FINANCIAL SYSTEMIs Shadow BankingReally Banking?The size of the shadow banking sector was close to $20 trillion at its peak and shrank to about $15 trillion last year, making it at least as big as, if not bigger than, the traditional banking Bryan J. Noeth and Rajdeep Senguptahe term “shadow banking” has been out that, because of sudden liquidity needs of Tattributed to 2007 remarks by econo-individual agents or businesses, this function mist and money manager Paul McCulley cannot be performed by individual agents or to describe a large segment of nancial businesses alone—therein lies the rationale intermediation that is routed outside the bal-for a bank. Banks are able to achieve this ance sheets of regulated commercial banks transformation by exploiting the fact that and other depository institutions. Shadow only a small fraction of depositors have banks are de ned as nancial intermediaries liquidity needs at a given time. erefore, the that conduct functions of banking “without bank can store a small fraction of its deposits access to central bank liquidity or public sec- in the form of liquid assets (readily convert-1tor credit guarantees.” As shown in Figure 1, ible to cash) and lend out the rest in the form the size of the shadow banking sector was of term (illiquid) loans. is function is close to $20 trillion at its peak and shrank also known as qualitative asset transforma-to about $15 trillion last year, making it at tion because, by changing the maturity of its 4least as big as, if not bigger than, the tradi-assets, the bank also changes their banking system. Given its size and However, by performing this function, role in the nancial crisis, it would be useful a bank is essentially rendered fragile. e to understand the mechanics of shadow fragility comes from the fact that even a banking. To do so, some basics of traditional healthy bank can be the victim of a bank banking need to be understood . If all depositors demand their deposits Simply put, banks are intermediaries that back, the bank would have to liquidate all obtain funds from lenders in the form of its assets (even those that are not liquid) to deposits and provide funds to borrowers in ful ll depositors’ demands. Since almost 3the form of loans. e principal function no bank can liquidate all its assets within a of a bank is that of maturity transforma-short period without su ering a loss in value, tion—coming from the fact that lenders a problem of illiquidity can essentially turn prefer deposits to be of a shorter maturity into a problem of insolvency and the collapse than borrowers, who typically require loans of the bank. Accordingly, depositors are for longer periods. It is important to point acting rationally when they withdraw their 8 The Regional Economist| October 2011
FIGURE 1deposits even at the smallest hint of bad 5news. More o en than not, such bank runs Shadow Bank vs. Traditional Bank Liabilitiesare hardly limited to just one bank, precipi-$25,000tating what is called a banking their inherent fragility, banks typi-cally require credit enhancemen$20,000ts in the form of insurance of deposits or emergency 6access to funds from the central bank. In $15,000Shadow Bank Liabilitiesmost countries, public funds are the source Traditional Bank Liabilitiesof such provisions of emergency funding. $10,000Indeed, the nancial history of the United States is replete with stories about bank runs $5,000and bank failures prior to 1934. In that year, the Federal Deposit Insurance Corp. was $0created, ending runs on commercial banks 195219571962196719721977198219871992199720022007in the : Federal Reserve Board/Haver Analytics and calculations from Adrian, Ashcraft, Boesky and , the end of bank runs does not imply the end of bank failures. Indeed, the inclusion of such credit-enhancement loans that are essentially withdrawable measures, especially those funded by third on demand. At the loan origination end parties, creates a signi cant moral hazard for are nance companies and even tradi-7banks. Banks investing in risky loans ben-tional banks that engage in the activity of e t from higher returns on the slim chance originating loans, much like the traditional of success, whereas the taxpayer is le to bail banking system. Banks view raising such out depositors in the likely event that the e shadow banking system intermedi-8banks fail. Regulations seeking to prevent ates between the ultimate consumer of funds capital as costly and often such moral hazard require banks to hold (borrower) and the wholesale investor of engage in practices that signi cantly higher capital for increased funds, whose liquidity needs may preclude riskiness of loans (assets) on their balance long-term investments. Shadow banking would help prevent them sheet—known as a risk-weighted capital comprises a chain of intermediaries that are from having to do so. adequacy requirement. Banks view rais-engaged in the transfer of funds channeled ing such capital as costly and o en engage upstream in exchange for securities and loan One such practice is the in practices that would help prevent them documents that are moving downstream. 9creation of off-balance-sheet from having to do so. One such practice is erefore, what was once accomplished the creation of o -balance-sheet entities to under a single roof in the traditional bank-entities. ... This practice host some of the banks’ assets and, thereby, ing system is now done over a sequence of is often viewed as one of reduce their regulatory capital require-steps in the shadow banking system, each ments. is practice is o en viewed as one performed by specialized entities that are the major reasons behind of the major reasons behind the creation and not vertically integrated. the creation and growth of growth of shadow Deposit End Broadly speaking, credit intermediation shadow the Shadow Banking Systemthrough the shadow banking system is much like that through a traditional bank—it ful-Most advanced economies have solved lls the principal function of qualitative the problem of bank runs by the creation of asset transformation. However, unlike tradi-deposit insurance. In 1980, deposit insur-tional banking, which involves a simple pro-ance in the . was capped at $100,000; cess of deposit-taking and originating loans a er the crisis, this limit was raised to that are held to maturity, shadow banking $250,000. is meant that the demand for employs a much more complicated process safe, short-term investments from large, to achieve maturity transformation. At the cash-rich nancial and non nancial com-deposit end of the shadow banking system panies remained unful lled. e shadow are wholesale investors (providers of funds) banking system ful lled this demand in two using the repo market and money market ways—both of which made extensive use of intermediaries such as money market mutual widely available nancial (MMMFs) to provide short-term e rst of these arrangements uses repo, The Regional Economist| 9BILLIONS
FIGURE 2investors is to purchase shares in money The Creation of Securities from Loansmarket mutual funds. In MMMFs, inves-tors pool funds to invest in high-quality BorrowerBorrowershort-term securities of the government and BorrowerBorrowerBorrowerBorrowercorporations. Notably, investments (shares) in MMMFs are withdrawable on demand. CASH TO e safety of investments in MMMFs comes FUND LOANOriginatorOriginatorfrom the fact that the securities they invest Processes and funds Processes and funds individual loansindividual loansin are regulated to be of high quality and short maturity, such as Treasury bills and LOAN PURCHASE PRICEhighest-grade commercial paper. While Aggregator/Seller/SponsorTreasury bills are regarded as securities with Processes loans from originator and forms poolsno credit risk, commercial paper is backed by assets that possess some credit risk. To NET OFFERING PROCEEDSalleviate concerns for investors, Rule 2a-7 of the Securities and Exchange Commission’s UnderwAdministratorriterConduit/SPVCreates conduit or Sells certi cates to investor (See Figure 3 foInvestment Company Act of 1940 restricts r details.)special purpose vehicle (SPV)and collects offering proceedsthe quality, maturity and diversity of invest-ments by MMMFs. Loan DocumentsCash-rich investors looking for safe invest-InvestorInvestorInvestor Fundsments that are withdrawable on demand InvestorCerti cates can either purchase shares in MMMFs that of SecuritiesOFFERING PROCEEDSare redeemable on demand or can purchase securities under a repo agreement, whereby The diagram shows a simpli ed, the seller promises to purchase the securi- ve-step process for converting loan ties back at a later date. e two avenues are originations into nal securities. First, or repurchase, transactions, whereby rms somewhat di erent. Investments in MMMFs auto loans, student loans, mortgages and other loans are originated by regu-with surplus cash buy securities for cash only are in the form of a continuing contract with lated commercial banks and unregulated and then resell them back a er a short term. variable returns. On the other hand, a repo nancial rms. Second, a warehouse E ectively, this repo transaction is a short-transaction is a one-time contract with xed bank (aggregator) buys loans from one term cash loan to the seller of the security, returns. or more originators and pools the loans. Third, the pooled loans are sold to an with the security acting as collateral on the administrator, usually a subsidiary of a The Loan Origination End loan. Repo transactions can be open-ended large commercial or investment bank; of the Shadow Banking Systemand rolled over on a daily basis, making them the administrator creates a special ana is section refers to the processes by logous to deposits at a traditional bank purpose vehicle (SPV) to hold the loans; the SPV issues securities against that are withdrawable on demandwhich the securities used in the deposit end . However, loans held in its portfolio. Fourth, the unof the system are created, either to be used as like demand deposits, which derive their securities created by the SPV are sold by safety from deposit insurance, repo transac-collateral in a repo transaction or as invest-an underwriter, typically an investment tments for MMMFs. e processes described ions derive their safety from the underlying bank. Finally, the securities are bought by are a simple prototype of numerous ity that is the collateral on the loan. In the event of default on the loan, the lenderschematics involved in the creation of such retasecurities. In practice, the chains used in ins the right to sell the security in the open market and collect the proceedswarehousing, securitization and servicing . To enhance the safety of the transactionscan be signi cantly more complicated than , repos are overcollateralized—that is, the the illustrations given intermediation has moved from loan amount is typically less than the face value of the securities used as collateral. In an originate-to-hold model of traditional thbanking to an originate-to-distribute model is manner, overcollateralization imposes a “haircut” on the repoof modern securitized banking. Economist , a haircut that var-ies with the credit risk on the security put Gary Gorton argued in a book last year that up for coderegulation and increased competition in llateral. Naturally, haircuts on repo transactions using Treasury securities banking rendered the traditional model of are lower than habanking unpro table. In modern banking, ircuts using comparable private-label securorigination of loans is done mostly with a ities. eview to convert the loan into securities—a second alternative for cash-rich 10 The Regional Economist| October 2011
practice called securitization, whereby the signal the quality of those on upstream to all participating enti-transaction, processing and servicing fees e h and nal step of the process ties—administrator, aggregator and nally are the intermediaries’ principal source involves the purchase of securities by the to the originator of the loans. At each stage, of . e investor is then entitled to therefore, each participating entity relies on Figure 2 illustrates the process of convert-receive monthly payments of principal and the sale of the securities and loan docu-ing loan originations into nal securities. interest on the securities from the SPV in ments for revenue. In addition, almost all e starting point in this process is the origi-their order of priority. e order of priority of the participating entities require sources nation of loans such as auto loans, mortgages on the payment of principal and interest is of short-term funding. is can arise for and student loans by regulated commercial determined by payment rights accorded to two reasons. First, as described earlier, the banks and unregulated nance companies. investors, depending on the class or tranche maturity on the securities can be of a shorter Under the traditional model of banking, this of security certi cates purchased. e order length than the maturity of the loans, requir-loan would reside on a bank’s balance sheet, of payment is determined in advance and ing the entity to roll over the securities or use with the bank holding capital against the stated on the indenture (legal document) that short-term funds to pay investors. Second, loan. Under the securitized model of bank-circumscribes the deal of securities generated at each stage in the process of securitization, ing, the bank arranges to sell the loan. in the process. At this stage, the ultimate the need for short-term funding arises in the e second step of the process involves investors of such securities can hold them interval between the purchase of loans and warehousing the loan. is includes a ware-on their balance sheet, sell them or even use their subsequent sale downstream. house bank that purchases loans from one or them as collateral in a repo has also been observed that all of the more originators to form a pool of such loans. entities typically use a whole host of short-Is Shadow Banking Really Banking? e warehouse bank is also known as the term instruments, like nancial commercial e ve steps above describe the simplest aggregator, seller or sponsor. In some cases, paper, ABCP and repo transactions, to ful ll 11process of securitization by which securities this entity can be the same as the origina-their short-term funding requirements. To are created from originated loans. In some tor. Typically, this nancing occurs in the the extent that each entity uses short-term cases, segments of the process are repeated form of an extension of a line of credit from funding in the creation of assets (loans and to create more securities. Typically, the the warehouse bank to the originator of the securities) of longer maturity, these enti-class of securities issued depends on the loan (a nance company or a small commu-ties perform the functions of a bank. In maturity and type of underlying collateral nity bank) that closes on the loan with such this sense, individual entities of the credit funds. e loan documents are then sent downstream to the warehouse bank to serve The process transforms longer-term loans with signi cant as collateral for the line of risk into instruments of shorter maturity and of e third step in the process involves a sale of the pooled loans to an administrator, typi-considerably lower risk that are redeemable on a subsidiary of a large commercial or intermediation process ful ll the functions investment bank. e role of the administra-(loans originated upstream). For example, mof banking. tor is to purchase the loans from the aggre-ortgage-backed securities that are backed Moreover, the process as a whole trans-gator and create the special purpose vehicle by residential or commercial mortgages typi-forms longer-term loans with signi cant (SPV), which would nally hold the loans. cally have longer maturities than does asset-O credit risk (such as the origination of en, the administrator of the SPV receives backed commercial paper (ABCP) that is mortgages upstream) into instruments of a fee for services rendered. e SPV issues typically backed by loan receivables or credit 10shorter maturity and of considerably lower securities against loans held on its portfolio. card receivables. MMMrisk that are redeemable on demand (such as (See sidebar on Page 12.)Fs are among the principal investors e fourth step involves the sale of the in short-term ABCPinvestment shares in MMMFs). In so doing, . As mentioned above, MMMthe credit intermediation process as a whole securities created by the SPV. Almost Fs nance such investments with mimics the function of a bank. always, the securities are not sold directly by shares that can be redeemed on demand. On the administrator—the creator of the trust. the other hand, repo transactions employ Shadow Banking and the Typically, the administrator sells the cer-securities of longer maturity as collateral Financial Crisis of 2007-2008ti cates of the trust to the underwriter. e for short-term borrowings of cash. In both Given the discussion at the beginning underwriter, which is generally an invest-cases, the liability formed is theoretically ment bank, purchases all such securities wof this essay, an obvious corollary that fol-ithdrawable on demand and of shorter mlows is the fragility of the shadow banking from the administrator with the respon-aturity than the assets nanced. In this wsystem. In traditional banking, the fragility sibility of o ering them up for sale to the ay, the mechanics of the shadow banking originates in a run by the bank’s depositors. ultimate investors. Notably, the underwriter system typically resemble the functions of a In securitized banking, the run comes from can even retain some of these securities in commercial bank. its own portfolio. Retaining the riskiest In the creation of securities, the cash securities is o en viewed as a mechanism to proceeds from the sale of securities are continued on Page 13The Regional Economist| 11
The Special Purpose Vehicle Plays a Key Role in Shadow Bankinghe Special Purpose Vehicles (SPV) are often provide an implicit guarantee beyond as insurance against such risk. In addition, Ttypically organized as trusts to which the their contractual obligations to provide sup-investors can require credit enhancement seller/sponsor transfers the loan documents port to the SPV in the event of deterioration in (against credit risk on loans that may default) 13(receivables)—sometimes on a rolling basis. asset the form of a letter of credit from a bank The trust issues securities or trust certi cates, The conduit for securitization is formed by or insurance company. The entities providing which are then sold to investors. the SPV and various third parties that provide the liquidity and credit enhancements, as well Notably, SPVs are legal entities with no liquidity and credit enhancements to increase as administrative services, are external to the employees and no locations, merely created the marketability of the security certi cates SPV. It is possible that the administrator of the by the administrator to hold the pool of loans sold to investors (Figure 3). In some cases, the SPV is the same entity providing the liquidity and generate the securities. Technically, an maturity of the certi cates issued is shorter and credit enhancements. SPV is bankruptcy-remote; this implies that if than the maturity on the originated loans, Interestingly, the credit enhancements on the administrator (creator of the SPV) were to requiring the conduit to roll over maturing the securities can also be internally generated. enter a bankruptcy procedure, the administra-securities to pay off investors. Consequently, Two popular ways in which credit enhance-tor’s creditors cannot seize the assets of the investors are exposed to roll-over risk and ment is achieved are overcollateralization SPV. On the other hand, administrators will may require some form of liquidity provision and loan subordination (tranching). Overcol-lateralization is achieved when either the SPV purchases loans at less than face value or issues certi cates whose total program FIGURE 3 size is less than that of the value of the loans The Special Purpose Vehicle and Conduitpurchased or both. Seller/SponsorTranching is the process by which payouts on the obligations are sliced, or tranched, into LOAN DOCUMENTSclasses, whereby the highest (senior-most) class of securities has seniority of claim over subordinated securities. Accordingly, the more senior-rated tranches are less risky and gener-SECURITYSpecial CERTIFICATESally have lower yields and higher bond credit AdministratorPurpose Lratings than the lower-rated tranches. An SPV VehicleIQSUUIDPIPTOYmay sell tranches of various classes linked RTFEEby a waterfall structure—a term referring to Sloans that are paid sequentially from the most Liquidity Providersenior-rated tranches to most-subordinate Credit Enhancement Providertranches (Figure 4). It is important to note that the liquidity and credit enhancements on the securities can be provided by one or all of the methods stated sequence of payouts from the repay-FIGURE 4ment on loans determines the rating and Tranching of Securities in a Waterfall Structureliquidity of each class of securities. The lowest tranche is known as the equity tranche— LOWESTLASTLOWESTEXPECTED LOSSRISKYIELDbecause it refers to the practice whereby the administrator or underwriter retains this CLASS A TRANCHEtranche to mitigate problems of moral hazard Principal and adverse selection. However, this norm CLASS B Proceeds TRANCHE14has often been violated in practice. At the of PortfolioCLASS C peak of the recent nancial boom in the ., TRANCHEEQUITY underwriters were able to sell equity tranches TRANCHEFIRSto investors with appetites for high YIELDSequence of Payments12 The Regional Economist| October 2011FEESCREDIT SUPPORT
ENDNOTEScontinued from Page 11Brothers in September 2008. is led to a direct default on commercial paper issued 1, 2, 11, 14 See Adrian, Ashcra , Boesky and Pozsar. 3 the deposit end—the providers of whole-by Lehman Brothers, $785 million of which Strictly speaking, this description ts commercial banks, which along with thri institutions sale funding to the shadow banks. e two was held by the Reserve Primary Fund—one (savings and loans and credit unions) make up markets in which such runs are most likely of the largest MMMFs, with more than $65 the set of depository institutions in the . 4 In addition, credit intermediation involves are the repo market and the commercial billion in assets. Needless to say, the news “brokerage,” whereby the bank also reduces pre- paper market. of exposure triggered a run on this fund and post-contractual informational asymmetries e evidence on runs in the markets for and quickly spread to other MMMFs. To between the borrower and the lender. Note that this brokerage function is not necessarily wholesale funding demonstrated the parallel stem the run on MMMFs, the . Treasury exclusive to credit intermediation because many between traditional bank runs by depositors announced a temporary deposit insurance other intermediaries, such as used-car dealers, perform a similar function. For more, see work in the banking panics prior to 1934 and the covering all money market instruments only by Greenbaum and panic in credit markets that relied on three days a er the collapse of Lehman. 5 is key insight developed by Bryant and formal-wholesale funding. As wholesale funding ized in Diamond and Dybvig is arguably the most celebrated work in banking up for troubled shadow banks, they 6 See Diamond and forced to sell o assets in order to meet 7 See Wheelock and Wilson. 8 e reader may question the rationale liquidity demands of investors. Such a re See Morrison and White. 9 See Admati, DeMarzo, Hellwig and P of assets lowered thbehind the development of the shadow bank-e prices of assets 10 See Anderson and Gascon for details on MMMFs on siming system and all its components. While ilar collateral throughout the mar-and ABCPs. 12 e evidence is somewhat di erent for the tri-ket, raising the cost of fundinsome analysts have asserted that the shadow g for healthy party repo market. See Copeland, Martin and shadow banbanking system is redundant and ine -ks for details. 13 is trend wcient, it is not di cult to see the bene ts of as rst pointed out for the See Gorton and market in a ssecuritized banking. Securitization allows eries of papers that are REFERENCES for risk diversi cation across borrowers, summarized in work by Gorton. In the Admati, Anat R.; DeMarzo, Peter M.; Hellwig, Mar-inproducts and geographic location. In addi-terdealer repo market, a run occurred tin F.; and P eiderer, Paul. “Fallacies, Irrelevant primarily through increased htion, it exploits bene ts of both scale and aircuts on the Facts, and Myths in the Discussion of Capital 12scope in segmenting the di erent activities securities posted as collateral. In the case Regulation: Why Bank Equity Is Not Expensive.” Research Papers 2065, Stanford University oof credit intermediation, thereby reducing f some securities, especially those backed Graduate School of Business, troubled mortgage loancosts. Moreover, by providing a variety of s, the haircuts Adrian, Tobias; Ashcra , Adam; Boesky, Hayley; and wsecurities with varying risk and maturity, it Pozsar, Zoltan. “Shadow Banking.” Sta Reports ere close to 100 percent—implying that 458, Federal Reserve Bank of New York, July nancial institutions opportuni-these assets were no longer eligible for repo Anderson, Richard G.; and Gascon, Charles S. “ e transactions. An inties to better manage their portfolios than crease in the haircuts on Commercial Paper Market, the Fed, and the 2007-2009 Financial Crisis.” Federal Reserve Bank of the repo impwould be possible under traditional banking. lies an increased demand for St. Louis Review, Vol. 91, No. 6, November 2009, Finally, and contrary to popular belief, this collateral on the same loan or, conversely, a pp. 589-612. reduction in the suppform of banking increases transparency and ly of funds for a given Bryant, John. “A Model of Reserves, Bank Runs, and Deposit Insurance.” Journal of Banking and amoundisclosure because banks now sell assets that t of collateral. Since the supply of Finance, Vol. 4, No. 4, 1980, pp. otherwise be hosted on their opaque llateral in the entire shadow banking sys-Copeland, Adam; Martin, Antoine; and Walker, Michael. “ e Tri-Party Repo Market before the tem is xed over the shobalance run, this meant 2010 Reforms.” Sta Reports 477, Federal Reserve the shadow banking system that thIn summary, ere was a signi cant liquidity crunch Bank of New York, November be viewed as a parallel system—one that (shortfall in the supply of funds) and a steep Diamond, Douglas W.; and Dybvig, Philip H. “Bank Runs, Deposit Insurance, and Liquidity.” Journal is a complement to and not a substitute for rise in the cost of funding through repo of Political Economy, Vol. 91, No. 3, June 1983, traditional banking. e challenge going . , Gary B. Slapped by the Invisible Hand: ard is to harness the bene ts and mitigate In the case of funding through MMMFs, e Panic of 2007. Oxford University Press, risks and redundancies of such a parallel the panic was witnessed in two major Gorton, Gary B.; and Souleles, Nicholas S. “Special banking system. shocks to the commercial paper market in Purpose Vehicles and Securitization.” in Carey, Mark; and Stulz, René M. eds., e Risks of Finan-2007-2008. e rst shock came around cial Institutions. University of Chicago Press, 2007. July-August 2007 with the collapse of certain Greenbaum, Stuart; and akor, Anjan V. Contem-Rajdeep Sengupta is an economist and Bryan porary Financial Intermediation: Second Edition. nancial entities that had invested heavily J. Noeth is a research associate, both at the Elsevier, subprime mortgages. is led investors McCulley, Paul. “Teton Re ections.” PIMCO Global Federal Reserve Bank of St. Louis. For more on to question the quality of even highly rated Central Bank Focus, ’s work, see , Alan; and White, Lucy. “Crises and Capi- ABCP. As a result, the spread of ABCP over org/econ/sengupta/ tal Requirements in Banking.” American Economic the federal funds rate increased from 10 basis Review, Vol. 95, No. 5, December 2005, pp. , David C.; and Wilson, Paul W. “Explain-points before the shock to 150 basis points in ing Bank Failures: Deposit Insurance, Regulation, the days a er the shock. and E ciency.” e Review of Economics and e second and more severe shock Statistics, Vol. 77, No. 4, November 1995, pp. with the collapse of Lehman The Regional Economist| 13
