Shadow Banking: Parallel and Growing?

The banking industry in its organized format is not very old. A century ago banks operated in a system with very limited regulation and little backing from the government. It was a system characterized by bank runs. The depression saw the introduction of the federal deposit insurance, which helped reduce bank runs and gave banking some credibility. Early on Banks have used short term liabilities to fund long term assets, which often led to bank runs. Bank failures can have huge negative impacts on the economy. To counter this American Governments helped them counter the risk of short term lending by giving them greater liquidity through deposit insurance. These put options, are difficult to price and this keeps the options for risk-taking very high. This can be kept in check only by greater regulation and limits.

In 2007 the Lehman brothers fell to such engagement of credit and risk taking. The crisis that followed was brought to check by the Feds intervention by introducing greater liquidity in the system. This helped the system to get ‘oiled’. The FDIC’s Temporary Liquidity Guarantee Program (TLGP) of financial institutions’ senior unsecured debt and corporate transaction accounts, and the U.S. Treasury’s temporary guarantee program of money market funds, are the modern-day equivalents of deposit insurance. The period 2007-09 saw the investment banks and other intermediaries play with asset based mortgages, derivatives, etc. The impression was that these assets were considered to be risk free and highly liquid.

The G20 is deliberating on how to regulate the shadow banking system, which is de facto a parallel financial system to the traditional, government-backed one. Consumer finance companies, pawn brokers, securities traders all come under the ambit of shadow banking. In view of the current financial crisis it includes asset backed commercial paper issuers and companies who develop and market highly complex derivative products.

Shadow banking uses asset backed securities to mop up short term credit from the repo market or money market funds. It then uses these funds for other lending purposes. They then lent this monies to corporates or in buying long term assets. When the realty market came crashing down, these assets quickly became `toxic’. Most of this was ‘off balance sheet’. Many banks bundled these toxic assets and sold them to bigger banks. Bigger banks in turn sold them to investors as mortgage backed securities with monthly EMI’s as payouts to investors. The shadow banking‘s liabilities stands at about $16 trillion as against $13 trillion liabilities of traditional banking (2011 1st quarter) according to New York Fed. This being a fairly unregulated market, the government can do little in terms of either monitoring it or containing should a ‘run’ occur.

According to Timothy Geithner, United States Secretary of the Treasury "The structure of the financial system changed fundamentally during the boom, with dramatic growth in the share of assets outside the traditional banking system… In early 2007, asset-backed commercial paper conduits, in structured investment vehicles, in auction-rate preferred securities, tender option bonds and variable rate demand notes, had a combined asset size of roughly $2.2 trillion. Assets financed overnight in triparty repo grew to $2.5 trillion. Assets held in hedge funds grew to roughly $1.8 trillion. The combined balance sheets of the then five major investment banks totaled $4 trillion.”

"In comparison, the total assets of the top five bank holding companies in the United States at that point were just over $6 trillion, and total assets of the entire banking system were about $10 trillion."

In 2007 the sub-prime mortgages started suffering as most consumers were unable to take on the higher mortgages as a result of a higher floating rate. Shadow banks found it tough now to mop funds from the repo market using asset backed securities. This was akin to putting a stop on the main valve of the shadow banking system. To further shake investor confidence came the fall of Lehman Brothers. Foreign investors stopped investing in asset-backed commercial paper. Shadow Banking was on a ‘run.

The world then saw the financial markets unraveling. It is still reeling under the impact of this ‘run’.

"What the world needs right now is a rescue operation. To do this, policymakers around the world would need to do two things: get credit flowing again and prop up spending.", says American political and economic commentator Paul Krugman.

This brings us to the essential question. How does a nation that employs such strict adherence to its parking fines and speed limits let its financial super power status go to waste? How does it sit by the sidelines and watch as a few players play the market as if it were the wild, wild west. Turning as it were a blind eye to the unscrupulousness of a few while the majority of the tax saving public watches their life’s net worth go down the drain? Shadow Banks alone are not responsible for this crime. Governments and government agencies are also complicit in this offence.

It is time for including banking into the mainstream. It is critical that regulators keep an eye for such high risk players. As a correct step in that direction the Fed has accepted Basel III norms of Tier I capital adequacy ratios. Still there is much more to be done. It is time to go back to an adherence to basics. Investors and market players need to be prudent  and think long term, rather than just short term high risk gains, the ground of shadow banking players.

In conclusion I would like to quote Krugman again who so accurately says "As the shadow banking system expanded to rival or even surpass conventional banking in importance, politicians and government officials should have realized that they were re-creating the kind of financial vulnerability that made the Great Depression possible—and they should have responded by extending regulations and the financial safety net to cover these new institutions. Influential figures should have proclaimed a simple rule: anything that does what a bank does, anything that has to be rescued in crisis the way banks are, should be regulated like a bank."

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