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An introduction to shadow banking

It looks like a bank, does banking but it’s not a bank — it’s a shadow bank. It is the mysterious force trending in the current global economy.

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Coined as early as 2007, Paul McCulley broadly described shadow banking as “The whole alphabet soup of levered up non-bank investment conduits, vehicles and structures” (IMF, June 2013 ).

According to the FSB, the shadow banking sector is worth over $71.2 trillion and has tripled in size over the last decade (FSB, 2015). One notable exception is the $400 billion segment of structured investment vehicles which ceased to exist after the financial crisis.

It may be split into two broad categories, shadow banks can be institutions such as hedge funds and investment banks which are fully autonomous from commercial banks, or financial institutions such as structured investment vehicles and conduits which may be directly linked and controlled by a commercial bank. They both share the characteristic of not holding deposits resulting in lower regulation compared to commercial banks (EBA, 2015).

This definition expanded on by the Federal Reserve, who have considered the term to include “Financial Intermediaries that conduct maturity, credit, and liquidity transformation without access to central bank liquidity or public sector guarantees” (Schwarcz, 2012). This definition is considerably more inclusive as it includes finance companies, money market mutual funds and much more.

In the author’s opinion, the current definition of shadow banking can be both inclusive and exclusive dependent on the context.

The history of shadow banking

Historically, the financial crisis provides excellent insight into the sensitive nature of shadow banking. Post financial crisis, it is easy to understand how large, fragile and interconnected the system is, and just how dependent it is on the traditional banking system.

During the crisis, one issue that arose was how shadow banking aided in hiding and magnifying the risks of traditional bank balance sheets. While the vast majority of this activity was normal banking activities, the use of complex asset sheet structuring led to distorted representations of the banking system, creating further uncertainty. This is less prevalent today, due to increased regulation (Yang, 2016).

As the U.K., the U.S. and other western countries see shadow banking at relatively stable levels, there is an extreme growth of this sector happening notably in China. There is a particular concern being drawn to the lack of clarity in terms of the type, extent and scope of current shadow banking in China with significant uncertainty around the outcome of this over the next few years (European Commission, 2015).

One key factor in the growth and success of shadow banking is that it remains relatively unregulated while during this period, traditional banks have faced increased scrutiny and regulation. In recent times, there is growing calls for increased regulation within the shadow banking sector from economists such as Bank of Englands Mark Carney and IMF director Christine Lagarde. This has, in turn, led to increased calls that with additional regulation should come access to traditional banking facilities. This may include liquidity from the central bank. In the author’s opinion, this risks merging both sectors even more, creating the prospect that one would be relatively redundant (Carney, 2016).

Many of the pre-financial crisis issues have been eroded completely. This includes the widespread abolishment of SIVs or structured investment vehicles which pre-crisis was estimated to be a $400 billion industry. The abandonment of this highly speculative financial vehicles helps align the entire shadow banking sector to become more resilient to future shocks or uncertainty (Broos & Carlier, 2012).

Additionally, changes in capital accounting practices and improved regulatory standards make this particular problem very unlikely to occur again. This is an iterative process and thus is constantly improving, a risk to this is the changing nature of the environment, as detailed below (ESMA, 2013).

In recent years, new forms of shadow banking completely outside the traditional regulated banking activities have emerged. This highlights the fact that shadow banking is not a single system but a constantly evolving and often unrelated encompassment of intermediation activities pursued by a diverse and wide-ranging set of financial market actors. A key growth factor of this, to reiterate, is that continued increase in regulation in the traditional banking sector is creating parallel increases in the attractiveness of the shadow banking sector (FSB, 2015).

However, in the author’s opinion, it is firstly important to separate and disaggregate the various activities that have manifested under the umbrella term of shadow banking, and to analyze and report on these particular segments in a case by case basis.

Furthermore, the author believes it is important to constantly monitor the links between these segments, with particular emphasis on direct and indirect links to the traditional banking sector.

Prior to the last financial crisis, large traditional banks provided both implicit and explicit support by the way of credit and liquidity for a diverse range of intermediation activities that including finance companies, non-bank mortgage lenders, structured investments vehicles and asset backed commercial paper conduits. These entities would often participate in high risk maturity and liquidity transformation which often came with significant leverage attached (Jeffers & Baicu, 2013).

Additionally, many entities created via securitization or otherwise assets which were perceived by many financial actors as cash equivalents, safe, short-term and highly liquid. During normal times before the financial crash they were widely perceived as being similar to demand deposits of traditional banks.

Throughout this period, traditional banks continued to engage with the wider shadow banking sector which in turn contributed to the illusion that shadow banks’ short-term liabilities may be comparable to cash. This was perhaps further induced by the traditional banks reliance on the shadow banking sector as a source of cheap short-term wholesale financing (FSB, 2015).

It was after the financial crisis that problems on liquidity with mortgage loans, in particular, were raised.

It was after the financial crisis that problems on liquidity with mortgage loans, in particular, were raised. (Source)

It was after the period of the financial crisis that concerns and questions were brought forward concerning the quality of the mortgage loans along with other assets underlying the liabilities of asset backed commercial paper conduits that this type of security was no longer considered highly liquid or cash equivalent. During this time, a “run” on this type of asset happened, in summary, many large banks suffered a run on their own short-term secured wholesale funding (IMF, 2016).

After this period, it is notable that while some types of shadow banking have largely ceased to exist (such as SIVs), other have been subject to increased regulation which should help prevent this issue happening again.

Furthermore, there are considerable advantages to some forms of shadow banking. At the macro level there can be observed an increase in the diversity of an economies capital providers which is associated with shadow bank intervention (Shao & Coghill, 2014).

Specifically, the creation and now wide spread adoption of equity mutual funds provide an array of savings options that previously did not exist. These serve a demographic for which ownership of a diversified portfolio of equities would have been practically challenging or financially impossible previously.

Consequentially, this provided a challenging environment for the liability side of traditional bank balance sheets. This is due to a reduction in the share of capital allocated to traditional deposits in traditional banks.

Non-bank intermediaries or shadow banks further extend credit to borrowers, which traditional banks either underserve or unserve entirely. A new source of this is non-bank activity in online market place lending, where new sources of data and technologies lower the fixed costs of making credit decisions. In turn, it increases the efficiencies or cost effective strategy to lend to entities such as small businesses (Zeoli, 2015).

This does not reliably help to create an assessment of the increased competition of traditional banks. The two most common factors would include the fact of risks being genuinely lower in that innovative technological change in increasing efficiency, or simply that the lower regulation has acted as a subsidy to this sector. It is certainly possible both helped contribute to the current growth and success of shadow banking in recent years.

Strictly in terms of risk, the umbrella of activities that occur within shadow banking should be less concerned with volume and more concerned with the vulnerability the activity creates. In the author’s opinion, not everything that some consider as shadow banking represents a market failure that inherently creates successive risk. In this tone, it would be wrong to assume that all shadow banking should be regulated to protect or safeguard wider financial stability.

The FSB’s 2015 annual report detailed some of the following points.

In terms of assessing the viability of regulation to be introduced to specific segments of shadow banking intermediation, then in the author’s opinion, an assessment must be made as to the balancing of socially beneficial credit, capital and savings options against any risks associated with the safety and stability the wider financial system (FSB, 2015).

In the author’s opinion, the following should be considered in terms of risk:

  • The extent or reliance on liquidity or maturity transformation
  • The growth or lack thereof of cash equivalent assets
  • The use of leverage and the degree of interconnectedness with the traditional banking sector

Going back to the previous point, one way to limit shadow banking growth that is a direct result of the lower regulation component would be to undertake and analyze the current traditional banking regulation and ensure they are not any more burdensome than is required.

Migratory risks of capital flowing from the traditional to shadow banking sector may be encapsulated where traditional banks have operational core product synergies. The loss of this may lead to wider decreases in efficiency for traditional banks. If this hypothesis holds true, there would be a strong argument that regulation that encourages migration to shadow banking is ultimately increasing the risks and vulnerabilities of traditional banks, and thus the wider financial system (Mullineux & Maurinde, 2003).

In the author’s opinion, the ultimate or greatest risk to the wider financial market stability is further funding runs and asset “fire sales” associated with the reliance on short-term wholesale funding that exists between the shadow banking and traditional banking sector. In this tone that the rapid withdrawal of short-term wholesale funds would lead to potential systemic disruption in the financial markets normally reserved for runs on traditional banks.

A personal insight

Interestingly, for countries such as the U.K. the volumes of wholesale funding remains lower than pre-crisis levels but remains large relative to the total size of the financial system, and thus still a concern. Additionally, the imposition regulated liquidity recovery ratios and the net stable funding ratios further reduce risk associated with abrupt changes in the short term wholesale market (FSB, 2015).

There are some additional institutional considerations that will be examined in line with how regulation may be presented and adopted in the coming years.

While statistically there is an inclination towards the merit of a case by case system for the assessment of the risks and benefits, the way in which this regulation is adopted is largely dependent on the institutional structures. Notably in the U.S., the FSB has been tasked with overseeing this sector, though it should be stressed that this type of regulation would not be ideal for all types of activities within the shadow banking sector so to properly address financial stability concerns (HM Treasury, 2009).

The second major issue may be in terms of which institutional regulator should make the assessments in resolving financial stability risks that are associated with shadow bank intermediaries. In the author’s opinion, it should be the institution most capable of acting effectively, which would likely be the optimal outcome from a policy perspective.

However, issues may arise from this. An example would be a regulator who has a pre-existing set of responsibilities for one sector who believed that the failure of regulators with responsibility for another sector to act on financial stability concerns is creating debilitating disadvantages for the companies in the original sector. Specifically, they may relax regulation on those firms in the traditional banking sector even though there may be consensus on agreement that the optimal outcome would be to retain regulation in the sector while having the other sector regulated under a set of constraints specific to its needs.

In conclusion

In summary, the FSB report detailed above shows growth of shadow banking within the U.S. and the U.K. as relatively modest, with both countries experiencing significantly higher levels of resilience to economic uncertainty or downturns than before the last financial crisis.

There is further good news in that innovation is leading to material increases in efficiency with this trend set to continue across both the traditional and shadow banking sectors.

While resilience is at higher levels compared to the last financial crisis, new forms of intermediation will inevitably create new risks, and the traditional forms may acquire new risk during the expansion and adaptation to an ever-changing environment.

In the author’s view, a case-by-case assessment for regulation which allow healthy forms of shadow banking to occur with little regulation while imposing strict regulation on risky segments of shadow banking is the optimal way forward. This already exists in a quasi-state in many countries, including the U.S. It is worth noting that regulators have currently no comprehensive plan toward developing an effective mechanism for this segment by segment regulatory basis.

A further observation is that the cause of the migration of this activity to the shadow banking sector has occurred due to the efficiencies gained by avoiding traditional regulation. While this is not the author’s opinion, there may be merit in the argument that regulating the shadow banking sector could lead to the traditional banking sector collapse, or as would be more likely, for efficiencies of healthy forms of shadow banking to disappear. The case by case approach would be a sensible solution to avoid loss of efficiency. Relatively safe activities should remain lightly regulated irrelevant of sector.

Sources

Broos, M., & Carlier, K. (6 June 2012). Shadow Banking: An Exploratory Study. Retrieved from Dutch Netherlands Bank.

Carney, M. (26 February 2016). Speech given by Mark Carney, Governor of the Bank of England. Retrieved from the Bank of England.

DISCLAIMER: This article expresses my own ideas and opinions. Any information I have shared are from sources that I believe to be reliable and accurate. I did not receive any financial compensation in writing this post, nor do I own any shares in any company I’ve mentioned. I encourage any reader to do their own diligent research first before making any investment decisions.

Karl Ahlstedt currently resides in Swansea, the heartland of Wales. He studied business and investment management at the University of Wales and Swansea University and proceeded to work in a fast, competitive environment at one of Wales largest hedge funds. Passionate about finance and investments this was the traditional career path many investment graduates took. Since then, and with the encouragement from friends and colleagues, Karl founded the Horizon Institute in late 2017. Today Karl provides analysis to local investment companies, and delivers guest lectures at the University of Wales. Disappointed in the education offered by get rich quick schemes that litter the internet, Karl set up The Horizon Institute to teach finance and trading to the same level as he received at top UK universities and investment firms. This approach has been expanded in 2018 to include a national teach training programme that aims to take the best financial experts, from hedge fund managers to economists to create compelling and up to date content that provides country-leading excellence in the field of financial education.

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