{
  "title": "Shadow Banking and Market Based Finance",
  "publication": "IMF News, September 14, 2017",
  "sourceUrl": "https://www.imf.org/en/news/articles/2017/09/13/sp091417-shadow-banking-and-market-based-finance",
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  "summary": "Shadow banking characterized by economic features that distinguish it from traditional banking and more resilient market-based finance:",
  "publishDate": "2017-09-14",
  "sections": [
    {
      "heading": "Shadow banking — A framework",
      "content": "- Shadow banking characterized by economic features that distinguish it from traditional banking and more resilient market-based finance:\n  - Extensive transformation of risk through complex structuring (pooling and tranching), credit enhancement, leverage, complexity, and opaqueness; maturity and/or liquidity transformation can be prominent.\n  - Intermediation often performed along a chain of specialized and interconnected intermediaries; reuse of collateral and lengthy collateral chains increase interconnectedness.\n  - No explicit or formal access to official sector backstops (discount window access, deposit insurance) as in traditional banks.\n  - Activity often benefits from the presumption of sponsor support (implied credit guarantees, credit lines), creating contingent liabilities for sponsors.\n  - Liabilities principally debt-financed in the wholesale market.\n- Resilience in market-based finance may derive from:\n  - Greater simplicity, transparency, and standardization (less complex/opaque structuring).\n  - Lower institutional interconnectedness (shorter collateral chains, absence of presumed third-party support).\n  - A more diverse, longer-term, and non-runnable funding base (debt and equity across retail & wholesale).\n- Stylized taxonomy (as presented in Table 1):\n  - 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).\n  - 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).\n  - 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."
    },
    {
      "heading": "Economic motivations and market failures",
      "content": "- Principal drivers and frictions that can explain emergence of riskier shadow banking features:\n  - Agency frictions and informational asymmetries: complexity and opaqueness magnify misaligned incentives (predatory lending, adverse selection in securitization).\n  - (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.\n  - 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.\n- Distinction emphasized:\n  - 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."
    },
    {
      "heading": "The post-crisis evolution in shadow banking",
      "content": "- Two key global changes since the financial crisis:\n  - Shift away from riskier shadow banking toward market-based finance (most pronounced in Advanced Economies).\n    - 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.\n    - 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.\n    - Interconnectedness has reduced; emergence of shorter collateral chains noted.\n  - Non-bank financial deepening in Emerging Markets (EMs).\n    - EM share of global ‘Other Financial Intermediaries’ (OFIs) assets increased from 4 percent in 2011 to 11 percent as of 2015.\n    - U.S. and U.K. saw the largest relative declines in their share of global OFI assets (5 percentage points each)."
    },
    {
      "heading": "Strengthening supervision and regulation — progress and remaining gaps",
      "content": "- Major reforms and impacts:\n  - 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.\n  - Reforms targeted at securities financing transactions (SFTs) and OTC derivatives to dampen liquidity mismatches and constrain non-bank leverage.\n- Examples of specific sectoral reforms and outcomes:\n  - Money Market Funds (MMFs):\n    - U.S. accounts for around 60 percent of global MMF assets.\n    - 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.\n    - Result: significant shift away from prime institutional MMFs; similar regulations in Europe to take effect over next 12-18 months.\n  - Securitization:\n    - Loan underwriting standards strengthened; expanded prudential consolidation; increased disclosure; credit retention (‘skin in the game’) requirements introduced.\n    - 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.\n    - 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).\n- Remaining implementation and policy challenges:\n  - FSB Peer Review: implementation of the Policy Framework for Shadow Banking Entities remains at a relatively early stage.\n  - Persistent issues:\n    - Continued operation of the ‘issuer pays’ model for credit rating agencies (CRAs).\n    - Cross-border regulatory arbitrage and uneven adoption of reforms (e.g., retention rules outside EU and U.S., variances in SFT reforms).\n    - Supervisory guidance to address banks’ ‘step-in risks’ for non-contractual and reputational exposures not finalized.\n    - In the U.S., share of MBS activity by government-sponsored entities expanded to 86 percent, up from 61 percent in 2006.\n  - Data and disclosure gaps remain, especially around collective investment vehicles and cross-border interconnectedness."
    },
    {
      "heading": "Policy challenges on the horizon — regional examples",
      "content": "- China — credit intermediation:\n  - China’s high savings rate and gradual financial liberalization led to large-scale financial deepening and inclusive credit intermediation.\n  - 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).\n  - 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.\n- United States — partial reemergence of structured leveraged finance:\n  - Leveraged loan market:\n    - New issuance set a record over the past year; outstanding volumes now more than 50 percent above the 2008 peak.\n    - Share of loans rated B+ or below reaccelerated to near record levels; covenant-lite share reaccelerated.\n    - 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.\n    - Investor composition: bank share of leveraged loans declined from around 25 percent a decade ago to less than 10 percent now.\n  - Subprime auto-loan ABS:\n    - Emergence of surge in relatively low-rated leveraged and subprime auto-loans; subprime auto-loan ABS stock still under $50 billion.\n    - $110bn of subprime auto-loans issued last year; delinquency and loan loss rates on the rise.\n  - Assessment: sector-specific risks monitored closely; currently viewed as non-systemic but warrant attention.\n- Europe — asset management supervision and data gaps:\n  - Asset management industry raises concerns around liquidity transformation, leverage within funds, operational risks, and securities lending.\n  - Supervisory challenges:\n    - European supervisors find it difficult to know composition of fund unit liabilities once distributed by intermediaries (vulnerability to synchronized runs).\n    - Leverage data collection makes it hard to distinguish gross vs. net exposure, and hedge vs. speculative derivatives use.\n    - Special purpose vehicles outside the regulatory perimeter limit visibility; Central Bank of Ireland active in investigating such entities.\n  - Initiatives underway to address data and categorization gaps for macro-financial surveillance, though further work remains."
    },
    {
      "heading": "Concluding observations and policy priorities",
      "content": "- Progress since the 2010 G20 Seoul Summit:\n  - 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.\n  - Business models of intermediaries have changed; reforms aimed at transforming structural characteristics and economic incentives of riskier shadow banking activities are underway.\n- Outstanding policy priorities:\n  - Harmonize retention rules across jurisdictions.\n  - Reform certain rating agency practices and reduce mechanistic regulatory reliance on CRAs.\n  - Wind back implicit official backstops and finalize supervisory guidance on ‘step-in’ risks.\n  - Close data and disclosure gaps for collective investment vehicles and cross-border interconnectedness.\n  - 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).\n- Overarching message:\n  - 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.\n\nTobias Adrian, International Monetary Fund — Speech prepared for the 33rd SUERF colloquium, Helsinki, September 14, 2017.\n\n---\n\n\n References\n\n- Tobias Adrian\n- PRESS CENTER\n- https://www.imf.org/en/home\n\nSource: https://www.imf.org/en/news/articles/2017/09/13/sp091417-shadow-banking-and-market-based-finance"
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    "Published: September 14, 2017",
    "Shadow banking characterized by economic features that distinguish it from traditional banking and more resilient market-based finance:",
    "Resilience in market-based finance may derive from:",
    "Stylized taxonomy (as presented in Table 1):",
    "Principal drivers and frictions that can explain emergence of riskier shadow banking features:",
    "Distinction emphasized:",
    "Two key global changes since the financial crisis:",
    "Major reforms and impacts:",
    "Examples of specific sectoral reforms and outcomes:",
    "Remaining implementation and policy challenges:",
    "China — credit intermediation:",
    "United States — partial reemergence of structured leveraged finance:",
    "Europe — asset management supervision and data gaps:",
    "Progress since the 2010 G20 Seoul Summit:",
    "Outstanding policy priorities:",
    "Overarching message:",
    "[Tobias Adrian](http://www.imf.org/external/np/bio/eng/ta.htm)",
    "[PRESS CENTER](http://presscenter.imf.org/)",
    "[https://www.imf.org/en/home](https://www.imf.org/en/home)"
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