How does monetary policy respond to the dynamics of the shadow banking sector?

• Date: 01 April 2020
• Author: Fredj Jawadi,Vitor Castro,Luca Agnello,Ricardo M. Sousa
• DOI: http://doi.org/10.1002/ijfe.1748
• Published date: 01 April 2020

RESEARCH ARTICLE

How does monetary policy respond to the dynamics of the shadow

banking sector?

*

Luca Agnello

1

| Vitor Castro

2,3

| Fredj Jawadi

4

| Ricardo M. Sousa

5,6

1

Department of Economics, Business and

Statistics (SEAS), University of Palermo,

Palermo, Italy

2

School of Business and Economics,

Loughborough University, Loughborough,

Leicestershire, UK

3

Economic Policies Research Unit (NIPE),

Campus of Gualtar, University of Minho,

Braga, Portugal

4

University of Lille, Lille, France

5

Department of Economics and Economic

Policies Research Unit (NIPE), Campus of

Gualtar, University of Minho, Braga,

Portugal

6

LSE Alumni Association, London School

of Economics and Political Science,

London, UK

Correspondence

Vitor Castro, School of Business and

Economics, Loughborough University,

Loughborough, Leicestershire LE11 3TU,

UK.

Email: v.m.q.castro@lboro.ac.uk

Abstract

We investigate the response of the central bank to the change in size of non-

bank financial intermediaries. Using quarterly data for the United States over

the period 1946:Q1-2016Q4, we find that when faced with an increase in the

asset growth of the securities' brokers and dealers and the shadow banking sec-

tor, the monetary authority reacts by raising the short-term nominal interest rate.

This response is stronger in the case of sharp variation in the size of the bal-

ance sheet of nonbank financial intermediaries. From a policy perspective, our

study suggests that an extended version of the original Taylor rule—embedding

both price stability and financial stability concerns—provides a good characteri-

zation of the monetary policy reaction function.

KEYWORDS

asset growth, inflation, monetary policy, nonbank financial intermediaries, shadow banking, Taylor

rule

JEL CLASSIFICATION

E21; E43; E51; E53

1|INTRODUCTION

Monetary policy making has substantially evolved over time.

In its original framework, monetary policy could be thought

as an institutional arrangement aimed at guaranteeing a stan-

dardized account unit to facilitate trade (Chadha, 2018). In

the late 18th and 19th centuries, the occurrence of banking

and financial crises led to the belief that a gold standard, low

public debt, and constrained policy rate changes were key to

the stability of the monetary exchange rate.

However, the World Wars I and II and the (previous

suspension and subsequent) downfall of the gold standard

paved the way for the implementation of countercyclical

fiscal and monetary policies. In this context, central banks

were established to provide fiscal support to states emerg-

ing from military conflicts, and inflation and growth

became key indicators for the evaluation of government

performance (Bordo, 2017). Not surprisingly, the post-war

period was characterized by a significant amount of effort

devoted to emphasizing the importance of central bank

* We are grateful to participants to the 2nd Society for Economic Measurement (SEM, Paris) Annual Conference, the 4th International Symposium in

Computational Economics and Finance (ISCEF, Paris), the 3rd International Workshop on “Financial Markets and Nonlinear Dynamics”(FMND, Paris), the

16th Annual Conference of the European Economics and Finance Society (EEFS) and the 49th Money, Macro and Finance (MMF) Annual Conference, and

to Joscha Beckmann, Georgios Chortareas, Gilles Dufrénot and Sushanta Mallick, for their constructive comments and suggestions that considerably

improved this paper. NIPE's work is financed by National Funds of the FCT –Portuguese Foundation for Science and Technology within the project

"UID/ECO/03182/2019".

Received: 23 April 2018 Revised: 3 January 2019 Accepted: 13 September 2019

DOI: 10.1002/ijfe.1748

Int J Fin Econ. 2019;1–20. wileyonlinelibrary.com/journal/ijfe © 2019 John Wiley & Sons, Ltd. 1

228 © 2019 John Wiley & Sons, Ltd. Int J Fin Econ. 2020;25:228–247.wileyonlinelibrary.com/journal/ijfe

independence, modelling the linkages between monetary

policy and real economic activity as well as understanding

the optimal policy response to fluctuations in the output

gap and the inflation rate and the advantages of an

inflation-targeting framework (White, 2001).

Against this backdrop, the original work of Taylor (1993)

is formulated, postulating that the central bank sets the short-

term interest rate on the basis of information about current

inflation and the business cycle. Several studies followed up,

developing different versions of the monetary authority's

reaction function, which included among others: (a) a lagged

interest rate to capture interest rate smoothing or monetary

policy inertia (Woodford, 1999); (b) features of forward-

looking behaviour, as well as the role of inflation targeting

(Clarida, Gali, & Gertler, 1998) or real-time data in the cen-

tral bank's information set (Orphanides, 2001); and (c) data

uncertainty (Orphanides, 2003) or misspecifications due to

correlation of shocks (Rudebusch, 2002).

Yet, the Great Moderation period and the subsequent

Great Recession made it clear that financial risks can mount

even if they do not initially materialize into business cycle

risks. Similarly, they questioned the so called “benign

neglect,”that is, the idea that central banks can mainly focus

on macroeconomic developments and generally ignore

financial booms (Filardo & Rungcharoenkitkul, 2016).

Indeed, the financial crisis of 2008–2009 has raised funda-

mental questions about the goals of monetary policy and the

role that the central bank can have in weathering the various

macroeconomic dynamics with which it is continuously con-

fronted.

1

For example, Taylor (2009) puts forward the argu-

ment that excessively expansionary monetary policy in the

pre-crisis period helps to explain the emergence and the

severity of the financial turmoil.

Thus, some authors highlighted the relevance of

“leaning against the wind”monetary policies (BIS, 2014,

2016; Borio & Lowe, 2002), whereby the central bank sets

a policy interest rate that is somewhat higher than what

would be consistent with a “pure”or “flexible”inflation

targeting regime in order to account for financial

stability effects (Svensson, 2017). Consequently, the

standard Taylor rule could incorporate the dynamics of

equity prices (Bernanke & Kuttner, 2005; Chadha, Sarno, &

Valente, 2004; Rigobon & Sack, 2004; Wongswan,

2009),

2

housing prices (Aoki, Proudman, Vlieghe, & G.,

2004; Bjornland, Jacobsen, & Henning, 2010; Iacoviello,

2005; Iacoviello & Minetti, 2008; Iacoviello & Neri,

2010), or, more generally, asset wealth (Sousa, 2010).

3

Castro and Sousa (2012) show that although asset

wealth composition (not asset prices) drives the

formulation of monetary policy, the central bank attempts

to counteract undesirable financial wealth fluctuations that

can lead to disruptions in housing wealth. Bank for Inter-

national Settlements (BIS;, 2015) notes that interest rate

hikes may be needed even in the absence of inflation and

continuing output gaps, and Field (2015) highlights that

rising leverage and debt service-to-income ratios call for

prompt policy measures. All in all, these extensions of the

standard Taylor rule would allow one to track the trade-off

between price and financial stability that confronts the cen-

tral bank and the risk-taking channel of monetary policy

(Adrian & Shin, 2010a, 2010b; Borio & Zhu, 2008).

Other pieces of research emphasized that financial stabil-

ity may not be achieved simply via “financial cycle-aug-

mented”Taylor rules, with interest rates rising above what is

warranted by macroeconomic prospects (Turner, 2017,

2018). Therefore, considerations about asset price bubbles,

financial fragility, and too rapid or imprudent credit growth,

among others, to specifically limit the procyclicality of the

financial system, target systemic risk, and mitigate its macro-

economic costs would be part of the macroprudential policy

toolkit (Borio, 2018; Łupi

nski, 2018; Papademos, 2009).

Despite this, a number of challenges remain unsolved includ-

ing (a) how regulatory policies may themselves fail to

account for continuous changes in the financial system

accruing to globalization, preferences, and technology shifts

(Claessens, 2016; Reinhart & Sowerbutts, 2018);

(b) whether responsibility for macroprudential policies

should be pursued by specialized prudential regulators and

supervisors or monetary authorities (Allen, 2015; Ingves,

2017; Kenç, 2016; Rotemberg, 2014); (c) how to coordinate

and calibrate monetary policy and macroprudential policies

(Turner, 2018); (d) the complacency about bond market

liquidity “illusion,”the rigidity of bank liquidity rules and

the virtual absence of macroprudential tools targeting the

nonbank system (Turner, 2017). Summing up, there is nei-

ther consensus, nor a unified institutional supervision frame-

work for the financial system (Barwell, 2018).

Since the Great Recession, there has also been an

increasing interest in understanding how central banks'

actions impact the balance sheet dynamics of financial

intermediaries (Adrian & Shin, 2010a, 2010b). In theory,

these nonbank entities might either dampen or amplify the

effects of monetary policy. On the one hand, they can

work in partnership with traditional banks in lending

money. On the other hand, they may magnify the trans-

mission of monetary policy if their risk appetite is more

sensitive to changes in the interest rate (IMF, 2016).

Indeed, financial intermediaries do not react to monetary

policy in the same manner (Nelson, Pinter, & Theodoris,

2018). Hence, understanding this dynamics is relevant

from a policy perspective, as the role of market-based

financial intermediaries (e.g., brokers and dealers and

shadow banks) has significantly increased over time.

These institutions lack access to public liquidity sources,

but they became important funding providers by

translating long-term, opaque, and risky assets into short-

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