## _sdn1212

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### Executive summary — overview and key functions
- Shadow banking: "credit intermediation involving entities and activities outside the regular banking system" (FSB, 2011); paper focuses on activities that are economically most bank-like—those that involve risk transformation and reduce counterparty risks.
- Two core functions emphasized:
  - Securitization: creates safe assets for savers by unbundling and repacking risks; converts long-term debt into “AAA” assets via tranching; makes assets short-term via maturity transformation vehicles funded in short-term money markets.
  - Collateral intermediation: specializes in efficient use of scarce collateral; facilitates intermediation while transforming risks and managing counterparty exposures.
- Expected outcome of appropriate policies:
  - An appropriate policy package may shrink the shadow banking system and lead it to perform its useful economic functions—providing safe claims and credit to borrowers—in better, less risky ways.

### Distortions, systemic risks, and subsidy effects
- Regulatory arbitrage contributed to the run-up to the global financial crisis.
- Runs and fragilities:
  - Risks of runs on private “safe” assets created by securitization and short-term funding structures.
  - Fragilities in collateral intermediation (including rehypothecation chains and velocity of collateral).
- Implicit and explicit guarantees:
  - Banks, dealer banks, and under some conditions money market funds can benefit from implicit or explicit guarantees, creating effective subsidies that amplify risk-taking.

### Policy priorities and framework
- Broad objective: limit regulatory arbitrage and “puts” to the safety net while regulating shadow banking activities that have valid economic rationales to reduce systemic risks.
- Priorities (verbatim as highlighted in the source):
  - Dealing with regulatory arbitrage;
  - Addressing systemic risks in the shadow banking system, which includes developing a regulatory approach to dealer banks, money market funds, the tri-party repurchase market, and dealing with innovation and complexity;
  - Considering demand-side pressures, including the merits of accommodating a shortage of safe and liquid assets with publicly guaranteed short-term debt;
  - Better measuring and monitoring the shadow banking system; and
  - Studying the shadow banking system’s macroeconomic effects and implications for monetary policy.
- Measurement and monitoring: better measurement is essential to inform policy.

### Box 1 — Literature review: drivers, functions, and size
- Demand for private money / private safe assets:
  - Institutional cash investors’ balances significantly exceed supply of short-term government debt and insured deposits.
  - Demand for safe assets as a ratio to GDP appears historically stable and met by public and private instruments.
  - Private safe-asset production exposes producers to tail risks via tranching; leverage and unstable expansions can arise from perceived safety.
  - Runs on private-money instruments (e.g., repo-based funding) are possible.
- Market failures in securitization:
  - Fragility arises from short-term funding; securitization enables higher leverage via repo funding; regulatory arbitrage and imperfect risk transfers emphasized.
- Collateral intermediation and structural dynamics:
  - Reuse of scarce collateral; dealer-bank centrality; legal rules can effectively subsidize derivatives and repo contracts with negative stability implications.
- Functions:
  - Liability-side: provides safe claims via securitization or increases safety via collateral transformation.
  - Asset-side: provides credit to borrowers enabled by attraction of savings to safe liabilities.
- Size, evolution, and geographic distribution (global figures):
  - Global shadow banking: $65 trillion in 2011, compared to $26 trillion in 2002.
  - Shadow banking was on average 25% of financial assets and 111% of aggregate GDP (global, 2011 measure).
  - Two-thirds of shadow banking now occurs outside the U.S.; notable in the euro area and the U.K.
- Securitization mechanics and demand:
  - Tranching steps: equity/mezzanine/AAA; sale of AAA to vehicles funded in short-term money markets; liquidity transformation via bank “puts” and money market funds issuing stable NAV claims.
  - Global corporate short-term savings: grew from less than $50 billion in 1990 to more than $750 billion in 2007 and over $1.2 trillion by end-2010.
  - Asset management complex cash holdings: grew from $100 billion in 1990 to over $2.5 trillion in 2007 and $2 trillion at end-2010.
  - Prime money funds grew to nearly $1 trillion by June 2007; government-only money funds remained at $300 billion pre-crisis.
- Securitization risks and crisis outcomes:
  - Tranching and ratings practices ignored correlations, producing tail risks.
  - Prime money funds saw outflows of over $300 billion between August and September 2008; government-only money funds saw inflows of over $500 billion.
  - Private-label securitization contracted significantly post-crisis.
- Collateral intermediation metrics and dynamics:
  - Volume of collateral transactions declined from $10 trillion to $6.1 trillion over the last three years referenced.
  - Stock of collateral declined from $3.4 trillion to $2.5 trillion over the same period.
  - Collateral velocity: 3 at end-2007, 2.4 at end-2010, and 2.5 at end-2011.
  - Table values presented in source:
    - 2007: 1.7, 1.7, 3.4, 10.0, 3.0
    - 2010: 1.3, 1.1, 2.4, 5.8, 2.4
    - 2011: 1.3, 1.05, 2.35, 6.1, 2.5
- Systemic collateral risks:
  - Dealer banks’ liquidity exposure when rehypothecated collateral must be returned.
  - Legal “safe harbor” provisions exempt some contracts from automatic stay in bankruptcy, reducing market discipline and effectively subsidizing counterparties.
  - Tri-party repo (TPR) market poses distinct systemic risks; U.S. TPR volumes approached $1.8 trillion (down from $2.7 trillion in 2007). TPR in continental Europe and England increased to roughly €1.1 trillion.

### Box 2 — Measuring and monitoring: estimates, gaps, and priorities
- Size estimates vary widely (private and official):
  - "$13 trillion to $60 trillion" (Deloitte, 2012).
  - New York Fed: "$20 trillion in 2008 and $16 trillion in 2010".
  - Singh (with collateral reuse): "$25 trillion as of 2007 and $19 trillion as of end-2011".
  - FSB aggregate-data estimates: "$60 trillion in both 2007 and 2010, and $67 trillion in 2011".
- Jurisdictional breakdown (FSB, 2011 data for 2011):
  - U.S.: "$23 trillion".
  - Euro area: "$22 trillion".
  - U.K.: "$9 trillion".
- Measurement trade-offs:
  - Gross measures capture total exposures but can include significant double counting; counting collateral reuse valid if measuring value in use.
- Priority data gaps and metrics needed:
  - Demand of nonbank institutional cash investors for safe, short-term, and liquid assets.
  - Collateral intermediation: ultimate sources and volume of source collateral, velocity, and collateral-chain length.
  - Degree of (under) collateralization of OTC derivative exposures.
  - More information on maturity transformation, leverage, interconnectedness, distribution of cash balances, and detailed disclosures on “cash and equivalents”.
- Institutional constraints:
  - Legal authority to request data from unregulated entities often lacking; legal changes may be required.
- Macroprudential framing:
  - Two complementary issue sets: better supervision/regulation/resolution of shadow banking entities; dealing with mismatches between demand and supply of safe and liquid assets.
- FSB shadow banking agenda (five work streams):
  - 1. Banks’ interactions with shadow banking entities.
  - 2. Money market funds.
  - 3. Other shadow banking entities (priority list; policy recommendations; methodologies for identifying systemically important global nonbank financial institutions).
  - 4. Securitization (risk retention, transparency, standardization).
  - 5. Securities lending and repos (overview and financial stability issues including lack of transparency, procyclicality, collateral re-use, fire-sale risks, cash collateral reinvestment, and collateral management/valuation).

### Box 4 — Polar regulatory views and policy trade-offs
- Two polar views:
  - View 1: Merge shadow banking into traditional commercial banks or expand the regulatory perimeter—ensures supervisory coverage but may compromise bank stability and contradict trading bans.
  - View 2: Sever links and establish firewalls, then leave shadow banking relatively unregulated—reduces moral hazard but may be impossible to fully separate and reduces policymakers’ information.
- Dealer banks (broker-dealers):
  - Business-model fragility: high leverage, procyclical businesses, unstable uninsured wholesale funding; all 14 major dealer banks are SIFIs.
  - Since the crisis, dealer banks accessed central bank liquidity through related commercial banks even when depository part can represent as little as 5 percent of the group’s overall balance sheet (the highest is 60 percent).
  - Regulatory and resolution gaps remain.
- Money market funds (MMFs):
  - Systemic and fragile; offer par guarantees that may require government support when asset values drop.
  - Policy options: lower average asset maturity; introduce capital requirements; require floating NAV; use two-class claims.
  - Trade-offs: capital requirements may relax investment standards and make MMFs quasi-banks; removing par guarantees could dramatically shrink the system; implicit guarantees may blunt reforms.
- Tri-party repo market:
  - Reliance on two private clearing banks in the U.S. (Bank of New York and JP Morgan) creates systemic risks.
  - Possible solution: transfer clearing functions to a “market utility”.
- Demand-side policies for safe-asset mismatch:
  - Prior mismatch peaked at roughly $2.5 trillion prior to the crisis after a $1.5 trillion surge in three years preceding it; mismatch has fallen since due to increased issuance of short-term government guaranteed debt.
  - Policy options include issuing more T-bills, central bank bills, or extending deposit accounts to nonbanks.
  - Challenges: debt-management implications, potential moral hazard, definitional complexity, and limited scope to address collateral intermediation risks.
- Macroeconomic implications:
  - Shadow banking is highly procyclical; secured lending relying on mark-to-market prices and margins amplifies cycles.
  - Potential mitigation: require margins or haircuts for certain asset classes to have minimums or be calibrated through the cycle.
  - Interaction with monetary policy: low interest rates and a steeper yield curve can increase payoffs to maturity transformation and risk-taking.
  - Fiscal implications: crisis responses can generate contingent liabilities and fiscal costs (examples cited: Primary Dealer Credit and Term Securities Lending Facilities; Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity and Commercial Paper Funding Facilities; Bear Stearns; AIG).

### Appendix 1 — OTC derivatives, CCPs, under-collateralization, and repo markets
- OTC derivatives and CCPs:
  - Regulatory efforts focus on moving OTC derivatives to CCPs; CCPs collect collateral and net bilateral positions.
  - Dodd-Frank Act allows the Federal Reserve to lend to key financial market infrastructures during crises.
  - Incentives to move OTC contracts include increasing bank capital charges on OTC positions not moved to CCP (BCBS, 2012).
- Size and exposures:
  - Notional value of OTC contracts: about $600 trillion.
  - Resulting exposures after netting: currently about $3 trillion, down from $5 trillion.
- Under-collateralization:
  - BIS estimates collateral supporting the OTC market is about $1.8 trillion, roughly only half of exposures.
  - Assuming collateral reuse rate between 2.5-3.0, the dedicated collateral is some $600 - $700 billion.
  - Some counterparties often not required to post collateral (sovereigns, quasi-sovereigns, large pension funds and insurers, AAA corporations).
- Tri-party repo (TPR) market:
  - Around 50 to 70 percent of repo operations in the United States are cleared using TPR.
  - Recent U.S. TPR volumes have approached $1.8 trillion, much below $3 trillion in 2008.
  - U.S. market serviced by two clearing banks (Bank of New York and JP Morgan), both determined to be systemic by the FSB.
  - Pledged collateral is held with custodians and cannot be repledged in the TPR arrangement.
  - Distinguishing U.S. feature: daily unwind process creating intra-day unsecured exposures for clearing banks.
  - TPR activity in continental Europe and the United Kingdom: roughly €1.1 trillion, serviced by Euroclear and Clearstream (which do not provide intra-day financing).
- Non-TPR repo and securities lending:
  - Non-TPR repo market estimated at about $750 billion, of which about $500 billion is in the United States.
  - Securities lending estimated at about $800 billion in the United States and about $200 billion in Europe.
  - Non-TPR market could be about 40 to 50 percent of overall repo activities.

*Source: _sdn1212 (IMF Staff Discussion Note content provided).*

### Executive Summary ......................................................................................................

### _sdn1212 - Executive Summary

### Overview
- Shadow banking: rapid growth over the past decade; provides financial intermediation functions distinct from banks and capital markets and requires proper understanding and regulation.
- FSB definition (quoted): “credit intermediation involving entities and activities outside the regular banking system” (FSB, 2011). The paper adopts a narrower focus on activities economically most bank-like—those that involve risk transformation and reduce counterparty risks.
- Two core shadow banking functions emphasized: securitization and collateral intermediation.

### Main functions and economic role
- Securitization
  - Creates safe assets for savers by unbundling and repacking risks.
  - Converts long-term debt into “AAA” assets via tranching and transfers credit risk.
  - Makes assets short-term through maturity transformation vehicles funded in short-term money markets.
  - Serves large institutional cash pools (short-term investments held through prime money funds) and banks seeking assets to secure repo funding.
- Collateral intermediation
  - Specializes in efficient use of scarce collateral.
  - Facilitates intermediation from savers to investors while transforming risks and managing counterparty exposures.

### Distortions, systemic risks, and subsidy effects
- Regulatory arbitrage: shadow banking exhibits aspects of regulatory arbitrage that contributed to the run-up to the global financial crisis.
- Runs and fragilities:
  - Risks of runs on private “safe” assets created by securitization and short-term funding structures.
  - Fragilities in collateral intermediation (including rehypothecation chains and velocity of collateral).
- Implicit and explicit guarantees:
  - Banks, dealer banks, and under some conditions money market funds can benefit from implicit or explicit guarantees.
  - These “puts” to the public safety net effectively subsidize the system and amplify risk-taking.

### Policy priorities and framework
- Broad objective: limit regulatory arbitrage and “puts” to the safety net while regulating shadow banking activities that have valid economic rationales to reduce systemic risks.
- Priorities for a comprehensive policy response (listed verbatim as the paper highlights):
  - Dealing with regulatory arbitrage;
  - Addressing systemic risks in the shadow banking system, which includes developing a regulatory approach to dealer banks, money market funds, the tri-party repurchase market, and dealing with innovation and complexity;
  - Considering demand-side pressures, including the merits of accommodating a shortage of safe and liquid assets with publicly guaranteed short-term debt;
  - Better measuring and monitoring the shadow banking system; and
  - Studying the shadow banking system’s macroeconomic effects and implications for monetary policy.
- Measurement and monitoring: better measurement of the shadow banking system is essential to inform policy (see Box references in the source for further development).

### Expected outcomes of appropriate policies
- An appropriate policy package may shrink the shadow banking system and lead it to perform its useful economic functions—providing safe claims and credit to borrowers—in better, less risky ways.

*Source: Executive Summary and Introduction of the provided content unit.*

### Box 1. A Review of Literature on the Economics of Shadow Banking

### Box 1. A Review of Literature on the Economics of Shadow Banking

### Key strands of the academic literature
- Demand for private money / private safe assets
  - Identified as a core driver of shadow banking growth (McCulley, 2007; Rajan, 2005).
  - Institutional cash investors’ balances significantly exceed the (inelastic) supply of short-term government debt and insured deposits (Greenwood, Hanson, and Stein, 2012; Pozsar, 2011; Turner, 2012).
  - Demand for safe assets as a ratio to GDP appears historically stable and met by public and private instruments (Gorton, Lewellen, and Metrick, 2012).
  - Mechanisms producing private safe assets expose producers to tail risks via tranching, diversification, and residual risk retention (Gennaioli, Shleifer, and Vishny, 2012a, 2012b).
  - Leverage and unstable expansions can arise from perceived safety (Geanakoplos, 2010).
  - Runs on private-money instruments (e.g., repo-based funding) are possible (Gorton and Metrick, 2012; Martin, Skeie, and von Thadden, 2011).
  - Private money creation may be excessive because agents do not internalize crisis costs (Ricks, 2012; Stein, 2012).

- Market failures in securitization
  - Mapping of flows and contractual links shows “puts” to large financial institutions supporting securitization (Pozsar, 2008; Pozsar and others, 2010).
  - Fragility arises from short-term funding that supports securitization (Stein, 2010; Gorton and Metrick, 2012).
  - Securitization enables higher leverage via repo funding (Adrian and Shin, 2009; Shin, 2009).
  - Regulatory arbitrage and imperfect risk transfers from banks are emphasized (Acharya, Schnabl, and Suarez, 2012).

- Collateral intermediation and structural dynamics
  - Shadow banks support collateral-based operations and reuse of scarce collateral (Singh and Aitken, 2010; Singh, 2011).
  - Financial innovations arise from structural changes and policy reforms and require adaptation in financial regulation and monetary policy (Mehrling, 2010; Singh and Stella, 2012).
  - Legal rules can effectively subsidize certain derivatives and repo contracts with negative stability implications (Tuckman, 2010; Summe, 2011; Perotti, 2012).

### Functions of shadow banking: liability- and asset-side roles
- Liability-side role: provides safe claims (via securitization) or increases safety of claims (via collateral transformation) for financial agents, including ultimate savers.
- Asset-side role: provides credit to borrowers, enabled by the attraction of savings to the safe liabilities created.

### Systemic risks highlighted by the financial crisis
- Securitization function broke down as aggregate risks were ignored, producing large real and financial spillovers.
- Collateral intermediation is systemically risky due to dealer-bank business-model instability and run risk from customers and short-term fund providers.
- Widespread regulatory arbitrage, high procyclicality of shadow banking, and fiscal risks associated with crisis management emerged, implying policy responses are required.

### Size, evolution, and geographic distribution
- Global shadow banking: $65 trillion in 2011, compared to $26 trillion in 2002.
- Shadow banking was on average 25% of financial assets and 111% of aggregate GDP (global, 2011 measure).
- While the U.S. has the largest system, two-thirds of shadow banking now occurs outside the U.S., notably in the euro area and the U.K., with rapid growth in many emerging markets.
- Securitization has contracted since the crisis, but collateral-based operations have remained strong.
- Shadow banking prominence is rising again as economic activity rebounds and traditional bank regulations tighten.

### Securitization: mechanics, demand, and risks
- Mechanics (risk-stripping and tranching)
  - Step 1: Tranching of cash flows into equity, mezzanine, and safe long-term “AAA” security (credit-risk transfer).
  - Step 2: Sale of long-term AAA security to a vehicle funded in short-term money markets, creating a safe, short-term asset (maturity-risk transfer). These structured money market instruments (SMMIs) included ABCP.
  - Step 3: Liquidity transformation via bank-provided “puts” and money market funds issuing stable NAV claims (liquidity-risk transfer).
  - Chains sometimes included CDOs and resecuritizations to create more AAA claims.

- Demand for safe assets by cash pools
  - Global corporate short-term savings: grew from less than $50 billion in 1990 to more than $750 billion in 2007 and over $1.2 trillion by the end of 2010.
  - Asset management complex cash holdings: grew from $100 billion in 1990 to over $2.5 trillion in 2007 and $2 trillion at end-2010.
  - Institutional cash pools and corporate cash pools grew by a factor of 30 over the past decade to equal almost half of traditional deposits (aggregate effect described; figure cited in source).
  - Prime money funds grew to nearly $1 trillion by June 2007; government-only money funds remained at $300 billion pre-crisis.

- Banks’ demand for securitized debt
  - By 2006, at least a third of AAA tranches of securitized assets were held by U.S. and European banks (Greenlaw and others, 2008).
  - Banks used securitized AAA claims as collateral for repo funding to raise wholesale funds and increase leverage.
  - Regulatory arbitrage reduced capital charges via affiliated investment vehicles (SIVs) or by holding higher-rated securitized claims.

- Risks in securitization
  - Tranching and ratings practices ignored correlations and aggregate exposures, creating buildup of “tail risks.”
  - When funding dried up, banks faced unexpected exposures from investment vehicles or reneged on implicit liquidity puts.
  - Banks and other investors (UBS, RBS, Lehman Brothers, Bear Stearns; pension funds, mutual funds, insurance companies) incurred large losses.
  - Prime money funds saw outflows of over $300 billion between August and September 2008; government-only money funds saw inflows of over $500 billion.
  - Private-label securitization contracted significantly post-crisis and may re-emerge in a different, less leveraged form.

### Collateral intermediation: mechanics, demand, and risks
- Mechanics of collateral operations
  - Collateral supports secured funding, securities lending, and hedging (including OTC derivatives).
  - Collateral quality varies widely, from U.S. Treasuries to CCC-rated bonds or equities; pledgeability depends on market-clearing prices.
  - A small number of dealer banks (all SIFIs) are central intermediaries in collateral chains, benefiting from fixed costs of entry, economies of scale, and network centrality, partly underpinned by perceptions of low counterparty risk.
  - Re-use ("rehypothecation") creates chains where a single unit of collateral supports multiple transactions (example: a U.S. Treasury bond used three times through hedge fund → prime broker → dealer → money market fund).

- Demand and metrics for collateral services
  - Volume of collateral transactions declined from $10 trillion to $6.1 trillion over the last three years referenced.
  - Stock of collateral declined from $3.4 trillion to $2.5 trillion over the same period.
  - Collateral velocity (volume of secured transactions divided by stock of source collateral): 3 at end-2007, 2.4 at end-2010, and 2.5 at end-2011.
  - Table 1 (sources of pledged collateral, volume of secured operations, velocity) (values presented in source text):
    - 2007: 1.7, 1.7, 3.4, 10.0, 3.0
    - 2010: 1.3, 1.1, 2.4, 5.8, 2.4
    - 2011: 1.3, 1.05, 2.35, 6.1, 2.5

- Systemic risks in collateral intermediation
  - Dealer banks’ liquidity exposure arises when rehypothecated collateral must be returned, forcing liquidation or new collateral sourcing (Duffie, 2010; Squam Lake, 2010b).
  - Runs by prime brokerage clients contributed to the failure of stand-alone U.S. investment banks in 2008.
  - When a dealer bank is also a depository institution, risks can be moved to the depository side, subsidizing shadow banking and increasing taxpayer exposure (Singh, 2012b).
  - Legal provisions (e.g., “safe harbor” for derivatives and repos) exempt some contracts from automatic stay in bankruptcy, reducing market discipline and effectively subsidizing counterparties; recent studies question the economic justification for these exemptions (Summe, 2011; Bolton and Oehmke, 2011a, 2011b; Duffie and Skeel, 2012; Bliss and Kaufmann, 2005; Perotti, 2012).
  - The tri-party repo (TPR) market poses distinct systemic risks; U.S. TPR volumes approached $1.8 trillion (down from $2.7 trillion in 2007). TPR in continental Europe and England increased to roughly €1.1 trillion.

### Overall view and policy implications
- Complexity, size, and measurement
  - The shadow banking system is complex, involves many nonbank agents, and is tightly linked to traditional banks and dealer banks; exact size is difficult to determine.

- Four components of a comprehensive policy response
  - (1) Dealing with regulatory arbitrage (recent regulatory actions focus here).
  - (2) Addressing systemic risks within shadow banking (including regulation of dealer banks and money market funds, and managing innovation and complexity).
  - (3) Addressing demand-side pressures (including possibly accommodating a shortage of safe and liquid assets with government or publicly guaranteed short-term debt issuance).
  - (4) Considering macroeconomic and monetary policy implications of shadow banking.

- Additional policy-relevant observations
  - Regulatory changes affecting securitization supply include: Basel III increasing costs of providing liquidity lines; accounting rules requiring consolidation of SIVs/conduits; tightened retention requirements; and tightened disclosure requirements (FSB cited in source).
  - Collateral intermediation’s importance is likely to grow because increased counterparty risk makes secured funding more attractive, global integration increases arm’s-length transactions, and new regulations (e.g., more collateral in derivatives and central clearing) increase collateral demand.

*Source: Box 1, “A Review of Literature on the Economics of Shadow Banking,” Staff Discussion Note content provided.*

### Box 2: Measuring and Monitoring the Shadow Banking System Better

### Box 2: Measuring and Monitoring the Shadow Banking System Better

### Measurement and size estimates
- Private sector estimates of the size of the shadow banking system vary greatly because scope, institutional coverage, and methodology are not uniform:
  - "$13 trillion to $60 trillion" (Deloitte, 2012).
  - New York Fed study: "$20 trillion in 2008 and $16 trillion in 2010" (Pozsar and others, 2010).
  - Singh (2012a) with collateral reuse: "$25 trillion as of 2007 and $19 trillion as of end-2011".
  - Financial Stability Board (FSB) aggregate-data estimates: "$60 trillion in both 2007 and 2010, and $67 trillion in 2011".
- Jurisdictional breakdown (FSB, 2011 data for 2011):
  - U.S.: "$23 trillion".
  - Euro area: "$22 trillion" (noted as far larger than the "$13 trillion" estimate of Bouveret, 2011).
  - U.K.: "$9 trillion".

### Measurement choices and implications
- Key definitional choices:
  - Whether to cover net or gross activities.
  - Whether to measure stocks or flows.
- Example of a gross measure (New York Fed study):
  - Includes all U.S. dollar denominated securitized assets (private and government sponsored).
  - Includes all nondeposit money market liabilities (including assets of banks, dealer banks, finance companies, government-sponsored enterprises, and a wide range of [now non-existent] maturity transformation vehicles funded in asset-backed commercial paper markets).
  - Includes money market mutual funds.
- Trade-offs:
  - Gross measures capture total exposures useful for financial stability purposes but can include significant double counting and overestimate the importance of shadow banking.
  - For collateral, counting reuse may be valid if measuring collateral value in use; otherwise, adjustments for double counting are necessary.

### Data gaps and needed metrics
- Large data gaps and lack of granularity in many countries; existing data can document some activities but are insufficient.
- Priority areas where better data are needed:
  - (1) The demand of nonbank institutional cash investors for safe, short-term, and liquid assets.
  - (2) Collateral intermediation: ultimate sources and volume of source collateral, its velocity, and the length of collateral chains.
  - (3) The degree of (under) collateralization of OTC derivative exposures.
- Additional needs:
  - More information on maturity transformation, leverage, and interconnectedness.
  - Data on distribution of corporations’ and asset managers’ cash balances by size.
  - More detailed disclosures on instruments included in “cash and equivalents”.
- Existing data sources that can help:
  - Aggregate flows of funds.
  - Surveys.
  - Hedge fund industry interfaces with dealers via prime brokerage.
  - Financial statements of large institutions, including footnotes (for pledged collateral).
- Institutional and legal constraints:
  - Many authorities believe they lack legal authority to request data from unregulated entities; legal changes may be required to enable data collection.

### Continuous monitoring and system structure
- Continuous monitoring is required because:
  - Some risky shadow banking practices are now less frequent, but financial innovation can generate new systemic risks.
  - Better and more granular data on transactions, market participants, financial flows, and interconnections are needed to detect emerging risks and respond.
- Simplified description of the shadow banking ecosystem (two key processes):
  - Securitization chains: transform risky assets into safe and liquid claims via tranching and use of puts from the main banking system.
  - Collateral chains: re-use collateral to reduce counterparty risk between borrowers and lenders; providers of collateral (hedge funds, real money, custodians for pensions/insurers/officials) are widely scattered.
- Key links with regulated and semi-regulated entities (many of which are SIFIs):
  - Commercial banks: active in securitization chains; provide explicit and implicit support to SPVs; invest in safe tranches.
  - Dealer banks: central role in intermediating collateral.
- Participants and flows (high-level):
  - Ultimate savers: short-term household and corporate savings and long-term household savings; access shadow banking through the asset management complex including money funds and insurance/pension funds.
  - Ultimate borrowers: corporations and households; associated investors include lenders seeking to securitize loans and leveraged investors (primarily hedge funds) borrowing against collateral.

### Policy framework and macroprudential approach
- Starting point: understand operations and demand factors; recognize that many shadow banking activities have valid economic and market rationales and should not be excessively restricted.
- Need for policy response:
  - Address systemic risk and regulatory weaknesses that enabled shadow banking practices pre-crisis (examples: use of affiliated investment vehicles to offload credit risks; insufficient provisioning for credit and liquidity guarantees; capital charges not reflecting structured-product risks).
  - Ongoing reforms coordinated by the FSB and others aim to reduce spillovers to the main banking system and the public safety net.
- Macroprudential path:
  - Adopt policy measures to correct market failures and externalities arising from shadow banking that can lead to systemic risk.
  - Two complementary sets of issues to analyze and address:
    - Better supervision, regulation, and resolution of shadow banking entities.
    - Dealing with mismatches between demand and supply of safe and liquid assets.
- Macroeconomic implications:
  - Shadow banking conditions affect monetary transmission in normal times and during crises.
  - Disruptions can generate significant economic spillovers and may trigger fiscal outlays.
  - Monetary policy can influence risk-taking in the shadow banking sector and the sector can affect policy transmission.

### The FSB shadow banking agenda (five work streams)
- 1. Banks’ interactions with shadow banking entities
  - Areas: consolidation rules for prudential purposes; limits on size and nature of a bank’s exposures to shadow banking entities (large exposure regime); risk-based capital requirements for banks’ exposures to shadow banking entities; treatment of reputational risk and implicit support.
- 2. Money market funds
  - Policy options to consider: mandatory move from constant to variable net asset value; enhancement of money market fund valuation and pricing framework; enhancement of liquidity risk management; reduction in the importance of ratings in the money market fund industry.
- 3. Other shadow banking entities
  - Steps: develop a priority list of entity types with significant shadow banking risks; start developing policy recommendations for prioritized entity types; prepare methodologies for identifying systemically important global nonbank financial institutions.
- 4. Securitization
  - Steps: analyze global regulatory and industry initiatives on risk retention, transparency, and standardization; identify and assess material differences in regulatory/industry approaches and their impact; develop policy recommendations, if needed, to address material differences identified.
- 5. Securities lending and repos
  - Areas: overview of securities lending, leveraged investment fund financing and securities borrowing, inter-dealer repo, and repo financing markets; key drivers; location of markets within the shadow banking system; overview of existing regulatory framework.
  - Financial stability issues highlighted: (i) lack of transparency, (ii) procyclicality of system leverage and interconnectedness through valuation, haircuts, and collateral re-use, (iii) other issues associated with re-use of collaterals, (iv) potential risks arising from fire sale of collateral assets, (v) potential risks arising from securities lending activities, (vi) shadow banking through cash collateral reinvestment, and (vii) insufficient rigor in collateral management and valuation.

*Source: Box 2: Measuring and Monitoring the Shadow Banking System Better (_sdn1212).*

### Box 4. “Polar” Views on Regulating Shadow Banking

### Box 4. “Polar” Views on Regulating Shadow Banking

### Polar regulatory views
- View 1: Merge shadow banking into traditional commercial banks or expand the regulatory perimeter.
  - Argument: Ensures supervisory coverage and helps prevent regulatory arbitrage.
  - Downsides highlighted:
    - Shadow banking is more procyclical, risky, and harder to regulate than traditional banks.
    - Merging can compromise commercial banks’ stability, including retail operations.
    - Contradicts proposals that ban or limit trading activities by commercial banks (example references: Volcker rule; Liikanen proposal).
- View 2: Sever links and establish firewalls, then leave shadow banking relatively unregulated.
  - Argument: Greater distance from commercial banks reduces spillovers and moral hazard from misuse of the public safety net.
  - Downsides highlighted:
    - May be impossible to fully separate traditional banking from shadow banking.
    - Commercial banks increasingly rely on hard and tradable claims (hedging, diversification, funding).
    - Large size of shadow banking activity can still produce macroeconomic and systemic externalities.
    - Moving activities outside the regulatory perimeter reduces policymakers’ information on operations.
- Supply-side models for private safe assets:
  - Limit issuance of private safe assets to regulated firms with special charters (Ricks, 2012) or narrowly funded banks (Gorton and Metrick, 2010).
  - Variants include vetting new products by an agency (Fielding, Lo, and Yang, 2010).

### Regulating risks within the shadow banking system — key issues
- Some parts are fragile, systemic, and lack appropriate supervision, safety net access, and resolution procedures.
- Urgent need reflected in FSB work program.
- Important open questions remain in policy and conceptual understanding of risks.

### Dealer banks (broker-dealers)
- Business-model fragility:
  - High leverage, procyclical businesses, unstable uninsured wholesale funding.
  - All 14 major dealer banks are SIFIs.
- Funding and moral hazard facts:
  - Since the crisis, dealer banks accessed central bank liquidity through related commercial banks even when depository part can represent as little as 5 percent of the group’s overall balance sheet (the highest is 60 percent; see Singh, 2012b).
  - This access offers stability but increases moral hazard as risky assets can be shifted to bank subsidiaries.
- Regulatory gaps:
  - Regulation and supervision of broker-dealers were insufficient during the crisis; orderly resolution is challenging.
  - A comprehensive framework for regulating broker-dealers equivalent to bank regulation is lacking.
- Policy implication:
  - Systemic risks and puts to the safety net from dealer banks likely persist.

### Money market funds (MMFs)
- Systemic fragility:
  - U.S. money fund industry remains systemic and fragile despite being smaller than before the crisis.
  - Offers par guarantees that may require government support when asset values drop.
- Policy options under discussion:
  - Lowering the average asset maturity of MMFs.
  - Introducing capital requirements.
  - Requiring a floating NAV (largely the case in Europe).
  - Using two-class claims on assets (one redeemable at par and the other contingent on the NAV).
- Trade-offs and consequences:
  - Capital requirements may relax investment standards, make MMFs quasi-banks, and necessitate bank-type regulation.
  - Removing par guarantees could dramatically shrink the system as investors shift to bank deposits and elsewhere.
  - Implicit guarantees may make removal of par guarantees ineffective.
  - Proposals can dramatically affect the MMF industry’s architecture.

### Tri-party repo market
- Core issues:
  - Current initiatives (limit duration of intra-day exposures; improve collateral management) do not address reliance on two private clearing banks (Bank of New York and JP Morgan) in the United States, creating systemic risks.
- Possible structural solution:
  - Transfer clearing functions to a “market utility” (as in some countries) to make the two banks less systemic and segregate tri-party clearing risks.
- Policy question:
  - How to strengthen the tri-party market without compromising its intermediary role between banks and broker-dealers, and between mutual and pension funds, requires more study.

### Financial innovation, complexity, and systemic resolution
- Problems highlighted:
  - Continuous instrument design change; risks not fully understood by investors or designers.
  - Complex systems with many links and implicit commitments are hard to resolve in stress.
  - Example: restructuring securitized household mortgages remains complicated due to many parties and varying incentives.
- Policy options:
  - Radical proposals exist (Fielding, Lo, and Yang, 2010) but their costs and effectiveness are uncertain.
  - More practical approach: macro-prudential framework to identify market failures and externalities and adopt corrective policy measures (reflected in FSB’s agenda).

### Demand-side policies: addressing the safe-asset mismatch
- Core issue:
  - Cash-pools’ demand for safe, short-term liquid assets in volumes larger than short-term government debt supply contributed to shadow banking growth (prime money funds, asset-backed commercial paper, repos).
- Economic mechanism:
  - Demand for safe assets and supply of government short-term debt are relatively price-inelastic, pushing government-guaranteed safe asset prices high and yields very low or negative, encouraging private safe-asset creation.
- Empirical note:
  - Prior to the crisis, mismatch peaked at roughly $2.5 trillion—after it had surged by $1.5 trillion in the three preceding years—and has fallen since due to increased issuance of short-term government guaranteed debt.
- Policy proposal:
  - Government could expand supply of safe, short-term liquid instruments (e.g., issue more T-bills) to crowd out private private safe-asset supply.
  - Central banks could issue central bank bills or extend deposit accounts to nonbanks as alternatives.
- Challenges and limitations:
  - Debt management implications: issuing more short-term paper shifts interest rate and operational risks to the government and may depart from minimal cost debt management rules.
  - Potential moral hazard: private sector may expect government accommodation of asset demand.
  - Definitional and operational complexity: “safe assets” definition is unclear, changing, and international; assessing demand-supply balances is complex.
  - Demand-side policies may insufficiently address systemic risks in other shadow banking areas (e.g., collateral intermediation).
  - Potential distortion: implicitly subsidizing banks’ investments in market-based debt instruments.

### Macroeconomic implications of shadow banking
- Procyclicality and real-sector effects:
  - Shadow banking is highly procyclical, amplifying lax lending in upturns and risks of fire sales in downturns.
  - Secured lending and repos rely on mark-to-market prices and margins/haircuts that adjust through the financial cycle; some collateral can become unacceptable in turmoil.
  - Securitization produces claims safe in most states but risky in others, contributing to tail risks.
  - Increased interconnectedness reduces idiosyncratic risk but raises spillover vulnerability.
- Drivers of procyclicality:
  - Mark-to-market rules; evolving margin requirements and lending standards relative to collateral values; compensation design.
  - Potential mitigation: require margins or haircuts for certain asset classes to have minimums or be calibrated through the cycle (CGFS, 2010; Valderrama, 2010; Fegatelli 2010; FSB, 2012c).
    - Implementation easier in tri-party repo markets with large official roles; harder in bilateral OTC collateral agreements.
    - May distort collateral price-setting.
- Interaction with monetary policy:
  - State of private safe asset supply and stock/velocity of collateral can affect monetary policy transmission.
  - Low interest rates and a steeper yield curve can increase payoff to maturity transformation and risk-taking, driving rapid shadow banking expansion and fragility.
  - Shadow banking conditions should be considered in monetary policymaking.
- Fiscal implications:
  - In crises, shadow banking may require public support with fiscal costs.
  - Examples: U.S. Federal Reserve support to dealer banks (Primary Dealer Credit and Term Securities Lending Facilities), MMFs (Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity and Commercial Paper Funding Facilities), and direct support/restructuring (Bear Stearns; AIG).
  - Contingent liabilities and fiscal risks remain unless systemic risks in shadow banking are addressed.

### Conclusion
- Shadow banking performs economically useful functions but also poses systemic risks.
- Research has not fully separated economic drivers from regulatory arbitrage, complicating policy design.
- A multifaceted policy response to systemic risks in shadow banking is necessary; effective measures may shrink the system but allow safer provision of its useful functions.
- More policy-oriented research is needed as components of the response are not yet clear.

*Source: Box 4. “Polar” Views on Regulating Shadow Banking (extracted from the supplied IMF content).*

### Appendix 1.  Over-the-Counter Derivatives:

### Appendix 1.  Over-the-Counter Derivatives: Central Counterparties and Under-Collateralization

### Central counterparties (CCPs) and regulatory incentives
- OTC derivatives markets span regulated systemically important financial institutions and the shadow banking world.
- Recent regulatory efforts focus on moving OTC derivatives contracts to central counterparties (CCPs).
- A CCP will be collecting collateral and netting bilateral positions.
- CCPs do not have explicit taxpayer backing, but they may be supported in times of stress. For example, the U.S. Dodd-Frank Act allows the Federal Reserve to lend to key financial market infrastructures during times of crises.
- Incentives to move OTC contracts could come from increasing bank capital charges on OTC positions that are not moved to CCP (BCBS, 2012).

### Size of OTC markets and exposures
- The notional value of OTC contracts is about $600 trillion.
- Notional measures overstate risk; a better estimate adds “in-the-money” (gross positive value) and “out-of-the money” (gross negative value) positions and then reduces by legally enforceable bilateral netting.
- Resulting exposures are currently about $3 trillion, down from $5 trillion.
- Source cited: Bank for International Settlements (BIS 2012, p. 23).

### Under-collateralization and collateral availability
- The Bank for International Settlements estimates that the volume of collateral supporting the OTC market is about $1.8 trillion, thus roughly only half of exposures.
- Assuming a collateral reuse rate between 2.5-3.0, the dedicated collateral is some $600 - $700 billion.
- Some counterparties (e.g., sovereigns, quasi-sovereigns, large pension funds and insurers, and AAA corporations) are often not required to post collateral.
- The remaining exposures will have to be collateralized when moved to CCP to avoid creating puts to the safety net.
- As such, there is likely to be an increased demand for collateral worldwide.

### Tri-party repo (TPR) market: structure, size, and risks
- A tri-party repo (TPR) operation is an arrangement whereby a clearing bank acts as an intermediary for two repo counterparties.
- Around 50 to 70 percent of repo operations in the United States are cleared using TPR.
- Recent TPR volumes in the United States have approached $1.8 trillion, much below the $3 trillion in 2008.
- The TPR market is a major source of wholesale funding for banks and dealer banks.
- The U.S. market is serviced by two clearing banks, Bank of New York and JP Morgan, both determined to be systemic by the Financial Stability Board.
- Pledged collateral is held with custodians and cannot be repledged in the TPR arrangement.
- Advantages of TPR:
  - Outsourcing collateral management to the TPR clearer.
  - Saving back-office costs for counterparties.
  - Creating economies of scale as securities are moved within the clearer’s books.
  - Allowing exchange of collateral baskets and outsourcing of haircut calculation, margin calls, substitution, pricing, and ancillary tasks.
- Distinguishing feature of the U.S. TPR market: the daily unwind process where collateral is returned to borrowers and cash to lenders at the start of the trading day and then returned to the clearing bank before close of business.
- Clearing banks can extend borrowers overdrafts as unsecured exposures during the day (although regulators may start demanding collateral on such overdrafts).
- The unwind process transfers risks twice during a day: secured overnight with ultimate lenders, and unsecured during the day with the clearing bank.
- Risks and vulnerabilities:
  - Clearing banks carry large-scale unsecured exposures relative to their capital.
  - Lenders see their positions as short-term and money-like, even for term contracts, creating vulnerability similar to other private safe asset arrangements.
  - Official sector support (e.g., Primary Dealer Credit Facility) helped avoid a run during the financial crisis similar to prime money market fund runs.
- Regulatory response focus:
  - Limiting the duration of intra-day credit by pushing unwind to later in the day.
  - Improving intra-day collateral management (Copeland, Marin, and Walker, 2010; Tarullo, 2012).
  - Intra-day exposures remain large and operationally difficult to reduce.
  - The systemic importance of Bank of New York and JP Morgan may preclude unwinding their roles.
- TPR activity in continental Europe and the United Kingdom has increased to roughly €1.1 trillion, serviced by Euroclear and Clearstream––which do not provide intra-day financing.

### Non-TPR repo and securities lending scale (comparative figures)
- The non-TPR repo market is estimated at about $750 billion, of which about $500 billion is in the United States.
- Securities lending is estimated to be about $800 billion in the United States and about $200 billion in Europe, according to the Risk Management Association.
- Hence, the non-TPR market could be about 40 to 50 percent of overall repo activities.

*Source: Appendix 1, "_sdn1212 - Appendix 1.  Over-the-Counter Derivatives: Central Counterparties and Under-Collateralization."*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/sdn/2012/_sdn1212.pdf_