Shadow banking system
The shadow banking system is a term for the collection of non-bank financial intermediaries that provide services similar to traditional commercial banksbut outside normal banking regulations.[1] The phrase "shadow banking" contains the pejorative connotation of back alley loan sharks. Many in the financial services industry find this phrase offensive and prefer the euphemism "market-based finance".[2]
This definition was first put forward by PIMCO (Pacific Investment Management Company) executive director Paul McCulley at a FED (Federal Reserve System) annual meeting in 2007.
Former US Federal Reserve Chair Ben Bernanke provided the following definition in November 2013:
Shadow banking has grown in importance to rival traditional depository banking, and was a primary factor in the subprime mortgage crisis of 2007–2008 and the global recession that followed.[4][5][6]
Overview
Paul McCulley of investment management firm PIMCO coined the term "shadow banking".[5] Shadow banking is sometimes said to include entities such as hedge funds, money market funds, structured investment vehicles (SIV), "credit investment funds, exchange-traded funds, credit hedge funds, private equity funds, securities broker dealers, credit insurance providers, securitization and finance companies"[7] but the meaning and scope of shadow banking is disputed in academic literature.[5]
According to Hervé Hannoun, deputy general manager of the Bank for International Settlements (BIS), investment banks as well as commercial banks may conduct much of their business in the shadow banking system (SBS), but most are not generally classed as SBS institutions themselves.(Hannoun 2008)[8][9] At least one financial regulatory expert has said that regulated banking organizations are the largest shadow banks.[10]
The core activities of investment banksare 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 do not show up on their conventional balance sheet accounting and so are not visible to regulators or unsophisticated investors. For example, prior to the 2007–2012 financial crisis, investment banks financed mortgages through off-balance sheet (OBS) securitizations (e.g. asset-backed commercial paper programs) and hedged risk through off-balance sheet credit default swaps. Prior to the 2008 financial crisis, major investment banks were subject to considerably less stringent regulation than depository banks. In 2008, investment banks Morgan Stanley and Goldman Sachsbecame bank holding companies, Merrill Lynch and Bear Stearns were acquired by bank holding companies, and Lehman Brothers declared bankruptcy, essentially bringing the largest investment banks into the regulated depository sphere.
The volume of transactions in the shadow banking system grew dramatically after the year 2000. Its growth was checked by the 2008 crisisand for a short while it declined in size, both in the US and in the rest of the world.[11][12] In 2007 the Financial Stability Board estimated the size of the SBS in the U.S. to be around $25 trillion, but by 2011 estimates indicated a decrease to $24 trillion.[13] Globally, a study of the 11 largest national shadow banking systems found that they totaled $50 trillion in 2007, fell to $47 trillion in 2008, but by late 2011 had climbed to $51 trillion, just over their estimated size before the crisis. Overall, the worldwide SBS totaled about $60 trillion as of late 2011.[11] In November 2012 Bloombergreported in a Financial Stability Board report an increase of the SBS to about $67 trillion.[14] It is unclear to what extent various measures of the shadow banking system include activities of regulated banks, such as bank borrowing in the repo market and the issuance of bank-sponsored asset-backed commercial paper. Banks by far are the largest issuers of commercial paper in the United States, for example.
Entities that make up the system
Shadow institutions typically do not have banking licenses; they do not take deposits as a depository bank would and therefore are not subject to the same regulations.[5] Complex legal entities comprising the system include hedge funds, structured investment vehicles (SIV), special purpose entity conduits (SPE), money market funds, repurchase agreement (repo) markets and other non-bank financial institutions.[17] Many shadow banking entities are sponsored by banks or are affiliated with banks through their subsidiaries or parent bank holding companies.[5] The inclusion of money market funds in the definition of shadow banking has been questioned in view of their relatively simple structure and the highly regulated and unleveraged nature of these entities, which are considered safer, more liquid, and more transparent than banks.
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.[5]
Hervé Hannoun, Deputy General Manager of the Bank for International Settlements described the structure of this shadow banking system to at the annual South East Asian Central Banks (SEACEN) conference.(Hannoun 2008)[8]
This sector was worth an estimated $60 trillion in 2010, compared to prior FSB estimates of $27 trillion in 2002.[13][18]While the sector's assets declined during the global financial crisis, they have since returned to their pre-crisis peak[19] except in the United States where they have declined substantially.
A 2013 paper by Fiaschi et al. used a statistical analysis based on the deviation from the Zipf distribution of the sizes of the world's largest financial entities to infer that the size of the shadow banking system may have been over $100 trillion in 2012.[15][20]
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.[19]
Role in the financial system and modus operandi
Like regular banks, shadow banks provide credit and generally increase the liquidity of the financial sector. Yet unlike their more regulated competitors, they lack access to central bank funding or safety nets such as deposit insuranceand debt guarantees.[5] (2009 & Hall)[19][21] In contrast to 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 in substance offer collateral as security against a cash loan, through the mechanism of selling the security to a lender and agreeing to repurchase it at an agreed time in the future for an agreed price.[19]Money market funds do not rely on short-term funding; rather, they are investment pools that provide short-term funding by investing in short-term debt instruments issued by banks, corporations, state and local governments, and other borrowers. The shadow banking sector operates across the American, European, and Chinese financial sectors,[22](Boesler 2012)[23]and in perceived tax havensworldwide.[19] Shadow banks can be involved in the provision of long-term loans like mortgages, facilitating 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.[19] Due in part to their specialized structure, shadow banks can sometimes provide credit more cost-efficiently than traditional banks.[19] A headline study by the International Monetary Fund defines the two key functions of the shadow banking system as securitization – to create safe assets, and collateralintermediation – to help reduce counterparty risks and facilitate secured transactions.[24] In the US, prior to the 2008 financial crisis, the shadow banking system had overtaken the regular banking system in supplying loans to various types of borrower; including businesses, home and car buyers, students and credit users.[25] As they are often less risk averse than regular banks, entities from the shadow banking system will sometimes provide loans to borrowers who might otherwise be refused credit.[19] Money market funds are considered more risk averse than regular banks and thus lack this risk characteristic.
The risks associated with shadow banking
Leverage (the means by which banks multiply and spread risk) is considered to be a key risk feature of shadow banks, as well as traditional banks. Money market funds are completely unleveraged and thus do not have this risk characteristic.
Recent attempts to regulate the shadow banking system
The recommendations for G20 leaders on regulating shadow banks were due to be finalised by the end of 2012. The United States and the European Union are already considering rules to increase regulation of areas like securitisation and money market funds, although the need for money market fund reforms has been questioned in the United States in light of reforms adopted by the Securities and Exchange Commission in 2010. The International Monetary Fundsuggested that the two policy priorities should be to reduce spillovers from the shadow banking system to the main banking system and to reduce procyclicality and systemic risk within the shadow banking system itself.[24]
The G20 leaders meeting in Russia in September 2013, will endorse the new Financial Stability Board (FSB) global regulations for the shadow banking systems which will come into effect by 2015.(Jones 2013)[7]
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