Shadow Banking in Advanced and Emerging Market Economies: Need for Better Regulation T. Sabri Öncü

What is shadow banking? Paul McCulley at the Federal Reserve Bank of Kansas City, Jackson Hole Economic Symposium in 2007 defined it as: the whole alphabet soup of levered up non-bank investment conduits, vehicles, and structures. D’Arista and Schlesinger (1993) called it the parallel banking system and defined it as: Over the last two decades, the US system has been reshaped by the spread of multifunctional financial conglomerates and the emergence of an unregulated parallel banking system. Along with other powerful trends like securitization, these events have broken down the carefully compartmentalized credit and capital marketplace established in New Deal legislation 60 years ago… Today, a variety of unregulated financial intermediaries operate on the fringes of the financial system. 2

What is shadow banking? A shadow banking system conducts maturity, credit and liquidity transformation outside the traditional banking. Thus, not only is shadow banking usually (but not always) less regulated than the traditional banking system, there is also no explicit access to central bank liquidity or public sector credit guarantees. A shadow banking system decomposes the process of credit intermediation into a sequence of discrete operations. Therefore, it can be a collection not only of single financial entities acting independently, but also of (and usually is) networks of multiple financial entities acting together: banks, formal and informal non-bank financial institutions, and even credit rating agencies, regulators and governments. A shadow banking system is highly leveraged. Further, while its assets are risky and illiquid, its liabilities are prone to “bank runs”. 3

FSB definitions of shadow banking (2011) Broad definition: The “shadow banking system” can broadly be described as “credit intermediation involving entities and activities outside the regular banking system”. Narrow definition: A system of credit intermediation that involves entities and activities outside the regular banking system, and raises i) systemic risk concerns, in particular by maturity/liquidity transformation, leverage and flawed credit risk transfer, and/or ii) regulatory arbitrage concerns. 4

Two problems with the FSB definitions Both definitions implicitly assume that banks are credit intermediaries. But banks are not credit intermediaries. They are in the business of financing through money creation. Consequently, banks (which are money creators) and NBFIs (which are credit intermediaries) should be regulated differently. Both definitions implicitly leave the banks out. However, any shadow banking system is essentially a network financial institutions which include banks. Many shadow banking activities are there to circumvent banking regulations, and are therefore a form of regulatory arbitrage, that is, a form of financial engineering through which firms capitalize on loopholes in regulatory systems in order to circumvent unfavourable regulation. 5

AssetsLiabilities LoansDeposits Capital Bank Balance Sheet When Banking was Boring 6

AssetsLiabilities Loans Deposits Capital Bank Balance Sheet AssetsLiabilities LoansEquity (Asset-Backed Securities) Special Purpose Vehicle When Banking was Still Boring: Securitization 7

AssetsLiabilities Deposits Capital Bank Balance Sheet AssetsLiabilities Debt (Asset-Backed Commercial Paper) Conduit Guarantees Loans Banking gets Exciting – First Kind 8

AssetsLiabilities Loans Deposits Capital Bank Balance Sheet AssetsLiabilities LoansAsset-Backed Securities Special Purpose Vehicle Banking gets Exciting – Second Kind Credit Rating Agencies AAA BB NR 9

AssetsLiabilities Loans Deposits Capital Bank Balance Sheet AssetsLiabilities LoansAsset-Backed Securities Special Purpose Vehicle Banking gets Exciting – Third Kind Credit Default Swaps + Guarantees Fannie Mae - Freddy Mac AIG Bond Insurers 10

FSB broad data Broad data from 2002 to 2014 for 26 jurisdictions and the euro area as a whole. Advanced Economies: Australia, Canada, Euro Area, France, Germany, Hong Kong, Ireland, Italy, Japan, Korea, Netherlands, Singapore, Spain, Switzerland, United Kingdom, United States. Emerging Market Economies: Argentina, Brazil, Chile, China, India, Indonesia, Mexico, Russia, Saudi Arabia, South Africa, Turkey. For nonbank financial institutions (NBFIs) broken down to pension funds (PFs), insurance companies (ICs) and other financial institutions (OFIs) 11

FSB narrow data Narrow data from 2010 to 2014 based on this classification. 12

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