Transcript It’s 2 p.m. in Hong Kong. Where is your collateral, and

Shadow Banking, Market Functioning and
Regulation
Manmohan Singh
Senior Economist
International Monetary Fund
Financial Structure and Regulation Conference, Feb 22,2013
ESRC/NIESR, London
Views are of the author only, and not attributable to the IMF
Outline
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The financial system has become considerably more complex over
the past two decades with an increasing nexus between banks and
hedge funds/asset mangers, mutual funds, insurance companies,
pension funds etc.
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Shadow banking is a form of market based credit intermediation.
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The nonbank/bank nexus and how the market intermediates and
connects the nonbank and bank worlds:
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collateral re-use
Creating “safe assets”
Leverage
Regulatory arbitrage or, extracting “puts” from the nexus with banks
OTC derivatives (and looking forward, the role of CCPs)
What is Shadow Banking?

They are not regulated in the same manner as banks:
• either lower or no prudential requirements (capital and liquidity)
• less intense or no supervision ....although they take on credit, market,
funding, and liquidity risks
• Very little systemic risk monitoring in key funding markets
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They are typically not back-stopped by a official financial safety net
• No access to central bank emergency liquidity facilities (unless in some
extreme situations where there is risk to financial system)
• No deposit insurance scheme
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Current data and analytical frameworks are not capable of
understanding and tracking their risks—e.g. Flow of Funds (in the US and
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elsewhere) is incomplete. Globally, shadow banking estimated around $65 trillion
in 2011, compared to $26 trillion in 2002.
On average 25% of financial assets and 111% of aggregate (relevant) GDP
Nonbank sectors are not small
(relative to the size of banks)
Sweden
India
Germany
France
Japan
United States
Belgium
Korea
Italy
Netherlands
Ireland
Spain
Brazil
China
Singapore
Mexico
Luxembourg
Australia
Turkey
Hong Kong
0%
10%
Insurers
20%
30%
40%
Pension Funds
50%
60%
70%
Investment Funds
80%
90%
Banks
100%
Depository & Non depository parts of a BHC
Banks, SIFIs and nonbanks
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A pressing need is to develop a comprehensive regulatory approach to
dealer banks. The dealer banks’ business model is inherently fragile. They
combine high leverage, procyclical businesses, and unstable, uninsured
wholesale funding.
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All major dealer banks are SIFIs. Since the crisis, all dealer banks have had
access to central bank liquidity facilities via their “bank” arms.
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The depository part may represent as little as 5 percent of the group’s
overall balance sheet. This increases moral hazard, as a dealer bank can shift
risky assets to its bank subsidiary.
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While driven partly by regulatory arbitrage, the shadow banking system
(nonbanks + banks)performs a number of economically useful functions
Bank regulations and Puts to Nonbanks
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Bank Holding Company that includes the “bank” is a legal
entity that is intertwined with the “bank”. Legally difficult to
separate (recall, the living will or subsidiary proposals). FSB’s
list of SIFIs with sheer disregard to “bank” fraction within
the Bank Holding Co.
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Nonbanks are outside the BHC—they are separate legal
entities who try to “extract” the public safety net put in
various ways.
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Regulators may be successful in regulating banks but not
both ( i.e., banks+ nonbanks)
Depository and non-Depository part
of a Bank Holding Company
Nonbank/bank nexus
Regulations focus—so far…
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To date, regulatory efforts have focused on fortifying the equity base
(ei) of the banking system and limiting the banking system’s leverage
(λ i) through leverage caps.
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Non-bank funding to banks was assumed to be “sticky” and mainly in
the form of household deposits.
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Regulatory efforts have ignored the sizable volumes of bank funding coming
from non-banks . Since the money holdings of asset managers (pension, insurers,
MMFs etc) are ultimately the claims of households, it follows that households
ultimately fund banks through both M2 and non-M2 instruments
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It is important to note, however, that while households’ direct holdings of M2
instruments reflect their own investment decisions, their indirect holdings of nonM2 instruments are not a reflection of their direct investment choices, but the
portfolio choice of their fiduciary asset managers.
Credit supply to the end-users is provided either by
equity ei , of the banking system (including leverage λ i )
and non-bank funding; “z” is important to understand.
Shadow banking during the crisis:
creation of private sector AAA securities
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Demand of investment banks to "churn" securitizable assets for fee
income. (e.g., regulatory weaknesses before the crisis includes use by
banks of affiliated investment vehicles (SIVs) to offload credit risks
(and economize on capital charges); credit and liquidity guarantees with
too little provisioning; and investments in structured products where
capital charges did not reflect underlying risks.
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Sometimes demand creates its “own supply” (although some may argue
that AAA were wanted for regulatory relief, etc)
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Public Sector demand for safe assets…recent policy papers suggest a
more explicit way for a “taxpayer put”. (discuss alternatives like
Reserve Bank of Australia’s proposal to provide safe asset/good
collateral)
Large part of AAA issuance was private sector
securitization (i.e., “burgundy” area)
Collapse in the private sector AAA
Collateral Re-use—
see last column (figures are in trillions!)
Sources of Pledged Collateral, Velocity and Overall Collateral
Year
2007
2010
2011
Sources
Hedge Funds
Others (in
(in trillions
trillions USD)
USD)
1.7
1.7
1.3
1.1
1.3
1.05
"Chain"
(velocity)
Overall collateral
<“source” times “chain”>
(in trillions USD)
3
2.4
2.5
10
5.8
6.1
Shadow Banking (via Collateral chains)
and QE
Shadow banking links nonbank agents to traditional banks/dealers.
Figure below highlights the private AAA creation --top half ; and
collateral reuse --bottom half ; but there is more to shadow banking
Identifying Systemic Nonbanks and their
Interconnectedness to Banks—US example
After the 2007/08 financial crisis, the Dodd-Frank Act created the Financial Stability
Oversight Council to designate nonbanks that were systemic to the U.S. financial
system. These nonbanks were not subject to the type of regulation and consolidated
supervision applied to banks, nor were there resolution mechanisms for them.
The basic criteria suggests that a nonbank may be considered SIFI if it has at least $50
billion in total consolidated assets and meets or exceeds any one of the following:
$30 billion in gross notional CDS outstanding for which the nonbank is the referenced
 $20 billion of total debt outstanding;
 $3.5 billion in derivative liabilities;
 15 to 1 leverage ratio, as measured by total consolidated assets to total equity; or
 10 percent ratio of short-term debt to total consolidated assets.
Based on above thresholds, the FSOC has estimated less than 50 nonbanks .
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Discuss UK …. (which nonbank sector matters?); examples--CCPs; bad collateral
Moving OTC derivatives to CCPs
CCP and shifting taxpayer “put”
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Generally speaking, large losses stemming to a bank from their OTC
derivative positions—if it leads to bailout —will typically be picked up by
taxpayer from the jurisdiction in which the bank is located.
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For example, derivative losses at branches of a Canadian bank in a foreign
jurisdiction (e.g., London) is a Canadian taxpayer liability. Ditto for say
Deutsche Bank branch in London (liability is of German taxapayer)
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However, moving OTC derivatives positions form say a Canadian bank to a
foreign CCP that is owned/incorporated in a foreign jurisdiction (UK),
shifts some of the Canadian taxpayer liability related to cleared OTC
contracts to a UK taxpayer liability if the UK had to bail-out the CCP.
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Benefits to the real economy from a CCP? How does it measure against
potential costs of a bailout for CCP?
Safe assets as a “public good”
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In the early phases of banking, merchants accepted gold deposits and issued
private paper claims. These claims were then passed around, like collateral in
the modern system. Because the chain of claims grew too long, and the
volume of outstanding claims too large, we got bank panics
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But once paper claims were backed by the full faith and credit of the
government this removed the discipline on the banks, which no longer
needed to hold gold (i.e., collateral/capital) to make their paper liabilities
credible. Absent regulation, bank capital buffers tended toward zero.
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Is there an echo of that sequence. Banks and shadow banks accept
securities as collateral rather than gold, swapping them for money. Now
some central banks step in, take the bad securities and provide the markets
with higher quality collateral/money) backed by the full faith and credit of
the public sector (if marked to market, okay). This may prevent permanent
collapse in the collateral markets; but discipline for shadow banks?
Safe Harbor—what does QFCs mean?
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Most contracts are subject to automatic stay once a company has filed
for bankruptcy. It’s like hitting the pause button. They stop being
enforceable while the bankrupt company tries to get its house in order.
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However, there are exceptions to the pause-state for certain financial
contracts, and this includes many, if not most, derivatives/repos. This is
a so-called “safe harbor” and keeps contracts in play mode; ostensibly
junior claimants can pull their money an incentive to get out first.
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Traditionally, banks had equity, debt, and deposits. If a bank failed, the
bank’s equity would be wiped out first, and then its debt; depositors
were senior. Now, however, bank debts are being replaced with QFCs
that cannot be touched (“jump the queue”). So, when a bank fails, the
equity gets wiped out first and there’s little cushion before the
depositors start losing money
Regulatory Proposals…so far
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If direct links were severed (e.g., as in how the Vickers proposal in the
United Kingdom aims to separate a bank’s retail operations from its other
activities), by virtue of its mere size shadow banking activity could still have
macroeconomic and systemic implications, since externalities with adverse
real-sector consequences can arise regardless.
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Also, by moving shadow banking outside the regulatory perimeter,
policymakers may have less information on how it is operating. in practical
terms.
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The idea of merging shadow banking activities into traditional commercial
banks goes against the spirit of some current proposals, such as the Volcker
rule in the United States and the Liikanen proposal in the European Union,
(banning or limiting commercial banks from engaging in some trading
activities)
Shadow banking: Monetary policy and
Macroeconomic implications
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Just as interest rate transmission can be impaired if the banking system
is weak, so do the broader channels of monetary policy transmission
depend on well-functioning capital markets, including shadow banking.
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The state of private, safe asset supply and the stock and velocity of
collateral can therefore affect monetary policy transmission, with
macroeconomic consequences. (and vice versa). When the interest rate
is low, a steeper yield curve that increases the payoff to maturity
transformation and risk-taking can lead shadow banking to expand
rapidly, potentially leading to financial fragility
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As such, the state of shadow banking needs to be considered in
monetary policymaking. In crises, disruptions to shadow banking can
have significant economic spillovers and may trigger fiscal outlays
Nonbank “puts” to taxpayers
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Nonbanks are coined “shadow banks” which has a pejorative
meaning. (due to the “puts”)
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Regulators should limit or eliminate “puts”—both explicitly
and implicitly. Puts may be
 Implicit such as the support for CCPs (or MMFs in the US)
 Explicit such as non-depository part of a Bank Holding Co.
 Unintended such as money or good collateral provided by centra
banks at subsidized haircuts (QEs and LTROs)
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Puts encourage moral hazard and lead to regulatory arbitrage (eg,regulatory
weaknesses before the crisis include the use by banks of affiliated investment
vehicles (SIVs) to offload credit risks (and economize on capital charges); credit
and liquidity guarantees with too little provisioning; and investments in structured