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Shadow banking comprises activities involving some element of maturity and liquidity transformation, credit extension, and risk transfer, conducted partly or wholly outside the “traditional” banking system. It covers a wide range of activities, including securitisation, repos, and money market funds (MMFS) as well as some activities of non-bank financial institutions such as finance companies and credit hedge funds.
Different investors have different time horizons and different degrees of tolerance for illiquidity and risk. Investors seeking safe places to park their cash holdings typically prefer to hold assets that are of short maturity and liquid. The economy benefits from the existence of safe assets – assets that can be accepted without constantly having to scrutinise the issuer’s financial statements. At the same time, many of the productive long-term investments in the economy – investments that are essential to build its productive potential – are inherently illiquid, long-term, and risky.
Confidence in shadow banking is partly based on collateral. For example, investors hold asset-backed securities mainly on the strength of the underlying assets, rather than on the reputation of the issuer – which may be an anonymous special purpose vehicle created for the sole purpose of holding the assets and issuing securities. Similarly, investors provide cash in repo transactions because, even if the institution receiving the cash were to default, the institution providing the cash would have a claim on the underlying asset.
In other cases, shadow banking assets are perceived to be safe because of the narrow range of activities in which they engage. For example, MMFs provide a close substitute for bank deposits, partly because they invest only in very liquid, short-term, low-risk securities. Other shadow banking institutions, such as credit hedge funds and finance companies, have structured their assets and liabilities in various ways to avoid being subject to runs. Thus, shadow banks have a variety of business models to maintain investors’ confidence and obtain access to financing. These models are different from those of regular banks, and from one another.
The weaknesses of both traditional banking and shadow banking were clearly exposed during the global financial crisis: both proved vulnerable to run-like behaviour despite features intended to bolster confidence. A number of core funding markets froze up as financial institutions lost the confidence to lend to one another. The flight from counterparty risk reflected the vulnerabilities of many banks, as well as the fragility of the shadow banking system. I won’t dwell on the vulnerabilities of the banks and how they are being addressed, since that has been discussed in considerable detail elsewhere, but I will discuss some of the weaknesses exposed in global shadow banking.
During the crisis, repo markets came under severe stress. Market makers and cash lenders became less able and willing to provide repo financing, and, as a result, some repo borrowers experienced difficulties financing even good-quality collateral. Borrowing limits were reduced, the terms of transactions shortened, haircuts on private securities accepted as collateral widened and the range of securities accepted as collateral narrowed down to all but the safest. The volume of repo transactions dropped off sharply. Such strains were experienced in Canada and around the world.
The Financial Stability Board (FSB) has mapped out international work on shadow banking, identifying five work streams: links between banks and shadow banking; money market funds; other shadow banking organisations; securitisation; and securities lending and repos.
The FSB has also begun monitoring the evolution of the sector and the associated risks. To guide the key reforms, the FSB has established some basic principles. The regulatory measures should be:
I would like to stress some common threads that run through the global reform agenda: reducing susceptibility to runs and liquidity freezes and better aligning incentives. As I have stressed, shadow banking delivers important benefits to the economy. There is a need for the liquidity and maturity transformation, credit extension and risk transfer it provides. In delivering these services, it is healthy to have an alternative to the traditional banking system that provides competition, diversity and innovation.
At the same time, reforms are needed to make shadow banking safer. Shadow banking should be made less susceptible to run-like behaviour and contagion. Aligning incentives –through transparency and appropriate regulation – is also essential. Canada has a stake in these reforms, both as a beneficiary of a more resilient global financial system and because our own shadow banking activities could be made more robust.
Since innovation is one of the key benefits of shadow banking, innovation is also a fact of life in regulating the sector. Shadow banking has been known to reinvent itself and will continue to do so in response to regulation. We will need to develop and adopt principles that are broad-based enough to encompass new activities.
Risk is inherent in the global financial system. We can’t stamp it all out, nor would we want to. Rather, the goal is to create incentives so that risk is allocated and managed appropriately, both in banking and in shadow banking activities, making the entire financial system stronger and more resilient.