Shadow Banks: Out of the Eyes of Regulators

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Shadow banks: financial institutions that "look like a bank and act like a bank" but are not subject to traditional bank regulation.
Term coined by Paul McCulley in a 2007 speech; originally emphasized US nonbank institutions performing maturity transformation.
Core intermediation functions (per the Financial Stability Board):
- maturity transformation: obtaining short-term funds to invest in longer-term assets;
- liquidity transformation: using cash-like liabilities to buy harder-to-sell assets such as loans;
- leverage: employing techniques such as borrowing money to buy fixed assets to magnify potential gains or losses;
- credit risk transfer: transferring borrower default risk from originators or issuers to other parties.
Examples of shadow-banking entities and activities:
- broker-dealers funding assets using repurchase agreements (repos);
- money market mutual funds pooling investors’ funds to purchase commercial paper or mortgage-backed securities;
- finance companies that sell commercial paper and use proceeds to extend credit to households;
- the securitization chain that turns home mortgages into mortgage-backed securities largely outside direct regulatory view.

Problems arise when investors simultaneously withdraw short-term funding, forcing shadow banks to sell assets ("fire sales"), which depress asset prices and propagate losses across entities.
Contributing features of shadow banking during the global financial crisis:
- lack of disclosure and information about asset values or even asset composition;
- opaque governance and ownership links between banks and shadow banks;
- little regulatory or supervisory oversight comparable to traditional banks;
- virtually no loss-absorbing capital or cash for redemptions;
- lack of access to formal liquidity support (for example, central bank funds) to prevent fire sales.
Interconnections with regulated banks amplified systemic stress:
- some shadow banks were controlled by commercial banks and were salvaged for reputational reasons;
- arm’s-length connections impaired markets (for example, commercial paper markets) that also funded banks;
- opacity made it unclear counterparty exposures and contingent claims.

Estimating the size of shadow banking is difficult because many entities do not report to regulators.
FSB global monitoring (mandated by the G20) expanded since 2011; covers 28 jurisdictions and the euro area.
Entity-based findings (end-2015 data):
- euro area shadow banking system: 33 percent of the total (up from 32 percent in 2011);
- US shadow banking system: declined from 33 percent to 28 percent.
Global totals reported across contributing jurisdictions:
- peaked at $62 trillion in 2007;
- declined to $59 trillion during the crisis;
- rebounded to $92 trillion by the end of 2015.
Functional (activity-based) categorization (27 jurisdictions): total $34.2 trillion, with asset-management-type activities making up some 22 percent of that total.
Limitations of current measures:
- FSB monitoring does not measure the amount of debt used to purchase assets (leverage);
- does not fully capture the system’s amplification potential or the channels transmitting problems across sectors (though some linkage attempts use balance sheet data between nonbanks and banks).

Authorities have increased data collection and enhanced monitoring to search for hidden vulnerabilities.
Banking supervisors are examining banks’ exposures to shadow banks and strengthening capital and liquidity regulations to contain contagion.
Some authorities have expanded reporting scopes and altered the regulatory perimeter to capture shadow-banking entities and markets.
Authorities are discouraging regulatory arbitrage—shadow banks tailoring behavior to fall under the weakest or no regulators, domestically or globally.
Ongoing challenges for authorities:
- piecing together disparate and incomplete data to assess systemic risks associated with activities, entities, and instruments in the shadow banking system;
- improving measurement of leverage and cross-sector linkages to better gauge systemic importance.

Content by Laura Kodres (Back to Basics). F&D Magazine page overview.