Sapienza Università di Roma Lecture Sixteen Shadow Banking

1. Sapienza Università di RomaLecture SixteenShadow Banking Prof. Gianfranco Vento - International Banking

2. What is shadow banking? Shadow banking referstobank-likefinancialactivitiesthat are conductedoutside the traditional commercial banking system, maywich are unreguleted or lightlyregulated. Shadow banking include familiarinstitutionsasinvestmentbank, money-marketmutualfunds, and mortagebrokers. The typesofcontracts are: • Repo; • ABS; • CDOs; • ABCP. Prof. Gianfranco Vento - International Banking

3. The growth of the shadow banking • The regulatorywichwasintroduced in Usa promoted the growthof the shadow banking system in threeways: • Restrictions on bankactivitiesencouregednonbankstodevelopnewservices: until 1980 Glass-StegalactrequiredtoFederalReservetolimit the interest rate that commercial bankscouldpaysavingsdepositors, creating market opportunityformoneymutualfunds. • With the separationbetween commercial bank and investmentbank, the latter led the rapidgrowthofmarket-basedformsofborrowing. Prof. Gianfranco Vento - International Banking

4. The growth of the shadow banking • Capital regulationsencouregedbanksto transfer assets and activitiesintooff-balancesheetvehicles; • Government supervision wasless intensive fornonbankfinancialinstitution:prudential or safety-and-soundness supervision wsaintroduced in the nonbankfinancialsector il wasnot intensive as a bank supervision. • Gramm-LeachBlileyactbroaded the scope for commercial bank holding companiesto partecipate in securitiesunderwriting and othertraditionalinvestmentbankcompanies. • Investmentbank and othernonbankfinacialinstitutionslike AIG, GE Capital werenotsubjectto the sameframeworkaswere holding bankcompanies. Prof. Gianfranco Vento - International Banking

5. Subgroups of the shadow banking There are threedistinctsubgroups: • The governament-sponsoredshadowbankig sub-system; • The “internal” shaodow banking sub-system; • The “external” shadow banking sub-system. Prof. Gianfranco Vento - International Banking

6. The governament-sponsoredshadowbankig sub-system The governament-sponsored shadow bankig sub-system: Thiskindofshadow banking system developednearly 80 years ago, with the creation the government-sponsoredenterprise s (GSE), wich are comprisedof the Federal Home LoanBank System (1932), FannieMae e FreddieMac. The GSE werenotfundingusingdeposits, butthrough capital markets. Prof. Gianfranco Vento - International Banking

7. The governament-sponsoredshadowbankig sub-system The GSEsemboidedfourtecniques: • Termloanswarehousingprovidedtobanksby the FHLBs; • Creditrisk transfer and trasformationthroughcreditinsurranceprovidedbyFannieMae and FreddieMac; • Originate-to-distributesecuritizationfunctionsprovidedforbanksbyFannieMae and FreddieMac; • Maturitytrasformationconductedthrough the GSE retainedportfolios, wichessentiallyoperatedasqusi-government SIVS. Theseentetiesqualifyasshadowbanksto the extentthattheywereinvolved in the traditionalbankactivitiesofcredit, maturity, or liquiditytrasformation, butwithoutbeingchartedasbanksndwithouthaving a meaningfulaccesto a lenderof last resort and anexplicitiesinsuranceoftheirlabilities. Prof. Gianfranco Vento - International Banking

8. Focus on FannieMae e FreddieMac • What are the originsofFannieMae e FreddieMac? • Fannie Mae was created in 1938 as part of Franklin Delano Roosevelt's New Deal. • The collapse of the national housing market in the wake of the Great Depression discouraged private lenders from investing in home loans. • Fannie Mae was established in order to provide local banks with federal money to finance home mortgages in an attempt to raise levels of home ownership and the availability of affordable housing. Prof. Gianfranco Vento - International Banking

9. Focus on FannieMae e FreddieMac • Initially, Fannie Mae operated like a national savings and loan, allowing local banks to charge low interest rates on mortgages for the benefit of the home buyer. • This lead to the development of what is now known as the secondary mortgage market. Within the secondary mortgage market, companies such as Fannie Mae are able to borrow money from foreign investors at low interest rates because of the financial support that they receive from the U.S. Government. Fannie Mae makes a profit from the difference between the interest rates homeowners pay and foreign lenders charge. • For the first thirty years following its inception, Fannie Mae held a veritable monopoly over the secondary mortgage market. In the 1970 in order to prevent any further monopolization, after Fannie Mae’ privatization, Freddie Mac was created. Prof. Gianfranco Vento - International Banking

10. The “internal” shaodow banking sub-system In the ’80 largebankschangedtheiroperationfrom originate toholdtooriginattodistribute. The bank, under pressure on bank’s profit margin, startingtoacquire the veryspecialistnonbankentitiesthatwereposing a competitive threat, and graduallyshiftmanyoftheiractivitiesrelatedtocreditintermediationintothesenewlyacquired. The change in the nature of banking wasinitially “inspired” by the secutizationprocessofconformingmortagesthrough the GSEs, and etendedtovirtuallyformsofloans and “perfected” intosecuritization-based, shadowcreditintermediationprocessovertime. Prof. Gianfranco Vento - International Banking

11. The “external” shadow banking sub-system • The externalshadow banking sub-system was a global network ofbalancesheets, with the origiantion, warehousing and securitizationofloansconductedmainlyfrom the Usa, and the funding and maturitytransformatinofstructuredcreditassetsconductedmainlyfrom the UK, europe and various offshore financialcenters. • Isdefinitedby: • The creditintermediationprocessofdiversifiedbroker-dealers; • The creditintermediationprocessofindipendent, non bankspecialistintermediaries; • The creditputsprovidedby private creditriskrepositories. Prof. Gianfranco Vento - International Banking

12. Financial instruments • Mostof the financialinstrumentstrade in the money market. • Unsecured commercial paper and asset-backed commercial paper; • Commercial Paperis a debt security thatmatures in 270 days or less and is a major source offunding in the Usa and abroad. • Corportae CP anFiancial CP are unsecured, but are notsubordinated. • Asset-backed commercial paperiscollateralized or securedby a claimtospecifassets. • Usuallythere are a credit or liquidityenhacementsbyparentfirm Prof. Gianfranco Vento - International Banking

13. Financial instruments • Repurchaseagreements; • Through the repo market, investorwithlargeassetholdings can led idleassetstoeffectively “borrow” cash on a short-termbasis. • Securities lending; • Securities lendingrefersto the assetlenderslendingtheirsecuritiesborrowers in returnforcashcollateral. • There are verysimilartorepotransactionsexceptthatthereis no standard maturity, securities are loanedratherthanpurchased, and cashistypicallyreinvestedby the securitieslender in cashinvestmentpools. Prof. Gianfranco Vento - International Banking

14. The shadow banking system’s fragility • High leverage: banking holding companieswereleveraged at 10-to 20-to1 prior the crisis. Leverageforinvestmentbankswas 30-to 40-to 1. Specialpourposeentitiescreated in the securitizationprocesstendedtohaveslimequitytraches, drivingtheirleverageas high as 100 to 1. • Reliance on short-termfundingmarkets: shadowbanksreliedfortheirfunding on short-termmarketssuchasrepo, ABCP. Wholsalefundingmarketshave a riskbecausesuchfunds can bewithdrawquickly . • Lackofexplicitgovernmentsupport: likedepositorinsurance and a lenderof last resort. Prof. Gianfranco Vento - International Banking

15. Shadow banking in numbers Source: Morgan Ricks “Sahodow banking and financialregulation” 30 Agust 2010 Prof. Gianfranco Vento - International Banking

16. Shadow banking in numbers Prof. Gianfranco Vento - International Banking

17. Shadow banking in numbers Prof. Gianfranco Vento - International Banking

18. Repo market • Repo and securitization are correlated. • The rise ofsecuritizationcoincidedwith the increaseddemandsforcollateral. • The repo market traditionally was confined to U.S. Treasury securities, but in the last 25 years it has grown to accept a broad range of securitized bonds as collateral. • Asset classes that came to be eligible for repo included all manner of securitized products, as well as tranches of structured products like collateral debt obligations. Prof. Gianfranco Vento - International Banking

19. Repo market Prof. Gianfranco Vento - International Banking

20. Repo market • Forlargedepositors, repo can actas a substituteforinsureddemanddepositsbecauserepoagreements are explicitlyexcludedfromChapter 11. • The repo, like derivatives, has a special status under the U.S. Bankruptcy Code: the contract allows a party to a repurchase agreement to unilaterally enforce the termination provisions of the agreement as a result of a bankruptcy filing by the other party. • Repo collateral can be rehypothecated, that is, the collateral received in from a repo deposit can be freely re-used in another transaction, with an unrelated third party. “high levels of velocity in repo markets” • Repo market is an important mechanism for obtaining leverage, expecially for hedge funds. Prof. Gianfranco Vento - International Banking

21. “Run on repo” • The panic occured when depositors in repo banks feared that one or more banks might fail and they would have to sell the collateral in the market to recover their money. • There was also the possibility that the collateral value might go down when it was sold. Investor increased rerpo haircuts. Prof. Gianfranco Vento - International Banking

22. “Run on repo” Prof. Gianfranco Vento - International Banking

23. “Run on repo” • The increase in haircuts means that there is a shortage of collateral. • There is an excess demand for U.S. Treasuries because of the flight to quality generally. • After Lheman Brothers failure, the haircuts continued to increase and some assets became unacceptable in repo. • The interbank market was paralyzed. Prof. Gianfranco Vento - International Banking

24. Some proposal • Securitization: Narrowfundingbanks (Gorton & Metricks) • The basic idea of Narrow Funding Banks is to bring securitization under the regulatory umbrella. • NarrowFundingBanks would be genuine banks with charters, capital requirements, periodic examinations, and discount-windowaccess. • All securitized product must be sold to NFBs; no other entity is allowed to buy ABS. NFBs would be new entities located between securitizations and final investors. • NFBs would become "the entities that transform asset-backed securities into government-overseen collateral", thereby seeking to ensure (through the more rigorous oversight) that repos are backed by higher quality collateral Prof. Gianfranco Vento - International Banking

25. Some proposal • Repo: licenses, elegiblecollateral, minimum haircuts • Anyregulationofrepomustmakereposafefordepositorsallowingfor the userepoforotherpourposes. • Non banksentities can engage in repo, butthisrequires a license. • Elegiblecollateralforbanksisrestricted (a.g. US Tresurysecurities). • Nonbankentities can useanytypesofcollateralbutthisissubjectto minimum haircuts and position limited. In fact position on grossnotionalamounts are tobe set byregulatoras a fuctionoffirmsize and the collateralused. Prof. Gianfranco Vento - International Banking

26. Next Lecture : Mergers and acquisitions Prof. Gianfranco Vento - International Banking