Cloak and Dagger: the shadow banking system
Written by Anisha // January 6, 2011 // Economic & Social Policy // 23 Comments
The financial crisis of 2007-09 introduced a vast number of new concepts and terms to the global lexicon but the sexiest of them all has got to be “shadow banking”. This lovely phrase calls to mind cold war novels, illegal bank accounts, counterfeit currency, multiple passports and a protagonist called Cooper who can blend into crowds. The reality is rather less colourful but far more incomprehensible.
Let’s start with a definition. This is not particularly easy. A recent London G20 meeting on financial stability issues came up with something that sounds like this: shadow banking activities provide a credit intermediation function involving maturity transformation but acting outside the banking system. In short, shadow banks raise short term deposit-like funding (usually from wholesale markets) and use these funds to advance credit. Sounds like a bank? Absolutely, but because they aren’t registered as banks, they aren’t regulated as banks either. Instead, these entities proliferate in shadows, away from the glare of regulation, in the form of diverse and complex creatures called SIVs ABCPs, ABS CDOs, VRDOs and even the more familiar MMMFs.
TMI? You haven’t seen anything yet. This marvelous picture (on page two of the linked document) created by the NY Federal Reserve in mid-2010 – and widely circulated among bankers and regulators alike – looks like it tumbled out of a homework assignment for a budding electrical engineer. The circuit board highlights the sheer complexity of the financial system. The top one-tenth of the diagram represents the conventional banking system. Everything below that falls into the opaque world of shadow banking. The authors recommend printing the map as a 36” by 48” poster: this world is vast and complex. If it took till the middle of 2010 to generate this map, then one can only imagine how baffled regulators must have been when the system short-circuited in the summer of 2007.
The growth of shadow banking was programmed to escape regulation; indeed, shadow banking advances credit to borrowers without the credit actually showing up on the bank’s balance sheet. Banks face high regulatory costs for every asset they possess on their balance sheet, with higher costs assigned to more risky assets. This not only prevents banks from amassing vast amounts of bad debt but also ensures that they hold enough capital to fund themselves out of trouble. These high costs, however, encouraged banks to push costly assets off their balance sheets and into vehicles which are not similarly regulated. These entities borrow short term and lend long term, taking on much higher leverage than banks. This credit intermediation chain has three key processes: loan origination, usually conducted by a bank or a finance company, loan warehousing, which is the process of creating entities to warehouse these assets off the balance sheet of banks, and asset distribution or funding, where the newly created securities are distributed to non-bank financial companies such as mutual funds, insurance companies and pension funds and so on. This relatively simple chain is often expanded to include a large number of steps in between replicating the same process over and over. Since the end-users (non-bank financial companies) demand highly rated liquid assets, shadow banking specializes in “low-risk” assets – such as AAA-rated asset backed securities. The high rating assigned to these products encouraged risk managers and regulators to ignore any concerns of a liquidity or maturity mismatch: a situation where shadow banks face a gap between the length and liquidity of their deposits relative to their assets. It was widely believed that in the event of a run on the shadow bank, the entity would easily sell its highly-rated securities and find the cash to pay its depositors, and in the mean time, it could also find temporary funding from private sector sources such as the repo market. Except, as we now know, if a run is big enough, liquidity vanishes overnight and financial institutions go bankrupt well before they get to the point of liquidating their assets. The collapse of Lehman Brothers led to precisely this: a run on the shadow banking system, necessitating huge taxpayer-funded bailouts.
And little wonder that the bailouts were as large as they turned out to be (the Fed disbursed a mammoth US$3.3tr to the global banking system). At the eve of the crisis, the US shadow banking sector was valued at US$20 tr, almost twice as large as the conventional banking sector at US$11tr (figures from the NY Fed article). While the sector did shrink during the asset price collapse of the crisis, it remains sensationally large at US$16 trillion to the banking system’s 13 trillion.
Another curiously arcane-sounding concept which fed into the growth of the shadow banking system is rehypothecation. When banks cut deals with sophisticated investors such as hedge funds, it usually requires that the fund post securities as collateral. Instead of using this collateral as a buffer against the possible failure of the hedge fund, the bank often rehypothecates the collateral by posting it as security in another deal. Through this churning, the same piece of collateral can essentially be used to support multiple multimillion dollar deals. Rehypothecation apparently accounted for business close to US$10tr, another mindboggling figure when one considers the risks involved.
Emerging economies like India and South Africa have so far remained free of such untrammelled financial innovation and shadow banking is as yet a shadow. However, gaming the regulatory system is hardly an alien concept to most Indians and one cannot imagine, particularly with the process of reform, that it will be very long before these creatures come to our shores.
Shadow banking has become the financial regulatory buzzword of 2011. If 2010 was the year of reining in the banks then 2011 is the year of looking beyond the banking system and peering into the shadows. Paradoxically, the increased regulation of banks only creates more incentive for bankers and financiers to take the back door. If nothing else, the crisis has taught us that regulators are likely to always follow a couple of steps behind the wiles of bright and well-paid finance sector professionals.
So is the next crisis already waiting in the shadows? Hopefully not. Regulators must act to shrink the shadow banking system and impose reasonable limits on its expansion. The rise of shadow banking from 2002-07 hardly passed unnoticed but it coincided with a benign period of easy prosperity around the world. No one wanted to stop the music/remove the punchbowl/call the cops [insert favoured financial crisis metaphor] when the good times were rolling. Henceforth, whenever supervisors start to relax and sink into the fantasy that “light-touch regulation” is all that’s required to keep the financial sector moving, whip out a copy of that 36” by 48” poster. That should wake them up, all right.
Incidentally, happy new year to everyone. I’ve returned to this blog after a bit of a break (come out of the shadows?) but I have every intention of writing more often this year!
23 Comments on "Cloak and Dagger: the shadow banking system"
Anisha-
Again an excellently explained article. Greatly illuminating. The “rehypothecation” practice was news to me. Sounds pretty risky
Subra
Thanks, Subra! Rehypothecation is completely crazy. The defence used by the bankers is that they only try these stunts with so-called sophisticated investors such as hedge funds, who know exactly what is going on with their posted securities. The problem is that no institution is sophisticated enough to keep track of the total risk added to the system as a whole when a sufficiently large number of market participants starts playing around with collateral. I would imagine that this is one pratice that regulators will want to take the axe to.
Shadow banking very lucidly explained. I was so taken up with the line diagram or shall we say the process diagram. Looks like a circuit / mother board. Have heard about hypothecation but rehypothecation is definitely something illegal. There must be some regulatory measures or an agency that must be tracking the assets under hypothcation to ensure they do not get rehypothecared. How does a lender otherwise ensure that he is not getting a dud as a collateral.
Thanks for reading this and the comment! Glad you enjoyed the post. Unfortunately rehypothecation is very legal in the US and EU. It’s restricted to off-balance sheet assets, of course, because obviously the same asset cannot appear on more than one balance sheet. The practice is usually just used by hedge funds when raising funding from the prime brokerage desks of large banks. Hedge funds have been willing to take the risk in the past because they get a better rate from prime brokers if they allow their collateral to be repledged. In the US the extent of rehypothecation is capped (only 140% of the customer’s debit balance can be rehypothecated in another deal) but in the UK there are no caps at all. It’s likely, though, that this practice will be restricted from here on.
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