How shadow bank­ing works

The Pak Banker - - OPINION - A.A.K.

ON JAN­UARY 5th, in a cam­paign speech in New York, Amer­i­can sen­a­tor Bernie San­ders pledged to break up banks that were deemed "too big to fail" and vowed to put a leash on their shad­owy cousins. Janet Yellen, Fed­eral Re­serve's chair, has ad­mit­ted that shadow banks pose "a huge chal­lenge" to the world econ­omy. In an edi­to­rial for the New York Timesin De­cem­ber, Hil­lary Clin­ton called for tough mea­sures to con­tain the global bo­gey­man. Politi­cians and econ­o­mists who of­ten have lit­tle in com­mon, unan­i­mously agree that shadow bank­ing, left to its own devices, has the po­ten­tial to trig­ger an­other fi­nan­cial col­lapse. What are shadow banks and why is there such a fuss about them them?

The term "shadow bank" was coined in 2007 by Paul McCul­ley of PIMCO, a big bond fund to de­scribe risky off-bal­ance-sheet ve­hi­cles hatched by banks to sell loans repack­aged as bonds. To­day, the term is used more loosely to cover all fi­nan­cial in­ter­me­di­aries that per­form bank-like ac­tiv­ity but are not reg­u­lated as one. Th­ese in­clude mo­bile pay­ment sys­tems, pawn­shops, peer-to-peer lend­ing web­sites, hedge funds and bond-trad­ing plat­forms set up by tech­nol­ogy firms. Among the big­gest are as­set man­age­ment com­pa­nies. In 2013 in­vest­ment funds that make such loans raised a whop­ping $97 bil­lion world­wide. Com­pa­nies look­ing for cash also lean on bond mar­kets that of­fer ex­traor­di­nar­ily low in­ter­est rates. Glob­ally, be­tween 2007 and 2012, firms thus raised $1.7 tril­lion by is­su­ing cor­po­rate bonds. Money-mar­ket funds that in­vest in short term se­cu­ri­ties like US trea­sury bills have taken off too. In China alone, they grew six times to 2.2 tril­lion yuan ($341 bil­lion) be­tween mid-2013 and De­cem­ber 2015. In De­cem­ber they hit a sweet spot when Fed­eral Re­serve hiked in­ter­est rates for the first time in nearly ten years. The Fi­nan­cial Sta­bil­ity Board, an in­ter­na­tional watch­dog es­ti­mates that glob­ally, the in­for­mal lend­ing sec­tor ser­viced as­sets worth $80 tril­lion in 2014 up from $26 tril­lion more than a decade ear­lier.

Shadow banks have flour­ished in part be­cause the tra­di­tional ones, bat­tered by losses in­curred dur­ing the fi­nan­cial slump, are un­der pres­sure. Tighter cap­i­tal re­quire­ments and fear of heavy penal­ties have kept them grounded. In China, where banks are dis­cour­aged from lend­ing to cer­tain in­dus­tries and are man­dated to of­fer frus­trat­ingly low in­ter­est rates on de­posits, non-banks fill the gap. About two-thirds of all lend­ing in the coun­try by shadow banks are in fact "bank loans in dis­guise", reck­ons the Brook­ings in­sti­tu­tion, a think tank. Crit­ics worry that un­like banks, which lend against de­posits from cus­tomers, non-banks loan money us­ing in­vestor's cash and ro­tat­ing lines of credit. This is es­pe­cially risky when skit­tish in­vestors who bet on short term gains with­draw their money at once. But non-bank fi­nanc­ing need not al­ways be a bad thing. It of­fers an ad­di­tional source of credit to in­di­vid­u­als and busi­nesses in coun­tries where for­mal bank­ing is ei­ther ex­pen­sive or ab­sent. It also takes some bur­den off banks which have big "ma­tu­rity mis­matches" (the dif­fer­ence be­tween the amount of time a de­pos­i­tor's money is parked in the bank mi­nus the time that it is loaned out). And be­lat­edly, reg­u­la­tors, too, are wak­ing up to the new fi­nan­cial or­der. Banks must now de­clare struc­tured in­vest­ment ve­hi­cles on their bal­ance sheets. Au­thor­i­ties have con­sid­ered im­pos­ing lev­er­age lim­its on var­i­ous forms of shadow banks in Amer­ica and Europe. In Jan­uary last year, Amer­ica's Fed­eral Hous­ing Fi­nance Agency pro­posed new rules that would re­quire all non-banks to have a min­i­mum net worth of $2.5m plus a quar­ter per­cent­age point of the out­stand­ing loan stock that they ser­vice. Only then would they be able to sell their loans to Fan­nie Mae and Fred­die Mac, which buy Amer­i­can mort­gages from banks, bun­dle them into se­cu­ri­ties and re­sell them to in­vestors with a guar­an­tee. The move aims to pro­tect the two govern­ment-backed hous­ing gi­ants against un­der-cap­i­talised lenders. It is a small start to rein in an in­dus­try that ac­counts for a quar­ter of the global fi­nan­cial sys­tem.

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