Shadow banking system

The shadow banking system is the collection of financial entities, infrastructure and practices which support financial transactions that occur beyond the reach of existing state sanctioned monitoring and regulation. It includes entities such as hedge funds, money market funds and structured investment vehicles. Investment banks may conduct much of their business in the shadow banking system (SBS), but they are not SBS institutions themselves.

The core activities of investment banks are subject to regulation and monitoring by central banks and other government institutions - but it has been common practice for investment banks to conduct many of their transactions in ways that don't show up on their conventional balance sheet accounting and so are not visible to regulators or unsophisticated investors. For example, prior to the financial crisis, investment banks financed mortgages through off-balance sheet securitizations and hedged risk through off-balance sheet credit default swaps.

The volume of transactions in the shadow banking system grew dramatically after the year 2000. By late 2007 the size of the SBS in the U.S. exceeded $10 trillion. By late 2009 the United States SBS had shrunk to under $6 trillion due to increased regulation, changes in business practice, and pressure from investors who in some cases no longer wanted their funds to be used in the shadow banking system. Globally, a study of the 11 largest national shadow banking systems found that they totalled to $50,000bn in 2007, fell to $47,000bn in 2008 but by late 2011 had climbed to $51,000bn , just over its estimated size before the crisis. Overall, the world wide SBS totalled to about $60 trillion as of late 2011.

Entities that make up the system

Shadow institutions do not accept deposits like a depository bank and therefore are not subject to the same regulations. Complex legal entities comprising the system include hedge funds, SIVs, conduits, money funds, and other non-bank financial institutions.

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.

The shadow banking system makes up 25 to 30 percent of the total financial system, according to the Financial Stability Board (FSB), a regulatory task force for the world's group of top 20 economies (G20).

This largely unregulated sector was worth about $60 trillion in 2010, having grown from an estimated $27 trillion in 2002, according to the FSB. While the sector's assets declined during the global financial crisis, they have since returned to their pre-crisis peak.

There are concerns that more business may move into the shadow banking system as regulators seek to bolster the financial system by making bank rules stricter.

Shadow bank's role in the financial system and their modous operandi

Like traditional banks, shadow banks provide credit and liquidity but, unlike their traditional counterparts, they do not have access to central bank funding or safety nets like deposit insurance. Unlike traditional banks, shadow banks do not take deposits. Instead, they rely on short-term funding provided either by asset-backed commercial paper or by the repo market, in which borrowers offer collateral as security against a cash loan and then sell the security to a lender and agree to repurchase it at an agreed time in the future for an agreed price. They are often based in tax havens, invest in long-term loans like mortgages, providing credit across the financial system by matching investors and borrowers individually or by becoming part of a chain involving numerous entities, some of which may be mainstream banks.

The shadow bank function is very important for a market economy because by providing funding to traditional banks facilitate the credit availability to businesses. In fact, without their funding, traditional banks would not be able to lend money, which would then slow growth in the wider economy. Given their specialised nature, shadow banks often can provide credit more cost-efficiently than traditional banks. The shadow banking system also offers credit and provides liquidity and funding in addition to that provided by the mainstream banking system.

Shadow banking institutions like hedge funds often take on risks that mainstream banks are either unwilling or not allowed to take. This means shadow banks can provide credit to people or entities who might not otherwise have such access.

The risks associated with shadow banking

As shadow banks do not take deposits, they are subject to less regulation than traditional banks. They can therefore increase the rewards they get from investments by leveraging up much more than their mainstream counterparts and this can lead to risks mounting in the financial system. Unregulated shadow institutions can be used to circumvent the strictly regulated mainstream banking system and therefore avoid rules designed to prevent financial crises.

Shadow banks can also cause a buildup of systemic risk indirectly because they are interrelated with the traditional banking system via credit intermediation chains, meaning that problems in this unregulated system can easily spread to the traditional banking system. As shadow banks use a lot of short-term deposit-like funding but do not have deposit insurance like mainstream banks, a loss of confidence can lead to "runs" on these unregulated institutions. Shadow banks' collateralised funding is also considered a risk because it can lead to high levels of financial leverage. By transforming the maturity of credit -- such as from long-term to short term -- shadow banks fuelled real estate bubbles in the mid 2000s that helped cause the global financial crisis when they burst.

Recent attempts at the regulation of the shadow banking system

In the United States the Dodd-Frank Act, passed in 2010, made provisions which go some way towards regulating the shadow banking system by stipulating that the Federal Reserve would have the power to regulate all institutions of systemic importance, for example. Other provisions include registration requirements for hedge funds which have assets totalling more than $150 million and a requirement for the bulk of over-the-counter derivatives trades to go through exchanges and clearing houses.

When Mark Carney was appointed chairman of the FSB in November, he said the global watchdog might introduce direct regulation of the shadow banking system to tackle the risks moving into this unregulated sector from the heavily supervised mainstream banking sector. According to Carney, regulating the shadow banking industry would be a top priority for the the FSB, which was likely to implement hard rules for activities like securitisation and money market funds, and use registration requirements to ensure more transparency in others.

The recommendations for G20 leaders on regulating shadow banks are due to be finalised by the end of 2012. The United States and the European Union are already approving rules to increase regulation of areas like securitisation and money market funds.

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.

In a June 2008 speech, Timothy Geithner, then President and CEO of the Federal Reserve Bank of New York, described the growing importance of what he called the "non-bank financial 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." In other words, lending through the shadow banking system slightly exceeded lending via the traditional banking system based on outstanding balances.

Risks or vulnerability

Securitization markets were impaired during the crisis

Shadow institutions are not subject to the same prudential regulations as depository banks, so that they do not have to keep as high financial reserves relative to their exposure. Thus 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. This high leverage will also not be readily apparent to investors, and shadow institutions may therefore be able to create the appearance of superior performance during boom times by simply taking greater pro-cyclical risks.

Shadow institutions like SIVs and conduits, typically controlled by investment banks, borrowed from investors in short-term, liquid markets (such as the money market and commercial paper markets), so that they would have to repay and borrow again from these investors at frequent intervals. 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 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 their ability to obtain funds from investors through investments such as mortgage-backed securities declined, these investment banks could not refinance 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.

From a technical standpoint, 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 problem, as 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. A sell off of assets could cause further price declines of those assets and further losses and selloffs.

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. 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.

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

In January 2012, the global Financial Stability Board announced its intention to further regulate the shadow banking system, in the interests of the real economy.

History and Origin of the term

The term "shadow banking system" is attributed to Paul McCulley of PIMCO, who coined it at Federal Reserve Bank of Kansas City's Economic Symposium in Jackson Hole Wyoming in 2007 where he defined it as "the whole alphabet soup of levered up non-bank investment conduits, vehicles, and structures." McCulley identifies the birth of the shadow banking system with the development of money market funds in the 1970s – money market accounts function largely as bank deposits, but money market funds are not regulated as banks.

The concept of hidden high priority debt dates back at least 400 years to Twyne's case in the UK, and to Clow v. Woods in the U.S. These legal cases led to the development of modern fraudulent transfer law.

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, in which he states:

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.

The full extent of the shadow banking system was not widely recognised until work was published in 2010 by Manmohan Singh and James Aitken of the International Monetary Fund, showing that when the role of rehypothecation was considered, the U.S. SBS had grown to over $10 trillion, about twice as much as previous estimates.

Examples

During 1998, hedge fund Long-term Capital Management failed and was bailed out by several major banks at the request of the government, which was concerned about possible damage to the broader financial system. It was highly leveraged and unregulated.

Structured investment vehicles (SIVs) first came to public attention at the time of 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 their balance sheets into special purpose vehicles or similar entities. This enabled them to bypass regulatory requirements for minimum capital ratios, thereby increasing leverage and profits during the boom but increasing losses during the crisis. New accounting guidance was planned to require them to put some of these assets back onto their books during 2009, with the effect of reducing their capital ratios. One news agency estimated the amount of assets to be transferred at between $500 billion and $1 trillion. This transfer was considered as part of the stress tests performed by the government during 2009.

The shadow banking system also conducts an enormous amount of trading activity in the OTC derivatives market, which grew rapidly in the decade up to the 2008 financial crisis, reaching over US$650 trillion in notional contracts traded (see the Bank for International Settlements (BIS.org) bi-annual report). This rapid growth mainly arose from credit derivatives. In particular these included:

• collateralised debt obligations (CDO)
• 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), a form of insurance against the default risk inherent in the assets underlying the CDO).

The market in CDS, for example, was insignificant in 2004 but rose to over $60 trillion in a few short years. Because credit default swaps were not regulated as insurance contracts, companies selling them were not required to maintain sufficient capital reserves to pay potential claims. Demands for settlement of hundreds of billions of dollars of credit default swaps contracts issued by AIG, the largest insurance company in the world, led to its financial collapse. Despite the prevalence and volume of this activity, it attracted little outside attention before 2007, and much of it was off the balance sheets of the contracting parties' affiliated banks. The uncertainty this created among counterparties contributed to the deterioration of credit conditions.

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

Contribution to the 2007–2012 financial crisis

The shadow banking system has been implicated as significantly contributing to the financial crisis of 2007–2012. 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.

Economist 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."

See also

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