Shadow Banking

by Stubborn Mule on 12 June 2012 · 27 comments

The Financial Services Authority (FSA) is the banking and financial services regulator in the UK. For now at least.

Back in 2010, the Chancellor of the Exchequer (the equivalent of the Treasury in Australian terms) announced plans to scrap the FSA in response to a failure during the financial crisis of the 10 year old “tri-partite system”. This tri-partite system split responsibility for national financial stability management between the Treasury, the Bank of England and the FSA. The government is now working on shifting  responsibility back from the FSA to the Bank of England, a process which will establish three new regulatory bodies: the Financial Policy Committee (FPC), the Prudential Regulation Authority (PRA) and the Financial Conduct Authority (FCA). More three-letter initialisations and, dare I say it, a new tri-partite system?

Until this process is complete, the FSA continues about its business. The chairman of the FSA is Lord Adair Turner, Baron of Ecchinswell. Turner is also a member of the steering committee of the G20 Financial Stability Board (FSB). In March this year, he spoke at the London CASS business school on the topic of “shadow banking” and its role in the financial crisis.

Shadow banking, a term coined by Paul McCulley in the early days of the crisis, refers to a diverse range of entities such as “structured investment vehicles” (SIVs), hedge funds and money-market funds which have evolved to provide some very similar functions to banks, while not being subject to the same regulatory controls. A nightmare scenario for any bank is a “run”, when too many people try to withdraw their deposits at the same time. Shadow banks can also fall victim to runs. These runs may not be very obvious outside the financial markets, there are no queues of angry depositors on the streets, but they can be just as dangerous and runs on shadow banks were in fact a major factor underlying the global financial crisis. For this reason, regulators like Turner and the FSB are not only focused on strengthening controls on banks, but on better understanding shadow banks and, if possible, subjecting them to regulation to reduce the chances of future financial crises.

So what is it that shadow banks do? To answer that, I’ll first go back to the basics of banking. Although banks have evolved to provide many other products and services, the essence of banking is taking deposits and providing loans. The diagram below illustrates the flow of capital from an investor to a bank and from a bank to a borrower. Having given the bank some money, the investor now has a financial asset in the form of a deposit (and the deposit is a liability from the bank’s point of view). Likewise, the loan now represents a financial asset for the bank (and a liability from the borrower’s point of view). So the bank acts as intermediary between savers and borrowers. In doing so, however, banks act as more than a simple broker matching borrowers and lenders. Most bank lending also involves maturity transformation. More colloquially, this is known as lending long and borrowing short.

Bank Capital Flows

The typical depositor wants their money to be readily available in an at call transaction account. Some may be tempted by higher interest rates to put money in term deposits, usually no longer than 6 months to maturity. On the other hand, most borrowers do not want their loans due and payable too quickly. Home buyers borrow in the expectation that their earnings over coming years will allow them to pay interest and principal on their loans. Likewise, companies making capital expenditure, building factories, buying equipment or acquiring other businesses borrow in the expectation that the revenue generated by their expanded business capability will allow them to repay their loans. In both cases, the term of the loans must match the timeframes over which earnings are generated.

Some lenders will be prepared to make longer term investments, some borrowers may be able to repay more quickly, but overall there is a mismatch in maturity preferences of lenders and borrowers. Banks are in the business of bridging this gap in preferences. In the ordinary course of events, they can allow depositors to withdraw funds before loans are due to be repaid, making use of funds from other depositors, borrowing from other banks or, in need, borrowing from the central bank. But if too many borrowers withdraw at the same time and the bank is unable to meet those demands, then the bank can fail. This is known as liquidity risk, and has become an enormous focus of regulators, risk managers and rating agencies around the world in the wake of the global financial crisis.

While the financial crisis certainly highlighted the dangers of liquidity risk for commercial and investment banks such as Northern Rock and Lehman Brothers, it was outside the traditional banking sector that the greatest liquidity problems arose, particularly as a result of securitisation.

Securitisation is a form of structured finance that predates the financial crisis by many years. Essentially it involves setting up a trust (or similar legal entity) which provides loans that become the assets of the trust (often referred to as a “pool” of loans). The funds to provide these loans are obtained by selling a special kind of bond to investors, known as asset-backed securities (ABS). Principal and interest flowing from the loan pool is collected by the trust and periodically passed through to investors.

ABS capital flows

The most common form of securities bundles up pools of home loans, in which case they are referred to as residential mortgage-backed securities (RMBS).

Unlike bank-lending, there is essentially no maturity transformation involved in financing by means of ABS. Investors cannot withdraw their money early from the trust, they have to wait until it is repaid by borrowers. The only other option for an investor wanting to “liquidate” their investment (i.e. turn it back into cash) is to find another investor to sell their securities to.
The problem with ABS is the overall mismatch of maturity preferences between borrowers and lenders. Without getting into the business of maturity transformation, there was always going to be a limit on how large the market for ABS could become. Faced with a problem like this, it was only a matter of time before innovative financiers came up with a solution. One such solution was asset-backed commercial paper (ABCP). This involves adding another step in the chain, often referred to as a “conduit”. The conduit was simply another legal entity which would buy ABS, funding the purchase by issuing short-dated securities known as asset-backed commercial paper.
ABCP capital flow

Just like a bank, the conduit is exposed to liquidity risk. Before the crisis, this risk was considered fairly low. After all, the assets of the conduit were readily trade-able securities. Most of the time the conduit could repay investors simply by issuing new ABCP to other investors but, in the unlikely event that no such investors could be found, it could simply sell the ABS. In some cases, investors were provided with additional assurance of repayment in the form of “liquidity backstops” provided by banks, essentially a guarantee that the bank would step in to repay investors in need (although these commitments were not always very clearly disclosed to bank shareholders). This whole arrangement was considered highly satisfactory and conduits typically received the highest possible rating from credit rating agencies.

Unfortunately, liquidity risk is a real risk as the world eventually discovered. Once the US mortgage market started to get into trouble in 2007, investors around the world began, quite reasonably, to be rather reluctant to invest in RMBS and other ABS. Prices on these securities began to fall. Managers of large-scale cash investment funds, until then enthusiastic buyers of ABCP, decided that more traditional cash investments were more attractive. The conduits were forced to sell ABS at precisely the time when prices were falling. Their selling pushed prices down further in a vicious cycle, a perfect illustration of the close relationship between funding liquidity risk (the risk of not being able to repay obligations) and market liquidity risk (the risk of being unable to sell financial assets at anything other than a painfully low price). As a result, some conduits were rescued by the banks backing them (“taking them back on balance sheet”), while others collapsed.

The problems of ABCP were just one example of non-bank liquidity failures during the financial crisis. Others include the venerable US money market fund, the Reserve Fund “breaking the buck” or Australian non-bank lender RAMS finding itself unable to continue funding itself by means of “extendible commercial paper” (ECP).

ABCP conduits, money-market funds, non-bank mortgage lenders along with many other non-bank financiers that make up the shadow banking sector had well and truly entered the business of maturity transformation and are all exposed to significant liquidity risk as a result. There are many linkages between banks and these shadow banks, whether through commitments such as liquidity backstops, direct lending or even partial or complete ownership. Regulators are concerned that too much risk in the shadow banking sector means too much risk for banks and too much risk for the financial system as a whole.

One strategy for regulators is to enforce a cordon sanitaire around banks, protecting them from shadow banks. But many, including Lord Turner, worry that is not enough to protect our global financial system with its complex interconnections from damage when shadow banks fail. Ideally they would like to regulate shadow banks as well, preventing them from running too much liquidity risk. But this is not an easy task. As the name suggests, it is not easy to see what is going on in the world of shadow banks, even for well-informed financial regulators.

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{ 27 comments… read them below or add one }

1 BernardK June 12, 2012 at 10:36 pm

oh yeah,

How to ensure safety; which means adding protection, but allowing innovation. I mean – we did see LOTS of innovation during Glass-Steagall et al.

Maybe an überBankerProfitTax (globally) that taxed the profits AND the risk…. Oh yeah – can’t work out the risk till the fan is covered.

Sorry Mule, it’s late, and I’m not well.

Well written, informative.

2 Magpie June 13, 2012 at 5:08 am

Very didactic, Stubby.

Let me put on a banker hat (it’s a black one, together with a big, black mustache).

These shadow banks emerged as a way to bypass the limitations inherent in maturity transformation.

Wouldn’t shadow banking regulations, if they involved keeping reserves, re-introduce these limitations?

3 Stubborn Mule June 13, 2012 at 8:53 am

@BernardK: interestingly, the pre-crisis growth in shadow banking came in a period during which liquidity regulation was much lighter than it will be once Basel III rules come into force. While shadow banking shrunk somewhat as a result of the crisis, I think that some regulators worry it will be back with a vengeance post Basel III.

@Magpie: the post did end up longer and more didactic than I expected. One challenge for regulators in regulating shadow banks is to catch them all. It’s a bit like stamping on a bump in the carpet, only to see a bump pop up somewhere else. Banks are easier to pin down: they have all have license to operate as part of the domestic payments system. Shadow banks, on the other hand, come in many shapes and colours. The only test is the duck test: if it walks like a duck (bank) and quacks like a duck (bank)…

4 Pfh007 June 13, 2012 at 9:03 am

I like the description shadow banking (and the post – nice and clear) it is a just a shame shadow banks dont suffer the same consequences as their natural brethren when the sun falls directly upon them.

Surely, the only problem with shadow banks is our fear of allowing them to collapse when their calculations dont pan out.

Consenting adults who make investments in shadow banks should wear the cost of failure.

At some point we need to let fail those that we believe are to big to allow to fail.

5 pfh007 June 13, 2012 at 9:52 am

Shadow banking sounds like, as the name seems to suggest, banking that struggles when exposed to sunlight (and perhaps garlic). In fact calling it banking at all is overly flattering.

One of the remarkable features of the modern world of financial sophistication is that there seems to be a major disconnect between the calculation of the risk of failure and the actual risk of failure.

Rather than trying to stamp out all the bumps in the carpet perhaps it is best to specify what bumps are to be regulated and leave the rest to the wild west of algorithms and irrational exuberance.

Those who like to sail beyond the horizon should accept that the dragons that live there, may eat them.

Of course that requires intestinal fortitude and preparations to be in place so that when one of these explorers of the financial deep starts to list dangerously they do not get the comfort of being labelled ‘too big to fail’ and large wads of taxpayer money or panic stricken ZIRP.

In recent times the economic policy around the world has been distorted beyond recognition by the desperate attempt to preserve many instituitons that should have failed or been nationalised.

No off balance sheet frolics for the banks, clearly defined shadows and make it clear that those that play in the shadows might get bitten, sunk or eaten depending on your preferred mix of metaphors.

6 Magpie June 13, 2012 at 4:20 pm


didactic = good (imo)

My question was along the lines of how effective can regulations be, long term.

Regulators and financial institutions could engage in a sort of arms race: measures cause the other side to devise countermeasures.

But in this arms race financial institutions probably have an advantage: financial institutions can devise and implement countermeasures to each regulation, as long as these countermeasures are not explicitly declared illegal.

Regulators, by contrast, are much more constrained (even if they were not captured by the institutions they are meant to regulate): laws need be passed, resources must be approved, research on the effects of the financial institutions must be conducted…

Don’t get me wrong: regulation is obviously needed. The question is whether this is a real solution.

7 Stubborn Mule June 13, 2012 at 7:43 pm

@Magpie: you are right that there is something of an arms race. I think that is inevitable and regulators have to become more dynamic. The first Basel Accord was in 1988 (the result of a committee formed in 1974). The second Accord was published in 2004 and implemented around 2006 (varying by jurisdiction…it’s still not in force in the US). The third was agreed in 2010 and will be implemented in coming years (some of it is already in force under the heading Basel 2.5). So the pace has increased and may continue to do so.

It may be necessary for regulation to become more creative. For example, it may be tricky to directly regulate shadow banks, but perhaps an easier target would be their investors. Superannuation/pension funds represent a large component of the wholesale investor market. If there were restrictions place on what sorts of investments they could make it may take the wind out of the sales of some types of shadow banking. That may or may not be a good idea, but I suspect lateral thinking is required on the part of regulators.

8 Stubborn Mule June 13, 2012 at 7:51 pm

@pfh007: if only consenting adults were at risk, regulators would not be too upset. What worries them is the knock-on effects. For example, regulators used to think that investment banks (i.e. Lehmans and Bear Stearns and the like) could do what they like as they had no retail depositors and, to that point, banking regulation was (almost) all about protecting depositors. The problem was that they had so many dealings with traditional commercial banks that an investment bank collapse could bring down other banks which could impact retail depositors and seriously damage the real economy. The fact that Bear Stearns was bailed out and Lehman Brother was left to fail shows that the powers that be were individually assessing the potential impact of failure on the system as a whole. Also, even though Bear was saved, equity holders lost most of their investment so it was really only their creditors who were rescued.

Some regulators have the view that, as long as banks are prevented from having exposure to shadow banks, shadow banks can do what they want: who cares if they fail. Others, including Turner, worry that the size of the shadow banking sector is such that widespread failures could still damage the real economy, causing future financial crisis. The aim in regulating these activities would be to protect the system rather than individual investors. Mind you, it’s worth keeping in mind that the consenting adults who invested in shadow banks before the crisis were, in some cases, you and me through our super funds!

9 AJ June 13, 2012 at 9:10 pm

Good post, thanks Mule.

Any entity that engages in maturity transformation is subject to a run. All it takes is confidence of depositors/funders of the entity to fall below a certain level and it is self fulfilling.

The only advantage banks have over shadow banks is access to the government lender of last resort facility and an implicit taxpayer guarantee on deposits. A privileged position.

It would be interesting to know how close Aussie banks came to a full scale run in late 2008… maybe some retired regulator will write a book in a decade or two and fill us in.

Dybvig and Diamond 1983 JPE:

10 Stubborn Mule June 13, 2012 at 9:25 pm

Thanks AJ. There’s no doubt that banks have a privileged position and being subject to regulation is part of the price of the ticket to play.

As for Australian banks in 2008, in my opinion Suncorp and, perhaps, Macquarie were closest to the edge.

11 Pfh007 June 13, 2012 at 9:27 pm

As you note preventing banks and others like super funds from investing in shadow banks by restricting their investment choices may be a more viable approach, than trying to predict and manage the latest bit of creative financial engineering.

Deny the fire fuel.

That would help limit the shadow bank players to those prepared to accept the risks and those that we are prepared and willing to let fail.

Naturally, articles by spin doctors will be quickly drafted demanding to know ‘why retirees are being denied access to superior returns’.

But we are getting ahead of ourselves as, notwithstanding the regular high minded statements, there is little sign that any countries are truly prepared to limit the potential of their financial sectors to build new high leverage soufflés.

Who would turn down the chance to be an international centre of financial innovation?

So the only real option might be to manacle the fools rather than those that would part them from their money.

12 Golden Orb June 13, 2012 at 11:55 pm

The other difference between the banks and the shadows is that the banks carry the credit risk in the traditional model. If the borrower can’t pay, the bank is not off the hook – it is still liable to the lender/ investor for the full amount of their deposit. But in the ABS, if the borrower defaults it flows straight through to the lender/ investor. That means that the people in the shadow bank making the decisions about whether to lend are not the ones that stand to lose if the the borrower defaults. But the lender / investor does not see all the information about the borrower’s capacity to pay. They depend on the value of the asset to at least cover the cost if the borrower defaults. Which it won’t if there is a bubble that bursts.

The shadow bank has no incentive to be conservative, or even balanced, in their decisions about who to lend to. That is the real problem – the credit checker being a broker rather than a lender, and nobody having both the incentive and the information to assess the credit risk properly. That is where the regulator should focus their efforts. The liquidity risk is only activated after investors lose confidence because of credit risk problems.

13 Magpie June 14, 2012 at 12:30 pm

I am afraid that I have to agree with this:

“Who would turn down the chance to be an international centre of financial innovation?
“So the only real option might be to manacle the fools rather than those that would part them from their money”.

The idea of accountability is all good and well: they played with fire, they got their fingers burnt. I’m all for it, as everyone else and their dogs is.

What should make us stop and think is that the usual suspects are also all for it.

And they will remain committed to accountability, until it is them who lose money. Then it will be gimme, gimme.

In a different context, that’s what was behind BHP-Billiton’s Jac Nasser’s statements about taxes and labour market regulation a few weeks ago.

They over-invested, hoping that commodity prices would increase forever; but they didn’t. Profits fell and share prices followed suit, while BHP-Billiton is already committed to a lot of new investment.

Faced with a shareholders’ backlash, let’s blame the Government and those pesky workers! If it achieves nothing else, at least it distracts shareholders for a while. And, who knows, it might scare the government into giving new concessions.

Incidentally, let’s remember that BHP-Billiton, Rio and Xstrata opposed the previous RSPT, even though the RSPT included dispositions to reduce the tax rate applicable when profits fell under some threshold. That was unacceptable to them then, when profits were above that threshold; they would probably think twice about it now, when they are below. But, of course, they can’t admit now the deal wasn’t as crappy as they said then.

That’s why Nasser also mentioned the “virtual nationalization” (or something to that effect), in his speech.

14 StBob June 16, 2012 at 9:08 pm

Mule, ECP sounds like the subversively named CCCP (Credit Contingent Commercial Paper) that we invented at A Bank in the late 90s? Did we ever get credit for that?

15 Zebra June 16, 2012 at 9:09 pm

Mule, ECP sounds like the subversively named CCCP (Credit Contingent Commercial Paper) that we invented at A Bank in the late 90s? Did we ever get credit for that?

16 Magpie June 16, 2012 at 10:30 pm


I think I get the “subversive” reference…

You mean… Cucurrucucú Paloma!

Masterpiece of the 50s musical kitsch!

PS: Long time, no read

17 Stubborn Mule June 17, 2012 at 7:45 pm

@Zebra the ECP is similar to the CCCP, although I believe that most of them only had a single extension option: typically they might have been 90 or 180 day paper with an option to extend by an additional 90 or 180 days respectively. It’s one of those options you can only exercise once: after RAMS started exercising their extension options, no-one would buy any of their new paper again.

18 Hollow Man June 25, 2012 at 10:34 am

I think TS Elliot nicely sums it all up:
Between the idea
And the reality
Between the motion
And the act
Falls the Shadow

19 Manny July 14, 2012 at 9:50 am

Good post. However I would come at it a bit differently. Maturity transformation necessarily runs liquidity risk. The shadow banking system allowed the banks (largely?) to offload this risk to non banking sector. The shadow banking system is significantly less concentrated than the banking sector. I would prefer the shadow banking sector to remain largely unregulated given the concentration in banking. The areas that probably deserve tightening are liquidity facilities provided by banks to shadows. Limit this.

Liquidity risks are potentially catastrophic. Better if they were more widely distributed through shadow banking.

20 Stubborn Mule July 14, 2012 at 5:09 pm

@Manny. That is certainly one school of thought: eliminate the possibility of banks providing liquidity support to shadow banks and allow shadow banks to do what they like and, if they fail, they’re big boys. After the likes of Long Term Capital and Lehman, however, many regulators have become concerned that shadow banks are intertwined in complex ways with the rest of the financial system (e.g. as counterparties to collateralised derivative trades) and that if there were widespread collapses, it would still be dangerous to the banking system and the economy as a whole. That’s not a consensus view yet, but Turner and others are increasingly of the view that it would be too dangerous to ignore shadow banks and only focus regulation on banks.

21 Manny July 14, 2012 at 8:02 pm

I think the central clearing of derivatives will alleviate some of the counterparty credit risk concerns.

I think the main reason for banking regulation is the safeguarding of depositor funds. What hedge funds (and perhaps to a certain extent money market funds) do is their shareholder/unit holder/debtors problems. As long as the concentration is diffuse, it will be alright. Regulations serve to increase the barriers to entry in a market and result in increasing concentration. I would be very wary of this.

Additionally if there is a widespread collapse then I would argue it would very likely result from an exogenous source. For example, tight monetary policy in the face of weakening nominal expectations (a la mid 2008). Shocks endogenous to shadow banking would mean losers give money to winners (zero sum). Generally everyone loses only if the shock comes from outside.

22 Stubborn Mule July 14, 2012 at 8:22 pm

@Manny one interesting thing about the move to central clearing is that the clearers will be the big (“too big to fail?”) banks like Citi, Deutsche and JPMorgan. Does the increased concentration negate the benefits?

23 Manny July 15, 2012 at 7:50 am

I totally agree with your comment re central clearing houses. But that is not a problem a shadow banking. In fact it illustrates a point about regulation increasing concentration in banking. There was a paper on this (in a way stating the obvious), but I can’t find it at the moment.

24 Stubborn Mule July 15, 2012 at 9:56 am

@Manny. Was it Duffie and Zhou? A friend has done some analysis that suggests a central clearer does reduce risk, as long as the credit quality of the clearer is good enough (which may be a big if!). I’ll see if I can get hold of a copy.

25 Manny July 15, 2012 at 11:23 am

I did see the Duffie & Zhou paper. But it sounds like the paper I am referring to sounds more like that the second one you allude to. Had something to do with the relative credit worthiness of parties backing the central clearer.

Full disclosure: I don’t usually have time to read many papers cover to cover. I generally read abstract and conclusion and then depend heavily on my computer’s search capabilities when I need to refer back to the detail (or refresh my memory). In this case, my system failed!

26 Stubborn Mule July 15, 2012 at 6:02 pm

@Manny: here is the paper by Mark Lauer.

27 Manny July 16, 2012 at 7:09 pm

I’ll have a look. There’s another paper* from JPM analyst that considers similar issues. I think this is the one that I was looking for earlier.

“The cost of protection from losses on the posted collateral is comparable to the cost of investment grade super-senior protection”


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