The ‘shadow banking’ sector can be an ill-defined financial segment that expands and contracts credit beyond your regulatory perimeter.
- It had been critical in the build-up and demise of the credit boom.
While much reduced since 2008, in america its size still exceeded bank assets in 2011.
- What have we learned because the crisis on shadow banking?
By definition, shadow banking isn’t an accurate category. In this column, I concentrate on financial intermediaries that take credit risk.
Banks acquire illiquid risky assets, funding them with inexpensive, demandable debt.
- Most investors prefer safe, short-term and liquid assets, so banks may use cheap funding, by promising liquidity on demand.
- That is made credible by deposit insurance and usage of central bank refinancing.
Confidence on immediacy means that demandable debt is routinely rolled over, thus supporting long-term lending and high leverage. 1
As bank credit volume is constrained by capital ratios and deposit base, financial markets have considered new methods to carry risky assets on inexpensive funding. Shadow banking requires creating a variant of demandable debt, credibly backed by a primary claim on liquidity.
However the dominant funding channel is issuing collateralised financial credit, such as for example repos or derivative-based claims. 2 Here is the way to obtain shadow banks’ very short-term, inexpensive funding source.
How do these liabilities deliver investors credible liquidity upon demand?
Security-pledging (the collateral part of collateralised financial credit) grants usage of easy and cheap funding because of the steady expansion in the EU and US of “safe harbour status” – the so-called bankruptcy privileges for lenders secured on financial collateral.
Critically, lenders in this collateralised financial credit transaction can immediately repossess and resell pledged collateral. In addition they escape almost every other bankruptcy restrictions such as for example cross default, netting, eve-of-bankruptcy and preference rules (see Perotti 2010).
- These privileges ensure immediacy for his or her holders.
- Unfortunately, they do so by undermining orderly liquidation, the building blocks of bankruptcy law.
The results became visible upon Lehmann’s default, when its massive stock of repo and derivative collateral was taken and resold within hours. This produced a shock wave of fire sales of ABS holdings by safe harbour lenders. While these lenders broke even, 3 their rapid sales spread losses to all or any others, forcing public intervention.
When the safe harbour provisions were massively expanded in a coordinated legislative push in america and EU (Perotti 2011), 4 they supported a fantastic expansion of shadow banking credit and mortgage risk taking. The guaranteed simple escape fed the ultimate burst in maturity and liquidity mismatch in the 2004-2007 subprime boom, where credit standards fell through the ground.
While shadow banks expanded with securitisation, they are able to also depend on the liquidity of assets they don’t own. They do that by borrowing securities from insurers, pension and mutual funds, custodians, and collateral reinvestment programmes. 5 In trade, the beneficial (i.e. real) owners of such securities receive fees for lending the assets plus they book these as yield enhancement. Borrowed securities are then pledged to ‘repo lenders’ (the short name for credit grantors in a collateralised financial credit transaction) or posted as margins on derivative transactions.
Experienced asset managers who lend securities in this manner protect themselves via collateral swaps, i.e. a related transaction where in fact the security borrower pledges collateral of lower liquidity. This so-called ‘liquidity risk transformation chain’ (which transforms illiquid assets into short-term credit) may have significantly more links.
The financial logic behind the liquidity risk transformation chain is clear. Security pledging activates the liquidity value of assets from long-term holders who don’t need it. Such extraction of unused liquidity value could be viewed as enhancing “financial productivity”. It really increase asset liquidity, and boosts securitisation. Yet this is often a illusory gain, flattering market depth in normal times, at the expense of greater illiquidity sometimes of distress.
The repo lenders and security lenders typically need a a lot more than one-to-one exchange to safeguard themselves against the chance of the collateral losing value. These ratios are called ‘haircuts’ since each $1 of collateral generates significantly less than $1 of credit.
A jump in market haircuts, and ultimately a refusal to roll over security loans or repos, may be the classic shadow bank run.
- As a security borrower cannot raise as much funding from its illiquid assets, it really is forced to deleverage fast or goes bust.
In both cases this triggers fire sales.
- Once repo lenders seize collateral, they have all reasons to desire to sell fast.
First, they aren’t natural holders. Second, they don’t have problems with a fire sale so long as the purchase price drop is significantly less than their haircut. Third, they know that others are repossessing similar collateral simultaneously, so they have a motivation to front sell.
- In addition, real cash investors that lost their original holdings will probably sell the repossessed, less liquid collateral.
First, they could desire to re-establish their portfolio profile. More critically, they legally have to sell within days in order to claim any shortfall in bankruptcy court.
- This leads to a dramatic acceleration of sales for assets originally focused on an extended holding period.
While central banks aren’t responsible for shadow banks, they do come under great pressure to avoid fire sales and create outside liquidity. This completes the banking analogy.
It really is now evident that shadow banks need the safe harbour privileges to reproduce banking. No financial innovation to secure escape from distress can match the proprietary rights granted by the safe harbour status, which ensure immediate usage of sellable assets. Traditional unsecured lenders took notice, and today request more collateral, squeezing bank funding capacity and limiting future flexibility.
Many attentive observers find this unconditional assignment of superpriority to repo and derivative claimants excessive. 6 Duffie and Skeel (2012) discuss within an excellent summary the merit of safe harbour. Within their words:
“Safe harbours may potentially raise social costs through five channels: (1) lowering the incentives of counterparties to monitor the firm; (2) increasing the power of, or incentive for, the firm to be too large to fail; (3) inefficient substitution from more traditional types of financing; (4) increasing the marketplace impact of collateral fire sales; and (5) lowering the incentives of a distressed firm to seek bankruptcy relief regularly.”
Each one of these arguments demand attention. Repo lenders and derivative counterparties enjoy not only immediacy in default, but also reset margins daily. By construction, this produces a distinctive safe claim. Just as insured depositors, these claimants are able to neglect credit risk, and perform no monitoring role.
Collateral lending, by divorce liquidity transformation, lengthens credit chains and expands the amount of connections among intermediaries, adding to systemic risk (Gai et al. 2011).
The primary proposals aim at restricting eligibility. Tuckman (2010) suggested only cleared derivatives should benefit from the status. Duffie and Skeel argue it might be limited by appropriately liquid collateral (thus not ABS!) and only transparent uses (derivatives listed on proper clearing exchanges).
In recent research (Perotti 2011), I would recommend that claims be publicly registered (just as secured real credit is) as a precondition for safe harbour status. This will ensure proper disclosure, necessary to macro prudential regulators, and avoids unauthorised or misunderstood (re)hypothecation.
Investors who want to claim superpriority in distress seek a scarce resource. They must be spending money on the privilege, and for just about any risk externality it generates. In normal times, a minimal charge ought to be levied on registered claims. Charges ought to be adjusted countercyclically, lowered in difficult times, and raised when aggregate liquidity risk accumulates, to brake an otherwise uncontrollable expansion.
Other approaches involve limiting the stock of safe harbour claims directly (Stein 2012) by a cap and trade model, which a registry receiving fees could support.
A crucial issue may be the treatment of collateral posted for central bank refinancing. For central banks to use as ultimate liquidity providers, their claims shouldn’t be undermined. A particular privilege for eligible collateral is justified, as central banks are by definition improbable to create fire sales.
Because of the safe harbour rules, a shadow bank can take risky illiquid assets and earn full risk premia with funding at the overnight repo rate. In what’s essentially a synthetic bank, repo and collateral swap haircuts become market-defined capital ratios.
Liquidity transformation across states and entities has procyclical effects.
It enhances credit and asset liquidity in normal or boom times, at the expense of accelerating fire sales in distress. While any reform to the shadow banking funding model should consider its favourable effects on asset liquidity and credit in normal times, the associated contingent liquidity risk isn’t at the moment controllable (neither is it well measured!). There can be an academic consensus a balance needs to be struck (Acharya et al. 2011; Brunnermeier et al. 2011; Gorton and Metrick 2010; Shin 2010).
Appropriate tools are also essential to align capital and risk incentives in banks and shadow banks (Haldane 2010). Security lending could also undermine Basel III liquidity (LCR) rules.
At the same time when all lenders seek security, questioning the logic of safe harbour provisions might seem unwise. Yet at the machine level, it really is simply impossible to promise security and liquidity to all or any. Uncertainty on the stock of pledged assets may create a self-reinforcing effect, feeding a frenzy among lenders to all or any seek ever-higher priority. That is already occurring, and is ultimately unsustainable at the average person and aggregate level.
Finally, it really is questionable if the highest degree of protection ought to be granted to collateralised lenders, also to shadow bank funding, over-all other investors. For each one of these reasons, regulators and the wider society have to make the best decision.
Acharya, Viral, Arvind Krishnamurthy, and Enrico Perotti (2011), “A consensus take on liquidity risk”, VoxEU.org, 14 September.
Brunnermeier, Markus, Gary Gorton, and Arvind Krishnamurthy (2011), “Risk Topography”, NBER Macroannual 2011.
Duffie, Darrell and David Skeel (2012), A Dialogue on the expenses and Great things about Automatic Stays for Derivatives and Repurchase Agreements, Stanford University, March.
Haldane, Andrew (2010), “The $100 Billion Question”, Bank of England, March.
Gai, Prasanna, Andrew Haldane, and Sujit Kapadia (2011), “Complexity, Concentration and Contagion”, Bank of England discussion paper.
Gorton, Gary, and Andrew Metrick (2010), “Regulating the Shadow BANK OPERATING SYSTEM”, Brookings Papers on Economic Activity, (2):261-297.
Perotti, Enrico (2011), “Targeting the Systemic Aftereffect of Bankruptcy Exceptions”, CEPR Policy Insight No. 52 and Journal of International Banking and Financial Law (2011)
Shin, Hyun Song (2010), “Macroprudential Policies Beyond Basel III”, Policy memo.
Stein, Jeremy (2010), “Monetary Policy as Financial-Stability Regulation”, Quarterly Journal of Economics, 127(1):57-95.
Tucker, Paul (2012), “Shadow Banking: Thoughts for a Reform Agenda”, Speech at the European Commission ADVANCED Conference, 27 April, Brussels.
Tuckman, Bruce (2010), Amending Safe Harbors to lessen Systemic Risk in OTC Derivatives Markets, Centre for Financial Stability, NY.
1 Historically, confidence was supported by high capital, reputation and limited competition. As competition increased and capital fell, central banks’ emergency liquidity transformation and deposit insurance allowed steadily higher credit and bank leverage.
2 Trivially, shadow banks could also access bank lines of credit (as SIVs did).
3 All of those other creditors had to hold back years to get significantly less than 20 cents on the dollar.
4 Limited safe harbour status was granted as exceptions in the 1978 US Bankruptcy code, limited by Treasury repos and margins on futures exchanges for qualifying intermediaries. These were broadened progressively to add margins on OTC swaps. The massive changes occurred in 2004, when any financial collateral pledged under repo or derivative contracts, whether OTC or listed, by any financial counterparty, found benefit from the bankruptcy privileges (Perotti 2011).
5 According to Poszar and Singh (2011): “By the end of 2010.. about $5.8 trillion in off-balance sheet components of banks linked to the mining and re-use of source collateral… down from about $10 trillion at year end-2007”.
6 Creation of new proprietary rights is exceedingly rare. Limited liability may be the last main case.