## 1. A Simple Financial Intermediation Framework

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### Modern asset management and limits of the simple framework
- Traditional view:
  - Households save long-term and place funds directly in capital markets or with asset managers who invest in long-term instruments.
  - Banks intermediate short-term savings and perform maturity transformation for long-term loans.
- Key critiques and conceptual shifts:
  - Asset managers are significant demanders of safe, short-term, liquid instruments (non-deposit money-claims).
  - Asset managers act as “source collateral mines” that routinely lend securities or accept cash collateral that can be re-used (re-pledged, or source collateral).
  - Interaction of asset managers’ demand for institutional money and supply of source collateral defines the shadow banking system and is not well captured by existing models or flow of funds data.
- Consequences:
  - Little need for maturity transformation outside banking is incorrect; shadow banking performs (reverse) maturity transformation.
  - Large demand for money-type instruments and collateral supply originates within the asset management complex rather than from traditional household deposit dynamics.

### Reverse maturity transformation (RMT) — definition, mechanisms, and scale
- Definition:
  - Reverse maturity transformation: transformation of long-term savings into short-term savings.
- Dominant mechanisms:
  - Asset management practices, derivatives strategies, liquidity management, and securities lending.
- Scale and importance:
  - RMT is the dominant source of marginal demand for money-type instruments despite long-term horizons of underlying household savings.
  - Creates large, centrally managed cash pools within the asset management complex.
    - In the aggregate, these cash pools account for over three-quarters of the $3.5 trillion in institutional cash pools at end 2010.
- Constraints on intermediation by traditional deposit-like instruments:
  - Institutional cash pools cannot earn zero interest, so fully insured, noninterest-bearing transaction accounts are unsuitable.
  - Large cash balances exceed deposit insurance limits ($250,000 in the US), creating significant uninsured exposures to banks which risk managers will avoid.
- Preferred instruments:
  - Short-term publicly guaranteed debt (e.g., Treasury bills, agency discount notes) and privately guaranteed wholesale funding instruments (e.g., repurchase agreements, asset-backed commercial paper, other asset-backed paper) — termed public and private non-M2 types of money.
  - U.S. Treasury bills and sovereign claims are the ultimate institutional money instruments: fully insured, extremely liquid, short-term, yield-bearing, and without duration risk.
  - When government-guaranteed short-term instruments are insufficient, the shadow banking system supplies privately guaranteed money-type instruments.

### Collateral mining and the shadow banking system
- Main mining channels:
  - Securities borrowing,
  - Reverse repurchase agreements (reverse repos),
  - Customer margin loans,
  - Margins from in-the-money OTC derivatives.
- Nature and value of source collateral:
  - Source collateral (collateral that can be re-used or re-pledged) is the most valuable form because repeated use lubricates markets but can produce leverage-like collateral chains.
  - Largest deposits of source collateral reside with asset managers: hedge funds, exchange traded funds, sovereign wealth funds, central banks, pension funds, insurance companies and mutual funds.
- Dealers and intermediation:
  - Dealers (the 10-15 banks active in collateral management, not traditional commercial banks) intermediate the collateral world to provide funding, settle trades, enhance client returns, and hedge counterparty risk on OTC derivatives.
- Reuse and leverage-like exposures:
  - Repeated reuse of source collateral creates off-balance-sheet leverage-like exposures for banks and long dynamic collateral chains that can cross borders and jurisdictions.

### Quantified implications and measurements
- Off-balance-sheet items of banks related to mining and re-use of source collateral:
  - About $5.8 trillion at end-2010.
  - About $10 trillion at year-end-2007 (declined to $5.8 trillion by end-2010).
- Aggregate shadow banking size adjustments (adding the above off-balance items to previous U.S. shadow banking estimates):
  - Totals up to $25 trillion at year-end 2007.
  - Totals up to $18 trillion at year-end 2010.
- Collateral mined from asset managers (source collateral volumes):
  - $3.3 trillion and $2.4 trillion at year-end 2007 and 2010, respectively.
  - Breakdowns: $1.6 and $1.3 trillion in hedge fund assets, and $1.7 and $1.1 trillion in real money assets at end-2007 and 2010, respectively.
- Institutional cash pools from asset management activities:
  - Investment Company Institute estimates for the U.S.: demand for money from asset managers’ holdings of short-term instruments was $400 billion and $500 billion at year-end 2007 and 2010, respectively.
  - Risk Management Association estimates for the U.S.: demand for money from securities lending was $1.2 trillion and $800 billion at end-2007 and 2010, respectively.
- Aggregate re-pledged (re-used) off-balance-sheet items across the largest U.S. and European banks (plus Nomura, Japan):
  - About $10 trillion at year-end 2007.
  - About $5.8 trillion at year-end 2010.
- U.S.–European interlinkages:
  - U.S. banks typically rehypothecate “collateral received that can be pledged” with European banks and vice versa; U.S. and European markets are roughly equal in size, so an approximate 50 percent addition to U.S. pledged collateral figures is used in aggregate comparisons.
- Alternative interpretation of funding to banks:
  - Gross volume of funding from non-banks intermediated by banks may have been $25 trillion and $18 trillion at year-end 2007 and 2010, respectively.
  - Example: Lehman, at the eve of its bankruptcy (end-2007), had $800 billion in pledged collateral that could be repledged in Lehman’s name, while its balance sheet size was about $700 billion.

### Implications for accounting, regulation, and macro/micro analysis
- Institution-level issues:
  - Off-balance-sheet collateral mining and reuse are not adequately covered by traditional accounting concepts and financial analyses.
  - These items are not directly addressed by Basel III.
  - Need for integrated analysis of large complex financial conglomerates that operate in both traditional and shadow banking roles.
- Aggregate/system-level issues:
  - Existing financial and monetary aggregates and the Flow of Funds accounts inadequately capture the size and interactions of shadow banking driven by asset managers’ money demand and collateral supply.
  - Measuring banks’ funding solely by deposits and interbank loans is incomplete; large non-M2 funding sources are asset manager-to-bank claims, not bank-to-bank claims as often assumed.
- Flow of Funds (FoF) limitations (summary from Box 3):
  - FoF contains ‘data gaps’ and aggregates items that straddle banks and non-banks, omitting flows of risks and collateral without "satellite" accounts.
  - Off-balance sheet entities (e.g., SIVs) and hedge fund holdings are obscured by aggregation and sectoral classifications.
  - Aggregation masks intra-system exposures and reduces FoF utility for early warning signals.
  - Derivatives data and under-collateralization (margin shortfalls) are difficult to discern in FoF.
  - Short-term instrument granularity is insufficient to track holdings by money funds, securities lenders, or corporate Treasurers.
  - Bank holding companies’ consolidated views are lost in FoF aggregation; 10Q/10K filings are often required for full consolidation.
  - Pledged collateral received by banks with rights to re-use is not fully reflected in balance sheets or FoF and is often buried in footnotes.

### Policy recommendations and areas for reform
- Regulatory and supervisory frameworks should:
  - Account for the role of asset managers as non-bank providers of funding to banks.
  - Integrate analysis of large financial conglomerates’ activities across traditional and shadow banking systems.
  - Address off-balance-sheet exposures stemming from the mining and reuse of source collateral.
  - Reconsider and fine-tune bank leverage definitions to incorporate collateral chains and sizable volumes of pledged collateral that churn between banks and nonbanks.
  - Recognize that regulatory measures pushing riskier activities outside the banking system (e.g., Dodd-Frank Act, Basel III) may increase shadow banking; monitor linkages and collateral chains accordingly.
- Statistical and monetary reporting:
  - Adjust Flow of Funds and other macro-statistical frameworks to better track institutional cash pools, source collateral stocks, re-use chains, off-balance sheet liabilities (e.g., ABCP, money funds), detailed short-term instrument holdings, derivatives under-collateralization or margin shortfalls, and consolidated balance-sheet views of bank holding companies.
  - Augment FoF with "satellite" accounts and off-balance sheet disclosures to capture flows of risks and collateral.
- Broader policy considerations:
  - When altering funding structures, consider supply of preferred safe assets: pushing banks away from short-term secured wholesale funding without increasing supply of safe assets (including sovereign bonds) may lead shadow banking to fill the void.
  - Pay attention to new collateral mines and mining techniques (e.g., corporations as securities lenders in the U.S.; collateral upgrade swaps with pension funds and insurers in the U.K.) as sources of off-balance-sheet cross-border interconnectedness.

*Source: 1. A Simple Financial Intermediation Framework (IMF working paper content).*

### 1. A Simple Financial Intermediation Framework ....................................................................3

### 1. A Simple Financial Intermediation Framework

### Modern asset management and the limits of the simple framework
- The traditional view: households (ultimate creditors) save long-term and place funds directly in capital markets or with asset managers who invest in long-term instruments; banks intermediate short-term savings and perform maturity transformation for long-term loans.
- This simple framework implies little need for maturity transformation outside the banking system and cannot explain shadow banking’s (reverse) maturity transformation.
- Asset managers are not passive long-term investors; they generate large demand for money-type instruments and are major suppliers of collateral to the shadow banking system.
- Key conceptual shifts:
  - Asset managers as significant demanders of safe, short-term, liquid instruments (non-deposit money-claims).
  - Asset managers as “source collateral mines” that routinely lend securities or accept cash collateral that can be re-used (re-pledged, or source collateral).
  - The interaction of these supply and demand aspects defines the shadow banking system and is not well captured by existing models or flow of funds data.

### Reverse maturity transformation (RMT)
- Reverse maturity transformation: substantial portions of long-term savings are transformed into short-term savings through asset management practices, derivatives strategies, liquidity management, and routine securities lending.
- RMT is the dominant source of marginal demand for money-type instruments in the financial system despite the long-term horizon of the underlying household savings.
- RMT creates large, centrally managed cash pools within the asset management complex.
  - In the aggregate, these cash pools account for over three-quarters of the $3.5 trillion in institutional cash pools at end 2010.
- Institutional cash pools arising from securities lending and other asset management activities cannot be effectively intermediated by traditional deposit-like instruments for at least two reasons:
  - They cannot earn zero interest (so fully insured, noninterest-bearing transaction accounts are unsuitable).
  - Large cash balances exceed deposit insurance limits ($250,000 in the US), creating significant uninsured exposures to banks which risk managers will avoid.
- Consequently, asset managers prefer short-term publicly guaranteed debt (e.g., Treasury bills, agency discount notes) and privately guaranteed wholesale funding instruments (e.g., repurchase agreements, asset-backed commercial paper, other asset-backed paper) — termed public and private non-M2 types of money.
- U.S. Treasury bills and sovereign claims are the ultimate institutional money instruments: fully insured, extremely liquid, short-term, yield-bearing, and without duration risk.
- When government-guaranteed short-term instruments are insufficient to meet institutional money demand, the shadow banking system supplies privately guaranteed money-type instruments.

### Collateral mining and the shadow banking system
- Asset managers’ portfolios are routinely mined for collateral through:
  - Securities borrowing,
  - Reverse repurchase agreements (reverse repos),
  - Customer margin loans,
  - Margins from in-the-money OTC derivatives.
- Source collateral (collateral that can be re-used or re-pledged) is the most valuable form because repeated use lubricates markets but can produce leverage-like collateral chains.
- Dealers (the 10-15 banks active in collateral management, not traditional commercial banks) intermediate the collateral world to provide funding, settle trades, enhance client returns, and hedge counterparty risk on OTC derivatives.
- The largest deposits of source collateral reside with asset managers including hedge funds, exchange traded funds, sovereign wealth funds, central banks, pension funds, insurance companies and mutual funds.
- The repeated reuse of source collateral creates off-balance-sheet leverage-like exposures for banks.

### Quantified implications and measurements
- Estimated off-balance-sheet items of banks related to mining and re-use of source collateral:
  - About $5.8 trillion at end-2010.
  - About $10 trillion at year-end-2007 (declined to $5.8 trillion by end-2010).
- Aggregate shadow banking size adjustments (adding the above off-balance items to previous U.S. shadow banking estimates):
  - Totals up to $25 trillion at year-end 2007.
  - Totals up to $18 trillion at year-end 2010.
- U.S.–European interlinkages: U.S. banks typically rehypothecate “collateral received that can be pledged” with European banks and vice versa; U.S. and European markets are roughly equal in size, so an approximate 50 percent addition to U.S. pledged collateral figures is used in aggregate comparisons.

### Implications for accounting, regulation, and macro/micro analysis
- At the institution level:
  - Off-balance-sheet collateral mining and reuse are not adequately covered by traditional accounting concepts and financial analyses.
  - These items are not directly addressed by Basel III.
  - A more integrated analysis is required for large complex financial conglomerates that operate in both traditional and shadow banking roles.
- At the aggregate/system level:
  - Existing financial and monetary aggregates and the Flow of Funds accounts inadequately capture the size and interactions of shadow banking driven by asset managers’ money demand and collateral supply.
  - Measuring banks’ funding solely by deposits and interbank loans is incomplete; large non-M2 funding sources are asset manager-to-bank claims, not bank-to-bank claims as often assumed.

### Policy recommendations and areas for reform (as identified)
- Regulatory and supervisory frameworks should:
  - Account for the role of asset managers as non-bank providers of funding to banks.
  - Integrate analysis of large financial conglomerates’ activities across traditional and shadow banking systems.
  - Address off-balance-sheet exposures stemming from the mining and reuse of source collateral.
- Statistical and monetary reporting:
  - Adjust Flow of Funds and other macro-statistical frameworks to better track institutional cash pools, source collateral stocks, and the re-use chains that materially affect leverage and liquidity in the financial system.

*Source: 1. A Simple Financial Intermediation Framework (IMF working paper content).*

### Box 1. What Is Reverse Maturity Transformation?

### Box 1. What Is Reverse Maturity Transformation?

### Definition and core concept
- Maturity transformation: transformation of short-term deposits into long-term loans (typically done by banks).
- Reverse maturity transformation: transformation of long-term savings into short-term savings.
- Much of reverse maturity transformation occurs in the shadow banking system and arises from at least three activities.

### Three principal activities driving reverse maturity transformation
- Asset managers’ holdings of short-term instruments
  - Technical reasons: manage constant inflows and outflows; inflows may first be parked in short-term instruments; holdings may be kept in reserve to cope with withdrawals.
  - Tactical reasons: allocations to short-term instruments as a source of return for market-timing active managers.
  - Investment Company Institute estimates for the U.S.: demand for money from these activities was $400 billion and $500 billion at year-end 2007 and 2010, respectively. These combine a relatively large and stable technical component and a relatively small and more cyclical tactical component.
- Funds with synthetic (derivatives-based) investment strategies
  - These funds typically invest client funds in short-term instruments and overlay derivatives (futures, swaps) to gain exposure to duration, foreign exchange, or credit risk.
  - Example: instead of investing in Brazilian bills outright, a global bond fund manager may invest synthetically via Treasury bills plus non-deliverable reais forwards.
  - Market participants envisage significant volumes from these strategies, but no available aggregate data on demand for money from these strategies.
- Collateral mining via securities lending (primarily against cash collateral in the U.S.)
  - Securities borrowers wire cash to securities lenders as collateral; securities lenders place these funds into cash collateral reinvestment accounts and invest in short-term instruments.
  - Risk Management Association estimates for the U.S.: demand for money from this corner of asset management was $1.2 trillion and $800 billion at end-2007 and 2010, respectively.
  - Note: these figures are lower than total volume of source collateral mined because not all securities lending is against cash collateral; some is against securities collateral.

### Collateral mining and source collateral
- Asset managers are ultimate sources of collateral in the shadow banking system; they are subdivided broadly into:
  - Levered accounts (hedge funds).
  - Unlevered or real money accounts (exchange traded funds, sovereign wealth funds, central banks, pension funds, insurance companies, mutual funds).
- Dealers obtain (or “mine”) collateral:
  - From levered accounts: via repo funding against collateral and prime-brokerage borrowings (margin loans) against collateral.
  - From unlevered accounts: via custodians acting as securities lenders (unlevered accounts as principals, custodians as agents).
- Estimated total volume of collateral mined from asset managers (source collateral):
  - $3.3 trillion and $2.4 trillion at year-end 2007 and 2010, respectively.
  - Breakdowns: $1.6 and $1.3 trillion in hedge fund assets, and $1.7 and $1.1 trillion in real money assets at end-2007 and 2010, respectively.
- Re-pledging and dynamic collateral chains
  - Source collateral can be re-pledged (legal right for the dealer receiving collateral to re-use it in its own name), creating dynamic collateral chains.
  - Since a single piece of source collateral can be re-used multiple times by several dealers, aggregate re-pledged collateral reflects both the volume of source collateral and the velocity (re-use rate) of source collateral.
  - Aggregate re-pledged (re-used) off-balance-sheet items across the largest U.S. and European banks (plus Nomura, Japan):
    - About $10 trillion at year-end 2007.
    - About $5.8 trillion at year-end 2010.
  - Implication: large volumes of source collateral accrue to global banks and can be recycled in financial markets, producing cross-border interconnections that straddle multiple jurisdictions.

### Example: repeated use of collateral creating dynamic chains
- Illustration (descriptive example):
  - Hedge fund obtains funding from prime broker (dealer1) via repo against Treasury collateral (Treasury is source collateral).
  - Dealer1 may re-pledge Treasury collateral to dealer2 to meet collateral posting requirements (e.g., for an out-of-the-money interest-rate swap).
  - Dealer2 may in turn re-pledge the Treasury to an asset manager, which may then re-use the Treasury to post collateral to dealer3 for an in-the-money FX swap.
- Single piece of source collateral can underpin: consumer funding, management of interest-rate and foreign-exchange risks, trade settlement, and security for uninsured cash investors.
- These repeated re-uses produce dynamic chains distinct from simple credit intermediation chains.

### Reinterpretation of intermediation and leverage implications
- Traditional banking-system accounting (as presented in the text) interprets total lending to ultimate borrowers as funded by:
  - Total debt funding to banks provided by non-banks (outside claimholders).
  - Total equity of the banking system.
- Traditional view: non-bank funding (red balloon) is relatively “sticky” (largely household deposits/M2), so rapid increases in aggregate credit come via increased leverage and interbank claims.
- The text’s alternative interpretation:
  - Significant funding to banks comes from the asset management complex via source collateral and non-M2 institutional cash pools; non-bank funding is not limited to household deposits.
  - In the U.S., gross volume of funding from non-banks intermediated by banks may have been $25 trillion and $18 trillion at year-end 2007 and 2010, respectively.
  - Even with M2 stable, the banking system can lever up because short-term institutional funds are primarily non-M2 liabilities; supply of privately guaranteed non-M2 liquid assets is largely a function of institutional demand for short-term claims.
  - Therefore, shadow banking is primarily an asset-manager-to-bank phenomenon rather than only an interbank phenomenon.
  - As the financial system levers up, collateral chains generally get longer (evidence: pre-Lehman end-2007 relative to post-Lehman).

### Policy implications and recommendations
- Regulatory focus should extend beyond fortifying banking-sector equity and limiting leverage to address sizable volumes of bank funding coming from non-bank asset managers via source collateral and institutional cash pools.
- Regulators may need to reconsider and fine-tune bank leverage definitions to incorporate collateral chains and the sizable volumes of pledged collateral that churn between banks and nonbanks.
  - Example: Lehman, at the eve of its bankruptcy (end-2007), had $800 billion in pledged collateral that could be repledged in Lehman’s name, while its balance sheet size was about $700 billion.
- Attention needed on new collateral mines and mining techniques emerging post-Lehman (e.g., corporations as securities lenders in the U.S.; collateral upgrade swaps with pension funds and insurers in the U.K.) as examples of off-balance-sheet cross-border interconnectedness and collateral chains.
- Regulatory efforts altering funding structures should consider the supply of preferred safe assets:
  - Current approaches push banks away from short-term, secured, wholesale funding and incentivize more deposits and term funding; unless supply of safe assets (including sovereign bonds) is addressed, shadow banking will likely fill the void.
- Regulatory measures that push riskier activities outside the banking system (e.g., Dodd-Frank Act, Basel III) may increase the shadow banking world; its linkages to traditional banking warrant closer attention and possible adaptation in regulatory approach (dynamic collateral chains differ from credit intermediation chains).
- Flow of funds accounts, as currently designed, are insufficient to understand the shadow banking system; enhancements are suggested (referenced as Box 3 in source) to avoid leaving significant volumes of financial transactions untabulated in the shadows.

*Source: Box 1. What Is Reverse Maturity Transformation? from the provided IMF content unit.*

### Box 3. Flow of Funds Data and Limitations

### Box 3. Flow of Funds Data and Limitations

### Summary of limitations in Flow of Funds (FoF) statistics
- FoF statistics (such as those produced by the U.S. Federal Reserve System) capture banking sector and other financial data but omit or aggregate aspects that straddle banks and non-banks.
- Even in mature markets like the United States, FoF contains ‘data gaps’ that require complementary analysis of off-balance sheet statistics and linkages with sectors outside the regulatory perimeter.
- The FoF accounts presently only reflect the flow of savings and investment of an economy; they do not track flows of risks and collateral without additional "satellite" accounts.

### Key findings and evidence of gaps
- Off-balance sheet entities:
  - SIVs (special investment vehicles), off balance sheet entities, were sizable in the run up to the 2007/08 financial crisis.
  - Although SIVs are picked up in FoF data, data is aggregated and there is no way of tracing back to the banking sector off balance sheet liabilities such as ABCP (asset backed commercial paper), and money funds, via Flow of Funds.
  - Hedge funds holdings of financial assets are buried in FoF’s “household” sector.
- Aggregation masks intra-system exposures:
  - By aggregating and netting across all banks, the FoF loses relevant information (example: security lending on L130 of the FoF page 83 is shown “net” in line 20 and would not highlight a large positive build up in bank X and a negative build up in bank Y).
  - Thus FoF has limitations for early warning signals of the banking sector.
- Derivatives and under-collateralization:
  - Derivatives data is difficult to discern in the FoF.
  - Financial statements do not provide the under-collateralization (or margin shortfall) of derivative positions.
  - Example structural allocation: for some recent members of the ‘banking community’ Goldman Sachs has most plain vanilla derivatives books in the bank while equity and commodities derivatives are conducted out of the brokerage subsidiary; most of the (notional) derivatives for Morgan Stanley were still being conducted outside the commercial bank.
  - Derivatives unbundle risks associated with securities that transmit the flow of savings and investments; FoF will ultimately have to include "satellite" accounts that track the flow of risks and collateral.
- Short-term instrument granularity:
  - FoF uses the term “open market paper” to capture money market instruments such as financial, nonfinancial and ABCP, Treasury bills, agency discount notes, etc.
  - The breakdown of short-term instruments is not granular enough.
  - It is impossible to track detailed holdings of short-term instruments (e.g., money funds’, securities lenders’ or corporate Treasurer’s holdings of short-term investments).
  - Instruments of maturity transformation and the holders of risks related to maturity transformation are close to impossible to track through FoF accounts.
- Bank holding companies and consolidation issues:
  - Bank holding companies such as Citibank, JP Morgan, Deutsche Bank, Goldman Sachs and Morgan Stanley are not fully reflected in banking statistics.
  - Example: the holding company has 10 times the assets of the bank.
  - FoF shows all elements of the holding company (bank, dealer, asset manager etc) but “tears” the holding company X’s balance sheet and then aggregates all banks in one sheet; all dealers in another sheet etc., causing loss of the overall picture of the holding company.
  - To see build-up of all business positions of the bank holding company from its various components under one roof, one must go back to the 10Q/10K filings.
- Collateral chains and pledged collateral:
  - Nonbank linkages with banks are not fully captured in FoF statistics.
  - Pledged collateral received by banks with rights to re-use is not fully reflected in the balance sheet or the FoF statistics.
  - Such pledged collateral information, often buried in footnotes to financial statements, sheds light on systemic risk via collateral chains that connect nonbanks to banks.

### Implications and suggested augmentations
- FoF needs to be augmented by other information sources, including off-balance sheet disclosures and footnotes to financial statements, to capture:
  - Off-balance sheet liabilities (e.g., ABCP, money funds).
  - Detailed holdings of short-term instruments and instruments used in maturity transformation.
  - Derivatives under-collateralization or margin shortfalls.
  - Consolidated balance-sheet views of bank holding companies (requiring 10Q/10K-level consolidation).
  - Satellite accounts that explicitly track flows of risks and collateral to reflect modern financial system workings.

*Source: Box 3. Flow of Funds Data and Limitations*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2011/_wp11289.pdf_