Shadow banking is “money market funding of capital market lending”. Financial globalization and the revolution of modern finance are behind this. Shadow banking is a system has global funding, because it’s the global dollar money markets, of local lending, because the loans are originated for some local purpose. Very different from standard banking, prices are being generated for both money market and capital market. There are dealers who are quoting bid-ask spread, that is where the prices come from. Dealers are key in that they’re the ones who make liquidity.
Traditional Banking vs Shadow Banking
The traditional banking can be demonstrated using this balance sheet:
- The bank is just taking retail deposits from members of the community.
- The bank is also making retail loans to members of the community
- The bank is holding cash reserves, and capital buffer, so that’s the liquidity and the solvency backstop.
- If the bank run out of liquidity or solvency there’s a further backstop in the government:
- the Federal Reserve Bank is liquidity backstop, and
- the FDIC is capital backstop
However, we’re not in the world of traditional banking anymore. Shadow banking is everywhere and will be the future. Shadow banking can be considered as market-based credit.
The loan becomes RMBS (Residential mortgage-backed security), there are 3 entities between the loan and the deposits.
- The RMBS are divided into high / mid / low quality tranches.
- The high tranches are hold by shadow banks, and are used as collateral for money market funding (RP and ABCP).
- RPs are bought by MMMFs (money market mutual funds), who uses RPs as assets to fund “deposits”.
Instead of being retail, the shadow banking system is largely a whole-sale system. Nonetheless, it’s also maybe not local, a lot of this was abroad. The government backstop is not anywhere to be seen in the system. There is a kind of immature private liquidity backstops.
Immature Liquidity Backstops
The liquidity backstops are presented as Liquidity put in the balance sheets. It was kinda immature, because it was not a government liquidity backstop (the liabilities in the traditional banking system), but a private liquidity backstop (the assets of shadow banking system):
- Assets of shadow banks
- Liquidity put is the promise written in contract that in case you cannot issue RPs and borrow from a money market mutual fund, the bank will lend you whatever you need to roll that over
- Assets of money market mutual funds
- Typically MMMFs had some larger banking entity that was backstopping them, and it was a private backstop.
The government backstops are backstops for the traditional banks, which in turn were backstops for the non traditional banks. So indirectly the government was on the hook.
Immature Solvency Backstops
There’s a solvency backstop too, in fact in a way this was even more immature:
- RMBS are broken down into tranches.
- Shadow bank having the high tranche with money market funding (RP). The shadow bank is getting sort of capital put, by using CDS – if the high tranche falls in value, this credit insurance rises in value. It’s meant to ensure the solvency of the shadow bank. The
CDS on Hiis the contingent assets of shadow bank.
CDS on Hiis the liability of Insurance company (say AIG).
- An investment bank (say Lehman Brothers) is making a market in these CDSs. They have CDS on both sides of their balance sheet, but these things are going to move together.
There are other tranches that have to be placed somewhere in order to make this go:
- The mid tranche was held by a pension fund or an insurance company as an asset, and maybe they used CDS on Mid tranche as a way of controlling their risk.
- The low tranche being held by a credit hedge fund of some kind that’s taking big risk. And it’s controlling its risk by buying some CDS on that low tranche.
|Pension / Insurance|
|CDS on Mid|
CDS on Lo
CDS on Mid
CDS on Low
Well, we know what happened, Lehman (the investment bank) went away. AIG (the insurance company) went away and the prices went into free fall. All these different balance sheets and everything interacted in ways that nobody kind of even understood how they were all connected until it all collapsed.
These immature liquidity backstops and immature solvency backstops proved their immaturity by basically collapsing under stress. Everything drops onto the balance sheet of the Fed. The fed tripled its balance sheet, more or less, overnight after Lehman and AIG.
Global Banking and Modern Finance
The shadow banking system was essentially tapping a global funding market. If a country wants to spend more than its domestic savings in order to develop its economy, it can tap those global funding markets, make loans, and develop its economy. However the country is taking exchange risk, since it is lending in local currency, but it is borrowing in dollars.
Shadow banking is exactly tapping that global funding system, because shadow banking eliminates the foreign exchange risk. Understanding that helps you now understand why the crisis of the shadow banking system was a global crisis. It was a crisis because it immediately affected the global funding system.
Shadow banking was taking advantage of some developments that are really relatively recent. First is securitization, which cam with financial globalization. Further, the development of global capital markets, where we have the development of derivatives markets for moving the risk around.
Conceptually you could imagine that modern financing would be like this:
- Shadow bank is holding RMBS, funding them in the money market, stripping out all the risk using derivatives. That’s basically like a quasi-treasury bill, for which you should be able to finance in the money market without risks involved in that.
- On the other side, an asset manager can get exposure (for his customer’s capital) to risk return, not by holding any risky assets, but entirely with derivatives. A long position in derivatives and exposure to risk is equivalent to outright holding of the residential mortgage backed securities, it’s equivalent.
So in this over-simplified example of shadow banking, all the risk is transferred, just by stripping the risk out and moving it over to others..
|Capital funding bank|
|Global money dealer|
(CDS, IRS, FXS)
|MM funding||MM funding||“deposits”||“deposits”||Capital|
(CDS, IRS, FXS)
Thinking about regulating the shadow banking system of the future:
- Key players in market-based credit system are money dealers and derivative dealers, not shadow banks per se.
- Distinguish between the matched book dealers and the proprietary dealers (the speculative dealers). Focus on liquidity for the matched book dealers and capital for the proprietary ones.
- The survival constraint is not just about payment flows but also about collateral flows.
Three World Views
|Money view||The present determines the present.|
Cash flows emerging from past production meet cash commitments engaged with an eye on future production, and the balance or imbalance between the two poses the problem that is solved every day by the monetary apparatus.
|Economics view||The past determines the present.|
Current flow of goods being produced is the consequence of capital investments made over many generations in the past.
|Finance view||The future determines the present.|
Current capital values are a consequence of ideas about future income flows, which we discount back to the present.
The steps from the finance view to the money view:
- Appreciate that market liquidity, by which we mean the ability to buy or sell without moving the price in volume fast, depends on the dealer system.
- The ability of dealers to provide market liquidity depends on their own funding liquidity, their own capital also.
- Ultimately, the ultimate source of funding liquidity is the central bank.
Banking system has selective control over liquidity allocation, who gets spending power and who does not get spending power. This is a tremendous power. The banking system selective control is about choosing whether to discipline or elasticity for individuals and for the economy as a whole.
For more on Shadow Banking, please refer to the wonderful course here https://www.coursera.org/learn/money-banking
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