What Is Shadow Banking?
FINANCE & DEVELOPMENT, June 2013, Vol. 50, No. 2
Laura E. Kodres
Many financial institutions that act like banks are not supervised like banks
If it looks like a duck, quacks like a duck, and acts like a duck, then it is a duck—or so the saying goes. But what about an institution that looks like a bank and acts like a bank? Often it is not a bank—it is a shadow bank.
Shadow banking, in fact, symbolizes one of the many failings of the financial system leading up to the global crisis. 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.”
Paul McCulley of Pimco coined the term shadow banking.[2] 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"[3] but the meaning and scope of shadow banking is disputed in academic literature.[2]
The shadow banking system is a term for the collection of non-bank financial intermediaries that provide services similar to traditional commercial banks. Former Federal Reserve Chair Ben Bernanke provided a definition in April 2012: "Shadow banking, as usually defined, comprises a diverse set of institutions and markets that, collectively, carry out traditional banking functions--but do so outside, or in ways only loosely linked to, the traditional system of regulated depository institutions. Examples of important components of the shadow banking system include securitization vehicles, asset-backed commercial paper (ABCP) conduits, money market mutual funds, markets for repurchase agreements (repos), investment banks, and mortgage companies." Shadow banking has grown in importance to rival traditional depository banking but was a primary factor in the subprime mortgage crisis of 2007-2008 and global recession that followed.[1][2]
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)[4][5] At least one financial regulatory expert has said that regulated banking organizations are the largest shadow banks.[6]
The core activities of investment banks are 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.[7] 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.[7] 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 andGoldman Sachs became 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 crisis and for a short while it declined in size, both in the US and in the rest of the world.[8][9] 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.[10] Globally, a study of the 11 largest national shadow banking systems found that they totaled to $50 trillion in 2007, fell to $47 trillion in 2008 but by late 2011 had climbed to $51 trillion, just over its estimated size before the crisis. Overall, the world wide SBS totalled to about $60 trillion as of late 2011.[8] In November 2012 Bloomberg reported on a Financial Stability Board report showing an increase of the SBS to about $67 trillion.[11] 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.
As of 2013, academic research has suggested that the true size of the shadow banking system may have been over $100 trillion as of 2012.[12]
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;
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).
Home mortgagesShadow 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
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