PDF4Share

Shadow Banking

The rapid growth of the market-based financial system since the mid-1980s changed the natureof financial intermediation in the United States profoundly. Within the market-based financialsystem, “shadow banks” are particularly important institutions. Shadow banks are financialintermediaries that conduct maturity, credit, and liquidity transformation without access tocentral bank liquidity or public sector credit guarantees. Examples of shadow banks includefinance companies, asset-backed commercial paper (ABCP) conduits, limited-purpose financecompanies, structured investment vehicles, credit hedge funds, money market mutual funds,securities lenders, and government-sponsored enterprises.

Shadow Banking

Shadow banks are interconnected along a vertically integrated, long intermediation chain,which intermediates credit through a wide range of securitization and secured fundingtechniques such as ABCP, asset-backed securities, collateralized debt obligations, and repo.This intermediation chain binds shadow banks into a network, which is the shadow bankingsystem. The shadow banking system rivals the traditional banking system in the intermediationof credit to households and businesses. Over the past decade, the shadow banking systemprovided sources of inexpensive funding for credit by converting opaque, risky, long-termassets into money-like and seemingly riskless short-term liabilities. Maturity and credittransformation in the shadow banking system thus contributed significantly to asset bubbles inresidential and commercial real estate markets prior to the financial crisis.We document that the shadow banking system became severely strained during the financialcrisis because, like traditional banks, shadow banks conduct credit, maturity, and liquiditytransformation, but unlike traditional financial intermediaries, they lack access to publicsources of liquidity, such as the Federal Reserve’s discount window, or public sources ofinsurance, such as federal deposit insurance. The liquidity facilities of the Federal Reserve andother government agencies’ guarantee schemes were a direct response to the liquidity andcapital shortfalls of shadow banks and, effectively, provided either a backstop to creditintermediation by the shadow banking system or to traditional banks for the exposure toshadow banks. Our paper documents the institutional features of shadow banks, discusses theireconomic roles, and analyzes their relation to the traditional banking system.

The financial crisis of 2007-2009 is not unprecedented in the context of the banking crises of the free banking era. Over 100 years ago, the traditional banking system was an inherently fragile, shadow banking system operating without credible public-sector backstops and limited regulation. While there is some evidence that the creation of the Federal Reserve System as lender of last resort in 1913 lead to a reduction in the occurrence of bank runs, it did not completely eliminate them (see Friedman and Schwartz (1971)). It was only after four years of Depression that in 1933 federal deposit insurance was introduced through the Federal Deposit Insurance Corporation (FDIC), which ultimately transformed banking into a stable activity insulated from deposit runs. Credit intermediation involves maturity, credit, and liquidity transformation which can significantly reduce the cost of credit relative to direct lending. However, the reliance on short-term liabilities by banks to fund illiquid long-term assets is an inherently fragile activity that is prone to runs. As the failure of banks can have large, adverse effects on the real economy (see Bernanke (1987) and Ashcraft (2005)), governments chose to shield them from the risks inherent in reliance on shortterm funding by granting them access to liquidity and credit put options in the form of discount window access and deposit insurance, respectively. The presence of these put options, combined with the difficulty of accurately pricing them, creates well-known incentives for excessive leverage and risk-taking, and motivates the need for prudential regulation and risk limits.

Like the traditional banking system of the 1900s, the shadow banking system of the 2000s engaged in significant amounts of maturity, credit, and liquidity transformation, which made it just as fragile. In a further parallel, the run on the shadow banking system, which began in the summer of 2007 and peaked following the failure of Lehman, was only stabilized after the creation of a series of official liquidity facilities and credit guarantees: the Federal Reserve’s emergency liquidity facilities amounted to functional backstops of the steps involved in the credit intermediation process that runs through the shadow banking system, and the liabilities and mechanisms through which it is funded.
Meanwhile, the FDIC’s Temporary Liquidity Guarantee Program (TLGP) of financial institutions’ senior unsecured debt and corporate transaction accounts, and the U.S. Treasury’s temporary guarantee program of money market funds, are modern-day equivalents of deposit insurance. While today’s traditional banking system was made safe and stable through the deposit insurance and liquidity provision provided by the public sector, the shadow banking system—prior to the onset of the financial crisis of 2007-2009—was presumed to be safe due to liquidity and credit puts
provided by the private sector. These puts underpinned the perceived risk-free, highly liquid nature of most AAA-rated assets that collateralized credit repos and shadow banks’ liabilities more broadly. However, once private sector put providers’ solvency was questioned, even if solvency in some cases was perfectly satisfactory, confidence in the liquidity and credit puts that underpinned the stability of the shadow banking system vanished, triggering a run. Ultimately, a wholesale substitution of private liquidity and credit puts with official liquidity and credit puts became necessary to stop the run, but not before large portions of the shadow banking system were already gone.

Category : Banking
Website : www.newyorkfed.org
Download : 883 views times
Language : English
Size : 1 MB

Related EBook