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What is Shadow Banking?

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By Stijn Claessens, Assistant Director in the Research Department of the International Monetary Fund, Professor of International Finance Policy at the University of Amsterdam and Lev Ratnovski, an economist in the Research Department of the IMF. Cross posted from VoxEU

There is much confusion about what shadow banking is and why it may create (systemic) risks:

  • Some equate it with securitisation.
  • Others with non-traditional bank activities, or non-bank lending.

Regardless, most think of shadow banking as activities that can create systemic risk. This column proposes to describe shadow banking as ‘all financial activities, except traditional banking, which require a private or public backstop to operate’.

Backstops can come in the form of franchise value of a bank or insurance company, or a government guarantee. The need for a backstop is a crucial feature of shadow banking, which distinguishes it from the “usual” intermediated capital market activities, such as custodians, hedge funds, leasing companies, etc.

It Has Been Very Hard to Define “Shadow Banking”

The Financial Stability Board (2012) describes shadow banking as “credit intermediation involving entities and activities (fully or partially) outside the regular banking system”. This is a useful benchmark, but has two weaknesses:

  • First, it may cover entities that are not commonly thought of as shadow banking, such as leasing and finance companies, credit-oriented hedge funds, corporate tax vehicles, etc. (Figure 1).
  • Second, it describes shadow banking activities as operating primarily outside banks.

But in practice, many shadow banking activities, for instance, liquidity puts to securitisation structured investment vehicles, collateral operations of dealer banks, repos, and so on, operate within banks, especially systemic ones (Pozsar and Singh 2011, Cetorelli and Peristiani 2012). Both reasons make the description less insightful and less useful from an operational point of view.

Figure 1. Spectrum of financial activities

claessens fig1 22 aug

Note: see Claessens et al. (2012) for more discussion of the mechanics of shadow banking processes.

An alternative – ‘functional’ – approach treats shadow banking as a collection of specific intermediation services. Each of them responds to its own demand factors (e.g., demand for safe assets in securitisation, the need to efficiently use scarce collateral to support a large volume of secured transactions, etc.). The functional view offers useful insights. It stresses that shadow banking is driven not only by regulatory arbitrage, but also by genuine demand, to which intermediaries respond. This implies that in order to effectively regulate shadow banking, one should consider the demand for its services and – crucially – understand how its services are being provided (Claessens et al. 2012).

The challenge with the functional approach is that it does not tell us what the essential characteristics of shadow banking are. While one can come up with a list of shadow banking activities today, it is unclear where to look for shadow banking activities and risks that may arise in the future. And the functional approach is challenged to distinguish activities that appear, on the face of it, similar, yet differ in their final (systemic) risk (e.g., a commitment to provide for credit to a single firm vs. liquidity support to structured investment vehicles). Related, most studies focus on the US and say little about shadow banking elsewhere. In Europe, lending by insurance companies is sometimes called shadow banking. ‘Wealth management products’ offered by banks in China and lending by bank-affiliated finance companies in India are also called shadow banking. How much do these activities have in common with US shadow banking?

A New Way to Define “Shadow Banking”: All Activities that Need a Backstop

To improve on the current approaches, we propose to describe shadow banking as ‘all financial activities, except traditional banking, which require a private or public backstop to operate’. This description captures many of the activities that are commonly referred to as shadow banking today, as shown in Figure 1. And, in our view, it is likely to capture those activities that may become shadow banking in the future.

Why Do Shadow Banking Activities Always Need a Backstop?

Shadow banking, just like traditional banking, involves risk transformation – specifically, credit, liquidity, and maturity risks. This is well accepted by the existing literature, and fits all shadow banking activities listed in Figure 1. The purpose of risk transformation is to strip assets of ‘undesirable’ risks that certain investors do not wish to bear.

Traditional banking transforms risks on a single balance sheet. It uses the law of large numbers, monitoring, and capital cushions to ‘convert’ risky loans into safe assets to back deposits. Shadow banking transforms risks using a different mechanism. It aims to distribute the undesirable risks across the financial system (‘sell them off’ in a diversified way). For example, in securitisation shadow banking strips assets of credit and liquidity risks through tranching and providing liquidity puts (Pozsar et al. 2010, Pozsar 2011, Gennaioli et al. 2012). Or it facilitates the use of collateral to reduce counterparty exposures in repo markets and for over the counter derivatives (Gorton 2012, Acharya and Öncü 2013).1

While shadow banking uses many capital markets type tools, it differs also from traditional capital markets activities – such as trading stocks and bonds – in that it needs a backstop. This is because, while most undesirable risks can be distributed away by shadow banking processes, some residual risks, often rare and systemic ones (‘tail risks’), can remain. Examples of such residual risks include systemic liquidity risk in securitisation, risks associated with large borrowers’ bankruptcy in repos and securities lending, and the systematic component of credit risk in non-bank lending (e.g., for leveraged buyouts). Shadow banking needs to show it can absorb these risks to minimise the potential exposure of the ultimate claimholders who do not wish to bear them.

Yet shadow banking cannot generate the needed ultimate risk absorption capacity internally. The reason is that shadow-banking activities have margins that are too low. To be able to easily distribute risks across the financial system, for example, shadow banking focuses on ‘hard information’ risks that are easy to measure, price and communicate, e.g., through credit scores. This also means these services are generally contestable, with too low margins to generate sufficient internal capital to buffer residual risks. Therefore, shadow banking needs access to a backstop, i.e., a risk absorption capacity external to the shadow banking activity.

The backstop for shadow banking needs to be sufficiently deep:

  • First, shadow banking usually operates on large scale, to offset significant start-up costs, e.g., of the development of infrastructure;
  • Second, residual, ‘tail’ risks in shadow banking are often systemic, so can realise en masse.

There are two ways to obtain such a backstop. One is private – by using the franchise value of existing financial institutions. This explains why many shadow banking activities operate within large banks or transfers risks to them (as with liquidity puts in securitisation). Another is public – by using explicit or implicit government guarantees. Examples include, besides the general too-big-to-fail implicit guarantee provided to those large banks active in shadow banking, the Federal Reserve securities lending facility that backstops the collateral intermediation processes, the implicit too-big-to-fail guarantees for tri-party repo clearing banks and other dealer banks (Singh 2012), the bankruptcy stay exemptions for repos which in effect guarantee the exposure of lenders (Perotti 2012), or implicit guarantees on bank-affiliated products (as widely described in the press regarding so called ‘wealth management products’ in China (see The Economist 2013, Bloomberg 2013a, 2013b)) or on liabilities of non-bank finance companies (as noted for India, see Acharya et al. 2013).

The Need for a Backstop as a “Litmus Test” for Shadow Banking

Assessing whether an activity requires access to a backstop to operate could be used as the key test of whether it represents shadow banking. For example, the ‘usual’ capital market activities (in the right column of Figure 1) do not need external risk absorption capacity (because some, like custodian or market-making services, involve no risk transformation, while others, like hedge funds, have high margins), and so are not shadow banking. Only activities that need a backstop – because they combine risk transformation, low margins and high scale with residual ‘tail’ risks – are systematically-important shadow banking.

Policy Implications

Acknowledging the need for a backstop as a critical feature of shadow banking offers useful policy implications:

  • First, it gives direction on where to look for new shadow banking risks.

Among financial activities that need franchise value or government guarantees to operate. Non-traditional activities of banks or insurance companies are ‘prime suspects’. It is hard to point to the shadow banking-like activities which may give rise to future (systemic) risks conclusively, but one example could be the liquidity services provided by sponsor banks to exchange traded funds, or large-scale commercial bank backstops for leveraged buyouts.

  • Second, it explains why shadow banking poses significant macro-prudential and other regulatory challenges.

Shadow banking uses backstops to operate. Backstops reduce market discipline and thus can enable shadow banking to accumulate (systemic) risks on a large scale. In the absence of market discipline, the one force which can prevent shadow banking from accumulating risks is regulation.

  • Third, it suggests that shadow banking is almost always within regulatory reach, directly or indirectly.

Regulators can control shadow banking by affecting the ability of regulated entities to use their franchise value to support shadow banking activities (as was done in the aftermath of the crisis by limiting the ability of banks to offer liquidity support to structured investment vehicles). Or by managing the (implicit) government guarantees (as is attempted in the US Dodd-Frank Act by limiting the ability to extend the safety net to non-bank activities and entities; or by general attempts underway to reduce the too-big-to-fail problem).

  • Finally, it suggests that the migration of risks from the regulated sector to shadow banking – often suggested as a possible unintended consequence of tighter bank regulation – is a lesser problem than some fear.

Shadow banking activities cannot migrate on a large scale to areas of the financial system that do not have access to franchise values or government guarantees. This by itself does not make spotting the activity occurring within the reach of the regulator necessarily easier, but at least it narrows the task.

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21 comments

  1. H. Alexander Ivey

    Pardon what is probably a rant from an old guy, but this post is pure BS from a 1% spokesman.

    The first paragraph, “shadow banking as ‘all financial activities, except traditional banking, which require a private or public backstop to operate’.”, shows the author’s lack of understanding of money and by which, financial activities. All financial activities are backstopped by money – either fiat currency, which is backstopped by the federal government or much more commonly, credit (money from a bank), which is also backstopped by the federal government (the government gives the bank a charter to make and receive credit).

    The rest of the post is an eye-glazing-over (due to its BS and its total lack of connection to how things really are done) read, full of $5 words saying that “shadow banking” is not really so bad, that it could be tamed with just some tinkering, and there is nothing that could be done, it’s just a force of nature. Dead give-aways for the 1% POV.

    Contrast this post with the posting above it in NC, http://www.nakedcapitalism.com/2013/08/a-very-profitable-part-of-banking-goes-totally-to-heck.html, which, while not talking directly about shadow banking, Mr Dayen covers the topic of shadow banking, in regards to home mortgages, in a much more clear fashion. Just think of shadow banking as unregulated banking – liar loans, inflated assessments, all-but-coercive lending practices, and you get the picture.

    1. Ben Johannson

      Agreed. I’ve found a much better definition is unregulated or “opaque” finance, which includes the OTC derivatives market.

        1. WorldisMophing

          That Rob Johnson testimony post was quite interesting.
          Disturbing how easily “Democracy” can be sabotaged…

  2. lxdr1f7

    The shadow banking system can grow disproportionately because of the large vome of money supporting it as result of the capacity of banks to origiante money in the form of deposits and also easy access to fed funds.

    If anyone is really interested in creating an effective and stable banking system then the issue of money creation and cheap access to money has to be addressed.

  3. craazyman

    I think they need to go back to the well on this one, lower the bucket down, and try again. :)

    1. craazyboy

      Holy Gubmint Backstop craazyman!

      Next thing they’ll tell us is the Black Death was a means of diversifying bubonic plague risk in rats.

  4. RueTheDay

    “Need” of a backstop is subjective. Most will claim they do not need it………until they need it.

    I would define it as any activity that contains maturity mismatch (long term assets funded by short term liabilities) and leverage (debt vs equity funding). It’s the combination of the two that makes something banking, shadow or otherwise.

  5. allcoppedout

    This is staffer flannel typical of Graeber’s bullshit jobbers. The backstop to all financial transactions is real work and the people and machines that produce our food, clean water, shelter,production. education and health services.

    Most of financialisation has involved taking money from legacy systems that have historic costs like redundancy payments, pensions, worker representation, health and safety, social and environmental responsibility, recreation clubs, honest tax payments, decent wages … $40 trillion of this was “shadowed” abroad to non-legacy plantations.

    A shadowy feature of this was that we thought we were setting aside deferred wages as pensions and savings to provide for old age, but in fact the whole system of money was being changed in front of our eyes. Thinking of some mad von Mises’ stuff I stumbled over the other day, great fortunes have indeed withered away – those of the worker collectives of the developed world. The rich, through their shadow finance agents, have become obscenely richer.

    The “shadow” element of banksterism is concealed by this lickspittle pedantry.

  6. F. Beard

    Traditional banking transforms risks on a single balance sheet. It uses the law of large numbers, monitoring, and capital cushions to ‘convert’ risky loans into safe assets to back deposits. some IMF guy [bold added]

    If that were true then why is government deposit insurance and a pet legal tender creator/lender, the central bank required?

  7. Chauncey Gardiner

    By initiating discourse about the definition of “shadow banking”, what is the IMF really attempting to accomplish here?

    IMO one possibility is that it is the first stage of a coordinated effort to thwart legislative reinstatement of the Glass-Steagall Act and thereby prevent regulation of current carte blanche derivatives speculation by the TBTFs in the hundreds of trillions of dollars, as well as regulation of “securitisation” activities.

    I suspect this all dovetails nicely into negotiations presently underway regarding the EU-US and “Trans-Pacific Partnership” trade agreements that will effectively abrogate national sovereignty across a range of affairs, including potentially sovereign control over our own money and financial system… and we have seen what that does to societies in the nations of southern Europe and elsewhere.

    Why are shadow banking “Margins too low”?… I believe it is because all backstops are now the Public, and market participants recognize that.

    1. psychohistorian

      I agree!

      When do the global plutocrats pull the handle on the next worldwide economic crash steered into outright military states with escalating debt for the 99%?

  8. RBHoughton

    Shadow banking sounds very much like what used to be called ‘accommodation bills business’ in 19th century.

    Some unknown chap trades millions on the backstop of an accommodation bill. The bill is issued by a known financier but is expressly agreed not to be drawn upon.

    1. Ms G

      How fascinating, RB.

      Was it ever the case that these accomodation bills were issued by known/trusted financiers to guarantee loans by other financiers to a government for, e.g., paying the costs of war, etc.?

  9. Denise

    So what’s the story with the toxic assets? I haven’t heard the term used for a long time. Did they get written off, or are they still on the books at fictional valuations?

    1. skippy

      Currently awaiting the amortizing cycle to finish… although it seems they can’t wait and are front loading faster than the process can wash the original load.

      skippy… didn’t mommy teach them not to mix whites with colours???

  10. CLARENCE SWINNEY

    OBAMA THE REGULATION KING?
    “Where Congress won’t act, I will” he proclaimed after the 2010 election.
    The Code Of Federal Regulations has increased from 71,224 pages in 1975 to 174,545 last year.
    Yet! A Gallup poll this year found 84% of Americans believe the government is doing the right thing or needs to do more to protect the environment. Two thirds would support stricter standards for food sold in public schools
    The 13,000 pages finalized during he Obama first term were slightly fewer than in the GW Bush first term.
    Howard Shelanski, the regulatory chief, told Congress last month he had turned up enough to could save $10 billion. But getting rid of this is easier said than done.
    Long sought rules to limit construction worker’s exposure to silica dust, require new rear view cameras on cars and give minimum wage rights to in-home care workers have been stalled for more than a year may get done

Comments are closed.