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Shadow Banking System

[vc_row][vc_column css=”.vc_custom_1440853933261{background-color: #e0e0e0 !important;}”][vc_column_text css=”.vc_custom_1490105114553{margin-top: 15px !important;margin-right: 10px !important;margin-bottom: 15px !important;margin-left: 10px !important;}”]Shadow banking means financial intermediation outside the reach of standard regulation. Shadow banks engage in term, credit and liquidity transformation similar to regulated banks and function principally to channel institutional cash pools to the funding of asset holdings. This makes them an essential part of financial markets. Often this intermediation takes place in a complex multi-institutional setting.  The special vulnerability of the shadow banking system arises from its dependence on collateral (asset) value and the absence of a safety net in form of central bank backstops.[/vc_column_text][vc_empty_space height=”6px”][/vc_column][/vc_row][vc_row][vc_column][vc_empty_space][vc_column_text]

The shadow banking system

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What is shadow banking?

Shadow banking means financial intermediation outside the regulated banking system. Modern shadow banking undertakes classic financial risk transformation, in particular credit and term transformation, with a particular emphasis on collateralized transactions (view post here). It even creates money and money-like claims.  An institution becomes a shadow bank by performing these functions, not through a specific legal form. Therefore, the shadow banking sector is comprised of various types of legal entities, including asset managers, government-sponsored entities (Fannie Mae, Freddie Mac in the U.S.), structured finance vehicles, broker-dealers, financial holding companies, and finance companies. Commodity trading firms are peripheral members of the shadow banking system to the extent that they act as financial intermediaries and engage in collateralized financing transactions (view post here).

Non-bank financial intermediation in its broadest definition has been estimated at 120% of global GDP at the end of 2013 (view post here). Investment funds and broker-dealers are the largest constituents. Shadow banking has been growing at a rapid pace since the great financial crisis, most notably through the asset management industry (view post here).While asset prices have a great influence on short-term trends and cycles in shadow banking, rising efficiency in the use of collateral, i.e. pledgeable assets for securitized transactions, drives the secular expansion.[/vc_column_text][/vc_column][vc_column width=”1/3″][vc_empty_space][vc_message message_box_style=”solid-icon” message_box_color=”grey” icon_fontawesome=”fa fa-comment-o”]”The FSB has defined shadow banking as ‘credit intermediation involving entities and activities (fully or partly) outside the regular banking system”

UK Financial Stability Board, 2014[/vc_message][/vc_column][/vc_row][vc_row][vc_column width=”2/3″][vc_column_text]

The function of shadow banking

The main systemic function of shadow banking is to channel the cash pools of institutions, such as non-financial corporates and asset managers, to the funding and leveraging of loans, bonds, and equities holdings (view post here). For example, cash managers “park” funds through short-term secured lending, while asset managers borrow against their securities to gain leverage. Key intermediaries of this process are dealer banks and money market funds. Dealer banks issue repos and money market funds issue shares with constant net asset values. Both are forms of “shadow money”. They are similar to regular monetary aggregates, such as M2, insofar as they always trade at par on demand and can easily be converted for settlement purposes.

Collateralization, i.e. the pledging of assets as security for repayment, is at the heart of the shadow banking system. The principal benefit of collateralization is that it facilitates short-term lending with low research and information cost (view post here). Thus, the lenders or depositor in a secured transaction only needs to know that the security’s value exceeds a critical threshold. He or she does not need the full information set for assessing the security’s exact value and the creditworthiness of the borrower.

Interestingly, the securities used as collateral are often sourced from asset managers and it has become practice to re-use pledged collateral. This means that the shadow banking system has become a catalyst for the build-up of so-called ‘collateral chains’, sequences of transactions that use the same asset for multiple securitizations. As a consequence, the role of asset managers and off-balance vehicles of banks in intermediation has increased, as has the importance of asset managers as source for ‘collateral mining’.

Institutions typically prefer shadow money over bank deposits for larger amounts, because the former are collateralized and diversified, while latter are largely unsecured and imply concentrated risk exposure to one or more banks. Hence, the shadow banking system establishes secured transactions-based wholesale funding. (view post here) in parallel to the classical unsecured deposit-based funding through banks.[/vc_column_text][/vc_column][vc_column width=”1/3″][vc_empty_space][vc_message message_box_style=”solid-icon” message_box_color=”grey” icon_fontawesome=”fa fa-comment-o”]”The beauty lies in the fact that collateralised lending obviates the need to discover the exact price of the collateral”

Bank for International Settlements, Working Paper[/vc_message][/vc_column][/vc_row][vc_row][vc_column width=”2/3″][vc_column_text]

The systemic risks of shadow banking

Unlike regulated banks, shadow banks typically have no direct and explicit access to public sources of liquidity or credit backstops. They are not usually counterparties in central bank operations. This means that shadow banking has only limited capacity to withstand liquidity pressure and may itself become a catalyst of market turmoil, particularly when it has grown is size and when its difficulties feed back to regulated banks (view post here).

Moreover, unlike traditional money, shadow money is constrained by the value of assets that serve as collateral. The underlying secured financing is vulnerable to market shocks. In a crisis the  classical vicious cycle of lower asset prices and lower collateral value would probably be accentuated by two aggravating forces:

  • First, collateral values are likely to fall more than asset prices when uncertainty is rising (view post here). Indeed, the whole point of collateralized transactions is for the lender to save transaction costs and not having to worry about the exact value of the underlying security. If these worries arise nonetheless they inevitably catch lenders “uninformed” triggering outsized risk premia.
  • Second, a decline in collateral values usually translates in additional collateral calls possibly compounded by higher haircuts and margins requirements. This is a tightening of credit conditions and may enforce a reduction in secured lending and leverage, standard conditions for fire sales. The nexus between asset prices and secured lending also easily extends to unsecured lending, including money markets, which means that all systemically important markets could seize up at the same time (view post here). Altogether, widespread collateralization establishes links between leverage, asset prices, hedging costs and liquidity across many markets. Trends are mutually reinforcing and can escalate into fire sales and market paralysis.

Regulators fear that shadow banking has been conducive to excessive leverage in the economy and may exert systemic pressure through sudden stops and asset fire sales. Leverage in modern financial systems arises not only from bank balance sheets but also from off-balance sheet transactions that involve banks and other institution. The latter has grown in importance in the 2010s, is hard to track in official statistics and is probably less stable (view post here). The risk of fire sales is a particular concern in private repurchase operations (view post here), the main market for funding of securities holdings. Moreover, distress in collateralized transactions is likely to spill over to regulated banking activity for two reasons.

  • First a large part of shadow banking system is either owned or funded by regulated banks. Ownership is common for special purpose vehicles or European asset managers. The funding link is strong to corporates or leveraged funds.
  • Second, regulated banks are directly involved in shadow banking through their broker-dealer activities. Even if they act only as intermediaries on a matched-book basis, they still incur risk. For example, in order to achieve collateral efficiency dealer banks engage in re-hypothecation (re-pledging of collateral). And in order to minimize balance sheet usages, they use their scope for netting positions. This means that in case of market distress and collateral value losses, dealer banks face rollover risks, which are not dissimilar to a classical deposit run (view post here).

Shadow banking becomes a systemic risk particularly if it grows rapidly relative to other markets and is motivated predominantly by regulatory arbitrage (view post here). These risks may end up being “put” to the public safety net, as many shadow-banking-related entities—banks, dealer banks, and (under some conditions) money market funds—benefit from implicit or explicit guarantees. These “puts” make the system effectively subsidized (view post here).[/vc_column_text][/vc_column][vc_column width=”1/3″][vc_empty_space][vc_message message_box_style=”solid-icon” message_box_color=”grey” icon_fontawesome=”fa fa-comment-o”]”Low uncertainty thus leads to shadow banking-driven booms in liquidity transformation that spur economic booms while also building up economic fragility.”

Alan Moreira and Alexi Savov[/vc_message][/vc_column][/vc_row]


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