Rise of Shadow Banking Seminar Reflection

Part I Summaries of the seminar

The seminar on “The rise of shadow banking” by Mr. Philippe Delhaise told us about some basic information of shadow banking, like definition, history, different appearances around the world, benefits and potential issues.

Definition

Before talking about shadow banking, we need to know about what is not shadow banking, or traditional banks. Traditional banks provide services like lending, payment, safekeeping of financial assets and so on. Traditional banks have strict regulations for two main reasons: one is to protect its depositors(depositors put their money in the bank instead of other place because they incapable to protect their assets or the transaction cost of traditional bank is relatively low compared with other institutions providing more secure service), while how much the bank can protect its depositors depends on many factors, such as, whether the bank itself is strong enough(whether it has enough reserves or strong backup), the deposit guarantees schemes or even whether the government will provide emergency aids to the banks. Another is to control the supply of money, which is also used by the central government to maintain its monetary policy. The governments want to control the supply of money because when bank lends out money, it will create a spiral of money. Once the government lose control of the supply of money, overheating in economy or inflation may occur (for too much money supply and too little money supply, respectively).

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Shadow banking does not mean underground banking or illegal transaction. There’re different definitions about shadow banking, simply speaking, shadow banking is some institutions lend money without being licensed to do so. The Financial Stability Board defined shadow banking as “credit intermediation involving entities and activities outside of the regular banking system”. That is, shadow banking provides channel without regulations from the government, or more market-based. The key difference between shadow banking and traditional banks is which party will take the financial risk when the borrower default.

Although shadow banking becomes a hot topic this year and the term was proposed in 2007 just as the financial crisis in USA was about to explode, it has been existing for many years. In contrast to the word “shadow”, it is visible in our daily life and legalized. The term is used to summarized the novel financial transactions in USA, like repurchase agreements and other securities products, which are also included in the services extended outside the traditional channel by the banks. Repurchase agreements transactions, or “Repo” in short, is one appearance of shadow banking that are familiar in USA and Europe. Compared with traditional commercial banking, the transaction costs is smaller and the efficiency is higher. Parties involved in the “Repo” specify the requirement on the collateral to maintain the transaction efficiency. For example, they use collateral instruments that can build liquidity, value fluctuation and risk profile easily so that they can save time cost or do not need to set up a new one next time. Standard collateral are also encouraged because it will reduce the cost to deal with collateral values maintaining issues and also help to reduce the risk of the lender. Reverse “Repo”. While in China, IOU (short for “I own you”) is one of the popular form of shadow banking. For example, company A cannot borrow money from banks easily because of its low credit while company B can borrow money from banks without difficulties though it has no need to borrow money. Then company B can still borrow money from banks and then lend it to company A with charges. As a result, company A can borrow money with higher interest rate but actually lower transaction costs. Although this kind of lending can help company A to develop, it still creates some risks due to lack of regulation. Firstly, company A may default the loan, which bring costs to the lending bank and the depositors in return because the bank does not intend to lend the money to company A with such low interest rate or transaction cost, or, the lending bank does not prepare well to deal with the default of company A with such low credit. Secondly, it may cause systemic risk. For example, using some payment that is off-balance sheet liability like acceptance draft will not be recorded to have impacts on monetary policy. Thirdly, systemic risk and other impacts can further result in losing control of money supply.

In conclusion, shadow banking brings both benefits and potential issues. Firstly, shadow banking may lower the transaction cost because in a free market, the cost may decrease to the equilibrium price. Secondly, it may help companies with little access to lend money in traditional way to raise funds and develop, which increase the efficiency for the whole society. Thirdly, increasing needs from credit risk management and liquidity risk also requires the development of shadow banking system.

However, potential issues cannot be ignored as well. For traditional banks, the rising of shadow banking actually threats their traditional services because of the relative higher transaction cost of traditional banks and maturity mismatches. Shadow banking itself also bring risks to unprofessional depositors and investors, especially those invest in wealth management products provided by traditional banks because those depositors and investors may not understand or be reminded that they need to take the financial risk themselves. Last but not least, government may also lose control of money supply, which has great impacts on the whole society as well.

Part II Analyzes and Discussions

Mr. Philippe Delhaise stands firmly that shadow banking brings more benefits than risks and he believes that there’s no need to put too many regulations on shadow banking system because the market can handle these kinds of problems. After doing some study of the benefits, potential risks and recommended regulation on shadow banking, I agree with Mr. Philippe Delhaise’s comment that shadow banking has more benefits and it will help the society to develop while I believe that necessary regulations are needed to prevent problems caused by potential risks.

Benefits of shadow banking

In “The Paradox of Shadow Banking”[1], Marcus Stanley listed the following benefits brought by the shadow banking system. Firstly, it allows the borrowers access to money besides regular banks, which is a much wider resource; secondly, shadow banking system provides different ways to transform illiquid assets to cash, which means more easier ways are provided; thirdly, investors can choose among risk-return tradeoffs products which have different scope and range according to their own tastes. In this way, more investors will be attracted to the market, which will boost the volume of available credits. Fourthly, the existence and development of shadow banking system also provides more professional services that are not (well) prepared by the regular banks. Such kind of functional diversification and specialization may help to improve the efficiency and better serve different clients. Last but not at least, with less regulations, more advanced technics may be well developed in the shadow banking system, which was also mentioned by Mr. Philippe Delhaise.

In “Shadows No More: The Shadow Banking System Steps Into The Spotlight”[2], Robert McNatt listed reasons behind lower transaction costs of shadow banking compared with regular banks: lower requirement on capital due to different regulations and market-driven requires.

Swati Ghosh, Ines Gonzalez del Mazo, and Inci Ötker-Robe raised the idea that shadow banking also serves as alternative funding when regular banking faced crsis, which in some way diversifies the risks in “Chasing the Shadows: How Significant Is Shadow Banking in Emerging Markets?”[3].

Potential issues/risks

However, potential risks cannot be avoided and that’s why necessary regulations are required. In [3], the lack of customer protection rules to limit rehypothecation of assets may lead to excess leverage, which will result in the excess of money supply; procyclicality caused by value fluctuations of assets may amplify the instability of financial system; lack of direct official support, the shadow banking system has difficulty in facing large-scale withdrawals; due to the complicated connection between shadow banking system and regular banks, failure of either side may cause disasters to the other; since regular banks extends their services to shadow banking service, they may try to transfer regulated service to avoid official regulation, which will make the regulation useless or even increase the risks because clients or other financial sectors believes that their services are under regulations.

Although the potential issues are obvious and dangerous, regulations on shadow banking is still at the startup stage compared to the fast development of shadow banking system. Here will list some regulations that are implemented in some developed countries that were discussed in “Risk Taking, Liquidity, and Shadow Banking: Curbing Excess While Promoting Growth, Chapter 2”[2].

[

Current regulations

USA:

1. prime institutional money market mutual funds will be required to transact at a floating net asset value and daily share prices float with the market-based value of their portfolio securities;
2. Hedge against retained credit risk portion are prohibited;
3. Banks are required to calculate assets of asset-backed commercial paper programs in their risk-weighted assets;

Europe:

]

Principle of regulations

The Financial Stability Board(FSB) proposed five general principles for regulators:

1. Focus: The regulation should target the potential risks that brought by shadow banking system. The regulator should also pay attention to whether the proposed regulations will cause other risks(noticed that shadow banking system itself was fuled by complicated regulations in traditional banks);
2. Proportionality:
3. Forward-looking and adaptable: Regulations should not be only designed to fix the current problem. It should be more flexible and able to fix the potential issues in the future. The regulation system should keep pace with the fast development of shadow banking system;
4. Effectiveness: Regulations are designed to avoid arbitrage opportunities that takes advantages of bugs in regulation system like differences between financial systems. It should avoid creating new bugs.
5. Assessment and review: Regulators should access the effectiveness and efficiency of the regulations, learn from other regulators and learn from the experience.

FSB also proposed 11 recommendations in 5 areas based on a detailed regulatory mapping exercise:

1. Regulations on bank’s interaction with shadow banking entities

Recommendation 1: Shadow banking services provided by banks should be included in its balance sheet and this rule should be applied internationally.

Recommendation 2: Keep exposure to shadow banking under a limited portion.

Recommendation 3: Make sure the risk brought by shadow banking services can be measured and recorded

Recommendation 4: Make sure the interaction between banks and shadow banking services is transparent

2. Regulatory reform of money market mutual funds(MMFs)

Recommendation 5: Further reform should be implemented

3. Regulation of other shadow banking entities

Recommendation 6: Should strengthen regulation on capital and liquidity for prudent purposes

4. Regulation of securitization

Recommendation 7: Enhance transparency requirement of securitization products

5. Regulation of securities lending and repos

Recommendation 8: Repos should be reviewed carefully for prudent purposes

6. Other recommendation

Recommendation 9: Enhance monitoring on shadow banking activities

Recommendation 10: Enhance underwriting standards

Recommendation 11: Weakening the role of credit rating agencies