What Is Shadow Banking System - Essay Example

Shadow Banking System Lecturer’s Due Introduction Shadow banking refers to the utilization of money market instruments to supply short term finance to the existing long term assets. Shadow banking system refers to a set of financial intermediaries who support and facilitate the creation and implementation of credit across the world financial system. However, unlike other financial institutions such as normal banks, members are not exposed or subject to any regulatory oversights. Examples of intermediaries not subjected to convections and regulations include hedge funds and unlisted derivatives. Examples of activities carried out include credit default swaps. Several institutions have various ways used to perceive and treat shadow banking. The New York Federal Reserve Bank equates shadow banking to a complex system in which the institutions batch individual loans into bundles and sold to investors as collateralized assets. The discussion below comprehensively describes shadow banking and provides a review of what shadow banking entails. It provides background information about shadow banking mostly in the United States. The literature review provides a statistical overview on some of the studies carried out and analyzes the data drawing some conclusions on the shadow banking. Purpose of the project The project intends to provide readers with a comprehensive insight on the shadow banking including its services and drawbacks. Secondly, study reviews provide basic information on some of the factors influencing shadow banking and compare it to traditional banking systems. Background Money regulations Like any other organizations banks need to earn money in order to ensures progressive running of the business. The Central Bank and clients’ money are the two main sources of money in banks. Banks borrow money from the Federal Reserve System and also gain more through client deposits. However, these institutions follow a set number of regulations that govern the handling of money. Some of these regulations include: A bank should keep a set percentage of its funds as cash either in the vault or in the Central Bank. Through this, clients can access funds from savings whenever need arises. It also allows the bank to issue out loans to qualified clients without delay. While issuing out loans, the bank should consider the 5-Cs; capacity, collateral, condition, capital and character (Endeley, 2005). These five elements stand as credit qualification requirements, which facilitate borrowing money from a bank. For customers benefit, banks should provide information to their clients when dealing with services such as saving, borrowing or shares. Creating awareness is an important aspect as it prevents any misapprehensions. Client’s money deposited into any bank should be deposited into the client’s account immediately and the firm should only pay money into a Client Bank Account. The money should be paid either for opening or maintaining a customer’s account. Banks should not withdraw any amount over the customer’s request. The bank should withdraw the precise amount as stipulated by the client. A firm should not hold a client’s money when dealing with branches outside the country. The client should be informed of the account held in the other country. Other financial institutions apart from Apart from commercial banks, the commercial world also possesses several financial institutions that provide hedge funds, market funds, off balance sheets and other services. Some of these companies include: Investment banks Besides depositing and withdrawing services, an investment bank stands as an intermediary, which performs a variety of activities for businesses and states. It performs other activities such as underwriting debt and capital funds, acts as a link between security issuer and public investors, making markets and facilitating mergers with other associations. They are not subjects to regulations as normal banks. Savings and loans (S&Ls) These form of institutions fall under the non-financial banking category, but they provide services almost similar to banks. S&Ls emerged as a response to some of the drawbacks associated with commercial banks. They offer loans at lower rates and pay high interest rates on savings. Credit Unions They refer to credit companies recognised by the state that provide loans at low rates and pay high interest rates on deposits. However, credit unions restrict themselves to private members. They mostly served groups such as church groups and employees of a certain company. Shadow banks Established as an outcome of the credit crisis, shadow banks replicate some of the services provided by regulated banks. Shadow banks are a collection of investment banks, hedge funds, insurers and other non-bank institutions. They have greatly assisted the U.S residential mortgage market by buying mortgage bonds from investment banks. What can Shadow Banks Provide? The fast growth of the American economy since the 1980s led to the establishment Shadow Banks. They are important institutions, which provide diverse financial assistance. Shadow banks provide intermediary services that conduct maturity, credit, and liquidity conversion without the consent of the central bank. A vertical link connects all shadow banks which constitute of credit hedge funds, money market mutual funds, security lenders and structured investment vehicles. Shadow banks grant credit money at a low interest rate (Pozsar, 2010). Credit conversion refers to the development of the quality debt issued by an agent through the use of priority claims. The credit quality if senior deposits are better than that of underlying loans due to the existence of junior equity. Secondly, Maturity conversion is the use of short term deposits to fund long term loans, which builds the liquidity for the savers. Thirdly, liquidity transformation refers to the process of utilizing liquid assets to fund illiquid assets. For example, an illiquid loan might trade at a lower price as compared to a liquid loan. These are some of the services presented by shadow banks. Differences between banking and shadow banking The most notable difference between shadow banking and banking bases itself on regulation. Traditional banks receive their funds from the Federal Reserve, which makes them follow certain regulations and procedures. On the contrary, the shadow banking uses batch funding from other non-financial institutions; therefore, making it a non-regulated system. Unlike banks, shadow banking lacks liquidity systems, which makes them insecure (Radoselovics, 2012). U.S banks access their funds from the Federal Reserve enabling them to prevent any losses through asset liquidation. For this reason, the state considers shadow banks as insecure entities. The link between regular banks and shadow banks The interconnection between traditional banking and shadow banking began after the financial crisis. According to the Federal Reserve Bank, the prime channels through which the two systems interconnect are: Traditional banks may form part of the shadow banking vertical chain. Normal banks can provide funds to shadow banks through provisions of funding and contingent credit lines (Moschella, 2013). Regular banks can invest in financial products created by shadow banking. The shadow banking system can lend funds to traditional banks through money market mutual funds. Apart from the direct links, the two systems can be linked indirectly through risks. Risks taken by shadow banks may spread to regular banks via ways such as massive sale of assets could lead to a reduction in the price of financial and real estates. What if shadow banks fails? The failure of shadow banking leaves many economies devastated. Some of the penalties include liquidity risks and risk inherent in proxy hedging. Based on liquidity risks, banks need to continuously roll over their deposits in order to fund their loans and provide liquidity when needed. However, the failure of shadow banking systems may lead to fund refute by investors leading to inability to liquidate. Instability also leads to a reduction in hedge funds thus reducing capital for the shadow banks. Implications of the financial crisis on shadow banking Prior the 2007-2009 financial crisis, shadow banking systems provided loans through offering liquid, short term liabilities against risky long term assets (Walby, 2009). Prices on residential and real estate mortgages appreciated. The intermediary process allowed the reduction of rates on loans during the run-up of the financial crisis. However, progressive crisis led to severe straining of funding leading to its downfall. The most significant implication of the global financial crisis is the revelation of deep interconnection between shadow banks and regular banks. During economic disasters in the world economy, outcomes such as deep rapid inflation affect states. Both traditional and shadow banks result to borrowing from one another. Additionally, through creation of securitized loans, part of security instruments may remain in the balance sheets of regular banks and the other, in other regular. Such interconnection may lead to financial instability (Pozsar, 2010). The financial crisis leads to negative outcomes between two economies. The lack of comprehensive data initiates problems. At an international dimension, issues in global finance could be transmitted from one economy to another. The connection between U.S shadow banking and European Banking amplified the results and led to the transmission of the crisis from U.S to Europe. Can shadow banks be regulated? Regulatory reforms aim at controlling shadow banking, since the financial crisis. Some of these reforms include: Indirect control, which refers to the ruling of the interactions between shadow banks and banks. This involves including of any shadow bank in a regular bank’s balance sheet. Regulating money market funds. It limits the rate of borrowing between shadow banks and regular banks. Regulating security lending, this refers to treatments of banks’ implicit support to shadow banking entities (Narain, 2012). Famous shadow banks Some of the general shadow banks include Finance companies whose function involves loan organization, credit hedge funds, money market mutual and structured investment vehicles (Hackmann, 2013). Credit hedge funds are a diverse group of investment groups that help out in providing significant economic value to investors. Financial companies help in loan organization and credit funding. Money market mutual invest in short-term debt securities such as U.S treasury bills, this reduces losses due to liquidity risks. Structured Investment vehicle refer to a pool of investments that aim at benefiting from credit spreads between shortterm debts and long term finance products. Clearing house A clearing house is a financial body that grants settlement and clearing services to financial commodities and security transactions. It acts as an intermediary between two clearing firms, which reduces the chances of one clearing firm failure to honour settlements. It achieves this purpose through requiring collateral deposits, monitoring credit worthiness and providing guarantee fund to cover for any losses. Literature review The shadow banking is a very sensitive system to sudden panics and sales. It is the main reason for systematic risks ( McCulley, 2007). The shadow banking system constitutes three sub-groups; the government-sponsored shadow banking system, the ‘internal’ shadow banking system and the ‘external’ shadow banking system. The government sponsored shadow banking system began eighty years ago. They had a large influence in the financial system of the United States. Some of their activities include term loan warehousing, maturity transformation and credit risk transfer and transformation. Internal shadow banking systems participate in securitization, funding of credits and warehousing. These intermediaries use off balance sheets securitization and asset management, which enable less handling of capital. Finally, external shadow banking systems reveal similar functions and features to the internal ones. However, the only difference is that external systems deal with an international network of balance sheets. Similar to regular banking, shadow banking is inherently unstable. Its instability reveals itself in the United States financial system, which led to the global financial crisis. The system’s instability mainly lies under the intermediation provided and facilitated underneath unregulated banking system. Ramirez, (2013) describes the channel of instability by the establishment of shadow bank entities without any insurance on commercial papers. Short term funding makes shadow banking vulnerable to runs, especially when investors refuse to invest. The Lack of investment leads to the liquidity crisis. The figure below indicates the growth level rate between shadow banking and regular banking in the Euro area. (ECB, 2013) The table above represents the growth rate between shadow banking and regular banking from year 2000 to 2012. Based on the information represented above, the growth rate in the shadow banking seems to be higher than that of regular banking. As traditional banking experienced a decline in growth rate in 2002, shadow banking growth rate increased. At the height of the financial calamity in 2007, both banks experienced a decrease in growth rate, which extended to 2010. Despite equal loan funding function between shadow banking and traditional banking, there is a difference in generating capital funds between the two systems. Secondly, governments regulate traditional banking systems; therefore, this makes it incur many expenses. On the other hand, the unfettered nature of shadow banks enables them incur less costs. Finally, shadow banks offer low interest rates on their loans compared to traditional banking system; therefore, making them have a higher growth rate. Shadow banking in the world The USA holds the largest shadow banking system in the world. European countries relatively hold a large share in the global shadow banking system which constitutes 13% in UK, 8% in Netherland, 6% in France and 5% in Danish intermediaries. Despite the lack of enough data, a survey on data available shows a higher shadow banking activities in the U.S than in Europe. According to 2011 reports, shadow banking level in America equally matched those of the regular banking system. While in the Euro area, shadow banking activity measured half that of regular banking system. Regardless of its size in Europe, most of the countries consider it essential (Bakk-Simon, 2012). country USD trillions % of 2011 GDP % of World Total USA 23 152% 35% Euro Area 22 168% 33% UK 9 370% 13% World Total 67 111% 100% (FSB, 2012) The future of shadow banking Based on the future crisis, governments aim at formulating reforms that will assist in regulating some of the consequences of the shadow banking. Most of the reforms aim at regulating the link between traditional banking and shadow banking. With commercial banks subject to regulations, shadow banks are set to rise to avoid any regulation in order to improve the financial welfare. However, shadow banks may slowly collapse due to their unpredictable nature and lack of comprehensive data that may be used in its evaluation. States intend to combine both traditional systems and shadow banking systems in order to aid the economic and investment sectors. Combination could make shadow banking more sustainable and stable (Ordonez, 2013). Economies expect shadow banking to play an important part in the financial system although it will exist in a different form. Conclusion The shadow banking system developed from late 1960s to early 1970s. The term consists of activities including maturity, securitization, money market funds and the liquid transformation. Shadow banking belongs to the category of unregulated non-banking financial institutions. Shadow banking constitutes members such as financial companies, Structured Investment Vehicles and hedge funds. Compared to the traditional banking system, shadow banking system has a higher growth rate. However, due to its unregulated nature, shadow banking systems could be unstable, which may lead to exposure to certain risks such as hedge fund risks and liquidity risks. While current and future reforms aim at remediating the excess of the recent crisis, there is an increase in capital and liquidity standards for depository institutions such as insurance companies. Among other nations, the United States holds the largest amount of non-financial banking assets. Finally, data limitation remains the hugest challenge found in the shadow banking. Reference List Bakk-Simon, K., Borgioli, S., Giron, C., Hempell, H., Maddaloni, A., Recine, F., & Rosati, S. (2012). Shadow banking in the euro area: an overview: European Central Bank. ECB (2013). [Enhancing the Monitoring of Shadow Banking]. Endeley, R., & Thompson, R. B. (2005).Management of credit schemes for women entrepreneurs in Africa: a training manual. London: Commonwealth Secretariat and SFI Pub.. FSB. (2012). Globall shadow banking monitoring report 2012 Report. 2012 Hackmann, R. (2013). Wealth by stealth: Americas trojan horse: the background of the global financial crisis (Rev. ed.). S.l.: Trafford Publishing. McCulley, P., & Fuerbringer, J. (2007).Your financial edge: how to take the curves in shifting financial markets and keep your portfolio on track. Hoboken, N.J.: John Wiley & Sons. Moschella, M. (2013). Great expectations, slow transformation: incremental change in post-crisis regulation. Colchester: ECPR Press. Ordoñez, G. L. (2013). Sustainable shadow banking. Cambridge, Mass.: National Bureau of Economic Research. Narain, A. (2012). Building a more resilient financial sector reforms in the wake of the global crisis. Washington, D.C.: International Monetary Fund. Pozsar, Z. (2010). Shadow banking. New York: Federal Reserve Bank of New York. Radoselovics, J., & Monsálvez, J. (2012).Crisis, Risk and Stability in Financial Markets. Basingstoke: Palgrave Macmillan. Ramirez, S. A. (2013). Lawless capitalism: the subprime crisis and the case for an economic rule of law. New York: New York University Press. Walby, S., & Walby, S. (2009).Globalization and inequalities complexity and contested modernities. Los Angeles: SAGE Publications. Read More