Fed Gov. Stein: Shadow Banks More Vulnerable to Runs, Fire Sales

Traditional banks and their shadow banking counterparts both create private money, but they go about it in different ways, said Federal Reserve Governor Jeremy Stein.

He discussed those differences during a January luncheon in Philadelphia hosted by the American Economic Association and the American Finance Association.

Traditional banks rely heavily on cash deposits—a relatively safe and stable source of funding that makes banks less vulnerable to runs. Meanwhile, the shadow banking system—which includes hedge funds and money market funds— relies on an "early exit option," which gives investors the right to seize collateral essentially on demand. As a result, money in this relatively lightly regulated corner of the financial system is more prone to runs, Stein said. The traditional banking model is thus "better suited to investing in assets that are illiquid and subject to interim price volatility" such as agency mortgage-backed securities and other mortgage-linked securities, he said.

Stein drew from his work with Harvard economists Samuel Hanson and Andrei Shleifer and Robert Vishny of the University of Chicago. Their research aims to deepen understanding of the relationship between the commercial banking and shadow banking sectors and to gain insights into the economic role played by commercial banks.

January 23, 2014