Edited by Julian Burling and Kevin Lazarus
Edited by Phoebus Athanassiou
Edited by Jerry Markham and Rigers Gjyshi
Iris H.-Y. Chiu and Iain G. MacNeil
‘Shadow banking’ refers to a range of activities that have bank-like character, that is, credit intermediation, liquidity and maturity transformation, and that are undertaken outside the regulated banking system. This can mean activities carried out by non-bank entities that mimic bank-like activities, but can also refer to activities carried out by banks and other regulated firms that do not always operate within the established fabric of regulation they are subject to. Although such activities may be seen as a form of financial innovation, the relationship between innovation and regulatory arbitrage remains uneasy. The former is often viewed more positively than the latter, although it is clear from history that the former has often driven the latter (for example, the emergence of the Eurobond market). The Financial Stability Board (FSB) has provided leadership in developing international surveys of shadow banking activity around the world and policy thinking to govern these areas. In 2013, the FSB set out in a policy document the need to consider how shadow banking activity affects financial stability, but its focus was inevitably on known areas whose risks have played out in the global financial crisis of 2007–09. The spotlight on these areas has nevertheless led to regulatory reforms in many parts of the world, discussions of which are canvassed in this volume, but issues remain outstanding in relation to the effectiveness and scope of reforms.
Hossein Nabilou and Alessio M. Pacces
This chapter deals with the economic rationale for regulating shadow banking. It discusses whether the regulatory initiatives proposed by academics and policymakers are consistent with this rationale. We posit that the ultimate goal of financial regulation is to promote financial stability. Therefore, we evaluate shadow banking regulation based on its ability to reduce financial instability efficiently. Regulating shadow banking is challenging because shadow banking is often defined by reference to what it is not, namely, licensed or official banking. However, such an approach does not capture the essence of the shadow banking problem. The official banking system has implicitly or explicitly supported a significant part of what is known today as shadow banking. For instance, the asset backed commercial paper (ABCP) conduits or the structured investment vehicles (SIV), which were exposed to the United States (US) housing market during the global financial crisis (GFC), all enjoyed guarantees by banks – so-called ‘put options’ – by way of contract or reputation. The remainder of shadow banking was still problematic for financial stability because of the contracts in which shadow banks were counterparty to banks. American International Group (AIG), for instance, was counterparty to a significant part of the banking system relying on credit default swaps (CDS) to insure against the default of mortgage-backed securities (MBS).
Iris H.-Y. Chiu
The interpretation of ‘shadow banking’ and the mapping of the shadow banking universe is the subject of much academic commentary and policy discussions. This is because ‘shadow banking’ is often used as a catch-all term to refer to financial activities and transactions that may not be subject to traditional realms of regulation, but the amorphous nature of the term is unsatisfactory for informing debates on regulatory perimeter and policy. Often, a ‘functional’ approach is suggested in order to understand the nature of financial activities and transactions that are lumped into the shadow banking category. The functional approach focuses on the economic function of the financial activity in question, regardless of the type of institution carrying it out. By looking at the economic function performed by the financial activity in question, one may better be able to ascertain the underlying demand and supply for such function and the risks that such functions give rise to, particularly whether systemic risk is implicated. The approach may also highlight the functional similarities and differences with already-regulated financial activity in order to form views as to the regulatory perimeter for shadow banking activities. The functional approach to shadow banking is therefore a prima facie useful approach to surveying the universe of shadow banking and informing the policy-making process in relation to shadow banking activities and transactions at national and international levels. This chapter however raises queries as to the limitations of the functional approach, and whether such limitations would ultimately hamper the development of regulatory policy. In particular, we question whether the functional approach is too embedded in market-liberal assumptions, and stymies imagination in regulatory design by converging upon ‘like-for-like’ analyses and applications. Further, we query whether the functional approach, though conceptually promising, is subject to the legal arbitrage that it seeks to overcome. Nevertheless, this chapter does not deny the achievements made by adopting the functional approach and suggests how it should be put to optimal use.
Two of the central features of the money markets and the wider shadow banking system are securitisation – the packaging up of loans and other assets into tradable securities – and maturity transformation – the financing of longer-term assets through short-term liabilities. Traders and investors use a number of investment vehicles and financial market instruments as techniques to structure these activities. Secured financing transactions (SFTs) are one of these techniques. Repurchase agreements – or ‘repos’ as they are commonly known – are the most widely used form of SFT, and have become a key source of money market liquidity. As financial innovation has proceeded apace, repos have evolved from what was essentially a ‘back-office activity in the 1990s, [to become] integral components of the banking industry’s treasury, liquidity and assets/liabilities management disciplines [as well as] an essential transaction used by central banks for the management of open market operations’ The rapid growth of repos may be understood as one consequence of evolving legal and regulatory structures which advantaged non-bank and off-balance-sheet credit intermediation; indeed, the switch in bank business models from asset to liability balance sheet management has been heralded as ‘one raison d’être for the shadow banking system’. Higher repo volumes are a symptom of this emergence, providing liquidity for risk-averse institutions which do not have access to central bank funding or insurance, and as a source of finance for leveraged intermediaries – particularly banks and brokerdealers – in wholesale funding markets. Today, inter-dealer repo markets have largely replaced unsecured money markets as the source and use of overnight funds.
Pierre de Gioia Carabellese
Securitizations affect the way a credit institution operates. Alongside structured finance, they allow a bank to free capital and transform risk management. Securitizations allow lenders to refinance a set of loans or assets via their conversion into securities. As the lender organizes a portfolio of its loans in different categories of risk also according to the risk appetite of each investor, the cash flows of the underlying loans represent the returns to the investors. However, structured finance transactions have been identified among the main culprits for the 2008 financial crisis. As such, these transactions may pose a considerable threat to the stability of financial markets. Thus, securitizations, the stereotypical transactions of this kind, have challenged the supervisory authorities, given the dearth of regulation in this area until a decennium ago. Nevertheless, securitization markets are still believed to provide operators with unique opportunities to raise finance through alternative funding and diversified funding sources.
The US tri-party repo market is one of the most active and liquid in global capital markets. Even more specialized than traditional repo, tri-party repo has often operated in the shadows of global finance. The US Federal Reserve, however, has helped make this market more transparent and less volatile than it has been in the past. This chapter discusses the history, size and characteristics of the US tri-party repo market. It then discusses the need for these changes and the current status of this important shadow banking product after many of these reforms have taken place. In particular, it also discusses the systemic risks both before and after the reforms to global financial markets. This reform process could also help serve as an important model for future reforms to other areas of shadow banking. Repo is often held up as one of the pillars of shadow banking, creating ‘additional sources of funding and offers investors’ alternatives to bank deposits’. Also, repo is often grouped with other shadow banking activities such as securitization and securities lending. These activities are accused of operating in the shadows of the banking system because the transactions themselves, and often the entities that enter them, typically are not subject to traditional banking regulation and disclosure requirements. Tri-party repo is often held up as particularly worrisome owing to the financial leverage that it can create and the possibility of runs on the shadow banking system during times of market stress.
This chapter sets out to explore the role of hedge funds in the context of sale and repurchase agreements (so-called ‘repos’) – an important and increasingly high-profile facet of the shadow banking universe. In this respect, the focus is on bilateral repos – that is, repo transactions which are negotiated and settled directly between two counterparties without the use of a ‘triparty agent’. Hedge funds are major players in such repos and these markets are widely regarded as being opaque. More pertinently, the chapter seeks to critically analyse the ways in which, within the context of repo transactions, hedge funds may trigger and, in turn, transmit ‘systemic risk’ by way of a so-called ‘repo run’ – either within the shadow banking system itself, or, in ways which adversely affect, directly or indirectly, the traditional banking sector.