12 January 2013

VoxEU: Shadow banking - Economics and policy priorities

The risks associated with shadow banking are at the forefront of the regulatory debate. However, this column argues that there is as yet no established analytical approach to shadow banking which means that policy priorities are not clearly motivated.

Authors Stijn Claessens, Zoltan Pozsar, Lev Ratnovski and Manmohan Singh analyse securitisation and collateral intermediation – the two shadow banking functions most important for financial stability – and find that a solid framework that includes existing policy recommendations, as well as some alternative ones, begins to emerge.

The first key shadow banking function, securitisation, is a process that repackages cash flows from loans to create assets that are perceived by market participants as almost fully safe and liquid... Once economic activity and private credit demand recover, some of this securitisation may resume. Securitisation will, however, most likely resemble itself as it was in the 1980s: subdued, with better recognition of risks, relying on more sophisticated investors.

Another key function of shadow banking is supporting collateral-based operations within the financial system. Such operations include secured funding (of bank and, especially, non-bank investors), securities lending and hedging (including with OTC derivatives). Collateral helps deal with counterpart risks and more generally greases financial intermediation. One of the main challenges in using collateral is its scarcity. The shadow banking system deals with the scarcity through an intensive re-use of collateral, so that it can support as large as possible a volume of financial transactions. The multiplier of the volume of transactions to the volume of collateral (the ‘velocity’ of collateral) was recently about 2.5 to 3. 

A small number of dealer banks, all ‘systemically important financial institutions’, that is, banks whose failure could trigger a global financial crisis, are uniquely placed in their ability to facilitate collateral-based operations. The dealer banks derive comparative advantages from economies of scale and network centrality effects, and (undesirably) from the perceptions of very low counterparty risks thanks to being too big to fail... A distinct part of the collateral intermediation process, the tri-party ‘repo’ market presents its own, and very significant set of systemic risks.

Policy recommendations

The analysis of demand factors and regulatory weaknesses driving shadow banking helps clarify policy recommendations. Some parts of the shadow banking system are fragile and can pose systemic risks, yet commonly lack appropriate regulation. The most pressing concerns here are addressing risks in dealer banks, money market funds, and the tri-party ‘repo’ market; these are the focus of the recent Financial Stability Board proposals. Spillovers from the shadow to the traditional banking, and the possibility of banks using shadow banking for regulatory arbitrage also have to be addressed.

The crisis showed that demand-side pressures can lead to the creation of privately-provided safe assets, but these assets are unstable. Some proposals therefore suggest limiting the volume of shadow banking activities or integrating shadow banking in the main banking system. A more realistic proposal is to explicitly acknowledge the demand-side pressures by accommodating a shortage of safe and liquid assets with publicly guaranteed short-term debt.

It is also essential to consider broader macro-economic issues surrounding shadow banking. Shadow banking is highly procyclical: secured lending and repos rely on mark-to-market prices and margins/‘haircuts’ that adjust over the financial cycle; securitisation produces claims that are inherently exposed to ‘tail risk’. Shadow banking is also hard to resolve in times of distress, since it encompasses many agents with complex contractual links. Shadow banking is also likely to have important interactions with monetary policy, both affecting interest rate transmission and being affected (e.g. in determining risk-taking) by prevailing interest rates. These issues raise specific sets of policies.

Addressing policy issues in shadow banking is a complex task. Research is yet to catch up. Some outstanding analytical issues include better differentiating economically-useful shadow banking activities from regulatory arbitrage. If we can better understand the economic value of useful activities, we can get cost-benefit insights for better regulation. Regardless, a policy response to address evident systemic risks is necessary and urgent. Such response, if effective, will probably make the shadow banking system smaller in size but still able to perform its useful economic functions in much safer ways.

Full article

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