Shadow Banking

Introduction

The occurrence of financial crisis in 2008 was considered the worst of economic disaster ever since the Great Depression of 1929. The occurrence of the crisis defied the aggressive efforts done by the Treasury Department and Federal Reserve to have the US banking systems prevented from collapsing (Amadeo, 2017, p. 1). The financial crisis led to the Great Recession that saw pricing of houses falling more than it was the case during the Great Depression. The cause of the crisis was that the banks were creating excess money in quick successions as they used it to push the prices of houses while speculating on financial markets. This assignment is looking at the function of securitized lending and shadow banking in the 2008 financial crisis.

Securitization involves the process through which there is the creation of financial instrument by an issuer through the combination of other financial assets followed by the marketing of diverse tiers of the instruments that have been packaged to the investors. This process has the aim of promoting the liquidity in marketplace. A good example of securitization is the mortgage-backed securities. Therefore, securitized lending refers to the process by which lending by investors occurs through bonds, stocks and other securities to other market participants. Some of the biggest lenders are comprised of institutional investors including pension funds, exchange traded funds and mutual funds. In 2008, during the financial crisis, the security loans were at $2.3 trillion translating that the lending of securities had gained popularity and became big business. On the other hand, the concept of shadow banking refers to mainly the nonbank financial institutions engaging in what is referred to as maturity transformation. In this case, they raise short-term funds which they used in the buying of assets with longer maturities.

Figure 1: Shadow banking versus traditional banking intermediation

Retrieved from: http://www.valuewalk.com/2014/10/shadow-banking-imf/

The above figure is a representation of the flow of finances from lenders to borrowers. However, the flow chart lacks the reverse flows including money market funds and bank deposits and withdrawals. The blue boxes are representations of bank based economy while the rest are shadow banking segment. The brighter colored boxes in the middle are representative of shadow banking activities associated with advanced economies in the world. According to the figure, the securitized assets are emanating from the banks and non-bank lenders as well as securities coming from the dealers. The categories of lenders involve institutional investors as well as official sector institutions.

Securitized Lending in 2008 Financial Crisis

According to Claessens, Ratnovski and Singh, (2012, p. 4) securitization is an element of shadow banking that involves repackaging of the cash flows through the creation of assets seen by the participants in the market to be safe. In this regard, the risk faced is regulatory arbitrage through banks, possibility of money market funds runs. The execution of securitization was rampant during the financial crisis in 2008 as it sought to realize tight regulations but it later subsided. This however, was its failures in the market while it still remain a risk that could trigger the reemergence of another financial crisis. The mechanisms of securitization that is also referred to a risk-stripping involved the shadow banking transforming the debt instruments by securitization as well as tranching in safe clams that resemble money.

The financing of mortgage before the financial crisis around 2005 and 2006 involved securitization. The mortgages were sold in residential mortgage-backed securities (RMBS). The process involved the pooling of many (in thousands) mortgages together and selling them to the special purpose vehicle (SPV). The process went ahead to pay for their purchase through the issuance of investment-grade securities with varying seniority involved in the capital markets. In this regard, the process of securitization did not directly involve the public issuance of equity involving SPV.

Shadow Banking in 2008 Financial Crisis

There was great panic in 2007-2008 on the purchase and sale of market (repo market). According to Gorton and Metrick, (2012, p. 1), it was characterized with very large as well as short-term market that financed diverse securitization activities together with financial institutions. The overall result translated to the financial crisis being system-wide bank run. This kind of bank running did not actually take place in the traditional banking and hence it is a unique one. Its manifestation was in “securitized-banking” system. The difference between traditional banking and securitized banking is that the former is characterized with deposits and withdrawals while on the other hand the latter is with agreements of withdrawal of repurchase (“repo”). Another great difference about the operation of the two-banking system is the way they approach their operations. The traditional banking mainly makes and holds loans while having insured demand deposits that is the primary source of its funding. On the other hand, the securitized banking involves the repackaging and reselling of loans on the basis of repo agreements that in this case forms the primary source of funding. The activities of the securitized-banking were strongly attached to the operations of firms that initially were known by the name “investment banks” but at the same time they played a role in the commercial banks through the supplementing of the traditional banking activities.

The concept of repo contract as evident in the financial crisis can be equated to interest-bearing cash loan alongside securities collateral. The implied interest rate in repo contract is forming the main difference existing between price of purchase and the sale of securities. In this case, the securities are used as forms of collaterals protecting the investor of cash against what the providers are not able to provide as agreed initially (Baklanova, Copeland and McCaughrin, 2015, p. 24). Hence, the cash investor demands the exceeding of market worth of security by the loan worth. The over-collateralized amount by the loan is referred to as a haircut. It is worth noting that the repo contract had the function of being used while borrowing securities. According to Baklanova, Copeland and McCaughrin, (2015, p. 8), this process involved the security provider earning benefit through investing the money that it gets as given by investor of cash at an increased rate in comparison to that suggested by the repo contract.

The ushering of financial crisis was in August 2007 in a systematic fashion when the banking sector was not in a position to pay its debt. It was then followed by the depositors going to the banks to withdraw their cash but it was not possible by the banks as a result of the money having been lent out and the loans at that time were illiquid. The banks as a result were forced to suspend convertibility and focused on clearinghouses and issue certificates that were seen as makeshift currency (Gorton and Metrick, 2012, p. 2).

In general, the term shadow banking was coined by McCulley in 2007. Some of its aspects include firstly, private money, an investment that is considered as highly liquid, safe and redeemable. Secondly, it also shines some light on market failures in securitization process. The importance of shadow banks in the financial system as it supports collateral-based operation. Shadow banking serves two main intermediation roles including: firstly, the liability-side role and asset-side role

The Regulation of Shadow Banking

According to Plantin, (2014) the concept of shadow banking which involves securitized lending is largely to blame for the financial crisis in 2008. The resulting question involves the kind of shadow banking that need to remain in future because of the unregulated nature of previous one. In 2010 the Seoul G20 summit involving the financial stability board (FSB) was granted permission to draft regulatory proposals. The first task for the FSB was to have a clear definition of “shadow banking” which it clearly concluded that it refers to “a system involving credit intermediation involving activities and entities outside the regular system of banking”. The result was about the concept to be having three main characteristics. Firstly, credit termination where it performs as the regular banks. Secondly, involving several players interacting with one another in financial market. Thirdly, its entities are not subject to banking regulations and oversight (Plantin, 2014).

The regulation of shadow banking in the time of financial disaster was a challenge because its relationship with regular banks are in many ways connected. The practice of shadow banking at the commencement of the financial disaster almost doubled at around $60 trillion in comparison to the assets held by other banks that accounted for only $100 trillion. Its growth has been tremendous and in 2012 according to the FSB monitoring report it had reached $71 trillion in terms of assets. It growth was attributed to both the demand side and supply side contributing. For example, the supply side led to regulatory arbitrage that becomes a threat to financial market stability as it manufactures systematic risks.

One positive aspect of shadow banking is that it allows investors to have their risks spread over a variety range of products hence reducing the risks. In addition, it provided borrowers and banks the opportunity to have their sources of funding and liquidity diversified. It is worth noting that the application of shadow banking in both US and EU are entirely different and therefore regulation of the concept in the two regions take different approaches. The following are the approaches towards the regulation of shadow banking in the two region that could be used by other countries in the world as appropriate.

Workstream 1: the interaction of banks with shadow banking entities

At this stage the FSB will seek to address systematic risks that has been created by shadow banking through indirect regulation. This workstream has the aim of reducing the systematic risks through the regulation of the regular banks. Hence the FSB takes into account three main areas including, firstly, consolidation of bank’s interaction in a prudential way with entities of shadow banking; secondly, the introduction of prudential limits for the banks having been exposed to shadow banking entities and lastly increasing capital requirement for the banks in exposure to shadow banking entities.

These approaches in regulating shadow banking in the EU are addressed differently in comparison to the US. In the EU, the focus was to improve transparency through the consolidation of the balance-sheet exposed to shadow banking entities. On the other side, the US the regulation was indirect where there were first changes to the accounting rules regarding consolidation.

Workstream II: money market funds

Prior to the financial crisis, the institutional depositors regarded money market funds as free of risk alternative to deposit account in banks are simply a place meant for packing of money. But it was realized that the money market funds are in mainly backed by their parent money in form of guarantee. In this regard, the money market is typical of shadow banking entities. The instability involving money market banks got revealed during the financial crisis at a time when the depositors had started to lose confidence in the qualities of securities as well as doubt on the guarantee values for parent companies. In a bid to avoid regulatory arbitrage, the International Organization of Securities Commissions (IOSCO), came up with the definition of money market as investment funds seeking to preserve capital and avail liquidity on a daily basis while at the same time offering returns in relation to money market rates. The IOSCO therefore came up with policy measures to deal with the situation and these include the following: firstly, the money market funds to hold to have a minimized amount of liquid assets that provides strength prevent fire sales. Secondly, there is need to have stress tests conducted regularly; thirdly, having adequate tools to manage the outflows of deposits and thirdly, the money market funds investments to be in high-quality confines and in addition to that there should be clear establishment of limits with regard to maturity of portfolios remaining.

The EU in using this workstream, they had regulated the money market funds prior to the breakout of the financial crisis. Hence the Committee of European Securities Regulators (CESR) gave a non-binding guideline establishing common standards regarding market funds. As a result there emerged stricter standards regarding maturities, quality of fund portfolios and risk management among others. In the US on the other hand in light of the financial crisis, it was decided that there was an urgent need for regulation of money market funds. These regulations were meant to improve the liquidity as well as quality of money in the market.

Workstream III: other shadow banking entities

The regulation of shadow banking entities is essential but it had proved a challenge. The reason for the challenge lies in the fact that the shadow banking entities are very diverse as well as innovative in comparison to money market funds. The shadow banking entities that needed to be regulated are comprised of the following: exchange traded funds, credit investment funds, securitization of entities, private equity funds and trust companies among others. The listed shadow banking entities were very heterogeneous hence hard to regulate but upon the use of different risk profiles and business models it became manageable.

In regulating the shadow banking entities five economic functions were identified including: firstly, managing collective investment vehicles; secondly, provision of loans dependent on short term funding; thirdly, market activities intermediation independent of short term funding; fourthly, credit creation facilitation and lastly securitization-based credit intermediation. The objectives of the functions is to allow for the identification of sources of risks of shadow banking in the non-bank financial entities from a perspective of financial stability.

In regard to this workstream the EU upon the setting in of the financial crisis took the steps of regulating the unregulated financial institutions previously. The regulations have been on the use since 2013 in order to hedge all funds both investment funds and private equity funds. The US on the other hand had a quick response to the crisis through the passing of the Dodd-Frank Act. This act however, does not deal with the shadow banking directly but address the whole non-bank financial sector. In this regard, the Dodd Frank Act enables the FSIC to give a definition of the non-bank financial institutions and their financial activities hence regulating them accordingly.

Workstream IV: securitization

The process of securitization is known to be a critical funding source for financial institutions as well as other businesses. This is because they form an efficient way of diversifying risks. In the period of financial crisis, serious problems evolved such as excessive reliance on credit ratings, pricing of risk inadequacy and flawed credit-granting process among others. The process of securitization in regulating shadow banking was to retain risk in order to provide better incentives for assessing securitization associated risks.

While observing the risk retention strategy, the EU approached the situation by ensuring that banks at least retained 5% of exposure that was securitized. In the US, there was a proposition of risk retention requirement for the transactions of the ABS. hence the sponsor regarding securitization had to retain at least 5% of credit risk involving securitized assets.

There was also a disclosure requirement as a way of regulating the shadow banking in association with securitization while cascading the effects in between tranches with an aim of restoring investor confidence. Some of the disclosure requirements had existed long before the financial crisis. In using this method in dealing with shadow banking, the EU required a description of the cash flows where the financial institutions had only the opportunity to invest in securitization if it could demonstrate that it understood the risks involved. In the US, the rules required that the ABSs to give information regarding the expected cash flows including credit enhancement and agreed priorities.

Workstream V: securities lending and repos

The financial markets make use of repo transactions and securities lending as they are indispensible instruments used in the refinancing of funding companies and bans as well as ensuring liquidity. The recommendations in regulating shadow banking through securities lending and repos according to FSB’s were divided into three main categories: the first is the improvement of its transparency; secondly securities financing regulation and lastly, securities financing markets structural aspects. In addressing inadequacy of unavailability of data in security lending the FSB came up with a new group of data experts.

The EU regarding this workstream acknowledged the need for more data and greater transparency. The US on the other hand utilized the tri-party market in regulating the shadow banking. This approach resulted to a source of weakness at the time of financial crisis.

Shadow banking around the world

According to Riasi, (2015) the largest shadow banking systems are mostly in the advanced economies and stagnation in these regions are indicated by narrowly defined shadow banking. The growth of shadow banking in the developing economies have been strong over the years and in some cases outpacing the traditional banking systems. Despite the fact that shadow banking as concept takes many forms, it is worth noting that some e of the fundamental driving force are common to all of them. These include ample liquidity conditions and tightened banking regulations among others.

In the US and the UK, it was witnessed a rapid growth of shadow banking activities in 2007 most of which collapsed during the financial crisis in 2008. The European and the US financial systems had by that time over relied on securitization and repo financing. The rapid increment of defaults I the US housing markets in 2007 resulted to liquidity crisis in asset backed commercial papers and market for private-label securitization. This was also accompanied by the investors refusing to roll over their holdings.

The contributing factors towards shadow banking growth are numerous. Some of the factors contributing to its growth include regulatory arbitrage, a search for yield as well as the complementarities in relation to the rest of the financial systems.

Figure 2: the size of the shadow banking markets (Riasi, 2015)

Image by Riasi (2015).

The above graphs represent the growing of the shadow banking markets in the US and the UK. Graph one represent the securitization issuance where the US had high growth that was evident exponentially since 2000 to around 2007 where it started declining in the second graph about the U.S and European Repo markets, the data is representing. The third graph is a representation of MMFs as well as the investment fund assets in the emerging market economies. The fourth graph is representing the broker and financial companies. From this data, the growth exponents have been witnessed to have an exponential growth.

Figure 3: the contribution of shadow banking towards distress vulnerability of the banking sector (Riasi, 2015)

Image by Riasi (2015)

The above figure is a representation of the distress vulnerability of banking as contributed to by the shadow banking. The data shows the duration since 2007 to the year 2014. There are also representation of six elements including insurance, pension funds, MMFs, bond funds, equity funds and hedge funds all of which have experienced some crucial development and consequently the changes over the timeframe. From all the three graphs representing the US, the Euro area and the UK it is evident that the equity funds is the element that has been leading among others but it is more pronounced in the Euro area but less pronounced in the US area. On the contrary, the pension funds seems not to have appeared in Euro area for the whole period despite it having significant appearance for the US and UK for the same period of time.

The implication of the financial crisis of 2008 to the present modern banking system

From the above discussion on securitized lending and shadow banking we can see that the financial crisis in 2008 had great influence in the shaping of the banking system in the current era. Looking at the impact of the financial crisis on the basis of longer period, it led to the introduction of regulatory steps internationally through such avenues as consumer project Act and Dodd-Frank Wall Street Reform.

Prior to the crisis, there were regulations in the US and other parts of the world pressuring the banking industry to allow increased numbers of consumers to purchase homes. A good example is the two companies, Fannie Mae and Fredie Mae purchasing huge numbers of mortgage assets. The end result was many consumers especially in the US defaulting on their mortgage loans (Arie, 2016). The banks stopped lending to one another leading to it being tough for the local consumers to obtain credit. The result was that the US fell into a recession and the demand for goods imported fell and hence resulting to a global recession. The effect was that the confidence in the economy reduced as well as the share prices worldwide on the stock exchanges.

The international Basel Committee came up with proposals for liquidity standards and new capital for the banking sector globally. These reforms that were known as Basel III were passed in 2010 by the G20. However, the committee left it for countries to have the Act implemented independently in the individual countries (Arie, 2016). For example, in the US, the Dodd-Frank Act that got passed in 2010 is having a requirement for the banks in the US having more than $50 million in assets to adhere to strict liquidity and capital standards. In addition, it has new restrictions on compensations concerning incentives.

In addition to this, there was a legislation that influenced the creation of Financially Oversight Council with the inclusion of the Federal Reserve Bank as well as other agencies in order to have coordination of larger banks in this regard, the council has the ability of breaking up larger banks that are seen as risks because of their sizes (Arie, 2016). In response to this, a newly and orderly liquidation fund got established with an aim of providing financial assistance in liquidation of huge financial institutions that have trouble befalling them.

In the meantime, the final impact of the financial crisis in 2008 is yet to completely unfold. There are rules that have been adopted in bringing more transparency to the hedge fund as well as swap fund markets to provide the investors with the voice concerning executive compensation (Arie, 2016). In addition to this come up with whistle-blower program for those violating for instance securities.

The financial crisis in 2008 uncovered the systematic risks that are characterizing shadow banking and in extension securitized lending. In this regard, the process of securitization which was meant to create private and safe assets failed by breaking down because of ignoring some fundamental risks associated with it.

According to Delia, (2012) the financial innovation in the banking industry today for example that which regards the off-balance-sheet instruments has resulted in increased volatility in the entire banking industry. The financial stability as proved by the financial crisis, it plays a critical role within the financial system and in extension the economy as a whole. Currently, with the increased number of active financial institutions, in a number of countries, the financial stability in the whole world gains importance as the financial institutions do not want to enter into another financial crisis (Delia, 2012). In this regard they are more careful in evading factors that were recorded do have led to the crisis occurring in 2008.

Conclusion

From the lessons learnt from the financial crisis in 2008, the banks have been working based on a model where they take deposits from their clients and further lend the deposits out to other people as loans. Hence the banks fund their loans through the borrowing from the interbank markets (Carney, 2017). In the event that a bank has agreed to make a loan, it goes a head in borrowing similar amount of money from the interbank market at a rate that is slightly lower. In this case the lending precedes the borrowing in order to have the loan funded. The banks therefore get to charge the borrowers rates that are far much above what they themselves pay to borrow.

The strengths of the banks with their operational model of lending first and then funding later lies in the fact that the banks are able to thrive within their means. In this case the banks will not lend or provide loans more than what they can manage (Carney, 2017). This is restraining the banks to work just within their financial ability. On the other hand the disadvantage in this working model of the banks is in them getting loans from interbank. They are limited to a given amount depending on their financial ability. This in extension limits their fast growth as they can only get a given amount of money that might not be able to cater for their needs sufficiently. Most of these lessons have been learnt from the financial crisis of 2008 and therefore the banks have been on the lookout not to facilitate another crisis.

References

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Baklanova, V., Copeland, A.M. and McCaughrin, R., 2015. Reference guide to US repo and securities lending markets.

Carney, J. (2017). How the Banking System Really Works. [online] CNBC. Available at: https://www.cnbc.com/id/44931200 [Accessed 19 Nov. 2017].

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Riasi, A., 2015. Competitive advantages of shadow banking industry: An analysis using Porter diamond model. Business Management and Strategy, 6(2), pp.15-27.