Shadow banking system

From Wikipedia, the free encyclopedia

Financial market participants
Collective investment schemes
Credit unions
Insurance companies
Investment banks
Pension funds
Prime Brokers
Trusts
Finance series
Financial market
Participants
Corporate finance
Personal finance
Public finance
Banks and banking
Financial regulation
v • d • e

The shadow banking system or the shadow financial system consists of non-bank financial institutions that play an increasingly critical role in lending businesses the money necessary to operate.

Contents 1 Entities comprising the system 2 Importance 3 Risks or vulnerability 4 History 4.1 Examples 5 Contribution to the 2007-2009 financial crisis 6 See also 7 References

[edit] Entities comprising the system

Shadow banking institutions are typically intermediaries between investors and borrowers. For example, an institutional investor like a pension fund may be willing to lend money, while a corporation may be searching for funds to borrow. The shadow banking institution will channel funds from the investor(s) to the corporation, profiting either from fees or from the difference in interest rates between what it pays the investor(s) and what it receives from the borrower.

By definition, shadow institutions do not accept deposits like a depository bank and therefore are not subject to the same regulations. Familiar examples of shadow institutions included Bear Stearns and Lehman Brothers. Other complex legal entities comprising the system include hedge funds, SIVs, conduits, money funds, monolines, investment banks, and other non-bank financial institutions.

[edit] Importance

Many "shadow bank" like institutions and vehicles have emerged in American and European markets, between the years 2000 and 2008, and have come to play an important role in providing credit across the global financial system.^[1]

In a June 2008 speech, U.S. Treasury Secretary Timothy Geithner, then President and CEO of the NY Federal Reserve Bank, described the growing importance of the shadow banking system: "In early 2007, asset-backed commercial paper conduits, in structured investment vehicles, in auction-rate preferred securities, tender option bonds and variable rate demand notes, had a combined asset size of roughly $2.2 trillion. Assets financed overnight in triparty repo grew to $2.5 trillion. Assets held in hedge funds grew to roughly $1.8 trillion. The combined balance sheets of the then five major investment banks totaled $4 trillion. In comparison, the total assets of the top five bank holding companies in the United States at that point were just over $6 trillion, and total assets of the entire banking system were about $10 trillion."^[2] In other words, lending through the shadow banking system slightly exceeded lending via the traditional banking system based on outstanding balances.

[edit] Risks or vulnerability

Shadow institutions are not subject to the same safety and soundness regulations as depository banks, meaning they do not have to keep as much money in the proverbial vault relative to what they borrow and lend. In other words, they can have a very high level of financial leverage, with a high ratio of debt relative to the liquid assets available to pay immediate claims. High leverage magnifies profits during boom periods and losses during downturns.

Shadow institutions like investment banks borrowed from investors in short-term, liquid markets (such as the money market and commercial paper markets), meaning that they would have to frequently repay and borrow again from these investors. On the other hand, they used the funds to lend to corporations or to invest in longer-term, less liquid (i.e., harder to sell) assets. In many cases, the long-term assets purchased were the mortgage-backed securities sometimes called "toxic assets" or "legacy assets" in the press. These assets declined significantly in value as housing prices declined and foreclosures increased during 2007-2009.

In the case of investment banks, this reliance on short-term financing required them to return frequently to investors in the capital markets to refinance their operations. When the housing market began to deteriorate and the ability to obtain funds from investors through investments such as mortgage-backed securities declined, these investment banks were unable to fund themselves. Investor refusal or inability to provide funds via the short-term markets was a primary cause of the failure of Bear Stearns and Lehman Brothers during 2008.

In technical terms, these institutions are subject to market risk, credit risk and especially liquidity risk, since their liabilities are short-term while their assets are more long term and illiquid. This creates a potential problem in that they are not depositary institutions and do not have direct or indirect access to the support of their central bank in its role as lender of last resort. Therefore, during periods of market illiquidity, they could go bankrupt if unable to refinance their short-term liabilities. They were also highly leveraged. This meant that disruptions in credit markets would make them subject to rapid deleveraging, meaning they would have to pay off their debts by selling their long-term assets. ^[3]

The securitization markets frequently tapped by the shadow banking system started to close down in the spring of 2007 and nearly shut-down in the fall of 2008. More than a third of the private credit markets thus became unavailable as a source of funds.^[4] In February 2009, Ben Bernanke stated that securitization markets remained effectively shut, with the exception of conforming mortgages, which could be sold to Fannie Mae and Freddie Mac.^[5]

U.S. Treasury Secretary Timothy Geithner stated that the "combined effect of these factors was a financial system vulnerable to self-reinforcing asset price and credit cycles."^[6]

[edit] History

The term "shadow banking system" is attributed to Paul McCulley of PIMCO, who coined it at the 2007 Jackson Hole conference, where he defined it as "the whole alphabet soup of levered up non-bank investment conduits, vehicles, and structures."^[7][8][9]

The concept of credit growth by unregulated institutions, though not the term "shadow banking system", date at least to Prices and Production, by Friedrich Hayek, 1935, which includes:^[10]

There can be no doubt that besides the regular types of the circulating medium, such as coin, notes and bank deposits, which are generally recognised to be money or currency, and the quantity of which is regulated by some central authority or can at least be imagined to be so regulated, there exist still other forms of media of exchange which occasionally or permanently do the service of money.

...

The characteristic peculiarity of these forms of credit is that they spring up without being subject to any central control, but once they have come into existence their convertibility into other forms of money must be possible if a collapse of credit is to be avoided.

[edit] Examples

During 1998, hedge fund Long-term Capital Management failed and was bailed-out by several major banks with government urging, citing concerns of damage to the broader financial system. It was highly leveraged and unregulated.^[11]

Structured investment vehicles, (SIVs), first came to light during the Enron scandal. Since then, their use has become widespread in the financial world. In the years leading up to the crisis, the top four U.S. depository banks moved an estimated $5.2 trillion in assets and liabilities off-balance sheet into special purpose vehicles or similar entities. This enabled them to essentially bypass existing regulations regarding minimum capital ratios, thereby increasing leverage and profits during the boom but increasing losses during the crisis. New accounting guidance will require them to put some of these assets back onto their books during 2009, which will significantly reduce their capital ratios. One news agency estimated this amount to be between $500 billion and $1 trillion. This effect was considered as part of the stress tests performed by the government during 2009.^[12]

The shadow banking system also conducts an enormous amount of trading activity in the OTC derivatives market, which grew exponentially in the decade prior to the 2008 financial crisis, reaching upwards of $650 trillion dollars in notional contracts traded (see the Bank for International Standards (BIS.org) bi-annual report). Credit derivatives in particular, collateralised debt obligations (CDOs), tranches of interest rate obligations derived from bundles of mortgage securities, a variety of customized or synthetic innovations on the CDO model, and credit default swaps (CDS's), a form of quasi-insurance against the default risk inherant in the assets underlying the CDO's, saw the most rapid and explosive growth in this shadow market. The market in CDS's, for example, rose from insignificantly small in 2004 to over $60 trillion dollars in a few short years^[13]. Because credit default swaps were not regulated as actual insurance contracts, companies selling them were not required to maintain sufficient capital reserves to pay off on potential claims. Demands of settlement on hundreds of billions of dollars of credit default swaps contracts offered by a division of AIG, the largest insurance company in the world, led to their financial collapse. Despite the prevalence of this activity and the volume of contracts involved, it attracted little outside attention before 2007, and much of the activity was off-balance sheet for the entities affiliated banks. The uncertainty this created among counterparties was a contributing factor when credit conditions worsened.

Since then the shadow banking system has been blamed^[1] for aggravating the subprime mortgage crisis and helping to transform it into a global credit crunch.^[14]

[edit] Contribution to the 2007-2009 financial crisis

The shadow banking system has been implicated as significantly contributing to the financial crisis of 2007–2009. In a June 2008 speech, U.S. Treasury Secretary Timothy Geithner, then President and CEO of the NY Federal Reserve Bank, placed significant blame for the freezing of credit markets on a "run" on the entities in the shadow banking system by their counterparties. The rapid increase of the dependency of bank and non-bank financial institutions on the use of these off-balance sheet entities to fund investment strategies had made them critical to the credit markets underpinning the financial system as a whole, despite their existence in the shadows, outside of the regulatory controls governing commercial banking activity. Furthermore, these entities were vulnerable because they borrowed short-term in liquid markets to purchase long-term, illiquid and risky assets. This meant that disruptions in credit markets would make them subject to rapid deleveraging, selling their long-term assets at depressed prices.^[15]

Nobel laureate Paul Krugman described the run on the shadow banking system as the "core of what happened" to cause the crisis. "As the shadow banking system expanded to rival or even surpass conventional banking in importance, politicians and government officials should have realized that they were re-creating the kind of financial vulnerability that made the Great Depression possible--and they should have responded by extending regulations and the financial safety net to cover these new institutions. Influential figures should have proclaimed a simple rule: anything that does what a bank does, anything that has to be rescued in crises the way banks are, should be regulated like a bank." He referred to this lack of controls as "malign neglect."^[16]

[edit] See also

• Long-term Capital Management
• Recession
• Structured investment vehicle
• Subprime mortgage crisis
• Subprime crisis background information
• Subprime mortgage crisis solutions debate

[edit] References