Deposit insurance and the coexistence of commercial and shadow banks

Abstract

We investigate how deposit insurance affects the structure of the financial system in a general equilibrium setting in which a government insurer guarantees deposits at commercial banks, but not at shadow banks. With deposit-based or risky-asset-based insurance premia, price distortions induced by subsidized deposit insurance benefit shadow banks, by allowing these banks to trade to their advantage. Insured commercial banks and uninsured shadow banks coexist under subsidized deposit insurance. Capital requirements on commercial banks make shadow banking more attractive. The asset price distortion is eliminated when the aggregate subsidy to unsuccessful commercial banks equals the aggregate penalty to successful banks.