The London School of Economics and Political Science FM 409 Risk Management in Financial Markets SHADOW BANKING Presented by: Liu, Xiao, Zeng & Zhou 1

The London School of Economics and Political Science FM 409 Risk Management in Financial Markets Contents Introduce the shadow banking system Identify and model risk factors Regulate the shadow banking system 2

The London School of Economics and Political Science FM 409 Risk Management in Financial Markets What is shadow banking? 3

The London School of Economics and Political Science FM 409 Risk Management in Financial Markets Certain activities by the shadow banking sector are similar to those conducted by regular banking sector (Inverse Parallelism) NOT under financial regulation How do they operate and why they are important? Providing credit and generally increase the liquidity of the financial sector. 4

The London School of Economics and Political Science FM 409 Risk Management in Financial Markets Definitions of “Shadow Banking” ActivitiesEntitiesActivities and Entities Claessens and Ratnovski (2014): All financial activities, except traditional banking, requiring private or public backstop to operate FCIC (2010): Unregulated or lightly regulated bank-like intermediation Mehrling and others (2013): Money market funding of capital market lending Deloitte (2012): Market-funded, credit intermediation system involving maturity or liquidity transformation through securitization and secured-funding mechanisms Harutyunyan and others (forth coming): noncore liabilities capturing nontraditional funding McCualley (2007): Levered- up financial intermediaries with liabilities perceived akin to bank deposits Ricks (2010): Maturity transformation outside banking social contract Acharya, Khandwala, and Öncü (2013): Nonbank financial institutions that behave like banks, borrow short, leverage, and lend and invest long in illiquid assets, but less regulated Pozsar and others (2013): Entities that conduct maturity, credit and liquidity transformation without government guarantee or access to central bank liquidity FSB (2013c): Credit intermediation involving entities and activities outside the regular banking system Schwarcz (2012): Provision of financial products and services by shadow entities and financial markets Gorton and Metrick (2012): Institutions, old contracts (repo), and more esoteric instruments (ABCP, ABS, CDO and the like) Kane (2014): Entities with liabilities supposedly redeemable at par but without a government guarantee, and instruments that trade as if they have zero performance risk Narrow Definition Not all activities and entities outside regular banking system pose the same risk to financial system. Shadow banking only involves those who materially contribute risk. 5

The London School of Economics and Political Science FM 409 Risk Management in Financial Markets 20%-30% of Whole financial System Global 2002: $27 trillion 2011: $60 trillion (True size ~$100 trillion) USA 2007: $25 trillion 2011: $24 trillion Size and growth of the shadow banking system As a percentage of GDP (Left axis) In trillions of US dollars (Right axis) Advanced economies Emerging economies Shadow Banking Growth GDP Growth $36 trillion globally in 2014, increased by $1.3 trillion per year The shadow banking sector in emerging economies develops faster than GDP growth *Under FSB’s narrow definition, 26 major jurisdictions research Shadow banking size relative to GDP GDP versus shadow banking growth rates, %USD trillion Sources: National financial accounts data; other national sources; FSB calculations 6

The London School of Economics and Political Science FM 409 Risk Management in Financial Markets Shadow banking: institutions and products Shadow banks Hedge funds Mutual funds Investment banks (some unregulated services) Products Short-term: Asset-based commercial paper (ABCP) demanded by money market funds Long-term: ABS, CDO demanded by insurance companies, pension funds and mutual funds Banks Shadow banks Capital-money markets Asset managers Other shadow banks Money market funds Corporate treasurers Assets SPEs: Conforming loans Non- comforming loans SIVs: ABS Conduits: ABS CDOs Liabilities SPEs: ABS ABCP Other money market funding SIVs: CDOs ABCP Other money market funding Conduits: ABCP Off-balance-sheet banking: UnregulatedOn-balance-sheet banking: Regulated Capital-money markets Banks Capital-money markets Asset managers Other shadow banks Money market funds Corporate treasurers Assets Cash T-bills T-bonds Securities Mortgages Loans Credit loans Liabilities Shares Capital- money market borrowings Bond issues Deposits Governments Corporations Other banks Non-bank financial institutions Sellers of securities Buyers of securities Sellers of loans Buyers of securities 7

The London School of Economics and Political Science FM 409 Risk Management in Financial Markets Shadow banking & risks 8

The London School of Economics and Political Science FM 409 Risk Management in Financial Markets The shadow banking system as a systemic risk concern 9 Raise short-term and liquid funds but invest in long-term and illiquid assets (liquidity and duration risks) High leverage i.e. Before the crisis, Freddie Mac’s leverage ratio was 62x Risk factors Combined effects of factors Raise systemic concerns More likely to trigger a “bank-run” situation than traditional banks The amplifying process The build-up of leverage amplifies procyclicality: High asset prices Low margins/haircuts High leverage Higher asset prices Lower margins/haircuts

The London School of Economics and Political Science FM 409 Risk Management in Financial Markets To make it worse… The interconnectedness with traditional banking system can raise systemic concerns: Exacerbate the procyclical build-up of leverage and heighten the risks of asset price bubbles Amplify market rations when liquidity is scarce in the financial market 10 Securitized bonds Retail investors MMMFs* and other institutional investors SPV Banks Borrowers Shares $ $ Loans $ $ Collateral (incl. securitized bonds) $ Securitized bonds * Money-market mutual funds

The London School of Economics and Political Science FM 409 Risk Management in Financial Markets The shadow banking system as a regulatory arbitrage concern The shadow banking system gains a funding advantage relative to banks due to regulation Exploiting this advantage could undermine regulation and create new risks Even banks themselves may use shadow banking to increase leverage and find ways to circumvent their regulatory capital or liquidity requirements 11 Before the crisis, banks substituted asset backed commercial paper (ABCP) financing for regular bank lending because the capital requirements for ABCP backup lines were lower under Basel I. Example

The London School of Economics and Political Science FM 409 Risk Management in Financial Markets A simple model of shadow banks 12

The London School of Economics and Political Science FM 409 Risk Management in Financial Markets A simple model of shadow banks (Cont’d) 13

The London School of Economics and Political Science FM 409 Risk Management in Financial Markets A simple model of shadow banks (Cont’d) 14 Equilibrium

The London School of Economics and Political Science FM 409 Risk Management in Financial Markets A simple model of shadow banks (Cont’d) 15 Securitization endogenously arises to meet the demand “w” for riskless debt. Driven by marginal, risky, projects. By lowering idiosyncratic risk pooling boosts safe collateral and debt capacity. Growth of assets and leverage Pools allow intermediaries to earn a yield (“carry trade”) When at t = 1, returns are revealed, not much happens Some intermediaries do better than others (if securitization is partial), but all debt is truly safe Securitization is welfare improving.

The London School of Economics and Political Science FM 409 Risk Management in Financial Markets Securitization and local thinking 16

The London School of Economics and Political Science FM 409 Risk Management in Financial Markets 17

The London School of Economics and Political Science FM 409 Risk Management in Financial Markets Securitization and local thinking at t = 1 18

The London School of Economics and Political Science FM 409 Risk Management in Financial Markets Conclusions from the Model Under rational expectations, the shadow banking system is stable and improves welfare. When investors and intermediaries neglect tail risks, however, the expansion of risky lending and the concentration of risks in the intermediaries create financial fragility and fluctuations in liquidity over time. 19

The London School of Economics and Political Science FM 409 Risk Management in Financial Markets Regulation 20

The London School of Economics and Political Science FM 409 Risk Management in Financial Markets Establishing A System-wide Monitoring Framework Annual monitoring exercises since 2011 to assess global trends and risks in the shadow banking system 2015’s monitoring covers 26 jurisdictions, representing about 80% of global GDP and 90% of global financial system assets All non-bank financial intermediation All non-bank credit intermediation Non-bank credit intermediation with bank-like systemic risks Macro-mappingRisk-focused 21

The London School of Economics and Political Science FM 409 Risk Management in Financial Markets Strengthening the oversight and regulation of shadow banking 22 Mitigating risks in interactions with banks Reducing the susceptibility of MMFs to “runs” Improving transparency and aligning incentives in securitization Dampening risks in securities financing transactions Mitigating risks posed by other shadow banking entities

The London School of Economics and Political Science FM 409 Risk Management in Financial Markets Development of the guidance on the scope of consolidation for bank prudential regulation Implementation of the regulatory framework for haircuts on non-centrally cleared SFTs at the international level Implementation of policy recommendations related to structural aspects of the securities financing markets Operationalization of the global securities financing data collection and aggregation Findings on the possible harmonization of regulatory approaches to re-hypothecation … Transform shadow banking into resilient market-based financing Going Forward 23

The London School of Economics and Political Science FM 409 Risk Management in Financial Markets Thank you! 24