potentially hampers the economy. Multiple equilibria emerge that may lead to severe financial distress with large welfare losses.