Shadow Banking – What Traders Need to Know
Shadow banking refers to financial intermediaries that:
- conduct maturity, credit, and liquidity transformation, and do so
- without explicit access to central bank liquidity or public sector credit guarantees.
These entities operate outside the traditional banking system but perform bank-like functions.
The shadow banking system includes a diverse range of financial institutions such as:
- finance companies
- asset-backed commercial paper (ABCP) conduits
- structured investment vehicles (SIVs)
- hedge funds, and
- money market mutual funds
Key Takeaways – Shadow Banking
- Systemic Impact
- Shadow banks, though outside traditional regulation, are deeply interconnected with traditional banks.
- Disruptions in shadow banking can rapidly spread, which can affect asset prices and market liquidity across the financial system.
- Liquidity Risks
- Heavy reliance on short-term funding makes shadow banks vulnerable to sudden liquidity crunches, potentially leading to fire sales and market volatility.
- Yield Opportunities
- Shadow banking offers higher-yield investment alternatives, but with increased risks.
- Traders should carefully understand the risk-reward profile of any shadow bank-related securities (e.g., peer-to-peer lending).
- Regulatory Arbitrage
- Shadow banks often exploit regulatory gaps, which allows for higher leverage and risk-taking.
- This can create mispriced risks in the market that savvy traders might exploit or avoid.
- Role in 2008 Financial Crisis
- Shadow banking had a role in the 2008 financial crisis by facilitating the creation and sale of risky mortgage-backed securities (MBS) through unregulated entities like structured investment vehicles (SIVs) and asset-backed commercial paper (ABCP).
- These relied heavily on short-term funding and became illiquid when the housing market collapsed, triggering a systemic liquidity crisis.
Historical Context
The term “shadow banking” was coined by economist Paul McCulley in 2007, just before the global financial crisis.
It’s a somewhat pejorative term despite its important role in the global financial system.
The practices and institutions that make up the shadow banking system have existed for decades.
There’s always been a shadow banking system that’s existed outside of standard regulations.
The growth of shadow banking accelerated in the 1980s and 1990s, driven by financial innovation, regulatory arbitrage, and the increasing demand for credit.
Institutional Structures of Shadow Banks
Finance Companies
Finance companies are non-bank institutions that provide loans to consumers and businesses.
They typically fund themselves through commercial paper issuance and securitization.
Unlike traditional banks, finance companies don’t take deposits and aren’t subject to the same regulatory oversight.
Asset-Backed Commercial Paper (ABCP) Conduits
ABCP conduits are special purpose vehicles that issue short-term commercial paper backed by a pool of assets.
These conduits allow banks to move assets off their balance sheets while still generating fee income.
ABCP conduits played a part in the 2007-09 financial crisis due to their reliance on short-term funding and exposure to long-term assets.
Structured Investment Vehicles (SIVs)
SIVs are off-balance-sheet investment vehicles that invest in long-term assets while funding themselves through the issuance of short-term securities.
They try to profit from the spread between their assets’ returns and their funding costs.
SIVs were vulnerable during the financial crisis due to their maturity mismatch and reliance on market funding.
Money Market Mutual Funds
Money market mutual funds are investment vehicles that offer investors shares in a diversified portfolio of short-term, high-quality debt instruments – providing a higher yield than traditional bank deposits while maintaining a stable net asset value.
But they’re not covered by deposit insurance and can be subject to runs during times of financial stress.
Economic Functions of Shadow Banks
Credit Intermediation
Shadow banks are important in credit intermediation by providing loans to borrowers who may not have access to traditional bank financing.
This function expands credit availability in the economy.
Maturity Transformation
Shadow banks engage in maturity transformation by borrowing short-term and lending long-term.
This process allows them to offer higher returns to investors while providing longer-term financing to borrowers.
It nonetheless also exposes them to liquidity risk.
Liquidity Transformation
Shadow banks transform illiquid assets into liquid liabilities.
For example, they may securitize a pool of illiquid loans into tradable securities, improving market liquidity and facilitating risk transfer.
Risk Transformation
Through various financial techniques such as tranching and credit enhancements, shadow banks transform the risk profile of assets.
This process can create seemingly low-risk securities from higher-risk underlying assets, although it may also concentrate risk in certain parts of the financial system.
Intermediation Role in the Broader Financial System
Interconnectedness with Traditional Banks
Shadow banks are closely interconnected with traditional banks through various channels.
Banks often provide credit lines or guarantees to shadow banking entities, creating a link between the two sectors.
Additionally, banks may use shadow banking entities to move assets off their balance sheets or to engage in regulatory arbitrage.
Facilitating Securitization
Shadow banks are important in the securitization process.
Securitization involves pooling various types of contractual debt and selling their related cash flows to third-party investors as securities.
This process allows for the creation of liquid securities from illiquid assets.
This helps improve market efficiency and risk distribution.
Providing Alternative Investment Opportunities
Shadow banks offer investors alternatives to traditional bank deposits and government securities.
These investment options often provide higher yields – albeit with potentially higher risks.
This function helps to diversify investment opportunities in the financial system.
Supporting Market Liquidity
Engaging in various forms of financial intermediation enables shadow banks contribute to overall market liquidity.
For example, they:
- facilitate the trading of securities
- provide short-term funding to market participants, and
- support price discovery in various asset classes
Vulnerability During the 2007-09 Financial Crisis
Reliance on Short-Term Funding
Many shadow banking entities relied heavily on short-term funding, making them vulnerable to sudden withdrawals or “runs.”
During the crisis, as investor confidence eroded, these entities faced severe liquidity shortages, which led to fire sales of assets and market disruptions.
Exposure to Subprime Mortgages
Shadow banks were heavily exposed to the US subprime mortgage market through their investments in mortgage-backed securities and collateralized debt obligations.
When the housing bubble popped, these exposures led to large losses and insolvencies within the shadow banking system.
Lack of Regulatory Oversight
The shadow banking system operated largely outside the purview of traditional banking regulations.
This regulatory gap allowed for the build-up of excessive leverage and risk-taking.
In turn, this amplified the impact of the crisis when it unfolded.
Contagion Effects
The interconnectedness of shadow banks with the broader financial system led to contagion effects during the crisis.
Losses and liquidity problems in the shadow banking sector quickly spread to traditional banks and other financial institutions and worsened the overall financial instability.
Taxonomy of Shadow Banking Activities
Credit Intermediation
This includes direct lending activities by finance companies, peer-to-peer lending platforms, and other non-bank lenders.
Securitization-Based Credit Intermediation
This involves the creation and trading of asset-backed securities, mortgage-backed securities, and other structured products.
Market-Based Intermediation
This includes activities such as securities lending, repo transactions, and prime brokerage services provided to hedge funds and other institutional traders/investors.
Wholesale Funding
This includes the issuance of commercial paper, medium-term notes, and other short-term debt instruments used to fund shadow banking activities.
Funding Flows Within the Shadow Banking System
From Investors to Shadow Banks
Investors provide funding to shadow banks through various channels, including:
- purchasing commercial paper
- investing in money market mutual funds, and
- participating in securitization transactions
Within the Shadow Banking System
Funds flow between different shadow banking entities through:
- repurchase agreements (repos)
- asset-backed commercial paper
- collateralized loan obligations (CLOs)
- money market mutual funds, and
- structured investment vehicles (SIVs)
From Shadow Banks to Borrowers
Shadow banks channel funds to borrowers through direct lending, purchasing corporate bonds, and investing in various debt instruments.
Feedback Loops with Traditional Banks
Traditional banks often provide backstop liquidity facilities to shadow banking entities, creating a circular flow of funds between the two sectors.
Understanding these funding flows will be important for traders whose strategies have connections with these money and credit flows.
Disruptions in any part of this system can have broad consequences for financial markets and asset prices.