Working Paper

Towards a theory of shadow money

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What does the rise of shadow banking mean for monetary theory and practice? (How) should we change our traditional theories of money to capture the complex practices through which money is created in modern financial systems?

To answer these questions, we approach money as provisional promises to pay, promises hierarchical in nature (Minsky 1998, Bell-Kelton 2001, Wray 2003, Mehrling 2012a, Mehrling et al 2013, Pozsar 2014, 2015). Noting that shadow banking is distinctive from relationship banking in that debt relationships are typically organized via marketable securities, we define shadow money as repo liabilities supported by tradable collateral. It is the presence of collateral characterising such private promises to pay that confer shadow money its distinctive character. In modern money hierarchies, market participants have developed an intricate mechanism for maintaining the exchange of money proper (state and bank money) with shadow money, a mechanism that essentially relies on the liquidity of the underlying collateral. We examine the dynamic properties of hierarchies with shadow money, and the systemic liquidity challenges that central banks face in stabilizing shadow money.