The Rise of Shadow Banking - Example

The Rise of Shadow Banking EXECUTIVE SUMMARY Shadow banking has various implications, which have been documented alongwith it roles in the economic trading. The study has also identified that shadow banking involves important measures to boost the financial inclusion in the economy along with high risk. Moreover, based on proper analysis and evaluation of shadow banking, it has been recognized that various regulatory plays an important role in mitigating the risks associated with shadow banking. INTRODUCTION In the current scenario, the increase in the market based financial system has significantly changed the nature of the financial intermediation. In every economic system, banking plays an important role in supplying money and financial funds. The desirability for the need of money in the form of liquid cash is ultimately the combination of the uncertain cash flow of an individual or the need of production processes in order to increase the investment horizon. Moreover, in the absence of proper financial system in the economy it will lead to high loss of productivity or even liquidity of money. Besides, on the other hand the strong financial system will assist the economy to prevent unnecessary liquidation in the assets, along with high level of consumption to foster the economic growth of the nation. This, liquidity in the market is directly supplied through the instrument of capital markets and financial intermediaries. The liquidity is created in the economy through the capital market agents by meeting the cash flow needs of different traders and activities of capital market. These financial intermediaries act as a middleman in between the financial transaction. Moreover, commercial bank act as the key financial intermediaries in the economy with other intermediaries including, investment banks, stock brokers, mutual fund raising companies, insurance companies among (Murphy 1-24). Thus, the concept of financial intermediaries considers wider range of entities regardless of its size and operation that ranges from small brokerage, to the wider international institutions that help the investors to provide wider ranges of financial services. In this regard, after the huge financial crisis in the US during the year 2007, a new concept that consists of wide ranges of financial services i.e. Shadow Banking evolved. The term consists of various non-banking financial intermediaries, which assists the market to provide services similar to the non-traditional banking system. In accordance to the traditional banking system, there is only the direct intermediation between savers and borrowers in which people invest their saving in the bank as deposits. Moreover, bank utilizes these funds to provide loans to borrowers. On the other hand, the concept of shadow banking consist of activities including credit, liquidity and maturity transformation without the direct and open access to the public sources of liquidity. The concept of shadow banking is being conducted by the specialized financial intermediaries, which are known as shadow banks. Moreover, when this shadow banks are combined with other intermediation chain, it is then termed to be a shadow banking system. In this system, credits are being intermediated with the help of various secured funding method that includes asset-backed Commercial Paper (CP), Collateralized Debt Obligations (CDOs), Asset-Backed Securities (ABS) and Repurchase Agreements (repos). During 2007-2009 i.e. the period of financial crisis, this system helped to provide credits to the investor through short-term and long-term liabilities along with opaque assets. During this period shadow banking system had wider contribution in the real estate markets with high expansion of credit. Moreover, through the shadow banking system the cost of borrowing gets significantly lowered in respect of the increasing volatility of the cost of credit (Kodres 42-43). THESIS STATEMENT This essay focuses on discussing the concept of shadow banking system through considering the features of shadow banks, its role in the economy and analyzing its relationship with the banking system that are followed in the traditional market. Moreover, in this regard the paper will also identify the system its advantages in the economy through making augments in favor of justification and implication of same in the modern economic system. ANALYZING THE CONCEPT OF SHADOW BANKING SYSTEM The Financial Stability Board (FSB) describes shadow banking as “credit intermediation involving entities and activities (fully or partially) outside the regular banking system” (Financial Stability Board 2012). The concept of shadow banking system can be termed as a securitization of the traditional funding system. Thus, it enables to securitize the financial instruments including loans, leases, and mortgages among other instrument as the tradable instruments in the market. This method of funding is also traded in the form of commercial paper and repo. Besides, through this mechanism investor hold the money market instruments rather than the cash deposits in the banks. Unlike the traditional form of banking system, shadow bank also conducts wider range of credit intermediation activities. However, in the traditional banking system, this credit intermediation activity were undertaken under a single roof, by the bank but through the mean of shadow banking this activities are now being performed under diversified chain with the assistance of various non-bank financial intermediaries in the entire process of trading. These non-banking financial intermediaries undertake “vertical slicing” of various traditional banking intermediation including loan origination, loan warehousing, ABS issuance, ABS warehousing, ABS CDO issuance, ABS intermediation and wholesale funding among others. Correspondingly, in shadow banking this activities are been performed in the electronic form in a much sequential order through applying series of step with specific funding technique. Thus, shadow credit intermediation activity is just an analogous of the credit intermediation process that was being followed in the traditional trading banking system. This system overlaps the traditional process of fund deposit in the bank or holding the security till the period of maturity that was conducted in the earlier banking system with more sophisticated and complex mechanism through securitization of previous lending process. Moreover, with the help of this system intermediation process the more risky and long-term loans instruments is transformed into risk free as well as short term money market instrument for instances the share, debenture or Net Asset Value (NAV) shares and the mutual funds, which are traded in the daily basis and have high liquidity (Pozsar, Adrian, Ashcraft and Boesky 1-16). Consequently, company, government as well as the inhabitants highly relied on the banking sector to meet their financial requirements. However, growing advancement and channelizing in other non-banking companies in the market provides wider spectrum of instruments to meet such demands. Thus, in order to the foster the economic growth bank provides extensive variety of services through putting direct exposure to the investor with the mean of providing wider ranges of instruments. This banking measure will allow generating economic efficiency through the mean of financial innovation in the market (Pozsar, Adrian, Ashcraft and Boesky 1-16). It is important to state that shadow banking has few key roles to play. The first role is to offer safe claims in the financial system to the various agents and the other role is to offer credit to the borrowers. SHADOW BANKING REGULATION In order to regulate the shadow banking system FSB enhances the regulation and forms a working groups, which work in the global scenario to improve the control over this system. This reform is taken into consideration because the concept of shadow banking has a global reach. This acts as a ‘systemic risk transmitter’ during the time of emergency. Besides, due to the global reach of shadow banking the tightened financial regulation measures will be imperative to diminish and reduce any adverse impact of the same in the economy. Thus, the FSB is classified as an important working group that helps to create framework of policies to monitor and provide recommendation on the issues of shadow banking system. Moreover, various other industrial groups provide regulatory measures in the shadow banking. Likewise, the Institute of International Finance has also with regards to the shadow banking put policymaking along with the Securities Industry and Financial Markets Association (SIFMA) (Adrian and Ashcraft 1-32). HOW SHADOW CREDIT INTERMEDIATION WORK Different subgroups in the shadow banking system include government-sponsored, internal, independent and external. Internal systems are those activities of shadow banking, which are conducted with the support and proper assistance of bank holding companies. On the other hand, external system activities are conducted by the non-bank financial intermediaries that include the nonbank institution, brokers, dealers and the insurance companies among others. On Contrary, independent shadow banking covers all the shadow banking activities independently without the assistance of any other financial institutions. However, the government sponsored shadow specialized banking system assists to provide the credit intermediation services that are having the government guarantees attached with it. In this regard it is worth mentioning that shadow bank credit intermediation incorporates various steps. The process of Shadow Credit Intermediation Process has been evaluated below: (Source: Adrian and Ashcraft 1-32) SHADOW BANKING AND COMMERCIAL BANKS The financial statement of commercial bank does not comprise shadow banking, because credit intermediation is having access to credit guarantees that are provided by the Federal Reserve as well as Federal Deposit Insurance Corporation (FDIC). Additionally, the commercial banks may be included in the activities of shadow banking through the credit as well as the liquidity lines. (Adrian and Ashcraft 1-32). WHY SHADOW CREDIT INTERMEDIATION BE REGULATED In 2007-2009 during the time of financial crisis the shadow banking system concept had collapsed. This largely affected the five key investment bank of which one wind-up and two were acquired by the banks and the other two was established as the bank holding company. Moreover, this has seriously affected the securitization activity, which widely affected the various shadow banking institutions including the Structured Investment Vehicle (SIVs) and Collateralized Debt Obligation (CDOs). Additionally, with the fall of shadow banking institutions and the various activities of shadow banking has widely affected the financial stability of various related organizations. Underwriting standards were the midpoint of issues that affected the assets of the entities whereas, weakness in the wholesale funding affected liabilities. However, this weakness in the shadow banking led to create various reforms in the government sector through setting up backstops to undertake significant measures. In this regard, these backstops consist of both in terms of liquidity facilities as well as solvency guarantees (Adrian and Ashcraft 1-32). HOW SHADOW CREDIT INTERMEDIATION REGULATED In the current scenario, various challenges are faced in the shadow banking system, which affects the economic performance. In this regard, various regulatory institutes have undergone regulatory reforms in the shadow banking system. This reform has undergone mainly in three areas that includes reform in the money markets activities, implication of the banking system over the shadow banking system and enhancement in the securitization as well as credit ratings activities. Thus, this reform is continuously working in the current market to strengthen the economy of the market (Adrian and Ashcraft 1-32). SECTORS IN SHADOW BANKING Repurchase Agreements. Repurchase agreement of shadow banking system is quite similar to the traditional banking deposit. In this type of agreement one party sells, the assets to another party at the agreed price along with signing the contract of repurchase for the future date in a higher prices. Moreover, the difference in the price of the contract and future price is quite similar to the loan activities of the bank in which it charges interest on a loan. Likewise, the asset that has been traded between the parties is also similar to the mortgage security for the loan agreement. Failure to purchase the assets in the future date will lead to transfer of the ownership to the other party that keeps in respect of the payment. Besides, in certain scenario the third party in the contract was also been hired in order to provide the assistance in the repo transactions along with the role to settle the contract and disputes if arises. Moreover, the intermediaries that include both bank and non-banks may undertake the fund through the repos instead of insured deposits. However, unlike the deposit, if the repo is set for the shorter duration as compared to the intermediary’s assets, which will lead the intermediary to bear the exposed maturity, mismatch or interest rate risk among others (Kodres 42-43). Nonbank Intermediaries. It helps to provide fund loans to various investors that need to borrow funds. Nonbank intermediaries include mortgage companies and other investment firms’ that provides various services to the investors. Correspondingly, in this regard nonbank intermediaries engaged in sale of short term bonds in order to acquire longer term mortgages. Non- bank intermediaries through the assistance of repo transactions helps to acquire debt that has been issued by the sovereign governments (Kodres 42-43). Asset Backed Commercial Paper. Commercial paper is the traditional security instrument that is traded by the commercial banks in the form of commercial loans with the help of securities markets. ABCP is a short-term debt security, which is secured by the commercial loans that can be issued by both banks and nonbanks (Kodres 42-43). Securitization. Securitization is unlike the ABCP, which is also funded through the securities markets. In securitization, a trust has been created in order to acquire assets unlike the loans agreement. Trust issues new security under its own name that passes through the asset payments to holder of security. This measure has been undertaken by the private label firms, which does not require the guarantee of the issuer in order to cover credit risk (Kodres 42-43). Money Market Funds (MMFs). Money market funds includes mutual fund that is required to be conducted in the lawful manner through inventing the money of the investors in the low-risk securities. Moreover, the fund has been raised in the MMFs through selling shares that does not include any deposit or need to be insured. This fund also holds the short-term debt through the mean of government securities, commercial paper and certificates of deposit instruments of the various companies along with the other low-risk and liquid securities (Kodres 42-43). ARGUMENTS From the above discussion it is quite evident that the concept of shadow banking has both positive and negative effect in the economy. The concept of shadow banking in the current context has become a universal phenomenon. In this regard, it can be affirmed that in the instance of advanced economies along with having the strong financial system the concept of shadow banking assisted to transform the risk through securitization. On the other hand, in the developing stage the activities of shadow banking help to provide aid to the banking activities or more financial illusion. Moreover, due to high negative effect of shadow banking over the economic condition the regulatory measure is also important to reduce the adverse effect of same. In this regard, the US has passed Dodd-Frank Act during the year 2010 in order to strengthen the shadow banking activities (Business Standard Ltd “What is shadow banking?”). IMPORTANCE OF SHADOW BANKING Through the analysis of the concept of shadow banking it is found that shadow banking is very important concept, before taking any financial decision for any business organization as well as investors. There are various financial instruments under the shadow banking, which are quite similar to the traditional banking system by various intermediaries, which helps organizations to raise their financial requirements. Moreover, these instruments have their different features, characteristics, advantage and disadvantages along with associated benefits and cost. Thus, through better understanding of the shadow banking investors can aid to analyze about whether they get appropriate return for the risk they bear from undertaking decision regarding the investment (Business Standard Ltd “What is shadow banking?”). HELP TO DEVELOP MORE INSIGHTS ABOUT THE ECONOMY Correspondingly, shadow banking works in different manner than the banking system and intermediation activities with the less transparency than the conventional banking system. Moreover, it also plays a prior role over the generation of apparent efficiencies of the any economy through creating high financial illusion. Besides, during the time of crisis shadow banking created systemic risk transmission through the traditional banks as well as the capital market activities. Therefore, the concept of shadow banking helps to provide better insight over the economic activities through rendering the need of such unregulated entities. Thus, the phenomenon of shadow banking is growing in various nations’ in the current scenario. Moreover, it also provides high interest loan to various companies as well as governments. Apparently, the concept provide better insight over the economy as it plays important role to encourage economic growth through meeting the financial requirements of small, private and newly establish enterprises (Claessens, Pozsar, Ratnovski, and Singh 1-31). Works Cited Adrian Tobias and Adam B. Ashcraft. “Shadow Banking: A Review of the Literature.” Federal Reserve Bank of New York Staff Reports, No. 580. (2012): 1-32. Print. “What is shadow banking?” Business Standard Ltd. 2014. Web. 24 Nov. 2014. Claessens Stijn, Zoltan Pozsar, Lev Ratnovski and Manmohan Singh. “Shadow Banking: Economics and Policy.” International Monetary Fund (2012): 1-31. Print. “Strengthening the Oversight and Regulation of Shadow Banking.” Financial Stability Board. 2012. Web. 24 Nov. 2014. Kodres Laura E. “What Is Shadow Banking?” Finance & Development, (2013): 42-43. Print. Murphy Edward V. “Shadow Banking: Background and Policy Issues.” Congressional Research Service (2013): 1-24. Print. Pozsar Zoltan, Tobias Adrian, Adam Ashcraft and Hayley Boesky. “Shadow Banking.” FRBNY Economic Policy Review (2013): 1-16. Print. Read More