Shadow banking system
Encyclopedia
The shadow banking system is the infrastructure and practices which support financial transactions that occur beyond the reach of existing state sanctioned monitoring and regulation. It includes entities such as hedge funds, money market funds and Structured investment vehicle
s. Investment banks may conduct much of their business in the shadow banking system (SBS), but they are not SBS institutions themselves. 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 dont show up on their conventional balance sheet accounting and so are not visible to regulators.
The volume of transactions in the shadow banking system grew dramatically after the year 2000. By late 2007 the size of the SBS in the U.S. exceeded $10,000 billion. By late 2009 the SBS had shrunk to under $6,000bn due to increased regulation, changes in business practice, and pressure from investors who in some cases no longer wanted their funds to be used in the shadow banking system.
s, conduits
, money fund
s, and other non-bank financial institution
s.
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.
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." In other words, lending through the shadow banking system slightly exceeded lending via the traditional banking system based on outstanding balances.
Shadow institutions like SIVs and conduits, typically controlled by investment banks, borrowed from investors in short-term, liquid markets (such as the money market
and commercial paper
markets), so that they would have to repay and borrow again from these investors at frequent intervals. 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 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 their ability to obtain funds from investors through investments such as mortgage-backed securities declined, these investment banks could not refinance 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 Brothers
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 problem, as 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.
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. 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.
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."
of PIMCO, who coined it at the 2007 Jackson Hole
conference, where he defined it as "the whole alphabet soup of levered up non-bank investment conduits, vehicles, and structures." McCulley identifies the birth of the shadow banking system with the development of money market funds in the 1970s – money market accounts function largely as bank deposits, but money market funds are not regulated as banks.
The concept of credit growth by unregulated institutions, though not the term "shadow banking system", date at least to Prices and Production, by Friedrich Hayek
, 1935, in which he states:
The full extent of the shadow banking system was not widely recognised until work was published in 2010 by Manmohan Singh and James Aitken of the International Monetary Fund
, showing that when the role of Rehypothecation was considered, the U.S. SBS had grown to over $10 trillion, about twice as much as previous estimates.
failed and was bailed out by several major banks at the request of the government, which was concerned about possible damage to the broader financial system. It was highly leveraged and unregulated.
Structured investment vehicles (SIVs) first came to public attention at the time of the Enron scandal
. Since then, their use has become widespread in the financial world. In the years leading up to the crisis, the top four U.S. depository banks moved an estimated $5.2 trillion in assets and liabilities off their balance sheets into special purpose vehicles
or similar entities. This enabled them to bypass regulatory requirements for minimum capital ratios, thereby increasing leverage and profits during the boom but increasing losses during the crisis. New accounting guidance was planned to require them to put some of these assets back onto their books during 2009, with the effect of reducing their capital ratios. One news agency estimated the amount of assets to be transferred at between $500 billion and $1 trillion. This transfer was considered as part of the stress tests performed by the government during 2009.
The shadow banking system also conducts an enormous amount of trading activity in the OTC derivatives market, which grew rapidly in the decade up to the 2008 financial crisis, reaching over US$650 trillion in notional contracts traded (see the Bank for International Settlements (BIS.org) bi-annual report). This rapid growth mainly arose from credit derivatives. In particular these included:
The market in CDS, for example, was insignificant in 2004 but rose to over $60 trillion in a few short years. Because credit default swaps were not regulated as insurance contracts, companies selling them were not required to maintain sufficient capital reserves to pay potential claims. Demands for settlement of hundreds of billions of dollars of credit default swaps contracts issued by AIG
, the largest insurance company in the world, led to its financial collapse. Despite the prevalence and volume of this activity, it attracted little outside attention before 2007, and much of it was off the balance sheets of the contracting parties' affiliated banks. The uncertainty this created among counterparties contributed to the deterioration of credit conditions.
Since then the shadow banking system has been blamed for aggravating the subprime mortgage crisis
and helping to transform it into a global credit crunch
.
Economist Paul Krugman
described the run on the shadow banking system as the "core of what happened" to cause the crisis. "As the shadow banking system expanded to rival or even surpass conventional banking in importance, politicians and government officials should have realized that they were re-creating the kind of financial vulnerability that made the Great Depression
possible—and they should have responded by extending regulations and the financial safety net to cover these new institutions. Influential figures should have proclaimed a simple rule: anything that does what a bank does, anything that has to be rescued in crises the way banks are, should be regulated like a bank." He referred to this lack of controls as "malign neglect."
Structured investment vehicle
A structured investment vehicle was an operating finance company established to earn a spread between its assets and liabilities like a traditional bank...
s. Investment banks may conduct much of their business in the shadow banking system (SBS), but they are not SBS institutions themselves. 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 dont show up on their conventional balance sheet accounting and so are not visible to regulators.
The volume of transactions in the shadow banking system grew dramatically after the year 2000. By late 2007 the size of the SBS in the U.S. exceeded $10,000 billion. By late 2009 the SBS had shrunk to under $6,000bn due to increased regulation, changes in business practice, and pressure from investors who in some cases no longer wanted their funds to be used in the shadow banking system.
Entities that make up the system
Shadow institutions do not accept deposits like a depository bank and therefore are not subject to the same regulations. Complex legal entities comprising the system include hedge funds, SIVStructured investment vehicle
A structured investment vehicle was an operating finance company established to earn a spread between its assets and liabilities like a traditional bank...
s, conduits
Special purpose entity
A special purpose entity is a legal entity created to fulfill narrow, specific or temporary objectives...
, money fund
Money fund
A money market fund is an open-ended mutual fund that invests in short-term debt securities such as US Treasury bills and commercial paper. Money market funds are widely regarded as being as safe as bank deposits yet providing a higher yield...
s, and other non-bank financial institution
Non-bank financial institution
A non-bank financial institution is a financial institution that does not have a full banking license or is not supervised by a national or international banking regulatory agency. NBFIs facilitate bank-related financial services, such as investment, risk pooling, contractual savings, and market...
s.
Shadow banking institutions are typically intermediaries between investors and borrowers. For example, an institutional investor
Institutional investor
Institutional investors are organizations which pool large sums of money and invest those sums in securities, real property and other investment assets...
like a pension fund
Pension fund
A pension fund is any plan, fund, or scheme which provides retirement income.Pension funds are important shareholders of listed and private companies. They are especially important to the stock market where large institutional investors dominate. The largest 300 pension funds collectively hold...
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.
Importance
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.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." 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 prudential regulations as depository banks, so that they do not have to keep as high financial reserves relative to their exposure. Thus they can have a very high level of financial 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 SIVs and conduits, typically controlled by investment banks, borrowed from investors in short-term, liquid markets (such as the money market
Money market
The money market is a component of the financial markets for assets involved in short-term borrowing and lending with original maturities of one year or shorter time frames. Trading in the money markets involves Treasury bills, commercial paper, bankers' acceptances, certificates of deposit,...
and commercial paper
Commercial paper
In the global money market, commercial paper is an unsecured promissory note with a fixed maturity of 1 to 270 days. Commercial Paper is a money-market security issued by large banks and corporations to get money to meet short term debt obligations , and is only backed by an issuing bank or...
markets), so that they would have to repay and borrow again from these investors at frequent intervals. 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 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 their ability to obtain funds from investors through investments such as mortgage-backed securities declined, these investment banks could not refinance themselves. Investor refusal or inability to provide funds via the short-term markets was a primary cause of the failure of Bear Stearns
Bear Stearns
The Bear Stearns Companies, Inc. based in New York City, was a global investment bank and securities trading and brokerage, until its sale to JPMorgan Chase in 2008 during the global financial crisis and recession...
and Lehman Brothers
Lehman Brothers
Lehman Brothers Holdings Inc. was a global financial services firm. Before declaring bankruptcy in 2008, Lehman was the fourth largest investment bank in the USA , doing business in investment banking, equity and fixed-income sales and trading Lehman Brothers Holdings Inc. (former NYSE ticker...
during 2008.
In technical terms, these institutions are subject to market risk, credit risk
Credit risk
Credit risk is an investor's risk of loss arising from a borrower who does not make payments as promised. Such an event is called a default. Other terms for credit risk are default risk and counterparty risk....
and especially liquidity risk
Liquidity risk
In finance, liquidity risk is the risk that a given security or asset cannot be traded quickly enough in the market to prevent a loss .-Types of Liquidity Risk:...
, since their liabilities are short term while their assets are more long term and illiquid. This creates a problem, as 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
Lender of last resort
A lender of last resort is an institution willing to extend credit when no one else will. The term refers especially to a reserve financial institution, most often the central bank of a country, intended to avoid bankruptcy of banks or other institutions deemed systemically important or 'too big to...
. 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.
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. In February 2009, Ben Bernanke
Ben Bernanke
Ben Shalom Bernanke is an American economist, and the current Chairman of the Federal Reserve, the central bank of the United States. During his tenure as Chairman, Bernanke has overseen the response of the Federal Reserve to late-2000s financial crisis....
stated that securitization markets remained effectively shut, with the exception of conforming mortgages, which could be sold to Fannie Mae and Freddie Mac.
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."
History
The term "shadow banking system" is attributed to Paul McCulleyPaul McCulley
Paul Allen McCulley is a former managing director at PIMCO. He coined the terms Minsky moment and Shadow banking system which became famous during the Financial crisis of 2007-2009....
of PIMCO, who coined it at the 2007 Jackson Hole
Jackson Hole
Jackson Hole, originally called Jackson's Hole, is a valley located in the U.S. state of Wyoming, near the western border with Idaho. The name "hole" derives from language used by early trappers or mountain men, who primarily entered the valley from the north and east and had to descend along...
conference, where he defined it as "the whole alphabet soup of levered up non-bank investment conduits, vehicles, and structures." McCulley identifies the birth of the shadow banking system with the development of money market funds in the 1970s – money market accounts function largely as bank deposits, but money market funds are not regulated as banks.
The concept of credit growth by unregulated institutions, though not the term "shadow banking system", date at least to Prices and Production, by Friedrich Hayek
Friedrich Hayek
Friedrich August Hayek CH , born in Austria-Hungary as Friedrich August von Hayek, was an economist and philosopher best known for his defense of classical liberalism and free-market capitalism against socialist and collectivist thought...
, 1935, in which he states:
The full extent of the shadow banking system was not widely recognised until work was published in 2010 by Manmohan Singh and James Aitken of the International Monetary Fund
International Monetary Fund
The International Monetary Fund is an organization of 187 countries, working to foster global monetary cooperation, secure financial stability, facilitate international trade, promote high employment and sustainable economic growth, and reduce poverty around the world...
, showing that when the role of Rehypothecation was considered, the U.S. SBS had grown to over $10 trillion, about twice as much as previous estimates.
Examples
During 1998, hedge fund Long-term Capital ManagementLong-Term Capital Management
Long-Term Capital Management L.P. was a speculative hedge fund based in Greenwich, Connecticut that utilized absolute-return trading strategies combined with high leverage...
failed and was bailed out by several major banks at the request of the government, which was concerned about possible damage to the broader financial system. It was highly leveraged and unregulated.
Structured investment vehicles (SIVs) first came to public attention at the time of the Enron scandal
Enron scandal
The Enron scandal, revealed in October 2001, eventually led to the bankruptcy of the Enron Corporation, an American energy company based in Houston, Texas, and the dissolution of Arthur Andersen, which was one of the five largest audit and accountancy partnerships in the world...
. Since then, their use has become widespread in the financial world. In the years leading up to the crisis, the top four U.S. depository banks moved an estimated $5.2 trillion in assets and liabilities off their balance sheets into special purpose vehicles
Special purpose entity
A special purpose entity is a legal entity created to fulfill narrow, specific or temporary objectives...
or similar entities. This enabled them to bypass regulatory requirements for minimum capital ratios, thereby increasing leverage and profits during the boom but increasing losses during the crisis. New accounting guidance was planned to require them to put some of these assets back onto their books during 2009, with the effect of reducing their capital ratios. One news agency estimated the amount of assets to be transferred at between $500 billion and $1 trillion. This transfer was considered as part of the stress tests performed by the government during 2009.
The shadow banking system also conducts an enormous amount of trading activity in the OTC derivatives market, which grew rapidly in the decade up to the 2008 financial crisis, reaching over US$650 trillion in notional contracts traded (see the Bank for International Settlements (BIS.org) bi-annual report). This rapid growth mainly arose from credit derivatives. In particular these included:
- collateralised debt obligations (CDO)
- interest rate obligations derived from bundles of mortgage securities
- a variety of customized or synthetic innovations on the CDO model; and
- credit default swaps (CDS), a form of quasi-insurance against the default risk inherent in the assets underlying the CDO).
The market in CDS, for example, was insignificant in 2004 but rose to over $60 trillion in a few short years. Because credit default swaps were not regulated as insurance contracts, companies selling them were not required to maintain sufficient capital reserves to pay potential claims. Demands for settlement of hundreds of billions of dollars of credit default swaps contracts issued by AIG
American International Group
American International Group, Inc. or AIG is an American multinational insurance corporation. Its corporate headquarters is located in the American International Building in New York City. The British headquarters office is on Fenchurch Street in London, continental Europe operations are based in...
, the largest insurance company in the world, led to its financial collapse. Despite the prevalence and volume of this activity, it attracted little outside attention before 2007, and much of it was off the balance sheets of the contracting parties' affiliated banks. The uncertainty this created among counterparties contributed to the deterioration of credit conditions.
Since then the shadow banking system has been blamed for aggravating the subprime mortgage crisis
Subprime mortgage crisis
The U.S. subprime mortgage crisis was one of the first indicators of the late-2000s financial crisis, characterized by a rise in subprime mortgage delinquencies and foreclosures, and the resulting decline of securities backed by said mortgages....
and helping to transform it into a global credit crunch
Credit crunch
A credit crunch is a reduction in the general availability of loans or a sudden tightening of the conditions required to obtain a loan from the banks. A credit crunch generally involves a reduction in the availability of credit independent of a rise in official interest rates...
.
Contribution to the 2007–2010 financial crisis
The shadow banking system has been implicated as significantly contributing to the financial crisis of 2007–2010. In a June 2008 speech, U.S. Treasury Secretary Timothy Geithner, then President and CEO of the NY Federal Reserve Bank, placed significant blame for the freezing of credit markets on a "run" on the entities in the shadow banking system by their counterparties. The rapid increase of the dependency of bank and non-bank financial institutions on the use of these off-balance sheet entities to fund investment strategies had made them critical to the credit markets underpinning the financial system as a whole, despite their existence in the shadows, outside of the regulatory controls governing commercial banking activity. Furthermore, these entities were vulnerable because they borrowed short-term in liquid markets to purchase long-term, illiquid and risky assets. This meant that disruptions in credit markets would make them subject to rapid deleveraging, selling their long-term assets at depressed prices.Economist Paul Krugman
Paul Krugman
Paul Robin Krugman is an American economist, professor of Economics and International Affairs at the Woodrow Wilson School of Public and International Affairs at Princeton University, Centenary Professor at the London School of Economics, and an op-ed columnist for The New York Times...
described the run on the shadow banking system as the "core of what happened" to cause the crisis. "As the shadow banking system expanded to rival or even surpass conventional banking in importance, politicians and government officials should have realized that they were re-creating the kind of financial vulnerability that made the Great Depression
Great Depression
The Great Depression was a severe worldwide economic depression in the decade preceding World War II. The timing of the Great Depression varied across nations, but in most countries it started in about 1929 and lasted until the late 1930s or early 1940s...
possible—and they should have responded by extending regulations and the financial safety net to cover these new institutions. Influential figures should have proclaimed a simple rule: anything that does what a bank does, anything that has to be rescued in crises the way banks are, should be regulated like a bank." He referred to this lack of controls as "malign neglect."
See also
- Long-term Capital ManagementLong-Term Capital ManagementLong-Term Capital Management L.P. was a speculative hedge fund based in Greenwich, Connecticut that utilized absolute-return trading strategies combined with high leverage...
- RecessionRecessionIn economics, a recession is a business cycle contraction, a general slowdown in economic activity. During recessions, many macroeconomic indicators vary in a similar way...
- Structured investment vehicleStructured investment vehicleA structured investment vehicle was an operating finance company established to earn a spread between its assets and liabilities like a traditional bank...
- Subprime mortgage crisisSubprime mortgage crisisThe U.S. subprime mortgage crisis was one of the first indicators of the late-2000s financial crisis, characterized by a rise in subprime mortgage delinquencies and foreclosures, and the resulting decline of securities backed by said mortgages....
- Subprime crisis background informationSubprime crisis background informationThis article provides background information helpful to understanding the subprime mortgage crisis. It discusses subprime lending, foreclosures, risk types, and mechanisms through which various entities involved are affected by the crisis.-Subprime lending:...
- Subprime mortgage crisis solutions debateSubprime mortgage crisis solutions debateThe Subprime mortgage crisis solutions debate discusses various actions and proposals by economists, government officials, journalists, and business leaders to address the subprime mortgage crisis and broader economic crisis of 2007-2010.-Overview:...