Shadow Banking

Faiyyad Hosein

The Financial Stability Board defines shadow banking as “credit intermediation involving entities and activities outside the regular banking system” (Strengthening the oversight and regulation of shadow banking 2012). The entities referred to in this definition include hedge funds, money market funds, and structured investment vehicles. The problems associated with shadow banking can be exemplified in the rise and fall of Long Term Capital Management, a massive hedge fund that was bailed out in 1998. Had it failed, it would have had catastrophic effects on the global financial system (Burton and Kishan 2009). This example illustrates the key problem with the shadow banking system – it is so intricately linked to the regular banking system that should one of its institutions fail, it could affect regular individuals and investors who need the highest level of financial protection.

The term shadow banking was actually coined by Paul McCulley of PIMCO (the world’s biggest bond fund) in 2007. He stated that it has lain hidden for years, untouched by regulation, yet free to create and package subprime loans into a host of three letter conduits only Wall Street wizards could explain (Gross 2007).The shadow banking system has been blamed at least in part for the 2008 global financial crisis. This Global Summitry report will attempt to determine the culpability of this system and what has been done in terms of existing legislation and what needs to be done going forward.

Prior to the 2008 financial crisis, mortgage lenders in the United States were insistent on lending to people who would not be approved for fixed rate mortgages; these sub-prime mortgages were issued at adjustable rates, which would reset after a certain amount of time. Sub-prime means not that the loans are charged at a rate below prime, but rather that the borrowers themselves were not credit worthy. Banks transacted a great deal of what has become known as “liar loans”, where low/no documentation was required, or NINA loans – “no income, no assets”. This was done because they could charge and earn higher interest rates on these sub-prime loans. Sub-prime loans accounted for more than 40% of mortgage loans at the peak of the bubble (Baker 2008).

The increased availability of loans created an inflated demand for housing which caused even more sub-prime borrowers to take out mortgages. Involved parties were convinced that the underlying asset would always go up in value and borrowers would be able to refinance their mortgages as needed. Another contributor to excessive mortgage lending was the fact that mortgage payments are tax-deductible in the United States. The added advantage of being able to reduce taxes payable made owning homes and mortgages appear even more attractive.

Banks were also taking these pools of mortgages and securitizing them to create mortgage-backed securities or Collateralized Debt Obligations (CDOs). These could then be issued third parties who wanted high-yield bonds; at this time these assets were considered to be only moderately risky. Banks would first securitize the AAA (best pool/tranche) mortgages; they would then recalibrate their risk model for the BBB (secondary) tranche of mortgages, so that the ratings agencies could award the Triple A rating to the top mortgages in this tranche. The banks could then issue these securities as high quality financial instruments to increase their lending and profits (see Exhibit 1). This process of securitization was ideal for banks because they could crystallize gains in a loan/lease portfolio and reload the balance sheet to do another round.

Hosein, Faiyyad - Shadow Banking - Image

When these mortgages rates reset from as low as 1.8% to upwards of 8%, the borrowers could not meet their mortgages and walked away from their houses. In the United States people are allowed to forfeit the mortgaged asset and be released from their loan obligation without their debtors coming after the rest of their assets, which is not true for many other jurisdictions. When these CDOs could not pay out, many financial institutions worldwide who were heavily invested in these securities, such as Lehman Brothers, were not liquid enough to meet their financial obligations and defaulted.

Hedge funds also greatly contributed to the financial crisis because of their loose regulation and the large amounts of capital involved. Financial innovation was also used to create many synthetic CDOs: in essence they were creating synthetic loans out of whole cloth 100 times over by constantly matching derivative buyer with seller. This process partially explains why the financial losses around the world were so large when compared to the initial downside of mortgage loans.

In the aftermath of this global financial crisis, the United States and the European Union have passed legislation seeking to regulate the shadow banking system. President Barack Obama passed the Dodd-Frank Wall Street Reform and Consumer Protection Act into law on 22 July 2010 (US House of Representatives 2010). Title IV contains several regulations which attempt to force financial institutions to cease operating within the shadow banking system. Prior to this law, it was assumed that those rich enough to invest in hedge funds could bear the potential losses of operating in a highly unregulated industry and there was no concern for the way hedge funds manipulate the market to the detriment of ordinary retail investors. Now hedge fund managers and private equity advisors must register with the Securities and Exchange Commission (SEC) as investment advisers and provide the necessary information about their trades and portfolios to assess their systemic risk. Prior to the introduction of this legislation, there were no requirements for financial advisers to provide any information.

The Dodd-Frank Act further changed the asset management thresholds of investment advisers so that an increased number of advisers will be under the relatively closer scrutiny of state securities authorities, as opposed to the federal SEC. The added legitimacy afforded advisers by being registered with the SEC will also be withheld until the adviser has $100 million in assets under management, with the slack created between the previous threshold and this new one being taken up by the state commissions.

The EU has also taken firm steps to bring the shadow banking system and hedge funds under further regulation through the Directive on Alternative Investment Fund Managers (AIFMs) (Commission of the European Communities 2009). This directive was issued with the objective of creating a comprehensive and effective regulatory and supervisory framework for AIFMs at the European level following the global financial crisis. The European Parliament voted through a final text of the Directive on November 11, 2010. The agreed upon proposals have to be written into national statute books by 2013.

The directive includes reforms such as requiring:

  1. a private equity fund to appoint an independent valuator and custodian;
  2. disclosure of a portfolio company’s business plan to its shareholders, its employees, and the public;
  3. investors not to invest outside the EU unless the country is under an equivalent regime; and
  4. levels of leverage undertaken by a fund to be controlled by limits imposed by the Commission.

The Solvency II Directive on Insurance regulation in the EU also addresses many shadow banking issues using comprehensive regulation and a risk-based economic approach. This includes a “prudent person principle” for investments and requires member states to authorize the establishment of an insurance special purpose vehicle (European Commission 2012).

Through the regulation of securitization, both the US and the EU have indirectly limited the activities of the shadow banking system. Section 941 of the Dodd Frank Act details potential improvements to the Asset Backed Securitization process (US House of Representatives 2010). At least 5% of the securities must be retained by companies that sell financial products like mortgage-backed securities, causing the institutions to retain at least some of the related credit risk. This is intended to curb the tendency banks have displayed of selling unfair or overly risky investments. These institutions also have the responsibility to analyze the underlying assets in detail and make truthful and timely disclosures about them in their financial statements. Similarly, the European Commission has stated in the Capital Requirements Directive II that the originators and sponsors of securitized assets now need to hold a substantial share of the underwritten risks (European Commission 2012).

According to a European Commission Green Paper on Shadow Banking written in March 2012, there are several important functions and benefits associated with the shadow banking system. These benefits include:

  1. alternatives for investors to bank deposits;
  2. focusing resources towards exact needs more effectively given increased specialization; and
  3. providing an alternative source of funding or credit creation for the real economy, which is very important when traditional sources of funding and regular banking are momentarily impaired (CICERO 2012).

However this paper also highlights the considerable risks associated with the shadow banking system, some of which are systemic given the interconnectedness between the traditional banking system and shadow banking entities. The transactions between the traditional and shadow banking systems are complex, have cross jurisdictional reach, and rely on the inherent mobility of the securities and funds market. These risks include:

  1. The fact that deposit-like structures may lead to runs. Shadow banking entities have similar financial risks as banks such as run, but they lack comparable supervision. Some shadow banking activities are financed by short term funding which could be affected by swift and substantial withdrawals by investors.
  2. The build up of high and hidden leverage within the Shadow Banking system. High leverage is a significant source of systemic risk in the financial sector as it is not subject to the proper regulation and if it crashes as did Long Term Capital Management in 1998, it could lead to major bailouts and use of taxpayer/government funding.
  3. Shadow banking entities can use the system for the circumvention of rules and regulatory arbitrage. Given the limited supervision in this area, it may avoid regulation for the possibility of increasing profits and risk such as perhaps having lower capital requirement than traditional banks performing this activity. This “regulatory fragmentation” can lead to where all financial entities try to push financial activities into the shadow banking sector in order to escape regulation and maximize profits.
  4. There is also the major risk of contagion and spill-over effects, where any failure in the shadow banking sector can lead to failure in the regular banking sector, affecting the majority of the population and unsophisticated investors who require higher levels of protection. Risks taken by shadow banks can be transferred to the regular banking sector through direct borrowing from the banking system and banking contingent liabilities.

From the above we can see that shadow banking did indeed play a significant role in the global financial crisis and that there are significant risks resulting from this system being left unchecked. However legislation has been put in place by both the European Union and the United States in order to limit the risks of the shadow banking system. Shadow banking activities can be useful, particularly for credit creation and funding.

The Financial Stability Board has identified five key areas in which it will be necessary to pass policies in order regulated the systemic risks associated with shadow banking. These areas are as follows:

  1. To reduce the risk of contagion between regular banking sector and shadow banking;
    To reduce the susceptibility of money market funds to runs;
  2. To mitigate the risks associated with other shadow banking entities;
  3. To assess and align the incentives associated with securitization
  4. To reduce risks and pro-cyclical incentives associated with secured financing contracts such as repos and securities lending (Financial Stability Board 2012).

The FSB has proposed the following policies to help mitigate and contain these risks going forward:

  • Restriction on the maturity of portfolio assets where the types of risk, funding and, investment objectives are all consistent. For example, there would be no funding of a long term risk with short term funding, thus the funding must match the risk being financed.
  • Limits on leverage tailored to the entity under consideration.
  • Limits on asset concentration, for example, a hedge fund which is 100% invested in securitized assets.
  • Limits on illiquid assets such as real estate, so that shadow banking entities can unwind positions as necessary and reduce the risk of a “fire sale” situation.
  • Liquidity buffers, where a portion of the entity’s assets must be held in highly liquid form to meet obligations as necessary.
  • Monitoring of ownership of different shadow banking entities to see if any one owner is concentrated in this sector.
  • Preventing off-balance sheet side pockets in an investment portfolio, where the impaired portion is legally separated to prevent them from impacting a funds return and the resulting redemption pressures.
  • Suspension or limits on redemptions so a fund does not lose all its capital in a “run” and has time to meet its obligations (Financial Stability Board 2012).
  • The shadow banking sector played a major role in the global financial crisis and regulation thus far has been passed to mitigate the significant associated risks. Though many issues still remain, there are advantages to a properly functioning shadow banking system. The Financial Stability Board has identified policy recommendations that would serve to effectively mitigate the risks associated with this system and it is hoped more extensive legislation will be passed in the future in order to maximize the benefit that can be derived from the shadow banking system.



    Baker, Dean. The housing bubble and the financial crisis. May 20, 2008.

    Burton, Katherine, and Saijel Kishan. Meriwether said to shut JWM hedge fund after losses. July 8, 2009.

    CICERO. European Commission Green Paper of Shadow Banking – A Cicero Cunsulting Special Report. March 20, 2012.

    Commission of the European Communities. Directive of the European Parliament and of the Council on Alternative Investment Fund Managers. April 30, 2009.

    European Commission. Future Rules (Solvency II/Omnibus II). November 26, 2012.

    Financial Stability Board. Strengthening the oversight and regulation of shadow banking. April 16, 2012.

    Gross, Bill. Beware our shadow banking system. November 28, 2007.

    US House of Representatives. Dodd-Frank Wall Street Reform and Consumer Protection Act. June 29, 2010.


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