Capstone Project - Draft 2 (ShadowBanking)

Shadow banking is a credit system that incorporates the institutions that are not within the banking system. The financial intermediaries involved in shadow banking work to create credit availability, but they are not subjected to regulatory oversight. It is possible, therefore, for such institutions to be established by the regulated banking institutions. The main reason shadow banking has escaped regulation is that it does not accept deposits (Chen et al., 2020). Shadow banking came into the market as innovators who financed real estate and other businesses without facing the regulatory oversight and the rules established on capital reserves and liquidity. Regulation of the institutions aims at preventing failure of financial institutions and guard against financial crises. Shadow banking increased in the 2000s where there was a boom in mortgage lending (Chen et al., 2018). The impact was that in 2008 the economic meltdown made the government consider the activities of the shadow banking system because it plays a role in extending credit and the systemic risks in the financial system.

Shadow banking can be similar to traditional banks because they provide loans and financial aid to borrowers. However, the functioning of these institutions is different. Traditional banks get deposits and lend loans to those seeking them (Farhi & Tirole, 2017). However, the shadow banks do not and hence build their loan funds differently. The shadow banks accept securities given by their customers to provide loans. These securities are used as bonds and sold to investors (Irani et al., 2020). Therefore, unlike the traditional banks, this is a financial sector that is vastly unregulated, and hence it is risky for individuals to invest in.

The banks are regulated to ensure that there is soundness within the financial system. Using interest rates and reserves, the governments can monitor and control the money circulating in the economy. For example, the banks are allowed to hold a given amount of capital (Abad et al., 2017). Through this regulation, the banks maintain stability in the system and hence cushion against losses. The Federal Reserve also assists the banks by acting as a lender of last resort. However, regulations are above the operations of the shadow banking industry. Although they provide similar services to the traditional banking system, the main aim is to channel loans from the lenders to the borrowers (Yang et al., 2019). The process is complex and different, and the loan originator sells the loans to another financial institution. Before approval, the loan is scrutinized.

The banks are there to provide different forms of loans to different people. There are student loans, house mortgages, and particular loans (Pellegrini et al., 2017). The loans differ depending on the needs of the consumers. Many factors are considered when approving loans in the banks, such as the borrower's repayment capabilities. However, shadow baking is a system that includes financial institutions offering a given form of a loan, such as real estate loans (Nabilou & Pacces, 2018). However, all these financial institutions match the lenders and borrowers for short-term funding, and liquidity funding is for long-term practices.

Financial intermediation in the traditional system involves accepting deposits and giving out loans. These institutions provide credit intermediation between lenders and borrowers using the balance sheet to ensure they have attractive savings (Tsai, 2017). However, credit intermediation of shadow banking system is unregulated under the law. They are not classified as banks simply because they are not allowed to take credit. Shadow banking is built on the platform of securitization and wholesale funding. The loans and leases are securitized and hence can be traded (Chen et al., 2020). The savers have control of the balances in the money marketas opposed to bank deposits. Therefore, unlike the traditional banks, where credit intermediation is carried under one roof, these institutions perform their duties using nonbank financial intermediaries in a process involving multiple processes.

The process of intermediation in shadow banking includes seven steps. The first one is loan origination. These processes are carried out in an order that is strict and sequential. This is because every step is undertaken by a different shadow bank using given funding techniques.

These include loans produced automatically and leases as well as non-conforming mortgages. They are provided by the companies funded through the medium-term notes.

Single or multi-seller conduits perform this. It is funded through the asset-backed commercial paper.

This is where the brokers or dealers are involved in the asset-backed securities.

These are the loans that are provided through trading books. The primary source of funding is through the repurchasing of the total return swaps.

The broker-dealers conduct these in the ABS syndicate desks.

This is performed by the companies classified as limited-finance companies. It can also be done through structured investment vehicles, credit hedge funds, or securities arbitrage conduits (Tsai, 2017). These include the MTNs, capital notes, and bonds.

The funding of the shadow banking activities is performed in the wholesale funding markets. This is where all the providers, such as the direct money market investors and the unregulated money market intermediaries, are found.

Shadow credit intermediation is a process that has an economic role that is similar to traditional banks. However, it breaks down the simple retail-deposit funded and hold-to-maturity lending practices present in the traditional banks(Tsai, 2017). Instead, it uses complex wholesale and securitization-based processes. Irrespective of this disadvantage, shadow banking transforms the long-term loans that are considered risky into credit risk-free short-term loans. However, not all the intermediation in the shadow banking sector goes through the seven steps. In some cases, they are more or less. For example, some intermediation processes go for two steps and are terminated. However, others go up to the last step (Fong et al., 2021). Depending on the length of the process, the complexity is determined.

Credit intermediation takes different functional forms. Therefore, it is essential to identify the structure and the characteristics of credit intermediation. Shadow banking is a resilient form of market-based finance (Rubio, 2017). It provides an opportunity and departure for the discussion of the impacts of financial stability. Comparing shadow banking and market-based finance shows that the former provides the transformations of the risk characteristics. This is provided by the pooling and tracking of the guarantee. This includes the transformation of liquidity and maturity. However, shadow banking faces opaqueness, complexity, and leverage. For example, the transformation of the portfolio of liquid provided by the banks under the balance sheet into an off-balance sheet liquid portfolio and the highly-rated securities which enjoy credit support features (Fève et al., 2019). This increased supply of money to shadow banking.

Comparing shadow banking and market-based finance shows that the former has lengthy networks. This, therefore, brings forth the risk of interconnected intermediaries, and hence the balance sheets include many entities. For example, when a loan originates from a non-banking institution, it has to be pooled and warehoused by the broker (Caverzasi et al., 2019). These are structured as asset-backed and collateralized debt obligation securities. They are assigned ratings by the credit rating agencies and funded through capital note issuing. However, this is an approach that is similar to other financial institutions. They both reuse collateral and involve lengthy chains (Abad et al., 2017). This raises the risk of heightened interconnectedness which is a risk.

Market-based finance results in a reduction in the spillover and hence bringing interconnectedness in the financial institutions. For example, direct loan firms may be extended by the long-term asset owner (Yang et al., 2019). Simultaneously, the credit risk can be borne by a single institution, and there will be no risk of a contagion effect, resulting in lengthy re-hypothecation chains. On the other hand, the shadow banking sector benefits from the presumption of private sponsors. This is a risky process when the investor returns are not met. In low banking margins, they cannot absorb the costs of the backstop (Chen et al., 2020). Therefore, they need to be subsidized institutions externally that can absorb the risks. In most cases, these external entities are cheap insurance.

Currently, shadow banking is mostly unregulated. This means that it is risky for any person to invest in such an institution. However, there is a need to establish regulation. One of the reasons why this sector should be regulated is because there is a possibility that this is a sector that the financial institutions use to escape the regulation requirements (Fong et al., 2021). This sector carries out the same things and activities as the traditional banks, and hence with no regulation, there is an increased risk of systemic risk. For example, before the 2008 crisis, commercial banks had created investment vehicles that were based on the long-term assets the banks helped. Therefore, the bank purchased these by issuing the short-term asset-based paper,which must be paid off upon maturity. This is an aspect that offered the investors the confidence and guarantee of the conduits. This meant no risk was transferred to the assets that were not appearing on the banks’ balance sheet (Yang et al., 2019). With this, the bank's tendency to over-leverage and hence escaping the capital regulations. Therefore, regulation will offer a consolidation into the balance sheet found in the traditional system.

The second reason why shadow banking should be regulated is the special activities involving high leverage, maturity, and liquidity. This means that, just like traditional banking, shadow banks are prone to panics and systemic events (Nabilou&Pacces, 2018). For example, a repo found in this system is like a deposit for the investor. The deposit has no insurance, although there is an assurance that there will be high liquidity on the securities that are used as collateral. The panic occurs when there is a change in the credit ratings in the securities. Rubio states that the 2007 crisis resulted from the wholesale banking panic which occurred in shadow banking (2017). There were apparent problems of subprime lending that were apparent. The asymmetric information made the investors unable to ascertain the counterparts' exposure to the aspects of the problem and solvency. The shadow banking firms ran on the other financial firms and took cash from the MMF without renewing their repo agreements, causing a rise in the repo margin.

Although the regulation of shadow banking institutions is essential, one thing is that the strategies used should not be particular on the activities of the shadow baking system. The regulation should try to prevent the systemic crisis and the financial crisis without increasing the costs incurred in regular time (Tsai, 2017). The regulations with the objectives of preventing the systemic crisis must ensure they understand why the crisis is occurring. The banking crisis causes the investors to withdraw their deposits and hence cause a shock in the economy. This means that prevention of systemic crisis needs the following four types of regulation. The first one is regulating and restricting the liquidity of the bank deposit instruments. This can include increasing the fees, suspending the convertibility, and reforming the bankruptcy laws (Pellegrini et al., 2017). The second approach is to regulate and restrict the deposit-like instruments in investments needed to fund long-term projects. Some possible policies may include capital requirements and restricting the use of client assets and liquidity requirements.

The third possible regulation should include reducing the asymmetric information on the assets used to back the deposits. This brings forth two more forms of regulation (Caverzasi et al., 2019). The institutions can result in regulating to deal with the systemic crisis once they have occurred. This is because even reasonableregulations cannot completely prevent all the systemic crises. This is why regulators mustfocus on coming up with the best policies to deal with the crisis as soon as they occur. These are policies aimed at restoring the system's solvency without imposing the externalities on the third parties. Thus, the solution to the financial crisis is to prevent escalation of the problem leading due to poor management.

The rising systemic risks in shadow banking have no access to public sources. This is because they are not a part of the county’s central bank operations (Chen et al., 2018). Shadow banking is thus only able to have a limited capacity of maintaining and withstanding the liquidity pressure. Thus, these institutions may become a catalyst to the market turmoil, especially when the institutions grow in size, making it difficult to regulate them (Chen et al., 2020). During a crisis, the vicious cycle, the assets, is constrained by the asset value, hence serving as collateral.

Two aggravating factors lead to the vicious cycle of low asset prices and collateral. The first case is when the collateral value falls at a greater rate than the asset prices (Yang et al., 2019). This increases the uncertainty. Collateralization of transactions aims to ensure the lender can save the transaction costs and not worry about the underlying security value. However, when these worries arise, the lenders are caught uninformed, increasing the risk premia. The second factor is when there is a decline in the collateral values, and hence the institutions are forced to call for additional collateral, increasing the margin requirements. The tightening of credit conditions may reduce the secured lending and leverage and the standard conditions. This means that the markets can seize up at the same time systemically (Irani et al., 2020). The spread use of collateralization establishes the links between the asset prices and the hedging costs hence escalating the market paralysis.

The regulators are afraid of shadow banking because it has excessive leverage in the economy. In modern times the leverage is coming from the bank balance sheets and off-balance transactions involving the non-banking institutions (Tsai, 2017). The latter ones have grown in the past years and hence making it hard to maintain reliable records on their operations. The collateralized transactions in this sector lead to spillovers because of two reasons. A large part of shadow banking is owned or regulated by the banks. This means that they get access to large leveraged funds (Fève et al., 2019). The second reason is that the primarily regulated banks have found a way of engaging in shadow banking through their brokers. In case of a risk, the dealer banks are at risk of rollover.

Shadow banking has considerably evolved significantly because it has remained unregulated. The rate at which it is expanding poses a risk to the deterioration of the credit conditions. For example, these institutions fuelled the crisis in 2007 by providing credit to under-qualified borrowers (Pellegrini et al., 2017). They were also involved in funding the exotic investments that collapsed, and the mortgages were forced to fall apart. From the time of crisis, the shadow banks have grown their global assets to $52 trillion. The main growth area is the collective investment vehicle where the hedge funds, money markets, and mixed funds are included. This area has seen the assets grow to $36.7 trillion (Abad et al., 2017). Irrespective of this growth, these institutions have become a systemic threat.

The main concern in the financial sector is that shadow banking is that borrowing short term and lending in the long term is benefiting some sectors compared to others. For example, this is the practice that led to Lehman Brothers' doom and shook Wall Street (Rubio, 2017). Some of the current landscapes due to these risks include high restrictions on the banks. This is because banks are the primary source of funding and a driver in shadow funding. By controlling the deposits in the banks, conventional lending is slowed down. The second landscape is that banking activities complement shadow banking (Yang et al., 2019). This is mostly because there are people who do not qualify for credit in the banks. Shadow banking accommodates all the people and enhances access.

Recently, there is a recent growth of calls to increase regulatory response and introduce tighter monetary conditions to curb shadow banks' growth. This is because they are seen as risk factors in developing systemic financial risks (Irani et al., 2020). From 2008 to 2014, the security regulators came up with tight measures to make it difficult for the trusts and securities firms to be used as conduits for the banks channeling business. This was upgraded in 2016, where the bank assessment was made to be carried out every quarter. In 2017, the Central Bank introduced a policy that the CDs will be used as interbank liabilities and subject to a cap (Farhi & Tirole, 2017). This led to the slowing down of the growth of shadow banking.

On the other hand, the slowing down in the shadow banks' growth is caused by a rise in interest rates and tighter financial conditions. These reduce the incentives received and hence making it difficult to lever up. The authorities are faced with a need to trade-off between financial stability and the supply of credit in the private sector (Farhi&Tirole, 2017). This is so because the deposit banks tend to provide credit to the state-owned enterprises due to the lower presumed credit risk.

The negative side of shadow banks is that irrespective of them taking similar risks as the banks, they are not subjected to the bank regulators' same risk controls. This is because they do not accept deposits from their customers (Caverzasi et al., 2019). They also do not receive the benefits of government backstops that prevent the panics and runs, ensuring stability in the financial market. This scenario played a role in 2007 and showed that the shadow banking sector could spread in different markets, causing significant disruption (Chen et al., 2020). Irrespective of the fact that this was a largely unregulated sector, the financial crisis has led to developmentof an improved regulatory framework by the Financial Stability Board. This is meant to ensure that risky operations such as opaque off-balance-sheet vehicles are well addressed inrules. However, the regulation of this sector is still less robust.

The shadow banks increase the risk of crisis due to the increased regulations of the banks. The increasing demand for credit and an appetite for the growth of products push the investors and the retail sector to search for alternative low-interest funding sources (Pellegrini et al., 2017).

Shadow banking is a symbol of the failings of the financial systems escalating to the global financial crisis. They raise short-term funds through borrowing in the money markets, and the funds are used with long-term maturities. However, they are not subject to bank regulation and hence cannot borrow from the Federal Reserve. They provide funding for products such as home mortgages. They turn home mortgages into securities through a securitization chain where mortgages are bought and sold by one or more entities (rani et al., 2020). The security value was equivalent to the mortgage loan package. These actions took place outside the view of the regulators.

Controlling the crisis posed by shadow banks requires that the regulators introduce a minimum liquidity requirement. This will act as a starting point in reducing their liquidity and prevent further crises in the financial markets (Abad et al., 2017). Other methods include increasing the disclosure that is provided to the customers borrowing from this sector. This is because the products offered to expose the consumers to a high leverage and a downside of the risks (Farhi&Tirole, 2017). There should also be an improvement in the investors' disclosure when it comes to credit-related investment products that are associated with risks to capital and the ability to redeem investments.

The problem exists because the investors are put in the shadow and do not get their money back within a short time. The global financial crisis was caused by the investors doubting the long-term assets and their worth hence withdrawing their funds simultaneously (Yang et al., 2019). The shadow banks were forced to sell their assets to repay the investors. This reduced the assets and similar assets' value, causing changes in the books to reflect lower market prices. This created a further uncertainty of their financial health. The withdrawal of investor funds made several shadow banks face difficulties in operating. Therefore, the shadow banking entities lack disclosure of asset information and have little regulatory supervision (Abad et al., 2017). Therefore, they cannot access formal liquidity to prevent fire sales, causing a crisis in the economy.

In conclusion, shadow banks can be classified as informal financial institutions that operate in the economy without facing traditional banks' same regulations. This is an aspect that makes the institutions operate high leverage. The shadow banks are rising in popularity since they do not accept deposits. However, they increase collateralization as they use the securities to obtain funding from the investors. The global economic crisis in 2007 was majorly due to the operations of the shadow banking institutions. The investors doubted the long-term assets provided hence withdrawing their funds and heightening the crisis. It is important to have regulations meant to ensure these institutions are controlled, and their activities do not raise financial crises. It is essential to control the bank deposits to ensure they do not increase these institutions' funding. Secondly, shadow banks need to be managed in terms of credit-giving practices. They have increased credit to the people banks considered unworthy. This increases their risks and hence impacts the economy.

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Appendices

Appendix 1: Market Securitization during the Financial Crisis