Shadow Banking and Market Based Finance
IMF News, September 14, 2017
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- Published: September 14, 2017
Shadow banking — A framework
- Shadow banking characterized by economic features that distinguish it from traditional banking and more resilient market-based finance:
- Extensive transformation of risk through complex structuring (pooling and tranching), credit enhancement, leverage, complexity, and opaqueness; maturity and/or liquidity transformation can be prominent.
- Intermediation often performed along a chain of specialized and interconnected intermediaries; reuse of collateral and lengthy collateral chains increase interconnectedness.
- No explicit or formal access to official sector backstops (discount window access, deposit insurance) as in traditional banks.
- Activity often benefits from the presumption of sponsor support (implied credit guarantees, credit lines), creating contingent liabilities for sponsors.
- Liabilities principally debt-financed in the wholesale market.
- Resilience in market-based finance may derive from:
- Greater simplicity, transparency, and standardization (less complex/opaque structuring).
- Lower institutional interconnectedness (shorter collateral chains, absence of presumed third-party support).
- A more diverse, longer-term, and non-runnable funding base (debt and equity across retail & wholesale).
- Stylized taxonomy (as presented in Table 1):
- Traditional Banking: single entity, formal ex-ante backstop: Yes, liabilities: debt and deposits, key risk transformations: liquidity, maturity, leverage, key resulting risk: Systemic risk (institutional spillovers).
- Shadow Banking: can involve many interconnected entities, formal ex-ante backstop: No / Indirect, implied sponsor support: Yes, main form of liabilities: debt mainly wholesale financed, key risk transformations: credit enhancement (pooling/tranching), resulting risk: Shift in price of risk (market risk premia).
- Market-based Finance: single/few entities, formal ex-ante backstop: No, implied sponsor support: No, liabilities highly diverse (short and long-term debt and equity), key risk transformations: less emphasis on credit enhancement and less opaque vs. shadow banking.
Economic motivations and market failures
- Principal drivers and frictions that can explain emergence of riskier shadow banking features:
- Agency frictions and informational asymmetries: complexity and opaqueness magnify misaligned incentives (predatory lending, adverse selection in securitization).
- (Mispriced) Sponsor backstops and contingent liabilities: subsidized external risk absorption can make certain activities viable only with presumed cheap insurance/support from banks or insurers.
- Regulatory arbitrage: circumvention of capital, liquidity, taxation, or information requirements; pre-crisis example: bank guarantees to ABCP conduits structured as liquidity-enhancing guarantees, reducing regulatory capital charges substantially.
- Distinction emphasized:
- Market price of risk vs. systemic risk: shifts in risk premia can have real effects (borrowing costs, wealth), but systemic risk more associated with amplification mechanisms (leverage, interconnectedness) that disrupt intermediation capacity.
The post-crisis evolution in shadow banking
- Two key global changes since the financial crisis:
- Shift away from riskier shadow banking toward market-based finance (most pronounced in Advanced Economies).
- On one measure (FSB Flow of Funds data): a roughly US$10 trillion swing toward market-based finance between 2007 and 2015, and a $6-7 trillion swing against all other types of non-bank credit intermediation.
- In U.S. Flow of Funds: assets intermediated through bond mutual and exchange-traded funds have more than doubled since 2007, while assets of broker-dealers, finance companies, ABS issuers and MMFs have almost halved.
- Interconnectedness has reduced; emergence of shorter collateral chains noted.
- Non-bank financial deepening in Emerging Markets (EMs).
- EM share of global ‘Other Financial Intermediaries’ (OFIs) assets increased from 4 percent in 2011 to 11 percent as of 2015.
- U.S. and U.K. saw the largest relative declines in their share of global OFI assets (5 percentage points each).
Strengthening supervision and regulation — progress and remaining gaps
- Major reforms and impacts:
- Basel III reforms improved recognition and capitalization of banks’ explicit and contingent exposures to shadow banking entities; off-balance sheet provision of credit insurance by deposit-taking institutions has declined.
- Reforms targeted at securities financing transactions (SFTs) and OTC derivatives to dampen liquidity mismatches and constrain non-bank leverage.
- Examples of specific sectoral reforms and outcomes:
- Money Market Funds (MMFs):
- U.S. accounts for around 60 percent of global MMF assets.
- Prime institutional MMFs in the U.S. now required to float their NAV; new tools for non-government MMF boards (liquidity fees, redemption gates); strengthened disclosures; bank sponsors required to capitalize MMF support lines.
- Result: significant shift away from prime institutional MMFs; similar regulations in Europe to take effect over next 12-18 months.
- Securitization:
- Loan underwriting standards strengthened; expanded prudential consolidation; increased disclosure; credit retention (‘skin in the game’) requirements introduced.
- Riskier residential mortgage-backed securities issuance (subprime, Alt-A, HELOC, Junior Liens) has all but ceased after previously topping out at just over $1 trillion in 2006.
- In the EU: retention rules require originators, sponsors, or original lenders to retain at least 5 percent net economic interest; in the U.S.: at least 5 percent retention (since December 2015 for RMBS, and December 2016 for other ABS).
- Remaining implementation and policy challenges:
- FSB Peer Review: implementation of the Policy Framework for Shadow Banking Entities remains at a relatively early stage.
- Persistent issues:
- Continued operation of the ‘issuer pays’ model for credit rating agencies (CRAs).
- Cross-border regulatory arbitrage and uneven adoption of reforms (e.g., retention rules outside EU and U.S., variances in SFT reforms).
- Supervisory guidance to address banks’ ‘step-in risks’ for non-contractual and reputational exposures not finalized.
- In the U.S., share of MBS activity by government-sponsored entities expanded to 86 percent, up from 61 percent in 2006.
- Data and disclosure gaps remain, especially around collective investment vehicles and cross-border interconnectedness.
Policy challenges on the horizon — regional examples
- China — credit intermediation:
- China’s high savings rate and gradual financial liberalization led to large-scale financial deepening and inclusive credit intermediation.
- Concerns: credit imbalances inside and outside the formal banking sector; structural features resembling shadow banking (hard-to-look-through risk transformations, expanded bank–non-bank interconnections, presumption of sponsor/official backstops, rising short-term wholesale financing).
- Authorities’ response: closing avenues for arbitrage between traditional and non-traditional banking; unwinding presumption of sponsor support for wealth management products. Early signals: bank claims on non-bank financial institutions and off-balance sheet wealth management products have essentially stopped growing.
- United States — partial reemergence of structured leveraged finance:
- Leveraged loan market:
- New issuance set a record over the past year; outstanding volumes now more than 50 percent above the 2008 peak.
- Share of loans rated B+ or below reaccelerated to near record levels; covenant-lite share reaccelerated.
- Market size: leveraged loan market equivalent to around 5 percent of U.S. GDP; in absolute terms, half the size of the subprime mortgage market at its peak.
- Investor composition: bank share of leveraged loans declined from around 25 percent a decade ago to less than 10 percent now.
- Subprime auto-loan ABS:
- Emergence of surge in relatively low-rated leveraged and subprime auto-loans; subprime auto-loan ABS stock still under $50 billion.
- $110bn of subprime auto-loans issued last year; delinquency and loan loss rates on the rise.
- Assessment: sector-specific risks monitored closely; currently viewed as non-systemic but warrant attention.
- Europe — asset management supervision and data gaps:
- Asset management industry raises concerns around liquidity transformation, leverage within funds, operational risks, and securities lending.
- Supervisory challenges:
- European supervisors find it difficult to know composition of fund unit liabilities once distributed by intermediaries (vulnerability to synchronized runs).
- Leverage data collection makes it hard to distinguish gross vs. net exposure, and hedge vs. speculative derivatives use.
- Special purpose vehicles outside the regulatory perimeter limit visibility; Central Bank of Ireland active in investigating such entities.
- Initiatives underway to address data and categorization gaps for macro-financial surveillance, though further work remains.
Concluding observations and policy priorities
- Progress since the 2010 G20 Seoul Summit:
- In Advanced Economies, many activities that amplified the global financial crisis have been made less systemically threatening: strengthened securitization practices, overhauled repo markets, more robust MMFs, and reduced interconnectedness between banks and shadow banks.
- Business models of intermediaries have changed; reforms aimed at transforming structural characteristics and economic incentives of riskier shadow banking activities are underway.
- Outstanding policy priorities:
- Harmonize retention rules across jurisdictions.
- Reform certain rating agency practices and reduce mechanistic regulatory reliance on CRAs.
- Wind back implicit official backstops and finalize supervisory guidance on ‘step-in’ risks.
- Close data and disclosure gaps for collective investment vehicles and cross-border interconnectedness.
- Monitor emerging challenges such as FinTech, given its rapid growth despite currently modest scale (credit intermediation by FinTech assessed at less than 1 percent of bank loans).
- Overarching message:
- Important progress achieved toward a system of resilient market-based finance that supports productive risk-taking and economic growth, but the target remains constantly moving and vigilance is required.
Tobias Adrian, International Monetary Fund — Speech prepared for the 33rd SUERF colloquium, Helsinki, September 14, 2017.