A primer on shadow banking

For many people, the term ‘shadow banking’ invokes images of something dodgy – perhaps dishonest bankers laundering money, criminals or terrorists. In reality, shadow banking, which is formally known as the alternative financial system, is an important part of the economies of the United States and other developed countries. To understand the alternative financial system, let us look at how financial markets and institutions efficiently match borrowers and savers.

Direct finance

Direct finance involves financial transactions directly between borrowers and savers through financial instruments in financial markets. Financial instruments used in direct finance are (1) equity securities, (2) debt securities, (3) asset-backed securities, and (4) hybrid securities.

1. Equity securities consist of common and preferred stock. Common stock is issued to the owners of a corporation. Common stockholders have a residual claim on the assets of a corporation and receive payment after all liabilities are paid. Common stockholders may receive dividends based on the profitability of a corporation. In contrast, preferred stock is senior to common stock, but has a subordinate claim on the assets of a corporation relative to all creditors. Preferred stockholders typically receive fixed dividends.

2. Corporations issue corporate debt securities to borrow from the public. Corporate debt securities include commercial paper, negotiable CDs, banker’s acceptances, repurchase agreements, and corporate bonds. Local, provincial/state, and federal/national governments issue government debt securities to borrow from the public. In the United States, government debt securities include Treasury bills, notes and bonds, while state and local governments issue municipal bonds. Municipal bonds may be either general obligation bonds or revenue bonds. General obligation bonds are secured by a state or local government’s pledge to use all legally available resources, including tax revenues, to repay bond holders. In contrast, revenue bonds are secured solely by the revenues generated by a specified entity associated with the purpose of the bond (e.g., airport revenue bonds are secured by landing fees and other airport revenues). Federal agency debt securities are a hybrid corporate and government debt security issued by Federal government-sponsored enterprises, such Fannie Mae and Freddie Mac, which are technically private corporations, but are guaranteed or owned by the Federal government.

3. Asset-backed securities are issued by both Federal government-sponsored agencies and private financial institutions. Asset-based securities are collateralised by a specified pool of underlying assets that generate interest and principal payments. Without a specific guarantee, the issuer of asset-backed securities is not responsible for the non-performance of the underlying assets.

4. Finally, hybrid securities are a broad group of securities that combine the elements of two broader groups of securities such as debt and equity (e.g., convertible bonds).

Indirect finance

Indirect finance occurs when borrowers and savers use financial intermediaries. There are three types of financial intermediaries: (1) depository institutions, (2) contractual savings institutions, and (3) investment intermediaries.

1. A depository institution is an institution that is legally allowed to accept money deposits from the public. Depository institutions include commercial banks, thrifts (savings and loan associations, mutual savings banks, savings banks) and credit unions.

2. Contractual savings institutions, such as insurance companies and pension funds, acquire funds from the public at periodic intervals on a contractual basis.

3. Investment intermediaries provide a service as intermediaries of financial markets, while investing money into the market. Investment intermediaries include finance companies, mutual funds, money market mutual funds, and independent investment banks.

Liquidity and risk

All financial intermediaries help to lower transaction costs between savers and borrowers, and diversify risk. However, banks and other depository institutions possess two unique capabilities:

1. They specialise in using non-public information to make “inside” loans to households and small- and medium-sized firms that cannot issue debt securities in financial markets.

2. They perform liquidity transformation, essentially transforming illiquid inside loans into deposits payable on demand.

Liquidity transformation is a highly valuable economic function. Absent this transformation, the demand for liquid assets would greatly exceed the supply of liquid assets; the credit available to households and small- and medium-sized firms would shrink; and real GDP would be much lower.

However, liquidity transformation is inherently risky. Since banks and other depository institutions make inside loans on the basis of non-public information, the public cannot readily determine the true financial condition of banks and other depository institutions. If the public fears that a bank or other depository institution may be insolvent, the public may run to such bank or other depository institution to withdraw all of their deposits before such bank or other depository institution is unable pay its depositors in full. Since banks and other depository institutions keep only small amount of cash on hand, a bank or other depository institutions cannot pay all of its depositors if they demand all of their deposits at once.

Without government intervention, a run may cause a bank or other depository institution to fail.

Historically runs have been contagious. That means the public may try to withdraw all of their deposits at once from all banks and other depository institutions. Without government intervention, contagious runs may cause many otherwise solvent, but temporarily illiquid banks and other depository institutions to fail, triggering a severe recession or even a depression.

During the 19th and early 20th centuries, governments in United States and other developed countries responded to the riskiness of liquidity transformation by: (1) chartering, supervising and regulating banks and other depository institutions; (2) enforcing capital and liquidity standards at banks and other depository institutions; (3) establishing central banks to act the lender of last resort during runs; and (4) providing deposit insurance.

Development of shadow banking

In the 1990s, an alternative financial system gradually evolved. Shadow banking involves loan origination, loan securitization and purchase of asset-backed securities to investment intermediaries, Federal government-sponsored enterprises, and other highly leverage, non-depository financial institutions. Shadow banking essentially separated the lending, managing and funding functions of commercial banks and divided them among different financial institutions.

1. Loan originators, commercial banks, other depository institutions, and mortgage bankers, made loans to households and small- to medium-sized firms.

2. Securitization firms, Federal government-sponsored enterprises and independent investment banks, bought loans from loan originators and packaged them into asset-backed securities.

3. Federal government-sponsored enterprises, independent investment banks and other highly leveraged non-depository financial institutions including asset-backed commercial paper conduits and special investment vehicles (SIVs) sponsored by commercial and investment banks, hedge funds, and finance companies (e.g., GMAC, Ford Motor Credit, GE), bought most of these asset-backed securities. Much of this leverage was achieved using complex financial instruments, which made it difficult for the public and regulators to monitor increasing risk levels.

The alternative financial system had almost as many assets as banks and other depository institutions in the United States by Sept. 30, 2007 when commercial banks and other depository institutions held $13.5 trillion while highly leveraged non-depository financial institutions held $12.7 trillion. However, these highly leveraged non-depository financial institutions that held asset-backed securities lacked adequate safeguards that had over time shown to be necessary for banks and other depository institutions. These institutions were not properly supervised by Federal officials and lacked (1) adequate capital and liquidity standards, and (2) access to a lender of last resort.

Exacerbating the situation, the Federal government-sponsored enterprises had an implicit guaranty from the Federal government on their Federal agency debt and asset-backed securities. Thus, the purchases of these securities assumed, correctly as it turned out, they were as credit-risk free as Treasuries.

The global financial crisis made the structural weaknesses of the alternative financial system painfully apparent. These flaws include:

1. Since loan originators quickly sold any loans that originators had extended, loan originators did not retain the credit risk from these loans, loan originators had a far weaker incentive to underwrite their loans properly than banks and other depository institutions that retained their loans. Moreover, Federal housing policy also contributed to a general decline in the underwriting standards for residential mortgage loans.

2. With weak or non-existent capital and liquidity standards, complex financial engineering allowed highly leveraged non-depository financial institutions to elevate their leverage to levels far higher than regulators, the public, or even in some cases their senior executives realised. The explicit Federal guarantee exacerbated this problem at both Fannie Mae and Freddie Mac. High leverage left a small margin for error. On Saturday, Sept. 6, 2008, the Federal Housing Finance Agency placed Fannie Mae and Freddie Mac into conservatorships, and on Monday, Sept. 15, 2008, Lehman Brothers was forced to file for bankruptcy.

3. No one thought that the alternative financial system would be subject to contagious runs. Prior to the financial crisis, money market mutual funds were considered ultra-safe; households and firms used money market mutual funds like checkable deposits at banks. On Tuesday, Sept. 16, 2008, however, the $62.6 billion Reserve Primary Fund “broke the buck” (i.e., its net asset value fell below $1.00) after it, wrote down its holdings of Lehman Brothers commercial paper. On Wednesday, Sept. 17, 2008, worried investors withdrew a record $144.5 billion from the money market accounts (compared with $7 billion in a typical week) and bought Treasuries, pushing their yield below zero. The run on money market mutual funds led banks to hoard cash, increasing their cash balances overnight from $2 billion to $190 billion. The run on money market mutual funds caused more than $1 trillion commercial paper market to seize up overnight. Money market mutual funds had been major purchasers of commercial paper. Now major non-financial corporations that nothing to do with the housing bubble and were solvent and profitable now confronted a funding crisis that if not quickly resolved would trigger missed pay-checks and payments to supplies, shutdowns and mass layoffs. This prospect forced Secretary of the Treasury Henry Paulson and Chairman of the Board of Governors of the Federal Reserve System Ben Bernanke to innovate. On Friday, Sept. 19, 2008, the Treasury guaranteed money market mutual funds.

On Tuesday, Oct. 21, 2008, the Federal Reserve agreed to buy commercial paper from money market funds that needed cash to pay for redemptions. In essence, Federal authorities had to apply the concepts of deposit insurance and lender of last resort from a banking context to the alternative financial system to break an economically destructive contagious run.

A number of issues remain a decade later. In the United States, Fannie Mae and Freddie Mac remain under conservatorships because of political disagreements over what role, if any, the Federal government should play in housing finance. Many of well-intentioned, but ill-conceived housing policies that led to the erosion of underwriting standards for residential mortgage loans also remain. Goldman Sachs and Morgan Stanley reorganised during the global financial crisis as bank holding companies and are no longer independent investment banks. Most of the SIVs have been wound down. However, the most vexing question is whether the Federal Reserve should have an explicit obligation to function as lender of last resort outside of commercial banks. And if so, how much supervision should Federal regulators have over the alternative financial system.

None of these questions have easy answers. A discussion of possible reforms will await the next article.

The author of this article, who goes by the name ‘Hamilton’ is a senior US economist who frequently writes under a nom de plume.