Shadow Banking, the Subprime Crisis, and Regulatory Gaps

Introduction to the Shadow Banking System

The term "shadow banking system" was coined by PIMCO's Paul McCulley in 2007 (Spanos, 2012) and refers to a banking system that includes financial intermediaries involved in creating credit across the global financial system whose functions are not subject to regulatory oversight (Investopedia, 2012). The question of whether shadow banking meets the definition of true banking has been widely debated. Given that the two systems perform similar functions — including credit intermediation and maturity transformation — the two should be considered parallel systems (Noeth and Sengupta, 2011).

The term shadow banking is used to describe any provision of credit taking place outside of the traditional deposit-funded lending system. This definition includes institutions ranging from pawnbrokers and consumer finance companies to securities dealers as well as firms that issue corporate bonds. Regulators, however, are most concerned with the system of institutions, instruments, and markets that mirror commercial banking. Shadow banking enables funds borrowed from short-term sources — such as the money markets — to be invested in longer-term, less liquid assets. Institutions engaged in this form of shadow banking include investment banks, hedge funds, structured investment vehicles, and issuers of asset-backed commercial paper (ABCP) (Armstrong, 2010). Shadow banks also provide securitization and secured funding techniques through the use of collateralized debt obligations (CDOs) and repurchase agreements (repos).

The shadow banking system provided sources of funding for credit by converting opaque, risky long-term assets into money-like, short-term liabilities. Pozsar, Adrian, Ashcraft, and Boesky (2012) argue that maturity transformation in the shadow banking system contributed to asset price appreciation in residential and commercial real estate markets in advance of the 2007–2009 financial crisis. During the financial crisis, the shadow banking system was severely strained; indeed, many parts of the system collapsed. This failure occurred because of credit intermediaries' reliance on short-term liabilities to fund illiquid long-term assets — an inherently fragile activity prone to runs. Shadow banking's vulnerability is due in large part to its inability to access public sources of liquidity, such as the Federal Reserve's discount window, or public sources of insurance, such as Federal Deposit Insurance.

In the past, the shadow banking system was not subject to regulation primarily because it did not accept traditional bank deposits. Consequently, many shadow banking institutions and instruments operated with higher credit, liquidity, and market risks while lacking capital requirements proportionate to those risks. Following the subprime mortgage meltdown in 2008, shadow banking activities came under increasing scrutiny and demand for regulation (Investopedia, 2012). However, with regulated banks facing tighter supervision and stricter new capital rules, regulators fear that even more credit will move out of the regulated banking industry into the shadow system (Armstrong, 2010).

The shadow banking system creates credit through a complex process of securitization, the use of commercial paper, and the repo market — as opposed to the traditional bank model, which uses deposits to fund loans. Securitization allows illiquid assets like mortgages to be converted into tradable asset-backed securities. Once converted, shadow banks can use these securities as collateral to borrow short-term money from money market funds or in the repo market, with the resulting cash used to fund further lending activities (Armstrong, 2010).

The scale of shadow banking is significant. Precise estimates are not available, but research from the Federal Reserve Bank of New York estimated the size of the shadow banking system at around $16 trillion in liabilities during the first quarter of 2010 — exceeding the traditional banking system, which was estimated to hold about $13 trillion over the same period. The $16 trillion figure itself represents a decline from an estimated $20 trillion before the global financial crisis (Armstrong, 2010).

Many experts believe that a run on the shadow banking system triggered the global financial crisis. Regulators are therefore concerned about the safety of the shadow banking system because, unlike traditional banking, there is no safety net of deposit protection schemes to prevent bank runs. When the global crisis unfolded as U.S. subprime mortgages began to default in 2007, shadow banks experienced increasing difficulty using securities linked to subprime mortgages as collateral in the repo market, which in turn meant losing access to their primary source of funding (Armstrong, 2010).

With the failure of Lehman Brothers, investors — fearing their level of exposure — withdrew cash from money market funds. In the face of stronger capital rules and tighter supervision resulting from the crisis, regulators believe that even more money will flow out of the traditional banking sector into the shadow banking system (Armstrong, 2010).

Shadow Banking and the Subprime Crisis

For a financial crisis to occur, multiple intermediaries must fail simultaneously, thereby disrupting the operations of a particular financial market. This disruption is usually the result of a detrimental external factor affecting many institutions at once, or a problem in one institution spreading to others through some internal contagion mechanism. Each individual institution may fail due to investment risk, hedging risk, counterparty risk, or liquidity risk. With liquidity risk, the institution is unable to sell assets at fair value due to time constraints (Hsu and Moroz, 2009). The shadow banking system failed due to a liquidity crisis in 2007 that resulted from bank runs.

Bank runs, which had largely been eliminated through various policy measures, began to reemerge during the subprime crisis. A bank run may be defined as a swift loss by an institution of deposits or other short-term financing, which causes failure from lack of liquidity. Although the traditional bank run is often pictured as depositors lined up outside a retail bank branch, the concept applies to other scenarios as well — for example, mutual fund investors who all decide to redeem their shares at once, a hedge fund that finds no lenders willing to roll over its repos, or a conduit that finds itself unable to sell short-term commercial paper to refinance expiring obligations (Hsu and Moroz, 2009).

The contagion mechanism that fuels bank runs can be triggered by an external economic problem, such as the default of a few banks causing direct losses at counterparties, or lower prices on assets held by other banks due to fire-sale liquidations. These problems reduce overall liquidity in the system. Most countries address the problem of bank runs by providing government guarantees for deposits up to a certain amount. Such guarantees work because, once depositors no longer bear the risk of a loss, they have no incentive to withdraw at the first sign of trouble (Hsu and Moroz, 2009).

Bank runs on the shadow banking system were a significant factor in the spread of subprime losses to the overall financial system. Because of their illiquid assets, highly leveraged shadow banks suffered from the loss spiral effect, by which they were forced to deleverage due to higher margin requirements and falling asset prices. Deleveraging in turn increased margin requirements and reduced asset valuations, thereby fueling the next round of the loss spiral (Hsu and Moroz, 2009).

While some experts believe that the run on shadow banks caused the subprime crisis, others argue that it was only the trigger — that the subprime crisis set off a run in a shadow banking market already susceptible to runs. Bank runs result from crises in depositor confidence, occurring when creditors become concerned that their bank is insolvent and rush to recover their funds. Because of FDIC insurance, such runs do not occur with traditional banks. In the shadow banking market, however, in the absence of deposit insurance, massive institutional depositors require collateral to secure their deposits, such as AAA mortgage-backed securities. This demand for collateral drove the escalating demand for mortgage-backed securities (Klein, 2010).

Stein (2010) argues that the subprime crisis did not so much expose a flaw in the basic concept of securitization as it exposed the "reckless and excessively complex way" in which it was applied to subprime mortgage loans (p. 3). The subprime crisis also demonstrated that traditional banks use shadow banking for the purpose of regulatory arbitrage — that is, a purposeful attempt to avoid rules that dictate how much capital banks are required to hold.

Conclusion

Given the amount of time that has elapsed since the subprime mortgage crisis, the shadow banking industry gets mixed reviews on making progress toward fixing the problems that the crisis exposed. One of the issues the subprime mortgage meltdown revealed was that few institutions or regulators actually understood the complexities of many securitized financial products. Because they were not well understood, their risk was underestimated, which in turn led to an inability to respond to bank runs. Almost no one was prepared for the spread of contagion and the resulting liquidity crisis.