Shadow banking

NOTRE  DAME  UNIVERSITY  –  LOUEIZE                                                                                                                        Faculty  of  Business  Administration  &  Economics                                Department  of  Accounting,  Finance  &  Economics  

ECN  431  –  International  Economics  

Shadow  Banking

Mechanisms,  Development,  Role,  Advantages  &  Risks  Submitted  to:  Dr.  Louis  HobeikaSpring  2014  

Prepared  by:  Mansour  Assaf   ID  2008  1318  

Melissa  Moubarak   ID  2010  1887  

Sami  Abou  Slaiby   ID  2010  2645  

Yara    El-­‐Kassis   ID  2009  3862  

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ABSTRACT  Shadow banking sector has significantly increased in size during the recent years. This paper

discusses the definition, mechanisms, types of transactions and the intermediaries who interfere

in the shadow banking system. Then, it exposes the benefits of shadow banks whenever they are

well structured and properly managed, along with the underlying risks to which the global

economy is exposed when they are not regulated properly. After discussing the subprime crisis

of 2008, and the role that the shadow banks played in it, it was necessary to describe the shadow

banking system in emerging markets since those countries are exposed to risks from shadow

banking activities, especially since their regulations and control over their activities is almost still

being developed. For that, we will mainly focus on the most prominent emerging country, China,

where shadow banks have grown rapidly along with the risks posed by that growth and the new

exposure to such activities. The last part discusses the regulations that are taken to limit the

growth of this system, their effectiveness and their limitations.

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TABLE  OF  CONTENT  I.   What is Shadow Banking? ..................................................................................................... 10  

1.   Definitions .......................................................................................................................... 10  

a.   Activities outside the Banking System ........................................................................... 10  

b.   Activities that need a backstop .................................................................................... 10  

2.   Activities commonly referred to as Shadow Banking ........................................................ 11  

3.   Mechanism of Shadow Banking ......................................................................................... 11  

4.   Shadow Risks ..................................................................................................................... 14  

5.   Benefits and costs ............................................................................................................... 15  

a.   Benefits ........................................................................................................................... 15  

b.   Costs ............................................................................................................................ 15  

II.   Shadow banking and Global Financial Crisis ........................................................................ 17  

III.   Shadow banking in Emerging Markets ................................................................................. 20  

1.   Characteristics & Role in Emerging Countries .................................................................. 21  

2.   Characteristics of Shadow banking risks in EMDEs .......................................................... 21  

3.   Shadow banking system in Central and Eastern Europe and East Asia ............................. 21  

4.   Shadow banking in China ................................................................................................... 22  

a.   China’s Shadow Banking System components ............................................................... 23  

b.   China’s Shadow Banking during the Credit Crisis ..................................................... 23  

c.   Key concerns ................................................................................................................... 25  

d.   Measures taken by Chinese Authorities: ..................................................................... 25  

IV.   Regulatory Reform ................................................................................................................ 27  

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Introduction    “If it looks like a duck, quacks like a duck, and acts like a duck, then it is a duck—or so the

saying goes. But what about an institution that looks like a bank and acts like a bank? Often it is

not a bank—it is a shadow bank” (Laura E. Kodres).

Bank’s activities are bound to obey to strict regulations in order to prevent the excessive risk-

taking, to provide safety to investors as well as depositors. Properly structured, and with risks

properly managed, the non-bank financial institutions with their intermediation activities can

provide benefits to investors, borrowers and the economy as a whole. However, the financial

crisis proved that certain non-bank activities and their interconnectedness with the regular

banking system might pose systemic risks, especially if those risks are not managed and

mitigated effectively.

The central message from this paper is to present shadow banking from its different perspectives,

its relationship to the global financial crisis and the risks it currently poses to the global

economy, and how these risks are controlled through wide-spread regulations.

Since it occurred that our all the group is majoring in finance, we have chosen this topic to first

helps us understand better the systemic risks built in the economy in the absence of proper

regulations and control, to learn more about the relation between international economics and

international finance and how they interrelate. The research on shadow banking helps us also

understand how shadow banking has contributed to the global financial crisis and the lessons

learned from that historical economic disaster that will be remembered for decades to come.

Making research on this topic sheds lights on the instruments used in banking and non-banking

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sectors, along with the associated risks of each of those instruments. Moreover, we understand

the interactions between markets and different players in the global economy.

After reading many academic papers, reports by international organizations and recent news, we

summarized our findings in this paper. We looked for charts from trusted sources that illustrated

well the subject. The main source of information was the “International Monetary Fund” (IMF).

We took information from the academic papers and reports with their accompanied statistics and

charts.

This paper will show the different aspects of the “Shadow Banking” system, its costs and

benefits. In later sections, we explain how the growth of Shadow Banking sector contributed to

the latest credit crisis. After that we take a look at the shadow banking in emerging markets, its

size and its risks. Then we focus on China, where the estimated size of the sector has reached,

according to some specialists, “worrying size” and may pose threat to the global economy. With

this growing size of shadow banking, some serious measures and regulations must be taken to

prevent the accumulation of risks built in the shadows. Some authorities have to step in to treat

the reasons behind the rapid growth of this sector, and limit the intervention of regulated banks

in the process to prevent the potential risks on deposits in this regulated sector, which is where

the Basel committee stepped in. These regulations and measures are discussed briefly in the last

section.

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Short  Literature  Review  Before exposing a topic, the definition of the concept should well be understood. shadow

banking is well defined in the following article:

Ø The first reference is an IMF working paper written by Stijn Claessens and Lev Ratnovski

entitled “What is Shadow Banking”. This paper defines shadow banking in different

perspectives, describes its activities and categorizes them between banking and non-banking

intermediation, and suggests the policy implications of these activities.

The mechanisms used by the shadow banking system are diverse and the intermediation

has many aspects, which are shown in these articles.

Ø The second reference is a paper written Zoltan Pozsar and Msanmohan Singh, entitled

“The Nonbank-Bank Nexus and the Shadow Banking System” interprets that the Shadow

Banking is largely an interbank phenomenon through the analytical framework of Banks and

Non-Banks. It describes how the demand and supply aspects of the asset management

complex determine together the shadow banking system, and how asset managers act as

ultimate sources of collateral in this system. They describe how it results in reverse maturity

transformation of non M2 types of money composing the money demand aspect: long term

savings are transformed into short term funding. Securities are lent out for use in the shadow

banking system that becomes collateral intense, when dealers don’t care about its source,

they only care about meeting the demand coming from the need to settle trades with other

dealers through rehypothetication (defined by “Investopedia” as The practice by banks and

brokers of using, for their own purposes, assets that have been posted as collateral by their

clients). As a consequence, a single piece of collateral may serve to underpin various

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financial transactions. Collateral comes in many forms, the most valuable are re-used as a

system lubrication, but build up the leverage like collateral chains between banks and asset

managers.

Ø The third reference is a paper written by Stijn Claessens, Zoltan Pozsar, Lev Ratnovski,

and Manmohan Singh entitled “Shadow Banking: Economics and Policy”, explains in

details the two main processes of Shadow Banking: Securitization and Collateral

Intermediation. Shadow Banking starts by the Securitization, which is the creation of “safe”

assets from debt obligations to transfer their credit risks, held by Commercial Banks and

institutional cash pools. Perceived as “safe”, they lead to unstable expansion of leverage, thus

market failures and the fragility of the short-term funding. The process of securitization

includes a reverse maturity transformation. Collateral Intermediation is likely to become

more important over time, even though it holds many risks. Liquidity exposure of dealer

banks arises when the prime brokerage clients request back their collateral, and when the

dealer banks are also depository institutions. Shadow banking is a complex ecosystem; it

combines multiple non-bank agents linked with traditional banks using the services of dealer

banks, through two processes: Securitization Chains and Collateral Chains. Moderately strict

policies need to be elaborated in a way that does not remove the Shadow Banking System as

whole, but to reduce its size, preserving its economic positive aspects. Shadow Banking has

its useful economic functions and they are to be preserved by establishing multifaceted

policy response to reduce its size so it can perform its role in a safer way.

Ø The fourth reference is a paper written by Swati Ghosh, Ines Gonzalez Del Mazo, and İnci

Ötker-Robe, entitled “Chasing the Shadows: How Significant Is Shadow Banking in

Emerging Markets?” shows the significant challenges with data availability, size and nature

of Shadow Banking in Emerging Markets and Developing Economies (EMDE), where they

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are even less discussed and understood. Even though Shadow Banking does not involve

intermediation as in advanced economies, it can pose systemic risks directly – as system

grows – and indirectly through its interconnectedness to the banking system. Policy makers

should insure that the Shadow Banking provide alternative but safe sources of funding to the

private sector. The risks include: potential of excess leverage, amplification of procyclicality,

instability of wholesale funding and potential bank run, regulatory arbitrage &

circumvention. Moreover, the main risks in EMDEs lie in the fact that the activities banks are

engaged in, the riskiness of these activities, how they are linked to the banking sector and

how they are regulated. In EMDEs shadow banking in poorly regulated or not regulated at all

making it and its actors difficult to track. Although relatively small in EMDEs, Shadow

Banking has grown rapidly, inciting the People’s Bank of China (PBOC) to introduce

measures allowing the economy to benefit from its advantages (alternative lending), while

delivering more safety to the financial system.

Shadow Baking has had a major effect on the financial crisis that started in 2007 and

reached its peak in 2008. Several articles and studies were considered to write the effects of

the shadow banking on the financial crisis.

Ø The fifth reference is an article written by Laura Kadres entitled “What is Shadow

Banking” and published on the International Monetary Fund website was used to understand

the essence of shadow banking. This article demonstrated the characteristics of the shadow

banking and the main paths that it may lead to.

Ø The sixth resource is the working paper written by Lysandrou Nesvetailova entitled: “The

Shadow Banking System and the Financial Crisis: a Securities Production Function

View”. This paper showed that the shadow banking amplified the impact of the financial

crisis but it did not cause it.

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Ø The seventh reference is the article written by Joel Havemann entitled: “The Financial

Crisis of 2008: Year in Review 2008”. This reference was used to look at an overview of the

financial crisis. It discusses the time of the crisis as well as how it folded and pinpoints some

international repercussions. An additional reference that was used to understand the financial

crisis is the article found in The Economist titled “The Origins of the Financial Crisis”.

Ø The eighth reference is a report written by Adam Ashcraft entitled “Shadow Banking: a

Review of the Literature” Presented to the Federal Reserve Bank of New York. It presents

preliminary finding on shadow credit intermediation. It shows the reasons behind the rise of

shadow banking and its relation to the 2008 crisis.

Ø The ninth reference is the article entitled “Why did Chinese Shadow Banking Surge after

2009” written by Joe Zhang. It explains the origin of China's shadow banking to financial

repression, which includes the artificially low interest rate in China.

Since the shadow banking puts the financial system at risk, there is an urgent need to take

the correct measures to prevent future crisis

Ø The tenth reference is the article written by İnci Ötker-Robe and Ceyla Pazarbasioglu

titled “Impact of Regulatory Reforms on Large and Complex Financial Institutions”. It

discusses how we can implement or enforce new regulations on shadow banks and

commercial banks without negatively affecting or crippling the growth of the economy. It

delves into proposals presented by the Basel committees, and how they are to be

implemented, their advantages and their deficiencies as well.

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I. What  is  Shadow  Banking?  The economist Paul McCulley created the term “shadow banking”. In general it has been very

difficult to define the term “shadow banking” because of its shallowness.

1. Definitions  

a. Activities  outside  the  Banking  System  

Financial Stability Board (FSB) (2012) describes shadow banking as “credit intermediation

involving entities and activities (fully or partially) outside the regular banking system.” This is a

useful benchmark, and has been much used but this definition has two weaknesses.

Ø First, it may be covering entities not commonly thought of as shadow banking, like leasing

and finance companies, credit-oriented, hedge funds, corporate tax vehicles, and others, yet

that do also intermediate credit.

Ø Second, it describes shadow banking activities as operating primarily outside banks.

However, in practice, many shadow banking activities (liquidity puts to securitization SIVs,

collateral operations of dealer banks, repos, etc.) operate within banks, especially systemic

ones.

Both of these reasons make the description less insightful and less useful from an operational

point of view (Claessens & Ratnovski, February 2014).

b. Activities  that  need  a  backstop  

In order to improve the approaches and definitions, shadow banking may be described as “all

financial activities, except traditional banking, which require a private or public backstop to

operate”. This describes many of the activities cited in the next section. (Claessens & Ratnovski,

February 2014).

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2. Activities  commonly  referred  to  as  Shadow  Banking  

A functional alternative approach is presented below, showing the main activities that shadow

banks undergo.

Ø Securitization: trenching of claims, maturity transformation, liquidity “puts” from banks to

SIVs, support to par value money funds.

Ø Collateral services, which are mainly conducted via dealer banks, include the following:

supporting the efficient re-use of collateral in repo transactions, for OTC derivatives and in

prime brokerage; securities lending.

Ø Bank wholesale funding arrangement, including the use of collateral in repos and the

operations of the tri-party repo market

Ø Deposit-taking and/or lending by non-banks, including that by insurance companies and

bank-affiliated companies.

The second definition is likely to capture the activities that might become shadow banking in the

future. In fact, some activities are recently described as Shadow Banking, such as the more

recurrent use of Real Estate Investments Trusts (REITs), leveraged finance, and reinsurance in

the U.S. fall under this definition (Claessens & Ratnovski, February 2014).

3. Mechanism  of  Shadow  Banking  

The procedure lies mainly on maturity transformation. Commercial banks participate in maturity

transformation when they use short-term deposits to fund long term loans. Shadow banks do

alike. They borrow short-term funds from the money markets and use them to purchase long

term assets. However, shadow banks are not regulated like commercial bank so they cannot rely

on the Federal Reserve in case of default, in addition to the noninsured funds; they are in the

“shadows”.

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The shadow banking system contributed to the overall leverage of the financial system. The new

financial participants that developed their activities in this context (SIVs, ABCP conduits,

monoline insurers) were highly leveraged. For instance, a Collateralized Debt Obligation (CDO)

with an equity tranche covering the first 3% of losses represents an investment in the underlying

assets that is leveraged about 30 times. Monoline insurers, depending on the measure used, were

leveraged 50 to 100 times. They fostered the expansion of the shadow banking system by

providing financial institutions with protection in the super-senior tranches of Asset Backed

Security (ABS) CDOs, which is far from their traditional business.

Figure 1: The Shadow Banking System Instruments

According to Financial Stability Board (FSB), shadow banks are individuals who are external to

the regulated banking structure who execute the central job of banking, that is, taking cash from

investors and providing it to debtors. This is known as credit intermediation that has four

significant features:

Ø Maturity transformation: earning money market funds to finance them in long-term assets.

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Ø Liquidity transformation: using money comparable to liabilities to purchase inflexible and

durable assets that are hard to be sold like mortgages.

Ø Leverage: adopting methods resembling to borrowing cash to buy fixed assets to expand the

possible gains or losses of speculations.

Ø Credit risk transfer: transmitting the risk of the borrowers from the initial investor of the

loan to another party.

Below this classification, shadow banks consist of brokers and dealers supplying their assets

through repurchase agreements (repos). This procedure consists of individuals who need

immediate liquidity, sell a security for a certain purpose and purchase it back as per a stipulated

agreement on a stated day. Money market mutual funds that group the funds of investors to buy

commercial paper or mortgage-backed securities are as well similar to shadow banks.

Consequently, it represents also the financial institutions that sell commercial paper and use the

earnings to lengthen credit to households. Figure 2 illustrates these participants in the shadowy

complex process.

Figure 2: The Participants in the Shadow Banking System

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4. Shadow  Risks  

As long as financers comprehend all the essentials activities and avoid too much of unjustified

risk to the financial scheme, there is none of mysterious things about earning cash from investors

who might want their money later on within a short period of time and capitalizing those funds in

assets with long-term maturities.

However, problems get up throughout the global financial crisis recently. Investors became

nervous about what was the value of long-term assets in reality. After that many decided to take

out their funds. This generated a big conflict; shadow bank had to sell, at a reduced price, assets

in order to repay these investors; this is called “fire sales”. At the peak of the disaster, numerous

of investors withdrew or would never desire to reinvest their funds in financial institutions like

banks and in nonbanks while they are facing thoughtful trouble. Conversely, if this had taken

place separately to the banking system, it could have been the one and only one faced to

shadowy and could have been shut down in a good manner. But real banks were also caught in

the shadows. Therefore, some shadow banks were measured by commercial banks and were

saved by their solider bank parent for reputational reasons.

In other circumstances, these networks were at arm’s dimension, but because of the very little

transparency, it was frequently uncertain who owed or would owe later, what to whom. All these

issues were hard to precise. In other words, shadow banking is described by a deficiency of

disclosure and information about the true and accurate value of their assets.

The authorized segment is gathering further and superior information and examining for unseen

weaknesses. Banking managers moreover are observing the disclosure of traditional bank to

shadow banks and trying to comprise it through such paths as capital and liquidity regulations

because this disclosure permitted shadow banks to disturb the traditional financial segment and

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mostly the economy. Likewise, because many shadow banking entities were informally regulated

or exterior from any regulation or authority, the consultants are planning for a growing of the

scope of information meant both for entities and the market they use. The authorities are making

sure that all shadow banks’ activities are well managed and directed to avoid and discourage

shadow banks from adopting their actions unless if they are supervised by regulators nationally

and worldwide.

5. Benefits  and  costs  

In general, despite the risks lying behind shadow banking, it is agreed that the financial

intermediation through nonbank channels offers some benefits to the financial system:

a. Benefits  

Ø Alternative to bank deposits for large investors: Institutional investors rely on shadow

banking rather than the traditional system relative to the large size of the cash pools they

hold. They channel resources efficiently towards specific needs.

Ø Alternative funding for the real economy: In case the traditional banking or market

channels become momentarily impaired, like during the credit crisis, shadow banks can also

provide the funding and the risk diversification. They can make credit available to the sectors

that might not be eligible to credit, providing investors as well, with a range of tools for the

liquidity, maturity and credit risk management (Ghosh et al., September 2012).

b. Costs  

Shadow banking can be a major source of systemic risk. As we will discuss in the next section,

the global financial crisis of 2008 originated from the shadow banking sector. There is a growing

recognition that shadow banking system may pose a greater risk than traditional banking. Even

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though they are exposed to the same financial risks, they don’t have the same level of regulation

and oversight (Ghosh et al., September 2012). The risks include:

Ø The potential for excess leverage: Securities financing transactions (STFs) on a

collateralized basis through repo market – involving commercial banks – and securities

lending transactions to raise more funds in a repetitive cycle through “Rehypothecation”

(Singh and Aitken 2010).

Ø Amplification of procyclicality: shadow banking system interaction amplifies

procyclicality, the mutually reinforcing interactions between the financial and the real sectors

of the economy: upward valuation of collateral assets increasing the credit availability and

SFTs margins being reduced in an upswing, encouraging further the borrowing against the

collateral, leading, in case of a downturn, to the dramatic decrease of assets value.

Ø Instability of wholesale funding and potential for “modern-style bank run”: The shadow

banking system operates through wholesale funding without the assurance of a Central Bank

as “lender of the last resort”. It performs significant maturity and liquidity transformation,

endangering the financial system, making it susceptible to a “bank run”, and other effects.

Ø Transmission of systemic risk: A complex web of interconnections links the shadow

banking activities to the traditional regulated banking sector, where commercial banks form a

part of this chain, supporting and facilitating the shadow banking activities. Subsequently,

the failure of any entity generates contagion affecting the overall system stability.

Ø Regulatory arbitrage: Shadow banking activities may arise from the tighter regulations

imposed on the banking institutions, which pushes the risky activities to the shadows. This

situation jeopardizes the effectiveness of the banking sector regulations, with the risks

becoming greater, particularly if both financial systems are still connected through the

ownership or financial linkages.

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II. Shadow  banking  and  Global  Financial  Crisis  

Shadow-banking system is a channel of dedicated financial institutions that transfer the funds

from the savers to the investors through several methods that are characterized by the secure

funding practices.

The year 2005 was marked by the first time ever that the US banks suffered no loss. 2006

followed and the US realized the same positive result. It looked like the economy was booming,

the real estate sector was on an all time high, assets’ values were skyrocketing, everyone was

profiting, whether it was homebuyers, employees, companies, the government – It was the

“ideal” state to be in.

But, lurking in the shadows was a huge catastrophe waiting to be realized, due to so many factors

from wrong ratings on asset-backed-securities, subprime mortgages, the securitization system,

the desire for profit by the huge investment banks who ignored any negativity in what they were

undergoing, loose regulations on the securitization process, to the unregulated shadow banking

system which helped fasten the process of the crisis…

Shadow Banking played an important role during the credit crisis. The credit crisis started in

2007 and reached its peak in the year 2008. It started with the fall of the Lehman Brothers, a

global financial services bank. Some economists describe it as the worst depression after the

Great Depression of 1930. This crisis affected the investment banking industry, insurance

companies, mortgage lenders and commercial banks throughout the world. In this section, we

will be discussing the shadow banking during the credit crisis.

Shadow Banking had a major role in amplifying and exaggerating the crisis. There are two main

characteristics in the shadow banking system that caused this amplification:

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Ø The shadow banking system created the Collateralized Debt Obligation (CDOs), which were

the center of the crisis.

Ø The world treated the financial crisis as a continuous process that started in 2007 and

escalated in September 2008. The 9th of August represents the specific point where it all

failed. The point where the trading of CDOs failed.

The banking system may cause several severe risks as it showed during the financial crisis but in

its essence it was not designed to fail. It is similar to a young boy riding a bicycle. A bicycle is

supposed to be fun and entertaining. Nobody tells the boy when he/she is buying the bicycle that;

if it is driven in an irresponsible manner it might cause death.

Thus we conclude the following, quoting Lysandrou Nesvetailova:” the shadow banking system

is a system of unregulated off bank balance sheet credit intermediation and maturity and liquidity

transformation activities conducted by bank’s owned or sponsored entities in the capital and

money market domains for the primary purpose of expanding the rate of production of yield

bearing debt securities required by the global investor community”. Figure 3 below shows the

outline of the commercial shadow bank at the time of the sub-prime crisis.

Figure 3: Outline of the commercial shadow bank

The securities supplied by the shadow banking system are distinguished into two categories,

short term and long term:

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Ø Short Term is mainly the asset-backed commercial paper (ABCP). The shadow banking

entities come among the first suppliers of the short term components that include the ABCP.

Ø Long Term is mainly the asset-backed securities and the CDO. The shadow banking entities

came to play an essential role in the pre crisis era through the two above-mentioned factors.

Both the short term and long term securities increase the factors that enable the shadow banking

to be a main driver to the financial crisis. Figure 4 below shows the expansion of the shadow

banking system in the US. It can be observed in the figure that there was an almost steady state

from 1990s till 2000s. A fast increase was observed from year 2000 till 2007. In year 2007 there

was the peek after which it started decreasing.

Figure 4: Growth of Shadow Banking in U.S.A

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III. Shadow  banking  in  Emerging  Markets  

International discussions on “shadow banking” have been almost concentrated exclusively on the

developed countries, ignoring the potential risks in emerging markets. Any global approach on

non-bank financial services should cover and assess the risks no matter where they occur (IIF,

June 2012).

After the global financial crisis, in emerging markets, shadow banking systems continued to

grow rapidly thus accumulating risks. Mark Carney, FSB Chairman and Bank of England

Governor, sees “shadow banking excesses in emerging markets as posing the biggest threat to

the global economy” (Borst, 2014).

The threat is focused around China, being the world’s second economy, having the largest

shadow banking system within the emerging markets. Despite the expressed concern about the

danger lying behind shadow banking, the FSB approach in addressing the problem is quite

ineffective since its methodology is designed for Anglo-American financial systems rather than

for emerging markets. These deficiencies result in a considerable underestimate of the shadow

banking system size in China and cover those who want to prevent regulatory action (Borst,

2014).

There are significant challenges with data availability, size and significance of Shadow banking

in the emerging market and developing economies (EMDEs). Therefore, they are less discussed

and, eventually, less understood. Based on a sample of selected EMDEs in East Africa and in

Central and Eastern Europe, the Shadow banking is relatively small in most of them, but has

grown remarkably during the recent years. (Ghosh et al., September 2012)

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1. Characteristics  &  Role  in  Emerging  Countries  

In EMDEs, shadow banking poses systemic risks, both directly and indirectly. Directly, the

importance of Shadow banking is growing in the total financial system, especially with the

simultaneous credit, market and liquidity risks undertaken by its participants. Indirectly, Shadow

banking is interconnected with the regulated banking system. Concurrently, shadow banks play

also an influential role in channeling alternative funding sources to EMDEs, especially with the

continuous deleveraging pressures from European Banks (Ghosh et al., September 2012).

2. Characteristics  of  Shadow  banking  risks  in  EMDEs  

The level of risk posed by the shadow banking system in EMDEs depends on several factors:

Ø The size and systemic important of the sector within the total financial sector

Ø The types of activities performed by the shadow banking sector and their riskiness

Ø The link with the banking sector

Ø Level of regulation

Unfortunately, the characteristics of shadow banks in EMDEs are hard to get and the available

information is fragmented (Ghosh et al., September 2012).

3. Shadow  banking  system  in  Central  and  Eastern  

Europe  and  East  Asia  

In East Asia, nonbank financial intermediation may provide important shadow banking services

in various regions, despite the dominance of traditional banking in the formal financial sector. It

is the largest in Philippines and Thailand, and its share has been gradually rising as shown in

Figure 5.

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Figure 5: Evolution of the Shadow Banking sector in selected EMDEs

In Central Eastern European countries, shadow banking grew rapidly until 2007, and lost most of

its share after the global financial crisis. The factors that encouraged the development of

nonbanking institutions in EMDEs are the same ones that stipulated the sector in developed

countries; the tighter regulations on the traditional banking sector made the intermediation more

costly, contributing to the growth of shadow lending in countries like China, Bulgaria, Croatia,

and Romania. Compared to the regulated traditional banking system, these regulatory gaps entail

that as the financial sector grows over time, an important part of it will remain out of the

systemic risk radar and could increase the systemic risks as previously discussed.

China’s shadow banking sector has gained significant attention recently and helps demonstrate

these risks (Ghosh et al., September 2012).

4. Shadow  banking  in  China  

The shadow banking in China is defined as lending outside the banking system, without

necessarily involving leverage and maturity transformation. The rapid growth of these lending

activities induced the People’s Bank Of China (PBOC), in early 2011, to the introduction of

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“Total Social Financing”1, in order to specifically track loans, entrusted loans and other credit

products intermediated by banks that are not often captured on their balance sheet. Nonetheless,

new products have appeared that prevent the disclosure on this broader metric, in sectors where

the investment yields high returns in exchange of high risk.

Shadow banking in China, occurring through a wide array of entities, is hard to track. Even

though difficult to measure, the Chinese shadow banking size is estimated to have reached

worrying proportions since 2011, and it has grown much due to the tightening control of credit,

and the underground started filling the gap (Ghosh et al., September 2012).

a. China’s  Shadow  Banking  System  components  

As defined by Jianjun Li and Sara Hsu, “China’s shadow financial system is comprised of non-

bank financial products, including bank-trust cooperation financial products, products issued by

trust companies and financial leasing companies, and Q-REITS3 and credit risk; and credit

creation products often produced by small loan companies, investment companies, credit

guarantee companies, insurance brokerage firms, pawn shops, private equity investment funds,

and venture capital funds”, but it is dominated by commercial banks (Li & Hsu, August 2013).

The main forms offered by these entities include informal lending and underground

intermediation, entrusted loans, and trust loans2 (Wealth Management Products) and bank

acceptance bills (Barclays Capital 2011; IIF 2012; South China Morning Post 2012).

b. China’s  Shadow  Banking  during  the  Credit  Crisis  

China, like any other country was affected by the global crisis. To offset this financial crisis, the

Chinese government encouraged a huge credit boom. Such credits were directed towards

1 China's  "total  social  financing"  (TSF),  a  liquidity  measurement  tool  invented  by  Beijing  in  2011,  to  help  Chinese  leaders  keep  tabs   on   fundraising   as   the   financial   system   diversified   away   from   state-­‐controlled   policy   lending.   The   TSF   is   an   economic  barometer  that  sums  up  total  fundraising  by  Chinese  non-­‐state  entities,  including  individuals  and  non-­‐financial  corporates.  2 Trust  loans  refer  to  credit  extended  through  a  specific  type  of  trust  product  created  jointly  with  banks  and  whose  underlying  assets  consist  solely  of  loans,  which  are  generally  short-­‐term  and  typically  mature  within  a  year.  Trust-­‐loans  are  sold  by  banks  to  their  retail  depositors  or  small  investors  after  securitizing  them  through  a  trust  mechanism.  

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infrastructure and construction projects. Figure 6 below shows the lending amount in billion

Renminbi. It reveals the difference between the actual lending and the target lending. As shown

in year 2009, the actual lending was higher than the target lending by 6000 billion.

Figure 6: Actual lending and target lending

As history has shown us before, after almost every economic boom, we have pause, and then a

quick, sudden economic downturn occurs where we see recessions, banking systems falling

apart, companies that were flourishing going bankrupt… So in China, parties were no longer able

to pay back the loans thus resulting in a contracted economy. As a result, shadow banking,

especially trust securities grew rapidly with insufficient oversight, due to the strict regulation of

the rational banking systems directed by the Chinese government. For the most part, this

represented an attempt to circumvent the interest-rate controls that made bank deposits

unattractive. Savers will turn to shadow banking thus losing some money on those investments,

so now savers will return back to banks. Now the Chinese government is making it clear that

shadow banking will not be bailed out, while the big banks are still obviously supported by the

government.

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c. Key  concerns  

Being outside the state supervision, there is a growing concern that shadow banking threats

China’s financial system’s stability:

Ø Direct linkages with banks: mainly through the issued letters of credit and their role in

entrusted loans and use of off-balance sheet Wealth Management Products (WMPs)3 to

attract deposits.

Ø Indirect linkages with banks: Isolated defaults have the potential to initiate widespread

redemptions, knowing that these defaults shall not be added directly to commercial banks

Non-Performing Loans (NPLs).

Ø Exposure to market, credit, and maturity/liquidity risk by trust companies: the main

risks seen with trust companies are their dependence on the assets prices, being subject to

potential correction and frequently risky pricing behavior for the sake of attracting

investments. This entails that any economy slowdown accompanied or not with a decline in

asset prices will trigger an increase in defaults.

This rapid growth of the underground lending and the related high borrowing rates increases the

emergence of potential social and political tensions. Shadow banking raises the concern of

weakening macroeconomic management making monetary policy ineffective (Ghosh et al.,

September 2012).

d. Measures  taken  by  Chinese  Authorities:  

Chinese authorities have undertaken some measures to address the risks posed by growing

underground banking activities:

Ø Monitoring and indirect regulation:

3 Wealth  Management  Products  (WMPs)  are  short-­‐term  products  to  savers  that  pay  high  interest  rates  but  allow  the  banks  to  bring  the  deposits  back  on  their  balance  sheets  at  the  end  of  each  month  to  meet  their  regulatory  requirements  

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o Establish a monitoring system for private lending.

o Banks are required to include, in their reserve requirement ratios, letters of credit and

bank acceptance bills.

o Preserve legitimacy of private lending for small and medium-sized enterprises (SMEs)

Ø Shadow banking related to bank-trust cooperation measures cover:

o Bank-Trust loans are to be limited to less than 30% of total bank-trust business.

o Banks are required to move back off-balance sheet trust cooperation by end of 2011

o Large banks should set aside risk-weighted capital of 11.5% for trust loans off-balance

sheet, and small banks set aside 10.5%

o Trust companies should set aside risk-weighted capital of 10.5% of capital for trust loans

that are off-balance sheet

o Trust companies are prohibited from distributing dividends unless the compensation

reserve is less than 150% of their NPLs or less than 2.5% of the trust loans extended in

the bank trust cooperation (Barclays Capital, 2011)

o Shadow banks are formalized through an experimental financial reform zone in

Wenzhou during March 2012, in an attempt to convert underground small loans

companies to local banks serving SMEs.

These measures are important in addressing the growing size of the Chinese underground

banking sector. Given the direct and indirect linkages to banks, monitoring and regulating this

sector and formalizing shadow lenders, should contribute to the reduction of these risks.

However, this rapid growth of this sector is a response to tight regulations on the deposits and

lending rates, directing borrowers to alternative means to access funds and for lenders alternative

higher returns on their savings. The effective and lasting solutions for this problem lie in

addressing the root causes of the problem (Ghosh et al., September 2012).

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IV. Regulatory  Reform  As we have seen in the report, the shadow banking sector led to severe negative consequences on

the global economy, like the subprime crisis of 2008, the European sovereign debt crisis and so

on. For these dangerous reasons, where economies are prone to collapse, countries to sink into

more debt, some solutions must be taken into consideration in order to enhance economic growth

and prevent or reduce this systemic crisis, which leads to “chaos” in the global financial markets.

During the aftermath of the fall of Lehman Brothers, and the new awareness regarding the

inefficiencies of all types of institutions and governments, and specifically the role that the

shadow banks played during that period, it is obvious that the regulations of the financial sector

along with risk-management were not able to capture the risks the banks were exposed to,

specifically, market liquidity. So many other weaknesses were also observed: lack of adequate

risk management systems, or lack of governance practices, ineffective supervision, etc.

This section discusses briefly the objective of the regulation of these financial institutions and the

necessary reforms to be adopted in order to promote a less leveraged, less risky, and thus a more

resilient financial system that supports strong and sustainable economic growth.

An important factor to take into consideration is that by regulating the financial systems, the

objective is not to cripple the growth and sustainability of the economy as a whole – in our case,

the intermediation of liquidity, which increases the money supply and boosts economies in

general.

G-20 Summit (April 2009)

In order to strengthen the financial system and increase the confidence of the people, the G-20

group of countries approved on a set of reforms.

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The Basel Committee on Banking Supervision (BCBS) came up with guidelines at the end of

2009 for banks to improve their loan requirements and to tighten the grip more on the business of

loans and liquidity management. Later in 2010, some of these guidelines were accepted and

agreed upon.

Before we discuss the main components that the BCBS proposed, it is important to know how

the shadow bank’s liabilities were picking up and ultimately outpacing the commercial bank’s

liabilities from the year 1990 till 2012, as shown in figure 7 below.

Figure 7: The trend of shadow bank liabilities vs. bank liabilities from 1990 to 2011 (Federal Reserve Bank of New York Stuff Report- February 2012)

In short, it is clear to say that liabilities of shadow banking are much higher than that of

traditional banks, which may result in a higher risk of default on interest payments due to the

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wide gap between deposits and loans, in other words, shadow banks bear higher risks than other

institutions.

BCBS Proposals

The main elements of the BCBS propositions are:

Ø Improving the quality of raising capital (Increasing the use of common equity to raise funds

and decreasing the amount of fixed-income securities).

Ø Enhanced risk identification for market and counterpart risk.

Ø A non-risk based leverage ratio as a backstop measure.

Ø Tighter liquidity criteria, specifically to control the gaps created by lending long and

borrowing or getting deposits for the short-term.

Ø Capital conservation buffers: From 1988 till today, we have had three accords, which are

Basel I, Basel II, and Basel III. In summary, Basel I focused on capital requirements for

banks. Basel II dealt with new rules on capital requirements, and created new regulations and

standards on how much capital financial institution must reserve and maintain (non-interest

earning reserves). Banks needed and were obliged to follow those guidelines and put aside

capital to decrease as much as possible the risks associated with its investing, but more

specifically, lending practices. Basel III (which its main elements were explained above) is

an extension of Basel II, with improvement in the banking sector’s ability to deal with

financial and economic downturns, to improve the risk management of the financial

institutions and strengthen as much as possible the transparency of banks and their activities.

For example, a very important requirement was put in effect, whereby requiring from every

international bank in the world, to create a “Financial Risk Management” (FRM) department

if it doesn’t have one already. New Basel III percentages were lately set for common equity, tier 1

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capital and conservation ratio. The Appendix at the end of the report illustrates the effect of the

reserve requirement regulation.

Figure 8 demonstrates that there is a considerable increase in the tier 1 capital and the

conservation ratio up to 2020, and the increase is gradual over time.

Figure 8: Basel III common equity and tier 1 capital changes

Currently, financial regulations combine two distinctive actions:

Ø Monitoring individual institutions and their impact on system stability.

Ø Investor regulation and consumer protection

The second action highlights the fact that the Security and Exchange Commission (SEC) is a

regulator that specializes in regulating the listed companies. Investors and consumers should

abide these rules. However, to cope with systemic crisis, such regulators are in need of more

systemic information to gather and analyze. To be more accurate about the information that

should be gathered, it must be reported from a wider range of financial institutions, such as

hedge funds and the shadow banking system. In addition to this, the systemic regulator will

operate capital rules with a systemic focus.

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It’s important to mention that in times of crisis, it’s the role of the central bank to interfere and

play its role in the resolution of problems occurring due to systemic crisis and improving the

economic cycle.

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Conclusion  Non-bank credit intermediation institutions have a valuable role in the financial systems, from

which all can benefit: investors, borrowers, banks, and the wider economy, while being

complementary to the traditional banking system. Regulated banks, non-rivals in this business,

may rely on these activities to provide services. Non-bank institutions can take many forms and

can perform a large set of activities that hold a large degree of risks to the global financial system

if not closely supervised and regulated.

Markets are constantly evolving and financial market innovations will always exist and these

shadow banks will always find a way to go on with their activities. This places an obligation on

the regulatory authorities to establish a control system that compromises between keeping the

benefits of the shadow banking system and avoiding the excessive risks, and the difficulty in the

regulations that need to take into consideration loopholes in the system that are being used day

by day, by corporations, banks and so on....

Shadow banking sector, with its intermediation tools and varied instruments, is complicated, thus

difficult to estimate and to regulate. The greatest risks lie in the association of shadow banking

activities with traditional banking sector activities. This puts the banking sector under the

pressure of a constant systemic risk, decreasing the confidence in the people, and making the

global economy more susceptible to crisis that are unseen. It is proved by the global financial

crisis, in which the whole financial system collapsed, that unless shadow banking activities are

properly managed, shadow banks will pose great systemic risks. These risks should be

monitored, assessed, and mitigated on a continuous and adaptive basis. The risk remains viable

in the emerging markets, where poor regulations and the growing size of this shadowy sector

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coincide, especially in China. As its name expresses, shadow banking, even if it is much

discussed, analyzed and explained, will always have a dark side that’s hard to depict and to

control. Will financial systems integrate it one day and keep it regulated and transparent like the

regulated banks? That, we will never know, at least for now.

References  

Ø Adrian, Tobias & Ashcraft Adam B.: Shadow Banking: a review of literature, Federal

Reserve Bank of New York, Staff report No. 580, October 2012. Retrieved from:

http://memofin.fr/uploads/library/pdf/sr580[1].pdf

Ø Claessens, Stijn and Ratnovski, Lev: What is Shadow Banking? IMF Working Paper

Research Department, February 2014. Retrieved from:

http://www.imf.org/external/pubs/ft/wp/2014/wp1425.pdf

Ø Claessens Stijn, Pozsar Zoltan, Ratnovski Lev, and Singh Manmohan: Shadow Banking:

Economics and Policy, IMF Staff Discussion Note SDN/12/12, December 4, 2012. Retrieved

from: http://www.imf.org/external/pubs/ft/sdn/2012/sdn1212.pdf

Ø Borst, Nicholas: Flying Blind, The Magazine of International Economics, Winter 2014.

Retrieved from: http://www.international-economy.com/TIE_W14_Borst.pdf

Ø Ghosh, Swati, Del Mazo, Ines Gonzalez, and Ötker-Robe, İnci: Chasing the Shadows: How

Significant Is Shadow Banking in Emerging Markets? Economic Premise, Poverty Reduction

and Economic Management Network (PREM), The World Bank, Issue 88, September 2012.

Retrieved from: http://siteresources.worldbank.org/EXTPREMNET/Resources/EP88.pdf

Ø Kodres, Laura E.: What Is Shadow Banking? - Back to Basics - Finance & Development, June 2013.

Retrieved from: https://www.imf.org/external/pubs/ft/fandd/2013/06/basics.htm

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Ø Li, Jianju and Hsu, Sara: Shadow Banking in China: Institutional Risks, Working Paper

Series Number 334, Political Economy Research Institute, University of Massachussets

Amherst, August 2013. Retrieved from:

http://www.peri.umass.edu/fileadmin/pdf/working_papers/working_papers_301-

350/WP334.pdf

Ø Recovery Strengthens, Remain Uneven, World Economic Outlook International Monetary

Fund, World Economic and Financial Surveys, April 2014. Retrieved from:

http://www.imf.org/external/pubs/ft/weo/2014/01/pdf/text.pdf

Ø Shadow banking: a forward-looking framework for effective policy, Institute of International

Finance, June 2012. Retrieved from: http://www.iif.com/download.php?id=aYFmUgfMDbA

Ø Pozsar, Zoltan & Singh, Manmohan: The Nonbank-Bank Nexus and the Shadow Banking

System, IMF Working Paper WP/11/289, Research Department, December 2011. Retrieved

from: http://www.imf.org/external/pubs/ft/wp/2011/wp11289.pdf

Ø Singh, Anoop and Kochhar, Kalpana: People’s Republic of China, International Monetary Fund

Country report No. 13/211, Staff Report for the 2013 Article IV Consultation, July 2013. Retrieved

from: http://www.imf.org/external/pubs/ft/scr/2013/cr13211.pdf

Ø Crash course, the Origins The origins of the financial crisis, The Economist, September 7,

2013 (from the printed version). Retrieved from:

http://www.economist.com/news/schoolsbrief/21584534-effects-financial-crisis-are-still-

being-felt-five-years-article

Appendix:  Depositing  and  Lending  Cycle    

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