Understanding the Shadow Banking System and its Impact on Financial Stability

1. Chapter 13 and 14Part ii Shadow Banking

2. What is Shadow Banking System (i) • “Shadow banking" is a term used to describe banking institutions, practices and instruments that operate beyond the reach of regulation – including hedge funds and money market fund that handles trillions of dollars.

3. What is Shadow Banking System (ii) • A new kind of semi-banking system that emerged in the 21st century. • Shadows banks are acting like Commercial banks but technically they are not CB because they are not regulated. • Such as Country Wide, a big shadow bank organization. • They make all kinds of loans, like credit card loan, car loan, home loan, boat loan, merchandise loan, etc

4. What is Shadow Banking System(iii) • Investment banks are taking the roles of Shadow banks, such as Lehman Brothers. • Investment banks may conduct much of their business in the shadow banking system (SBS), but most are not SBS institutions themselves • Convergence of banks creates big banks that have both CB and SB (IB) • JP Morgan Chase • Citi group • Bank of America

5. Comparison between CB and IB(i) • Both make loans for borrowers, such as homeowners. • CB receive deposits as resources for loans, not SB • CB get money @ 1% from depositors • CB loan them out @6% to homeowners as mortgage. • CB makes 5% of profits. • CB are insured by FDIC and CB can borrow at Fed discount window, not SB

6. Comparison between CB and IB(ii) • So how do SB make money? • Repo market to borrow for short term @ low rate • Repo is like short term loan but with collateral such as TB. • Use the borrowed short term fund to lend out for long term @ higher rate • Bundle the loans as securities (such as mortgage backed security) and sell them to • Hedge funds • Pension funds, etc

7. Can Bank Run Occur in SB? • Definitely. • When short term loan provider (repo investor) does not renew the loan, there is no liquidity for SB. • When you think this tends to occur? • We have seen this type of running happening in the crisis. • Why bank run does not occur in CB anymore?

8. One Example of How SB operates (I) • Imagine you can get loan from Wells Fargo @8%. • You found that Nationwide is charging 6%, all else equal. • You chose Nationwide’s loan. • After the deal is closed, what tends to happen with your loan? • Securitization of loans of yours and tens of thousands of others. • AAA bond, AA bond, A bond, and lower ranking ones • Securities were sold to investors • Eg., Pension funds invest in AAA bond and get 2% rate • Hedge funds invest in AA bond and get 3% or in BBB bond and get 4%, etc.

9. One Example of How SB operates (II) • But are those mortgage backed securities as safe as loans from CB? • CB’s loans are much safer • Fed is CB’s lender of last resort • CB has to meet capital adequacy ratio required by Fed • CB is insured by FDIC • CB has checks and balances from depositors • SB has no safe net from the government and thus is much riskier.

10. One Example of How SB operates (III) • So “bank run” would be more likely for SB • Leverage of SB is much higher than CB • No lending in repo market or short term market • One cause of the failing of Lehman brother and Bear Stern • Economist Paul Krugman described the run on the shadow banking system as the "core of what happened" to cause the crisis. Reference http://en.wikipedia.org/wiki/Shadow_banking_system

11. Why SB is still running • Before the crisis, about 60% of mortgage was issued by SB, and the rest is by CB • Demand is higher than that can provided by CB • So SB is a key component of our economy • Without SB, many homeowners could not buy their dream houses. • However, the assets (bonds) of SB (such as mortgage backed securities) are considered as toxic assets • too hard to price them to find investors. • Banks are becoming too big to fail.

12. Lehman Brothers Failed due to “Run on Repo” (i) • Lehman Brothers is a pure IB • It is acting as a SB as well • Lehman Brothers heavily involved in repo market to get access to short term capital • Repo is similar to deposit which is short term loan • Then invested the borrowed capital in subprime securities and other securities

13. Lehman Brothers Failed due to “Run on Repo” (ii) • So if repo investors (like depositors) fear of failure of Lehman Brothers • Due to housing market value declined and subprime securities’ value declined • They would not renew repo when it was due • The “run on repo” occurs. • The values of securities (subprime securities) held by Lehman Brothers declined • Lehman Brothers could not rescue itself • Government bailed out Bear Stern and Merrill Lynch and did not bail out Lehman Brothers.

14. Debate about Regulations on Shadow Banking (i) • Fed should regulate both CB and IB (SB) • Regulate hedge funds with assets over 150m • Formalize over-the-counter derivative trading • Dodd Frank Act provisions .

15. Debate about Regulations on Shadow Banking (ii) • The G20 is still trying to stop banks becoming "too big to fail", which covers banks the markets believe would be bailed out in a crisis. • Instead, the Institute of International Finance, a global association of financial institutions, has asked world leaders to adopt shadow banking regulations tailored to individual banking sectors, rather than imposing blanket regulations