U.S. leads the pack in monitoring shadow bank sector; IMF report shows how

November 5, 2014

The United States effort to begin reining in the risks from shadow banking was recognized by the International Monetary Fund in a recent report as being ahead of the curve, and parts of it could serve as a model for other countries.

U.S. regulators have, compared to their peers, taken preventative measures because of ”the measurable contribution of shadow banking to systemic risk in the financial system in the United States,” the report said. 

They are intent on keeping the momentum in light of the fact that the largest ”marginal contribution to the systemic risk” comes from pension funds, insurance companies and other types of shadow banks such as mutual and hedge funds, it said. This contribution is measured by evaluating the joint-probability distribution accounting for the losses to the financial system that occurs with a probability of 1 percent or less by each subsector in the economy.

The aggregate systemic risk posed by shadow banks is estimated by end-2013 to be 30 percent – about as much as the traditional banking sector.

What is shadow banking? 

Definitions of shadow banking offered so far are at best nebulous. Some studies define a shadow bank as an entity that is less regulated than a traditional bank, and one that lacks a formal safety net. Others define it based on the bank-like products or services that it offers.

The Financial Stability Board –an international body set up in the wake of the financial crisis of 2007 to monitor and make recommendations about the global financial system– has adopted both: “credit intermediation involving entities and activities outside the regular banking system.”

The good, the bad and the ugly 

In essence, shadow banks are non-bank financial companies providing services and products similar to those of banks, largely through noncore liabilities. While investment funds, money market mutual funds, asset management firms, mortgage real estate investment trusts, hedge funds, broker-dealers are generally cited among shadow banks and largely seen as beneficial to the industry, there are other kinds as well. Insurance and pension funds are sometimes also included.

A broader definition of shadow banks could include special purpose vehicles (SPV), the structured finance off-balance sheet entities mainly set up and used by banks — to monetize credit-sensitive assets, to decrease regulatory capital requirements, or for tax and accounting purposes– that have exacerbated the financial crisis because of their opacity.

Then, there are the “shadowy” shadow bank elements such as peer-to-peer lenders –those websites matching savers with borrowers, or even payday lenders, loan sharks, and pawnbrokers.

A growing share of the pie 

The origins of the shadow banking in the United States can be traced back to demands of institutional cash pools for alternatives to insured deposits and safe assets, a low real interest rate environment and growing bank regulations in the 1970s.

However, shadow banks’ recent growth – in areas such as in loans, and leverage funding — is due to traditional banks, which have been retreating from lending for the following reasons:

First, they have been repairing their balance sheets that were badly damaged due to loans that went sour.

Second, they have been prioritizing prudent risk management over aggressive risk taking. A global survey of more than 50 banks — representing 42 percent of global banking assets — on the current state of banks’ enterprise risk management (ERM) practices conducted jointly by McKinsey & Company and the Risk Management Association (RMA) earlier this year, found that banks have been shifting from a traditional focus on measurement, compliance and control, to providing a forward-looking view at the heart of decision making in the boardroom and throughout the organization.

Third, they still worry about the costly — and at times uncertain — measures strewn along the regulatory path they must tread along in the wake of the financial crisis. These measures come in the form of increased capital, liquidity requirements, as well as rules designed to address conflicts of interests – as with the Volcker rule severely curtailing proprietary trading and limiting banks’ ownership in hedge funds, and the derivatives reform channeling most of the OTC derivatives into central clearinghouses. Consequently, all these resulted in banks spinning off certain business lines such as their in-house asset management units, or derivative trading desks.

Shadow banks, meanwhile, free of such restraints, have been able to grab a bigger share of the business from their counterparts, the traditional banks, in the US, surpassing them in terms of asset size – now accounting between $15 and $25 trillion dollars.

Some of these shadow banks, such as asset management firms, are offering increased access to credit through long-term lending to the private sector by borrowing from institutional investors and extending retail piece-meal –essentially acting as match-makers. Broker-dealers, via repo-financing or other securities financing transactions (SFTs) where they can extend short-term lending for use of collateral, have done the same.

Other types of shadow banks have bought mortgage servicing rights (MSR), a line of business discarded by banks because of the high capital charges they entail. MSRs carry significant short-term risks in terms of compliance and operational factors such as interruption of servicing or delays in transfer.

In short, shadow banks improve market liquidity through maturity transformation and risk sharing in areas where banks may fail or be unwilling to provide services, acting, to quote Professor Simon Johnson of MIT, as a “spare tire” to the rest of the economy.

Risks 

Yet for all the expansion and the benefits they offer in complementing the traditional banking sector, shadow banks come with their bag of risks – all systemic and pro-cyclical in nature.

Shadow banks suffer from the run risk. Rather similar to the banking industry before deposit insurance coverage, they remain susceptible to bank runs, as happened to money market mutual funds (MMMF) in the recent financial crisis.

In times of stress, opacity and complexity of shadow banks may prompt investors to refrain from providing money or collateral as they flee to quality and transparency. The repercussions of such flight can be exacerbated through various channels of shadow banking (payment systems such as repo financing, for example) to the rest of the financial system – hence, the spill-over risk.

These risks are amplified because shadow banks lack the regulatory constraints that apply to their traditional counterparts. As such, they get away with using relatively vulnerable business models.

In particular, shadow banks do not enjoy coverage under a formal regulatory safety net: they neither benefit from a deposit insurance scheme, nor do they have access to central bank borrowing through the discount window or the assistance of a central bank as lender of last resort.

Unrestrained by regulatory stipulations such as capital and liquidity rules and reserve requirements applicable to traditional banks, certain types of shadow banks are also prone to take on more leverage through their use of uninsured debt or heavy use of collateral – through rehypothecation — in funding their loans.

The high level of credit intermediation (multi-step unsecured financing chains) intrinsic to the functioning of shadow banks may increase the aggregate systemic risk to the financial system in three ways. Firstly, the likelihood that a party in the intermediation chain may be negligent in carrying its due diligence is increased as the risk can be transferred to the next one in the chain. Secondly, the models that are used may fail to assess correctly the market value of the collateral and margins assigned. Lastly, margin calls and demands for more collateral usually come at a downturn – and amplify the systemic risk.

Problems with measurement 

It is difficult to quantify the absolute size of the shadow banking sector – its contribution to the real lending to the economy — mainly for number of reasons.

First, there is the problem of definition. There are various interpretations – and disagreements — over categorizations of institutions among various regulators and jurisdictions.

Second, double-counting can occur due to the complex chain of credit intermediation involved, and difficulty in obtaining data. Unlike banks, where linkages between borrowers and savers are easily traceable, the financial plumbing involving shadow banks can include various other parties such as dealer counterparties in the tri-party repo market, clearinghouses, and custodians.

A related problem is the broad aggregation of various types of non-money market funds into the category of “other” for classification and data reporting purposes.

Regulatory response 

U.S. regulators have taken measures to contain certain areas of the shadow banking sector.

SPVs / securitization 

Accounting rules developed since the financial crisis now make it much harder for banks to utilize SPVs to park suspect assets. Specifically, the rule FIN 46 requires consolidation of assets and liabilities of an entity with its parent company – therefore forcing it to hold additional capital — if it is established that this parent company has a controlling financial interest beyond simple equity ownership and voting rights.

In a similar vein, regulators have proposed credit risk retention requirements in securitizations and prohibition to hedge the retained credit risk portion, targeting particularly the non-bank lenders that are funded almost exclusively by the “originate to distribute” model of mortgage securitizations. This model has allowed lenders to originate new loans for immediate sale to a securitization vehicle, creating incentives to loosen underwriting standards as they would retain little or no post-securitization exposure to the underlying mortgages.

Securitization has experienced a relatively modest growth in the aftermath of the financial crisis, and currently appears unlikely to be a shadow banking practice that would pose a threat to the financial system.

Reform on money market mutual funds 

In July 2014, Securities and Exchange Commission (SEC) adopted a set of rules that improved the resiliency of the MMMF by requiring the funds (except retail and government MMMF) to transact at a floating NAV, and calibrate their portfolio securities with daily share price movements, thus allowing them to institute liquidity fee and redemption gates to stem runs in times of stress.

Tri-party repo market reform 

The Federal Reserve has taken multiple steps in limiting the risks posed by the use of short-term wholesale funding by shadow banks, effectively reducing its volume to a level lower to what immediately was before the crisis, while increasing its average maturity and collateral haircuts. The regulators have achieved these through an increase in regulatory charges on key forms of credit and liquidity support that banks provide to shadow banks, and by reducing reliance by borrowers in the tri-party repo market on intraday credit from clearing banks.

Furthermore, aware that the unusually flat yield curve environment and the lingering risk aversion from the crisis are temporary factors helping them in the overall reduction in short-term wholesale funding volumes, regulators are keen on working on three sets of proposals, which are to:

  • incorporate the use of short-term wholesale funding into the risk-based capital surcharge applicable to U.S. SIFIs.
  • modify Basel committee’s net stable funding ratio (NSFR) standard to strengthen liquidity requirements that apply when a bank acts as a provider of short-term funding to other market participants.
  • establish numerical floors for collateral haircuts in SFT including repos and reverse repos, securities lending and borrowing, and securities margin lending.

In conjunction with the third proposal, the Financial Stability Board (FSB) released a set of guidelines on October 14, 2014, about discounts applicable to collaterals handed over as part of repurchase-agreement trades and other securities-financing transactions that are not processed through clearing houses. The guidelines were considered to be “a big step forward in the FSB’s overall work program to transform shadow banking into resilient market-based financing conducted on a sound basis,” according to the Bank of England Governor Mark Carney, who chairs the FSB meetings.

Other regulatory response 

In addition to these efforts, the Dodd-Frank Act gives regulators — via the decision-making process of the Financial Stability Council (FSOC) — the power to designate any non-bank financial institution as systemically important (SIFI), thereby bring any deemed as such into the enhanced prudential supervisory fold. U.S. regulators have not shied away from using that route as they have already designated AIG, General Electric Capital, MetLife and Prudential Financial as SIFIs.

What more can be done? 

Clearly, with operations heavily bent on short-term unsecured borrowing, lacking a stand-alone balance sheets to cover tail risk – the risk of suffering losses beyond the value-at-risk point — and being unable to rely on support from the Federal Reserve, the growth in the shadow banking sector warrants regulatory attention.

The U.S. regulators have so far been vigilantly monitoring and evaluating the systemic risks shadow banks may pose to the financial system. They may now choose to focus on other ways to improve the resiliency of shadow banks. These can include regulation calling for better collateral management, such as on the issues of recycling collateral and potential shortage of acceptable assets that can be used as collateral, as well as honing on rules charging a potential liquidity premium applicable to unsecured funding.

(This article was produced by the Compliance Complete service of Thomson Reuters Accelus. Compliance Complete provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 400 regulators and exchanges. Follow Accelus compliance news on Twitter: @GRC_Accelus)

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