Chapter 13 and 14 Part ii Shadow Banking

What is Shadow Banking System (i) “Shadow banking" is a term used to describe banking institutions, practices and instruments that operate beyond the reach of regulation – including hedge funds and money market fund that handles trillions of dollars.

What is Shadow Banking System (ii) A new kind of semi-banking system that emerged in the 21 st century. Shadows banks are acting like Commercial banks but technically they are not CB because they are not regulated. – Such as Country Wide, a big shadow bank organization. – They make all kinds of loans, like credit card loan, car loan, home loan, boat loan, merchandise loan, etc

What is Shadow Banking System(iii) Investment banks are taking the roles of Shadow banks, such as Lehman Brothers. – Investment banks may conduct much of their business in the shadow banking system (SBS), but most are not SBS institutions themselves Convergence of banks creates big banks that have both CB and SB (IB) – JP Morgan Chase – Citi group – Bank of America

Comparison between CB and IB(i) Both make loans for borrowers, such as homeowners. CB receive deposits as resources for loans, not SB CB get 1% from depositors CB loan them to homeowners as mortgage. CB makes 5% of profits. CB are insured by FDIC and CB can borrow at Fed discount window, not SB

Comparison between CB and IB(ii) So how do SB make money? Repo market to borrow for short low rate – Repo is like short term loan but with collateral such as TB. Use the borrowed short term fund to lend out for long higher rate Bundle the loans as securities (such as mortgage backed security) and sell them to – Hedge funds – Pension funds, etc

Can Bank Run Occur in SB? Definitely. When short term loan provider (repo investor) does not renew the loan, there is no liquidity for SB. When you think this tends to occur? We have seen this type of running happening in the crisis. Why bank run does not occur in CB anymore?

One Example of How SB operates (I) Imagine you can get loan from Wells You found that Nationwide is charging 6%, all else equal. You chose Nationwide’s loan. After the deal is closed, what tends to happen with your loan? – Securitization of loans of yours and tens of thousands of others. AAA bond, AA bond, A bond, and lower ranking ones – Securities were sold to investors Eg., Pension funds invest in AAA bond and get 2% rate Hedge funds invest in AA bond and get 3% or in BBB bond and get 4%, etc.

One Example of How SB operates (II) But are those mortgage backed securities as safe as loans from CB? – CB’s loans are much safer Fed is CB’s lender of last resort CB has to meet capital adequacy ratio required by Fed CB is insured by FDIC CB has checks and balances from depositors – SB has no safe net from the government and thus is much riskier.

One Example of How SB operates (III) – So “bank run” would be more likely for SB Leverage of SB is much higher than CB No lending in repo market or short term market – One cause of the failing of Lehman brother and Bear Stern – Economist Paul Krugman described the run on the shadow banking system as the "core of what happened" to cause the crisis. Reference

Why SB is still running Before the crisis, about 60% of mortgage was issued by SB, and the rest is by CB – Demand is higher than that can provided by CB So SB is a key component of our economy Without SB, many homeowners could not buy their dream houses. However, the assets (bonds) of SB (such as mortgage backed securities) are considered as toxic assets – too hard to price them to find investors. Banks are becoming too big to fail.

Lehman Brothers Failed due to “Run on Repo” (i) Lehman Brothers is a pure IB It is acting as a SB as well Lehman Brothers heavily involved in repo market to get access to short term capital – Repo is similar to deposit which is short term loan Then invested the borrowed capital in subprime securities and other securities

Lehman Brothers Failed due to “Run on Repo” (ii) So if repo investors (like depositors) fear of failure of Lehman Brothers – Due to housing market value declined and subprime securities’ value declined – They would not renew repo when it was due – The “run on repo” occurs. – The values of securities (subprime securities) held by Lehman Brothers declined – Lehman Brothers could not rescue itself – Government bailed out Bear Stern and Merrill Lynch and did not bail out Lehman Brothers.

Debate about Regulations on Shadow Banking (i) Fed should regulate both CB and IB (SB) Regulate hedge funds with assets over 150m Formalize over-the-counter derivative trading Dodd Frank Act provisions.

Debate about Regulations on Shadow Banking (ii) The G20 is still trying to stop banks becoming "too big to fail", which covers banks the markets believe would be bailed out in a crisis. Instead, the Institute of International Finance, a global association of financial institutions, has asked world leaders to adopt shadow banking regulations tailored to individual banking sectors, rather than imposing blanket regulations