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Defining shadow banking by function
By definition, shadow banking is not a precise category. In this column, Perotti focuses on financial intermediaries that take credit risk.
Banks acquire illiquid risky assets, funding them with inexpensive, demandable debt.
Confidence on immediacy ensures that demandable debt is routinely rolled over, thus supporting long-term lending and high leverage
As bank credit volume is constrained by capital ratios and deposit base, financial markets have thought of new ways to carry risky assets on inexpensive funding. Shadow banking requires creating a variant of demandable debt, credibly backed by a direct claim on liquidity.
How can these liabilities deliver investors credible liquidity upon demand?
Perotti elaborates on the following:
He concludes by commenting that thanks to the safe harbour rules, a shadow bank can hold risky illiquid assets and earn full risk premia with funding at the overnight repo rate. In what is essentially a synthetic bank, repo and collateral swap haircuts act as market-defined capital ratios.
Liquidity transformation across states and entities has procyclical effects. It enhances credit and asset liquidity in normal or boom times, at the cost of accelerating fire sales in distress. While any reform to the shadow banking funding model should take into account its favourable effects on asset liquidity and credit in normal times, the associated contingent liquidity risk is not at present controllable (nor is it well measured!). There is an academic consensus that a balance has to be struck.
Appropriate tools are also necessary to align capital and risk incentives in banks and shadow banks. Security lending may also undermine Basel III liquidity (LCR) rules. At a time when all lenders seek security, questioning the logic of safe harbour provisions may seem unwise. Yet at the system level, it is simply impossible to promise security and liquidity to all. Uncertainty on the stock of pledged assets may create a self-reinforcing effect, feeding a frenzy among lenders to all seek ever-higher priority. This is already taking place, and is ultimately unsustainable at the individual and aggregate level.
Finally, it is questionable whether the highest level of protection should be granted to collateralised lenders, and to shadow bank funding, over all other investors. For all these reasons, regulators and the wider society need to make an informed decision. But the dominant funding channel is issuing collateralised financial credit, such as repos or derivative-based claims. This is the source of shadow banks’ very short-term, inexpensive funding source.