Shadow Banking, Market Functioning and Regulation Manmohan Singh Senior Economist International Monetary Fund

1. Shadow Banking, Market Functioning and Regulation Manmohan Singh Senior Economist International Monetary Fund Financial Structure and Regulation Conference, Feb 22,2013ESRC/NIESR, London Views are of the author only, and not attributable to the IMF

2. Outline • 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. • Shadow banking is a form of market based credit intermediation. • The nonbank/bank nexus and how the market intermediates and connects the nonbank and bank worlds: • 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)

3. 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 • 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 • Current data and analytical frameworks are not capable of understanding and tracking their risks—e.g. Flow of Funds (in the US and 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

4. Nonbank sectors are not small (relative to the size of banks)

5. Depository & Non depository parts of a BHC

6. Banks, SIFIs and nonbanks 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. All major dealer banks are SIFIs. Since the crisis, all dealer banks have had access to central bank liquidity facilities via their “bank” arms. 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. While driven partly by regulatory arbitrage, the shadow banking system (nonbanks + banks)performs a number of economically useful functions

7. Bank regulations and Puts to Nonbanks 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. Nonbanks are outside the BHC—they are separate legal entities who try to “extract” the public safety net put in various ways. Regulators may be successful in regulating banks but not both ( i.e., banks+ nonbanks)

8. Depository and non-Depository part of a Bank Holding Company

9. Nonbank/bank nexus

10. Regulations focus—so far… 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. Non-bank funding to banks was assumed to be “sticky” and mainly in the form of household deposits. 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 It is important to note, however, that while households’ direct holdings of M2 instruments reflect their own investment decisions, their indirect holdings of non-M2 instruments are not a reflection of their direct investment choices, but the portfolio choice of their fiduciary asset managers.

11. Credit supply to the end-users is provided either by equity ei , of the banking system (including leverageλ i) and non-bank funding; “z” is important to understand.

12. Shadow banking during the crisis: creation of private sector AAA securities 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. Sometimes demand creates its “own supply” (although some may argue that AAA were wanted for regulatory relief, etc) 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)

13. Large part of AAA issuance was private sector securitization (i.e., “burgundy” area)

14. Collapse in the private sector AAA

17. Collateral Re-use—see last column (figures are in trillions!)

18. Shadow Banking (via Collateral chains) and QE

19. 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

20. 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 . Discuss UK …. (which nonbank sector matters?); examples--CCPs; bad collateral

21. Moving OTC derivatives to CCPs

22. CCP and shifting taxpayer “put” 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. 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) 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. Benefits to the real economy from a CCP? How does it measure against potential costs of a bailout for CCP?

23. Safe assets as a “public good” 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 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. 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?

24. Safe Harbor—what does QFCs mean? 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. 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. 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

25. Regulatory Proposals…so far If direct links were severed (e.g., as in how the Vickersproposal 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. Also, by moving shadow banking outside the regulatory perimeter, policymakers may have less information on how it is operating. in practical terms. The idea of merging shadow banking activities into traditional commercial banks goes against the spirit of some current proposals, such as the Volckerrule in the United States and the Liikanen proposal in the European Union, (banning or limiting commercial banks from engaging in some trading activities)

26. Shadow banking: Monetary policy and Macroeconomic implications 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. 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 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

27. Nonbank “puts” to taxpayers • Nonbanks are coined “shadow banks” which has a pejorative meaning. (due to the “puts”) • 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. • Unintendedsuch as money or good collateral provided by central banks at subsidized haircuts (QEs and LTROs) • Puts encourage moral hazard and lead to regulatory arbitrage (eg,regulatoryweaknesses 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 products where capital charges did not reflect underlying risks