Nonbank financial intermediaries (NBFIs) have grown significantly relative to banks. We argue that this growth reflects a transformation of the activities and risks of banks and NBFIs, driven at least in part by changes in bank regulation. We document through new regulatory data, case studies, and empirical analyses that banks remain special as providers of both routine and emergency liquidity to NBFIs and that the sectors have become increasingly interdependent. We discuss some potential regulatory responses, including considering the two sectors holistically and exploring new ways to internalize the costs of systemic risk arising from bank-NBFI interconnectedness.

Data on firm-loan-level daily credit line drawdowns in the United States expose a corporate “dash for cash” induced by the COVID-19 pandemic. In the first phase of the crisis, which was characterized by extreme precaution and heightened aggregate risk, all firms drew down bank credit lines and raised cash levels. In the second phase, which followed the adoption of stabilization policies, only the highest-rated firms switched to capital markets to raise cash. Consistent with the risk of becoming a fallen angel, the lowest-quality BBB-rated firms behaved more similarly to non-investment grade firms. The observed corporate behavior reveals the significant impact of credit risk on corporate cash holdings. (JEL G01, G14, G32, G35) Received July 13, 2020; editorial decision July 17, 2020 by Editor Andrew Ellul

We develop a theory of optimal bank leverage in which the benefit of debt in inducing loan monitoring is balanced against the benefit of equity in attenuating risk shifting. However, faced with socially costly correlated bank failures, regulators bail out creditors. Anticipation of this generates multiple equilibria, including one with systemic risk in which banks use excessive leverage to fund correlated, inefficiently risky loans. Limiting leverage and resolving both moral hazards—insufficient loan monitoring and asset substitution—requires a novel two-tiered capital requirement, including a “special capital account” that is unavailable to creditors upon failure.

We present a model of equilibrium allocation of capital for arbitrage. If asset prices may fall low enough, it is profitable to carry liquid capital to acquire assets in such states. Set against this, keeping capital in liquid form entails costs in terms of foregone profitable investments. This trade-off generates occasional fire sales and limited arbitrage capital as robust phenomena. With learning-by-doing effects, arbitrage capital moves in to acquire assets only if fire sales are steep. However, once arbitrage capital finds it profitable to acquire assets, it requires similar returns elsewhere, inducing contagious fire-sale prices even for unrelated assets.