Shadow banking

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See also reform of the Federal Reserve, repo and SIV.

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.


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, structured investment vehicles, special purpose entity, money markets, bond insurance, investment banks, and other non-bank financial institutions.

Importance of the system

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.

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 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 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]

Federal Reserve Bank of New York on shadow banking

  • Source: Shadow Banking FRBNY Paper by Zoltan Pozsar, Tobias Adrian, Adam Ashcraft, and Hayley Boesky, July, 2010


The rapid growth of the market-based financial system since the mid-1980s changed the nature of financial intermediation in the United States profoundly. Within the market-based financial system, “shadow banks” are particularly important institutions. Shadow banks are financial intermediaries that conduct maturity, credit, and liquidity transformation without access to central bank liquidity or public sector credit guarantees.

Examples of shadow banks include finance companies, asset-backed commercial paper (ABCP) conduits, limited-purpose finance companies, structured investment vehicles, credit hedge funds, money market mutual funds, securities lenders, and government-sponsored enterprises.

Shadow banks are interconnected along a vertically integrated, long intermediation chain, which intermediates credit through a wide range of securitization and secured funding techniques such as ABCP, asset-backed securities, collateralized debt obligations, and repo. This intermediation chain binds shadow banks into a network, which is the shadow banking system. The shadow banking system rivals the traditional banking system in the intermediation of credit to households and businesses.

Over the past decade, the shadow banking system provided sources of inexpensive funding for credit by converting opaque, risky, long-term assets into money-like and seemingly riskless short-term liabilities. Maturity and credit transformation in the shadow banking system thus contributed significantly to asset bubbles in residential and commercial real estate markets prior to the financial crisis.

We document that the shadow banking system became severely strained during the financial crisis because, like traditional banks, shadow banks conduct credit, maturity, and liquidity transformation, but unlike traditional financial intermediaries, they lack access to public sources of liquidity, such as the Federal Reserve’s discount window, or public sources of insurance, such as federal deposit insurance.

The liquidity facilities of the Federal Reserve and other government agencies’ guarantee schemes were a direct response to the liquidity and capital shortfalls of shadow banks and, effectively, provided either a backstop to credit intermediation by the shadow banking system or to traditional banks for the exposure to shadow banks. Our paper documents the institutional features of shadow banks, discusses their economic roles, and analyzes their relation to the traditional banking system.

Collapse of the shadow banking system

Continuing the analysis of today's Z.1 report, we next focus on recent developments in the shadow banking system. And it's a bloodbath: total shadow bank liabilities dropped by $680 billion in Q2, and a massive $2.1 trillion YTD. If one wonders why Ben Bernanke (yes, it's technically TurboTim) continues to print trillions and trillions of debt, and it is still doing nothing (yet) to stimulate the system, here is your answer.

As credit will only exist if i) it is needed and ii) there are cash paying assets (or at least the myth thereof) to support its existence, the latest plunge in the shadow banking system is merely the most recent confirmation that the deleveraging in America is only just beginning. In fact, from the peak of the credit bubble in Q2 2008, through Q2, total bank liabilities (shadow and traditional) have plunged by $2.6 trillion, from $32.1 trillion to $29.5 trillion.

Yet it is the collapse in shadow banking that was responsible, with shadow liabilities falling by a stunning 20% from $21 trillion to $17 trillion in just over two years even as banks have benefitted from the transfer of cheap government cheap on their traditional lending books (think Fed intervention and QE, leading to record low interest rates).

What this means is very clear: the shadow banking system is collapsing, period. Yes, the rate of collapse is slower than in Q1, but the total plunge was still a whopping $4.2 trillion annualized for 2010. And the delta between Shadow Banking and Traditional liabilities has collapsed from $10.7 trillion at the peak in March 2008, down to under $4 trillion. This is a record amount of "money" being removed from the system, and explains why, for now at least, the velocity of money is nothing faster than a crawl.

That said, if and when this indicator plateaus and recommences climbing, will be a very "sensitive" moment for all deflationists and inflationists as it will mark the inflection point from credit contraction to renewed credit creation. Alternatively, the Fed can merely force credit into traditional bank liabilities, which banks can then proceed to use and purchase stocks and commodities, at a zero cost of debt. What that will do to select asset prices, we leave to our readers' imagination.

  • Implications of the Financial Crisis for Economics Chairman Ben S. Bernanke At the Conference Co-sponsored by the Center for Economic Policy Studies and the Bendheim Center for Finance, Princeton University, Princeton, New Jersey, September 24, 2010

Financial Crisis Inquiry Commission holds hearing on shadow banking system

Today, the Financial Crisis Inquiry Commission (FCIC) held the first of a three-day hearing entitled “The Shadow Banking System”. Testifying before the FCIC were the following witnesses:

Session 1: Investment Banks and the Shadow Banking System

  • Paul Friedman, former Senior Managing Director, Bear Stearns
  • Samuel Molinaro, Jr., former Chief Financial Officer and Chief Operating Officer, Bear Stearns
  • Warren Spector, former President and Co-Chief Operating Officer, Bear Stearns

Session 2: Investment Banks and the Shadow Banking System

  • James E. Cayne, former Chairman and Chief Executive Officer, Bear Stearns
  • Alan D. Schwartz, former Chief Executive Officer, Bear Stearns

Session 3: Regulation of Investment Banks

  • Charles Christopher Cox, former Chairman, U.S. Securities and Exchange Commission (SEC)
  • William H. Donaldson, former Chairman, SEC
  • H. David Kotz, Inspector General, SEC
  • Erik R. Sirri, former Director, Division of Trading & Markets, SEC

FCIC Chairman Phil Angelides opened the hearing, explaining the FCIC’s interest in studying the nature and scope of the “shadow banking system,” which he defined to include those largely unregulated institutions conducting bank-like activities outside the commercial system, such as investment banks and hedge funds. Mr. Angelides emphasized the extent to which investment banks affect the entire economic system, collectively financing trillions of dollars of economic activity through the sale and management of securitized products, structured products, commercial paper, asset-backed commercial paper, repurchase agreements and derivatives.

"The shadow banking system effectively collapsed onto the regulated banking system"

"...The shadow banking system performs a function similar to that carried out by banks and other financial institutions. In particular, it takes the short-term, highly liquid investments that households and other investors want to hold, and it uses them to fund the longer-term, relatively illiquid loans that businesses and households demand to finance their economic activity. However, while a bank performs this transformation of maturity, liquidity and credit risk from end to end within a single institution, the shadow banking system involves a wide range of institutions and markets in the process.

In particular, the shadow banking system has included money market mutual funds, enhanced money funds, other real money accounts and securities lenders as providers of short-term funding; banks, industrial loan companies, independent finance companies and other non-bank firms as originators of private credit; and an array of entities including structured investment vehicles (SIVs), securities arbitrage conduits, real estate investment trusts, broker dealers, clearing banks, hedge funds, mortgage insurers, monoline insurers and credit rating agencies as part of the maturity and credit transformation between the lenders and the borrowers.

Given the number of steps and firms involved, the process of intermediating credit through this system was a complicated one. However, it is not the multiplicity of steps itself that was problematic; indeed, analogous steps would be taking place within a financial intermediary in the traditional banking system. What was problematic was that these steps involved a wide range of firms that did not have adequate coverage under any one regulatory umbrella and that did not operate with the benefit of either government-guaranteed liabilities or the Federal Reserve's discount window.

The shadow banking system grew rapidly in the years leading up to the crisis. By the middle of 2007, the volume of outstanding credit that was securitized had reached more that $4 trillion. If the debt securitized by the government-sponsored enterprises (GSEs) is included, the amount of securitized credit had reached $9.5 trillion in 2007. Clearly, the shadow banking system was not in the shadows, but was a market-based credit intermediation system that was at least on par with the banking system in terms of its importance to the economy.

Moreover, this system was not completely separate from the traditional banking system. In fact, much of the risk that the shadow banking system had assumed was ultimately borne by banking organizations. Banks had provided backstop lines of credit and had other contractual or reputational reasons to absorb structured credit and other assets back onto their books once they could not be financed in the shadow banking system. In effect, regulated banks functioned to some degree as the lenders of last resort for the shadow banking system.

The entire financial system, both in the banks and outside, got caught. It was holding too much risk on too narrow of terms, it did not have sufficient capital, and it was too leveraged and dependent on short-term funding. As it became clear that the value of the U.S. housing stock had to decline considerably, these financial conditions complicated the adjustment. Indeed, what started as a seemingly narrow concern about subprime residential mortgage-backed securities cascaded into a widespread and abrupt re-pricing of credit more broadly and a desperate scramble for liquidity.

As market participants and investors came to realize that the system was overexposed, they began to withdraw funding. Credit lines were reduced, lending terms shortened and demand shifted towards high-quality collateral. Major funding markets came under tremendous strain and experienced run-like threats, including the triparty repo market, interbank lending markets, money market mutual funds and the commercial paper market. Facing significant redemptions, money market mutual funds withdrew from wholesale funding markets, including from both secured and unsecured commercial paper programs, which further exacerbated those dynamics. The withdrawal of funding raised the possibility of fire sales of assets, which, in a vicious circle, further heightened concerns about financial exposures and accelerated investors' flight to safe and liquid assets. Asset-backed securities markets virtually shut down as distressed asset sales by SIVs and other entities prompted sharp spikes in secondary market spreads.

The fact that the regulatory structure had allowed the shadow banking system to operate with less capital and liquidity than the regulated banking system added to the stress of the situation. However, banks and other traditional financial institutions were caught up in the same dynamics. In part, their involvement reflected the connection between the banking system and the shadow banking system noted earlier. As the shadow banking system came under pressure, regulated banks had to provide funding by extending lines of credit or by absorbing assets onto their balance sheets. As such, the shadow banking system effectively collapsed onto the regulated banking system.

The bottom line is that the entire system was suffering from a self-reinforcing cycle of liquidity runs and concerns about the solvency of financial institutions. An effective policy response had to address both aspects of this cycle..."

Treasury pledges to protect repos as Obama plan sparks concern

Treasury officials say they’re considering ways to sustain trading in the $3.8 trillion-a-day repurchase agreement market as the Obama administration plans a regulatory overhaul that may change how banks fund operations.

“We are dedicated to doing this in a way that does not disrupt market functioning,” said Lee Sachs, a counselor to Treasury Secretary Timothy Geithner and an architect of the administration’s financial industry agenda, in an interview.

President Barack Obama has proposed a fee on bank liabilities, proprietary trading limits and other regulatory changes designed to rein in risk taking after the worst financial crisis since the Great Depression. The proposals have raised concern that banks may reduce exposure on short-term liabilities by pulling back from the repo market, potentially jeopardizing the Federal Reserve’s plans to drain excess reserves from the banking system as the economy strengthens.

The repo market is primarily made up of overnight trades that exchange Treasury or mortgage debt for cash. The size of the market, which most securities firms use to finance holdings, is now about half of a peak $7 trillion level reached in the first quarter of 2008, before global credit markets froze.

“If there is less liquidity it always most affects the smaller players, the more-leveraged players and it could ultimately affect the U.S. Treasury,” said Jeff Kidwell, director of funding and Direct Repo at Boca Raton, Florida-based broker dealer AVM LP.

‘Less Willing’

The administration wants to recover government fees spent during the financial crisis through a levy on banks, which is projected to recoup at least $90 billion over 10 years. The fee, proposed as a 15-basis-point tax on liabilities other than insured deposits, could make repo transactions money losers for firms because profit margins on trades may be less than the fee.

“One of the modifications I expect would be to exclude Treasury repo, in part because the Fed wants to drain reserves using the repo market,” said Joseph Abate, a money market strategist in New York at Barclays Plc, one of the 18 primary dealers that trade with the central bank. “The 15 basis points fee would obviously make the banks less willing to participate in those transactions.”

The Fed withdrew $990 million in reserves through so-called reverse repos in December in a series of tests on how it may drain some of the $1 trillion in cash pumped into the economy last year. In a reverse repo, the Fed lends securities for a set period. At maturity, the securities are returned to the Fed, and the cash to the dealers.

Industry Oil

Government policy makers have acted to shield the repo market in the past. The House of Representatives passed a financial overhaul bill in December that would penalize fully secured creditors if a systemically important financial firm failed, after carving out an exemption for trades involving Treasury securities.

“The repo market is the oil in the industry of Wall Street finance, and financing is a key core part of the marketplace,” said Scott Skyrm, senior vice president and head of repo and money markets for NewEdge USA LLC in New York. If the Obama plan goes through “as it stands now, it could have a huge impact.”

Obama has also proposed limits on the types of activities banks can engage in, in an effort to prevent banks from taking risks with their customers’ money. When added to the proposed bank tax and the House bill, the combined effect could encourage banks to focus on government-insured deposits instead of a broader funding mix, said Chip MacDonald, a partner with Jones Day in Atlanta who specializes in banking deals.

“All of them sort of push people away from diversity of funding sources, especially liquidity sources,” MacDonald said. “They seem at odds with financial stability and all the work the regulators have done to restore interbank liquidity.”

Libor-OIS Spread

Regulators issued guidance in July instructing banks to manage their liquidity risk carefully and avoid funding concentrations.

The collapse of Lehman Brothers Holdings Inc. in September 2008 triggered a global credit squeeze that lasted into the following year and exacerbated the recession. When lenders perceived that Lehman might not pay repo loans or be able to post adequate collateral, they required more and higher quality assets from the firm.

The premium banks charge each other for short-term loans, the so-called Libor-OIS spread, a gauge of banks’ reluctance to lend, surged to a record 3.64 percentage points in October 2008 amid a near freeze in lending. It was 0.1 percent point today.

Proposal Details

“Undue reliance on any one source of funding is considered an unsafe and unsound practice,” the Fed, Federal Deposit Insurance Corp. and three other regulators wrote. FDIC Chairman Sheila Bair has spoken out in favor of curtailing reliance on short-term funding sources, particularly for making risky long- term loans.

Treasury officials say they will consider market impact when designing the details of the proposal. For example, there may be advantages to using average daily levels of bank exposure rather than quarterly figures.

“We have long realized that we would have to address these issues, but we wanted to discuss with industry and the Hill before releasing specific details on exactly how we this will be executed,” Sachs said.

BOE's Tucker on the shadow banking system

Paul Tucker of Bank of England has been taking the issue of financial stability with seriousness. He has been speaking on various issues in the past. In this speech, he looks at shadow banking.

He first looks at various kinds of shadow banks/systems developed before this crisis - money market mutual funds; finance companies; Structured Investment Vehicles and Asset Backed Commercial Paper; the prime brokerage services of securities dealers; the use of securities lending as a financing market; and the repo-financing of mortgage-backed securities.

He says we need to bring them in the regulatory ambit and keep looking out for regulatory arbitrage:

For those forms of financial intermediation that are dependent on banks for leverage and liquidity, it may be that we can develop macroprudential instruments that could be deployed to restrain excess by influencing banks’ supply of credit to them. That is another major area of work.

But where a form of shadow banking provides an alternative home for liquid savings, offering de facto deposit and monetary services, then I think we should be ready to bring them into the banking world itself. In the latest episode, constant-Net Asset Value, instant-access money funds and the prime brokerage units of the dealers seem to have been examples of that.

We have not seen the last of regulatory arbitrage. So we need policies and principles that stand in the way of its weakening the resilience of the system, while allowing enterprise and our capital markets to flourish.

Shadow banking and the US current account deficit

"... Yet the role of the Landesbanks in European, and especially American markets, deserves a prominent discussion. And not just any market, but the very shadow banking system which at last check was vastly bigger than regular plain-vanilla commercial banking. As even the New York Fed acknowledges in its recent paper "Shadow Banking", by Zoltan Poszar, in which there is a whole section on the critical Landesbank function in the shadow economy, "As major investors of term structured credits “manufactured” in the U.S., European banks, and their shadow bank offshoots were an important part of the “funding infrastructure” that financed the U.S. current account deficit," the proper functioning of the Landesbanks is crucial to maintaining a stable and efficient market funding structure.

This is actually extremely important, as for years most economists and pundits have considered only the non-shadow banking funding aspect of the massive US current account deficit (a topic most critical now that even the US is embarking on fiscal austerity, and the government sector will be unable to further fund the multi-trillion deleveraging ongoing int he private sector, thus pushing the topic of the current account to the forefront as Goldman did recently).

Generically, everyone has always looked at China and Japan as those parties responsible for funding the US Current account deficit.

Alas, that is only (less than) half the truth. As the New York Fed suggests, the shadow banking system is likely a more important economic funding factor than even China and Japan combined when it comes to the CA.

Which is why the all time record decline of over $1.3 trillion in shadow banking liabilities should be a far greater warning sign than any month to month change in China's UST purchasing patterns, than whether WestLB is "really" broke or only "never never" so, and than the debate whether China will decouple, float or just continue posturing vis-a-vis the CNYUSD exchange rate.

As everyone contemplates navels, a major portion of liability funding is literally evaporating as shadow banking implodes. Yet nobody bothers to discuss this most important to the future of the US economy topic.

For those who have not read the Poszar seminal and must read breakdown of the shadow banking system (an analysis we will discuss much in the coming weeks), and which he defines as: "financial intermediaries that conduct maturity, credit, and liquidity transformation without access to central bank liquidity or public sector credit guarantees", the salient section discussing European bank importance, and especially that of the Landesbanks, in the shadow banking system is as follows:

Some parts of the “internal” shadow banking sub-system specialized in certain steps of the shadow credit intermediation process. These included primarily undiversified European banks, whose involvement in shadow credit intermediation was limited to loan warehousing, ABS warehousing and ABS intermediation, but not origination, structuring, syndication and trading.

The European banks’ involvement in shadow banking was dominated by German Landesbanks (and their off-balance sheet shadow banks—securities arbitrage conduits and SIVs), although banks from all major European economies and Japan were active investors. The prominence of European banks as high-grade structured credit investors goes to the incentives that their capital charge regime (Basel II) introduced for holding AAA ABS, and especially AAA ABS CDOs. As major investors of term structured credits “manufactured” in the U.S., European banks, and their shadow bank offshoots were an important part of the “funding infrastructure” that financed the U.S. current account deficit.

Similar to (Financial Holding Companies') credit intermediation process, the maturity and credit transformation performed through European banks’ ABS intermediation activities were not adequately backstopped: First, while European banks had access to the ECB for funding, they only had access to euro funding, and not dollar funding. However, given that ABS intermediation involved mainly U.S. dollar-denominated assets, a euro-based lender of last resort was only a part of a solution of funding problems, as borrowed euro funds had to be swapped into dollars, which in turn needed willing counterparties and a liquid FX swap market at all times. As the crisis has shown, however, FX swap markets can become illiquid and dysfunctional in times of systemic stress. Second, similar to other shadow banks, the liabilities of European banks' shadow banking activities were not insured explicitly, only implicitly: some liabilities issued by European shadow banks— namely, German Landesbanks-affiliated SIVs and securities arbitrage conduits—benefited from the implicit guarantee of German federal states' insurance. European banks’ and other banks’ and nonbanks’ involvement in ABCP funded shadow credit intermediation activities is listed in Exhibit 12.


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