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We study banking competition in presence of shadow money. Investors choose between insured
deposits and uninsured off-balance sheet shadow money. Banks compete for investors by setting
corresponding interest rates and default endogenously. Our approach allows to quantitatively examine
the benefits and risks inherent in shadow money across time and states. We calibrate our
model to Chinese banking sector data using wealth management products (WMPs) as proxy for
shadow money. Implicit guarantees inherent inWMPs incentive banks to issue more shadow money.
The resulting supply of credit boosts economic growth but also builds up financial fragility that
potentially hampers economy. Multiple equilibria emerge which may lead to severe financial distress
with large welfare losses. Further, we show that banks are more fragile if adjusting rates on shadow
money is costly and that imposing capital requirements on shadow money is not a suitable policy
to enhance stability.
