Shadow Banking
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Shadow banking refers to credit intermediation that occurs outside the traditional banking system and makes up about a quarter of total financial intermediation globally. It involves entities raising short-term funds to invest in longer-term assets, similar to banks but without the same regulation. During the financial crisis, many shadow banking entities had to sell assets quickly due to investor withdrawals, reducing asset values and spreading uncertainty. The global shadow banking system peaked at $62 trillion in 2007 before declining. Growth is driven by investors seeking higher yields, regulatory arbitrage, and complementing traditional banking.
Shadow Banking
- 1. 1 Shadow Banking What is shadow banking Shadow banking, broadly defined as credit intermediation outside the conventional banking system, constitutes about one-fourth of total financial intermediation worldwide. The term “shadow bank” was coined by economist Paul McCulley in a 2007 speech at the annual financial symposium hosted by the Kansas City Federal Reserve Bank in Jackson Hole, Wyoming. In McCulley’s talk, shadow banking had a distinctly U.S. focus and referred mainly to nonbank financial institutions that engaged in what economists call maturity transformation. Commercial banks engage in maturity transformation when they use deposits, which are normally short term, to fund loans that are longer term. Shadow banks do something similar. They raise (that is, mostly borrow) short-term funds in the money markets and use those funds to buy assets with longer-term maturities. But because they are not subject to traditional bank regulation, they cannot—as banks can— borrow in an emergency from the Federal Reserve (the U.S. central bank) and do not have traditional depositors whose funds are covered by insurance; they are in the “shadows.” Shadow banks first caught the attention of many experts because of their growing role in turning home mortgages into securities. The “securitization chain” started with the origination of a mortgage that then was bought and sold by one or more financial entities until it ended up part of a package of mortgage loans used to back a security that was sold to investors. The value of the security was related to the value of the mortgage loans in the package, and the interest on a mortgage-backed security was paid from the interest and principal homeowners paid on their mortgage loans. Almost every step from creation of the mortgage to sale of the security took place outside the direct view of regulators. The Financial Stability Board (FSB), an organization of financial and supervisory authorities from major economies and international financial institutions, developed a broader definition of shadow banks that includes all entities outside the regulated banking system that perform the core banking function, credit intermediation (that is, taking money from savers and lending it to borrowers). The four key aspects of intermediation are • maturity transformation: obtaining short-term funds to invest in longer-term assets; • liquidity transformation: a concept similar to maturity transformation that entails using cash-like liabilities to buy harder-to-sell assets such as loans; • leverage: employing techniques such as borrowing money to buy fixed assets to magnify the potential gains (or losses) on an investment;
- 2. 2 Shadow Banking • credit risk transfer: taking the risk of a borrower’s default and transferring it from the originator of the loan to another party. Under this definition shadow banks would include broker-dealers that fund their assets using repurchase agreements (repos). In a repurchase agreement an entity in need of funds sells a security to raise those funds and promises to buy the security back (that is, repay the borrowing) at a specified price on a specified date. Money market mutual funds that pool investors’ funds to purchase commercial paper (corporate IOUs) or mortgage-backed securities are also considered shadow banks. So are financial entities that sell commercial paper and use the proceeds to extend credit to households (called finance companies in many countries). Why there is a problem As long as investors understand what is going on and such activities do not pose undue risk to the financial system, there is nothing inherently shadowy about obtaining funds from various investors who might want their money back within a short period and investing those funds in assets with longer-term maturities. Problems arose during the recent global financial crisis, however, when investors became skittish about what those longer-term assets were really worth and many decided to withdraw their funds at once. To repay these investors, shadow banks had to sell assets. These “fire sales” generally reduced the value of those assets, forcing other shadow banking entities (and some banks) with similar assets to reduce the value of those assets on their books to reflect the lower market price, creating further uncertainty about their health. At the peak of the crisis, so many investors withdrew or would not roll over (reinvest) their funds that many financial institutions—banks and nonbanks—ran into serious difficulty. In short, the shadow banking entities were characterized by a lack of disclosure and information about the value of their assets (or sometimes even what the assets were); opaque governance and ownership structures between banks and shadow banks; little regulatory or supervisory oversight of the type associated with traditional banks; virtually no loss-absorbing capital or cash for redemptions; and a lack of access to formal liquidity support to help prevent fire sales. How big is the shadow banking system Shadows can be frightening because they obscure the shapes and sizes of objects within them. The same is true for shadow banks. Estimating the size of the shadow banking
- 3. 3 Shadow Banking system is particularly difficult because many of its entities do not report to government regulators. The shadow banking system appears to be largest in the United States, but nonbank credit intermediation is present in other countries—and growing. Across the jurisdictions contributing to the FSB exercise, the global shadow system peaked at $62 trillion in 2007, declined to $59 trillion during the crisis, and rebounded to $67 trillion at the end of 2011. The shadow banking system’s share of total financial intermediation was about 25 percent in 2009–11, down from 27 percent in 2007. What Contributes to Shadow Banking Growth A search for yield, regulatory arbitrage, and complementarities with the rest of the financial system play a role in the growth of shadow banking. First, when government bond yields are low and investors are looking for higher-yielding assets, it is the shadow banking system that often supplies those assets—the search-for- yield effect. Second, tighter bank regulation encourages institutions to circumvent it through nonbank intermediation. Third, growth of shadow banking can be complementary to the rest of the financial system. In emerging markets, the growth of pension funds and insurance companies has often come along with the growth of investment funds and other nonbank intermediaries. References International Monetary Fund. (2014). SHADOW BANKING AROUND THE GLOBE:HOW LARGE, AND HOW RISKY? Global Financial Stability Report (October). Kodres, L. E. (2013). What Is Shadow Banking? Finance & Development , 50 (2) (June). Indrajit Roy Choudhury 22 January 2015