Learn more about shadow banking

Shadow banking. The term naturally conjures up images of Wall Street high-rollers engaging in practices on the edge of legality.

“It’s an unfortunate term,” says Robert Dannhauser, head of Capital Markets Policy at the CFA Institute in New York. Shadow banking, he explains, is market-based financing; that is, credit intermediation that takes place outside the traditional banking system. Done properly, “it diversifies channels of credit, building competition with banks, which hopefully drives down the price of credit, which is good for economic growth.”

But it isn’t always done responsibly, he adds. At the centre of the 2008 meltdown was the collapse of a portion of the shadow banking system, and much regulatory effort has been expended since to make sure it doesn’t happen again.

Two experts tell the story of how shadow banking works, its role in the crisis, and what’s left of the system.

Robert Dannhauser

head of Capital Markets Policy at the CFA Institute, New York.

Traditional banking basics

“Banks are in the business of borrowing short and lending long,” notes Dannhauser. Customer deposits are short-term liabilities, the bulk of which the bank lends out for longer terms. For example, your chequing account balance is used to bankroll another customer’s mortgage loan, which is illiquid and can have a term longer than 20 years.

The bank is engaging in maturity and liquidity transformation: it takes a liquid demand deposit and sends it out the door as a long-term loan. But the bank is still on the hook for that original deposit. “So banks are levered institutions, multiplying the effect of each dollar that comes in,” says Dannhauser.

The ratio of capital to lending activity has been a regulatory sticking point, especially in recent years. The recent Basel Accords, notes Dannhauser, require a higher capital buffer, which diminishes the multiplier effect. That cuts into the bank’s profits, but makes the system more resilient and stable.

Shadow banking

Maturity and liquidity transformation are also key features of shadow banking, says Dannhauser.

Take money market funds, one of the more straightforward shadow banking vehicles. Investors contribute money with the expectation their investment is liquid. “It’s […] akin to a bank deposit,” notes Dannhauser. The people who manage money market funds take those dollars and invest them in longer-term securities, which are typically highly liquid. “They’re not […] making individual mortgages, but they are investing in longer-dated maturities, sometimes going out as long as a year.”

Perhaps the most notorious shadow banking vehicles are securitized bundles of underlying assets, such as mortgages. “Securitization isn’t terribly different in concept from what a money market fund does,” says Dannhauser. “It’s taking a package of fairly illiquid, longer-term […] assets and creating a security with interest in those assets, and then transforming the liquidity profile to allow investors to trade it freely.”

These vehicles are usually divided into tranches. Cash generated by the investment is distributed to each tranche differently. If you’re risk-averse and want first dibs, you’ll get a lower return. If you’re willing to take on more risk, buy into a tranche further down the ladder. The returns are higher, but there’s less assurance of getting paid (see “Consider distressed bonds for returns,” AER May 2015).

One of the main problems with these vehicles pre-crisis was their black box character. “You didn’t really know, beyond some descriptive statistics, what the underlying pool of mortgages looked like. You certainly didn’t have access to what the underwriting criteria for those borrowers looked like,” such as their income, credit history or general ability to repay the mortgage.

Investors were relying on what credit rating agencies were saying about these securities’ creditworthiness. Things turned sour when the underlying assets began to deteriorate. “The classic example is the mortgage borrower who walks away from the house and the mortgage,” he notes. “Some of those might have had government guarantees around [them], so there’s less impact to investors, but certainly there were a number of securities created around pools of mortgages that didn’t have public or private insurance guarantees, so there were very real losses that are then suffered by investors.”

Meltdown

Mortgage-backed securities grew to a fairly large part of the credit markets (see “U.S. MBS issuance, 2004-2014,”).

“Big institutional investors, including banks, insurance companies and pension funds […] held big slugs of those kinds of securities in their portfolios. As prices of those securities began to decline, representing the deterioration of the underlying assets, many of those institutions were forced to try to offload their positions.” The sell-off was necessary because these institutions, by regulatory mandate, are required to hold investments that meet a minimum quality threshold, which their mortgage-backed securities had plunged below.

“This created a glut of sell orders, and not that many buy orders, which drove the price down [further], which then reinforced more selling,” explains Dannhauser. That downward spiral then negatively impacted pricing of other asset classes with no intrinsic problems. Because of the sell order glut on low-quality mortgage investments, institutions needing to raise cash had to dip into the higher-quality parts of their portfolios, whether bonds or stocks. When that happened en masse, prices for those otherwise strong holdings tanked because a new sell-order glut was created. “There’s a procyclical effect [that] brings the whole market down.”

Investors who held those same high-quality instruments but didn’t need to sell (e.g., ordinary retail investors) were on the sidelines watching in horror, without necessarily knowing why their portfolios were tanking. “For the folks who aren’t selling, [they’re] still going to see the effects in [their] portfolios because all [their holdings] are getting marked down, reflecting the last sale price, which is being depressed because [of] this fire sale.”

Given its role in the crisis, it’s understandable that shadow banking has negative connotations. But it’s a mistake to dwell on this side of the story, suggests Dannhauser. That’s because shadow banking can bring much-needed capital to critical parts of the economy. He says that small- and medium-sized businesses often struggle to get financing through traditional bank channels; shadow banking can fill that void. “Probably the most prominent shadow banking vehicle for business financing would be hedge funds […]. So, rather than going to [a traditional bank] and sitting down with one of their loan officers, you might arrange for direct financing from a hedge fund, which will hold that debt as part of its portfolio.” Peer-to-peer lenders have sprung up, allowing hedge funds to fund individual borrowers.

Zoltan Pozsar

director of Global Strategy and Economics at Credit Suisse, New York.

How it all started

How did shadow banking start, and why? It was a matter of necessity, says Zoltan Pozsar, who has led research on the subject for the New York Fed and the IMF, and is currently director of Global Strategy and Economics at Credit Suisse in New York.

Ordinary people with excess cash can deposit their money in banks because it’s safe. “[In the U.S.] the deposit is insured by the FDIC, which is part of the government; currency is issued by the Fed, so insured amounts of money [are] a sovereign claim.” Problems arise for institutions with large amounts of cash. “Money doesn’t exist for you in a sovereign form,” says Pozsar, because if you’re a hedge fund or corporate treasurer, “you can’t put your hands on currency—[your money] is only electronic.” Even if you could, deposit insurance only covers $250,000. “So, if you put $1 billion in a bank deposit, [that] deposit is basically a credit-risky instrument because you face a lot of unsecured, undiversified credit exposure to a single bank.”

Institutions needed a safe place to park their money outside of the banking system, and that’s how shadow banking arose. Pozsar elaborates: “The safest thing that institutions can put their hands on is, basically, a Treasury Bill, because it’s issued by the government, so there’s no credit risk. It’s not quite as liquid as a bank deposit because you have to trade it, and prices can [fluctuate] a penny here, a penny there, so it’s not exactly a par instrument like a bank deposit or currency, but it’s very close.”

Problem: there was a massive gap between available Treasury Bills and the amount of money institutions needed to park. “Treasury Bill supply was $1 trillion and demand for safe short-term assets was $5 trillion. Basically, this difference is what was absorbed by the shadow banking system.”

Shadow banking is “money market funding of capital market lending,” says Pozsar, “That is distinctly different from the loans and deposits of banks. Lending, on a bank balance sheet, [creates] a loan on the asset side [and] a deposit on the liability side. Neither the asset nor the liability is tradable; it’s very institution-specific [and] very static.”

Money market funding of capital market lending, on the other hand, “is all about tradable claims. The assets we’re talking about are loans in the form of bonds, which are tradable; and the liabilities are not deposits but repos, negotiable CDs and things of that nature.”

Riddle of the SPHINX

The structure of the shadow banking system pre-crisis was complex beyond the comprehension of most—including the people immersed in it.

For proof, check out a 2010 research paper published by the New York Fed, titled “Shadow Banking,” Staff Report No. 458. It features a map of the shadow banking system so dizzyingly intricate it had to be miniaturized like microfilm to fit on the page. Here’s that map:

Reproduced from Tobias Adrian, Adam Ashcraft, Hayley Boesky, and Zoltan Pozsar, “Shadow Banking,” Federal Reserve Bank of New York Economic Policy Review, vol. 19, no. 2 (2013), available at http://www.newyorkfed.org/research/epr/2013/0713adri.html.

Shadow banking grew at a relentless pace between 2000 and 2008, says Pozsar. “The increase [went] hand in hand with the rise of […] asset managers, hedge funds, corporate cash balances, FX reserves, [etc.] As [they] rose, demand for short-term, safe instruments rose with them. The mix of instruments from the sovereign didn’t adjust, so the private sector innovated.” So, at one end of the spectrum are T-Bills, “which are great, but there [wasn’t] enough of them. Then, on the other extreme, are bank deposits, which in large amounts […] you don’t want to touch with a 10-foot pole. In the middle, you have things like repos and money market funds, which are not perfect, but they’re the best thing you can get in lieu of T-Bills and they’re far better than large chunks of concentrated exposure to banks.” It worked fine, Pozsar says, as long as the collateral used in the repo markets, and the short-term funding instruments that money market funds bought, were backed by good assets. The seeds of the crisis were planted when low-quality assets started to creep in. “When the credit risk of that collateral went from AAA to sub-[prime], there was a panic, and because of the panic you had the crisis.”

Pozsar notes there wasn’t even that much bad collateral floating around. “The volumes were not that big, but […] it doesn’t really matter how little the volume of bad collateral was in the system.” The reason: institutions were so thinly capitalized that big losses on a relatively small amount of bad collateral left them in tatters.

“That’s the funding side of the story,” says Pozsar. “The amount of repo financing [that] dealers raised to finance their own inventory was about 10% of total repo borrowing. So, the bulk of the volume in repo markets went to finance someone else, and that someone else was basically levered fixed-income investors.” The aim of these investors, which in many cases were hedge funds, was to give their clients equity-like returns with bond-like volatility. Those clients were mainly pension funds.

“Pension funds are underfunded, and they have this issue of, ‘If I keep [the money] in bonds, it’s safe but it doesn’t yield anything. If I put it in equities it’s going to yield a lot, hopefully, but it’s going to be very volatile. So, I’m trying to get the best of both worlds.’ ” That, says Pozsar, was “the happy state of the ecosystem in 2008, before it blew up.” Since then, the Fed has stepped in to do what the now-collapsed shadow banking system was originally created to do. “The demand [of] institutions [for safe short-term assets] is still there; it’s just that it’s the balance sheet of the sovereign and the Fed absorbing it. [The Fed’s] increased issuance of short-term paper has basically offset the collapse in dealer repo. So, as far as the safe asset shortage […] is concerned—problem solved.”

But there’s still plenty of disappointment to go around. “The people who used to rely on dealers for financing […] are just not able to do all of these levered fixed-income plays like they used to.”

Bottom line: the shadow banking system still exists, “but it’s a shadow of its former self,” says Pozsar. He says it’s shrunk by about 70% from its peak, thanks to the U.S. Treasury creating more T-Bills and the Fed pumping more reserves into the system.