Download 1 shadow banking

Roberto Perotti
October 05, 2016
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1 SHADOW BANKING
THE SHADOW BANKING SYSTEM OF FINANCIAL HOLDING COMPANIES
1.1.1
The move to a originate-to-distribute, fee-based, wholesale-funded banking model
The model of the banking system macroeconomists have traditionally studied is as follows. It is
based on commercial banks, that fund themselves through deposits and some capital, use these funds to
extend loans which they hold until maturity, and earn money because of the difference between the rate
of interest on deposits and on loans. Thus, the model has four main characteristics:
deposit-funded;
credit-risk intensive (I.e., based on loans);
hold-to-maturity;
spread-based;
In recent decades, however, there has been a move to a system in which banks but also, and
importantly, other financial institutions fund themselves not only through deposits but also in the
wholesale money market of commercial paper and repurchase agreements (more generally, wholesale
funding is the funding of any financial institution through the sale of money market and longer-term
debt instruments); they invest the proceeds not only in individual loans but in securitized products; they
do not hold the loans to maturity but they securitize them and sell them as packages; and earn money
through the many fees involved in the process. Thus, this new model has the following four
characteristics:
wholesale funded in the money market;
less credit-risk intensive; more market-risk intensive (i.e. less based on loans, more on securitized
products) ;
originate-to-distribute (i.e., loans are securitized and sold as securities)
fee-based process.
In what follows, we will look at how this changes in the system of financial intermediation have
also radically altered the transmission of monetary policy and the tools that monetary authorities need to
use.
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1.1.2
The creation of financial holding companies
The main driver has been the quest for a higher return on equity, via higher and higher leverage,
achieved by incorporating intermediaries that are subject to less restrictive regulation of capital than
commercial banks..
To achieve this, banks became Financial Holding Companies (FHCs) that by acquiring brokerdealers and asset managers, could transform their traditional process of hold-to-maturity, spreadbanking to a more profitable process of originate-to-distribute, fee-banking. The FHC concept was
legitimized by the abolition of the Glass-Steagall Act of 1932, and codified by the Gramm-Leach-Bliley Act
of 1999.
The genesis of the FHC concept can be traced back to the gradual erosion of banks’ “specialness”
since the 1970s on both their asset and liability sides.
This erosion occurred due to the entry and growth of an army of specialist non-banks since the
late-1970s into the businesses of (1) credit intermediation (for example, finance companies) and (2)
retail and institutional cash management (for example, money market mutual funds). Money market
mutual funds differed from banks because they offered shares instead of deposits, hence they could
evade Regulation Q, that forbade banks from remunerating deposits. However, investors in a money
market mutual fund could write a check on his holdings in the MMMF, hence a MMMF had all the
advantages of liquidity of a deposit without the disadvantages of Regulation Q. In addition, MMMF had
less stringent capital requirements (could achieve higher leverage than banks), thus allowing higher
returns in good times. Because the invested in commercial paper, which was considered a safe
investment, they were perceived as very safe by investors.
Combined with the high costs and restrictions imposed by regulators on banks, growing
competition from specialist non-banks like MMMF put increasing pressure on banks’ profit margins.
Banks dealt with these pressures by starting to acquire these specialist non-bank entities, and gradually
shifted many of their activities related to credit intermediation into these newly acquired, lessregulated, non-bank subsidiaries—or shadow banks.
Eventually, what was regulated, restricted and “innovated” out of the banks found its way back
into them through these acquisitions
More and more banks originated loans with the intention of selling them instead of holding
them to maturity. This was done by involving a number of intermediaries that allowed FHC-affiliated
banks to lend with less capital than if they had retained their loans on their balance sheets. This
improved the RoE of holding companies.
1.1.3
How shadow banking works in practice
In practice, the move to a originate-to-distribute, fee-based, wholesale-funded banking model is
accomplished through several steps. Here is an example, although in practice one can obviously have
several variations on this.
Step1: Loan origination by commercial banks, finance companies etc.
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A commercial bank (which funds itself through deposits) of a FHC issues mortgages (which can be
comforming or non-comforming, or even a subprime mortgage); a finance company (which funds itself
through commercial paper) of a FHC issues an auto loan or a consumer loan.
Step 2: Loan warehousing by conduits.
These various types of loans are acquired by special purpose vehicles called single and multiseller conduits. These acquire the loans from the originators and pay for them by issuing asset backed
commercial paper. Thus, these conduits fund themselves on the wholesale market of commercial paper.
Step 3: Securitization, by issuance of Asset-Backed Securities (ABS) by Special Purpose Vehicles.
After an accumulation period in the conduit, described above, these warehoused loans are
taken out of the conduit and put in a Special Purpose Vehicle to back an Asset Backed Security. Thus, the
SPV funds itself via this ABS, in addition to the repos.
(NB: as we have seen in a previous chapter, a SPV is a “bankruptcy remote” entity in the sense
that the originator of the underlying loans cannot claw back those assets if the originator goes bankrupt.
Thus, it protects the investor in ABS from bankruptcy of the originator or the warehouses (the conduit)).
Step 4: ABS warehousing by conduits.
Like the loans in step 2, the ABS thus created are then warehoused: they are bought by conduits,
that fund themselves via repos or Asset backed commercial paper, where the ABCP is now backed by the
ABS instead than the pool of loans like in step 2. Thus, a ABS warehouse is maturity-mismatched. Because
the ABCP on its liability side is a short-term, money market instrument, while the ABS on its asset side is a
long-term instrument.
Step 5: CDO issuance by Special Purpose Vehicles.
The process restart to produce CDOs. The warehoused ABSs produced in step 4 are taken out of
the warehouse and put into another SPV that produces CDOs out of them. Thus, this SPV funds itself via
CDOs and repos. In further steps, other SPVs could create CDO2 etc.
Step 6: ABS and CDO intermediation by Structured Investment Vehicles
These ABS and CDO are bought and sold by a variety of intermediaries, including Structured
Investment Vehicles (vehicles created by FHCs, which retain dome of the tranches of ABSs and CDOs)
(SIVs), credit hedge funds, limited purpose finance companies (LPFCs), all of which fund themselves
wholesale with a variety of instruments including repos, commercial papers, ABCP, medium term notes
(MTNs) etc.
Step 7: Wholesale funding by Money Market Mutual Funds.
Underlying the whole system are money market mutual funds that fund shadow banks through
short-term repos, commercial paper, ABCP instruments and MTNs sold by the intermediaries listed above.
Note several important features of this process
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1. The shadow banking system
The participants in this intermediation process are called the “shadow banking system”. Its main
characteristic is that most of them do not have access to guarantees by the state nor to central bank
liquidity (the discount window). The commercial banks that enter in the traditional treatment of
monetary policy transmission have access to deposit insurance and to the discount window. All the other
entities that enter the process illustrated above do not.
We define as shadow banks those financial entities that engage exclusively in shadow credit
intermediation, i.e. those financial intermediaries that do not have access to central bank liquidity or
public sector credit guarantees.
2. The role of FHCs
The process of lending and credit intermediation is no longer reliant on banks only, but on a
process that spanned a network of banks, broker-dealers, asset managers and shadow banks—all under
the umbrella of FHCs.
Thus, whereas a traditional bank would conduct the origination, funding and risk management of
loans on one balance sheet (its own), an FHC would:
1) originate a loan in its bank subsidiary
2) warehouse the loans in an off-balance sheet conduit that is managed by the broker-dealer
subsidiary of the FHC, is funded through the wholesale funding market, and is implicitly guaranteed by
the liquidity of the bank
3) securitize the loans via the broker-dealer subsidiary, by transferring them from the conduit to
a bankruptcy-remote SPV
4) fund (retain) the safest tranches of the structured credit assets in an off-balance sheet ABS
intermediary (like a SIV), managed by the asset management subsidiary of the FHC, funded through
the wholesale funding market, and backstopped (guaranteed, although only implicitly) by the bank.
(Note that the just described credit intermediation process does not refer to the “life-cycle” of a
pool of loans originated by an individual FHC’s bank—legally, a self-originated loan pool could not pass
through this process. Rather it refers to the processing and intermediation of loans originated by third
parties on a system-wide level. )
3. The role of the commercial bank subsidiary of FHCs.
Although a bank subsidiary’s only direct involvement in an FHC’s credit intermediation process is
at the loan origination level, its indirect involvements are broader, however, as it acts as a lender of last
resort to the subsidiaries and off-balance sheet shadow banking entities (conduits, SPVs, SIVs) involved in
the warehousing and processing of loans and of structured products, in case these shadow banking
entities cannot obtain funds in the wholesale market. Also the commercial banks often provided implicit
guarantees in the form of backup liquidity lines from banks for ABCP issuers, like conduits and SIVs, i.e.
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the entities that warehouse loans or ABS or that intermediate ABS. Finally, commercial banks are involved
in the distribution of structured credit securities.
The end result is from deposit-funded, hold-to-maturity lending by commercial banks, to
wholesale-funded, securitization-based process by shadow banks.
4.The Federal reserve discount window
Despite the fact that FHC’s credit intermediation process depended on at least four entities other
than the bank, only the bank subsidiary of an FHC had access to the Federal Reserve's discount window
and benefited from liability (deposit) insurance from the government, but not the other subsidiaries or
their shadow banks.
5. Wholesale funding
Like in traditional banking, there are three actors in the shadow banking system: savers,
borrowers, and non-bank financial intermediaries, or shadow banks.
But unlike in traditional banking system, savers do not place their funds with banks, but with
money market mutual funds, which then invest these funds in the liabilities of the shadow banks, which
offer a wide spectrum of seniority and duration. Borrowers still get loans, leases and mortgages, but not
only from depository institutions, but also from entities like finance companies.
6. The maturity and (seeming) risk transformation operated by the shadow banking system.
Through this process, risky, long-terms loans (like subprime mortgages) are transformed into
seemingly risk-free, short-term instruments, like the $1, stable NAV shares issued my MMMFs, which
are withdrawable on demand, like a demand deposit by a bank.
1.1.4
The serial vs parallel nature of FHS, and the role of capital requirements
This interpretation of the workings of FHCs is radically different from the one that emphasizes the
benefits of FHCs as “financial supermarkets”. According to that widely-held view, the diversification of
the holding companies’ revenues through broker-dealer and asset management activities makes the
banking business more stable, as the holding companies’ banks, if need be, could be supported by net
income from other operations during times of credit losses. In the present interpretation, instead, the
broker dealer and asset management activities are not parallel, but serial and complementary activities to
FHCs’ banking activities.
The serial as opposed to parallel nature of the linkage between the broker-dealer and asset
management subsidiaries and the commercial bank subsidiary within an FHC is not necessarily bad, and
neither is the credit intermediation process described above. However, they became bad (in some cases),
as capital requirements to manage these linkages and conduct the process prudently were
circumvented through three channels of arbitrage. These were:
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(1) cross-border regulatory systems arbitrage,
(2) tax and economic capital arbitrage, and
(3) ratings arbitrage.
Cross-border regulatory arbitrage. For instance, many European banks including the German
Landesbanks were involved at the stages of loan warehousing, ABS warehousing, and ABS
intermediation (steps 2, 4 and 6 above) because of favorable capital treatment of investment in AAA
CDOs. So their role in shadow credit intermediation was limited to loan warehousing, ABS warehousing
and ABS intermediation, but not origination or structuring.
Thus, as major investors of structured products “manufactured” in the U.S., European banks, and
their shadow bank offshoots were an important part of the “funding infrastructure” that financed the U.S.
current account deficit
But at least two problems:
1) While these banks had access to ECB funding, it was in euros, not in dollars. They had to swap
these into dollars, but in times of troubles counterparts are unwilling to do so.
2) There was only an implicit insurance of the liabilities of European shadow banking activities
Regulatory, tax and economic capital arbitrage. As we have seen, SPV can have a more
advantageous tax and capital treatment than other entities.
Rating arbitrage. By creating SPV, which is legally isolated from its parent company, an FHC can
get a better rating for its products.
THE SHADOW BANKING SYSTEM OF INVESTMENT BANKS
Diversified broker-dealers (DBDs), or investment bank holding companies, (the pre-crisis group of
the five broker-dealers Bear Stearns, Goldman Sachs, Lehman Brothers, Merrill Lynch and Morgan
Stanley) imitated the same arrangements. However, it was less of a product of regulatory arbitrage, and
more a product of vertical integration. DBDs acquired lending platforms (finance companies) and asset
management units in order to vertically integrate their securitization businesses (from origination to
funding).
However, in the absence of limits on their leverage, DBDs conducted these activities at much
higher multiples of leverage than FHCs.
The credit intermediation process of DBDs is similar to that of FHCs with three main differences:
1) In step 1, since broker-dealers did not have commercial bank subsidiaries, they originated
loans from their industrial loan company (ILC) and federal savings bank (FSB) subsidiaries, and in turn,
from their ILCs’ and FSBs’ finance company subsidiaries. This because ILCs and FSBs were the only forms
of depository institutions (traditional banks) that DBDs could own without becoming FHCs.
2) Still in step 1, DBDs were particularly important originators of subprime and non-conforming
mortgages, commercial mortgages and leveraged loans.
3) In step 6, DBDs did not have securities arbitrage conduits and SIVs, but instead used internal
credit hedge funds, trading books and repo conduits. Partly due to this reason, DBDs’ intermediation
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process was more reliant on repo funding than that of FHCs’, which relied on a relatively even mix of
commercial paper, ABCP, Medium Term Notes (i.e., medium term debt), as well as repos.
THE SHADOW BANKING SYSTEM OF GOVERNMENT-SPONSORED ENTERPRISES
Historically, the first examples of shadow bank intermediaries are the Federal Home Loan Bank 1
system created in 1932, Fannie Mae, created in 1938, and Freddie Mac, created in 1970.
These Government Sponsored Enterprises (GSEs) have dramatically changed the way banks fund
themselves and conduct lending: the FHLBs were the first providers of what we call today the term
warehousing of loans, and Fannie Mae and Freddie Mac were cradles of the originate-to-distribute
model of securitized credit intermediation.
In fact, the GSEs were the first to adopt these four techniques:
1) loan warehousing, provided by the FLHBs
2) originate-to-distribute securitization provided for banks by Freddie Mac and Fannie Mae,
which created mortgage-backed securities (MBS) that they sold to banks. Note that GSEs are not involved
in loan origination (they were prohibited from doing so: they were meant to create a national secondary
market for mortgages ), only in loan processing and funding
3) maturity transformation provided through the GSE retained portfolio, which was essentially a
quasi-government SIV. In fact, one can interpret GSEs as off balance sheet shadow banks of the federal
government: like private sector SIVs, they retained a part of the MBSs created by the GSE and funded this
portfolio through agency securities implicitly guaranteed by the federal government)
4) Wholesale funding. Unlike banks the GSEs were not funded using deposits, but through
capital markets, where they issued short-term agency debt securities to money market investors, such
as money market mutual funds, and long-term agency debt securities to investors like fixed income
mutual funds, respectively. The funding “utility” functions performed by the GSEs for banks and the way
they funded themselves were the models for what we refer today to as the wholesale funding market.
From Wikipedia: The 12 banks of the FHLBank System are owned by over 8,100 regulated financial
institutions from all 50 states, U.S. possessions, and territories. Equity in the FHLBanks is held by these
owner/members and is not publicly traded. Institutions must purchase stock in order to become a member. In
return, members obtain access to low-cost funding, and also receive dividends based on their stock ownership. The
FHLBanks are self-capitalizing in that as members seek to increase their borrowing, they must first purchase
additional stock to support the activity. The mission of the FHLBanks reflects a public purpose (increase access to
housing and aid communities by extending credit to member financial institutions), but all 12 are privately
capitalized and, apart from the tax privileges, do not receive taxpayer assistance.
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PRIVATE INSURANCE TO THE SHADOW BANKING SYSTEM
FHCs and DBDs were highly reliant on private sector insurers in their abilities to perform
originate-to-distribute securitizations. These insurers included mortgage insurers, monoline insurers,
certain subsidiaries of large, diversified insurance companies, credit hedge funds and credit derivative
product companies.
Different entities correspond to specific stages of the shadow credit intermediation process.
- mortgage insurers specialized in insuring whole mortgage loans;
- monoline insurers specialized in insuring ABS tranches (or the loans backing a specific ABS
tranches);
- large, diversified insurance companies, credit hedge funds and credit derivative product
companies specialized in taking on the risks of ABS CDO tranches by selling CDS. CDS were also used for
hedging warehouse and counterparty exposures. For example a broker-dealer with a large exposure to
subprime MBS that it warehoused for an ABS CDO deal in the making could purchase CDS protection on
its MBS warehouse.
Effectively, these private insurers absorbed the tail risk out of the loan pools that were processed
through the shadow banking system, turning the securities that were enhanced by them into credit-risk
free securities (at least as far as investors’ perception of them went).
Obviously, as the case of AIG shows, they were credit-risk free only in so far as the insurer itself
was solvent.
FUNDING THE SHADOW BANKING SYSTEM
The shadow banking system relies on the issuance of money market instruments (such as CP,
ABCP and repo) to money market investors (such as money market mutual funds) for funding, as well as
the issuance of longer-term medium-term notes (MTNs) and public bonds to medium- to longer-term
debt investors (such as securities lenders, pension funds and insurance companies).
The funding of any financial institution (banks, non-banks, the GSEs and shadow banks) through
the sale of money market and longer-term debt instruments is called wholesale funding. The wholesale
funding market is a broad term that includes the bank-to-bank subset called the interbank market. By and
large, wholesale funding refers to the funding of the shadow banking system.
1.5.1
The borrowers of wholesale funds
The market for debt securities with a maturity of up to 13 months or less is generally referred to
as the money market. The universe of money market borrowers can be divided into three groups.
(1) non-financial borrowers
(2) agency (that is, GSE) borrowers
(3) financial borrowers.
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(1) Non-financial borrowers include nonfinancial corporations that issue non-financial
commercial paper; the U.S. Treasury, which issues Treasury bills; and state and local governments, which
issue short-term municipal bonds. Their liabilities are usually unsecured.
(2) Agency borrowers include the GSEs Fannie Mae, Freddie Mac and the FHLB system (or the
government-sponsored shadow banking sub-system), which issue agency discount notes. The GSEs’
motivations to borrow in money markets on a short-term basis include, for example, bridging the cashflow gap between purchasing and securitizing mortgages.
(3) Financial borrowers include money center banks, broker-dealers and private (that is, nonGSE) shadow banks. Unlike the money market instruments issued by non-financial and agency borrowers,
which are unsecured liabilities, the money market instruments issued by these financial borrowers are
either unsecured or secured. Unsecured wholesale money market instruments include large brokereddeposits, Eurodollar deposits and commercial paper (CP). Secured wholesale funding sources include
asset-backed commercial paper (ABCP). ABS and ABS CDOs also serve as collateral in repo agreements,
which were another major form of short-term secured funding technique in money markets.
Money center banks and broker-dealers typically “tap” into money markets for funding either
through CP or repo, while shadow banks rely on all the above money market instruments for funding.
Traditionally, money markets helped borrowers bridge short-term cash flow mismatches. Starting
in the 1980s, however, the mix of assets financed by money markets shifted away from mainly shortterm assets (such as trade receivables, credit card loans) whose funding involves only minimal maturity
transformation, to longer-term assets (such as 30-year, subprime mortgages), whose funding by money
markets involves considerable amounts of maturity transformation.
The reason is the threat posed to banks as credit intermediaries by diversified broker-dealers
through the latter’s innovative use of term securitization techniques. To counter the threat from brokerdealers, banks turned to the development and use of short-term securitization techniques such as offbalance sheet ABCP conduits to maintain their share of business, which at the same time also helped
them avoid capital requirements.
Thus, through this competition, the average maturity of loans funded in money markets
lengthened over time, and the volume of credit intermediated through short-term securitizations grew to
rival the volume credit intermediated through long-term securitizations.
Ultimately, it was the embedded rollover risks inherent in funding long-term assets through
short term securitization sold into money markets that triggered the run on the shadow banking system.
1.5.2
Backstopping the shadow banking system
A special feature of wholesale funding markets—and hence the funding of shadow banking
system—is that it intermediates predominantly institutional cash balances, such as those of
corporations, institutional investors and municipalities. In contrast, the traditional banking system is
more reliant on retail cash balances for funding (in the form of retail deposits)
Institutional cash balances are well-informed, herd-like and fickle, and as such, any entity, vehicle
or activity that relies on them for funding is an inherently fragile structure.
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As the crisis has shown, private insurance (in the form of CDSs) and credit lines from parent
banks (both of which provided enhancements to SPVs and SIVs that would secure them AAA rating) were
ineffective substitutes for deposit insurance, as the providers of these guarantees and insurance were
themselves contaminated during the crisis and scrambled for liquidity.
In the wake of Lehman’s collapse the Federal Reserve provided direct support to the broader,
non-bank and non-broker-dealer-affiliated parts of the shadow banking system.
Indeed, the Federal Reserve’s 13(3) emergency lending facilities that followed in the wake of
Lehman’s bankruptcy amount to a 360º backstop of the functional steps involved in the shadow credit
intermediation process. The facilities introduced during the crisis were an explicit recognition of the need
to channel emergency funds into “internal”, “external” and government-sponsored shadow banking subsystems.
Steps 1 and 2: the Commercial Paper Funding Facility (CPFF) is a backstop of the CP and ABCP
issuance of loan originators and loan warehouses
Step 3: the Term Asset-Backed Loan Facility (TALF) is a backstop of ABS issuance;
Step 4: Maiden Lane LLC was a backstop of Bear Stearns’ ABS warehouse, while the Term
Securities Lending Facility (TSLF) was a means to improve the average quality of broker-dealers securities
warehouses by swapping ABS for Treasuries;
Step 5: Maiden Lane III LLC was a backstop of AIG-Financial Products’ credit puts on ABS CDOs);
Step 6: Term Auction Facility (TAF) and the FX swaps with foreign central banks were meant to
facilitate the “onboarding” and on-balance sheet, dollar funding of the ABS portfolios of formerly offbalance sheet ABS intermediaries—mainly SIVs.
Step 7: the Primary Dealer Credit Facility (PDCF) was a backstop of the tri-party repo system
through which MMMFs and other funds fund broker-dealers in wholesale funding markets overnight.
AMLF and the Money Market Investor Funding Facility (MMIFF) served as liquidity backstops of regulated
and unregulated money market intermediaries, respectively.
Similarly, the FDIC’s Temporary Liquidity Guarantee Program (that covered the senior unscured
debt of various bank and non-bank financial institutions, and the deposit transaction accounts of
corporations) were also backstops to the funding of the shadow banking system, and are all modern-day
equivalents of deposit insurance.
Finally, backstops of the government-sponsored shadow banking sub-system included the large
scale purchases of agency MBS and agency debt by the Federal Reserve, with these purchases effectively
amounting to the funding of the activities of Fannie Mae, Freddie Mac and the FHLBs. Backstopping the
government-sponsored shadow banking sub-system did not require building facilities, since as OMOeligible collateral, the Federal Reserve could purchase agency MBS and agency securities outright.
REFERENCES
Z. Pozsar, T. Adrian, A. Ashcraft, and H. Boesky “Shadow Banking”, Federal Reserve Bank of New
York Staff Reports No 458, July 2010
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A. Ashcraft and T. Schuermann: “Understanding the Securitization of Subprime Mortgage Credit”
Federal Reserve Bank of New York Staff Report No. 318, March 2008
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