by Don Alexander, MBA
Associate, RSD Solutions Inc.
The shadow banking system is vast and plays an important role in financial intermediation. Analysts suggest that it played a small role in the early 1990s and now accounts for over 60% of US financial intermediation. A question is why did it arise and become so important? Some view it as regulatory arbitrage and others suggest it as the market fulfilling investors demand for “riskless” assets. A recent communique by Zoltan Pozsar; Can Shadow Banking Be Addressed Without the Balance Sheet of the Sovereign (Voxeu, Nov. 16th) explains some of the issues and potential policy options.
Shadow banking system is the name given to the financial infrastructure that exists outside the regulator’s remit. There are two ways to understand shadow banking: one a supply-side approach where banks use securitization-based credit intermediation process through various vehicles, funds and subsidiaries that are globally interlinked and two, the demand side which focuses on cash investors that provide banks with wholesale market funding rather than via traditional deposits. The volume of institutional cash pools increased from $100 billion in the early 1990s to over $3.5 trillion today.
The intersection of the two approaches indicates that shadow banking is a significant part of the risk-intermediation process, and for that reason the Financial Stability Board (FSB) has issued a set of recommendations to monitor its activities. Investors manage large cash pools, which replaced institutional deposits, in the form of repos and asset-backed commercial paper. These instruments are considered safer since they have layers of protection compared to unsecured deposits.
The privately guaranteed money involves risk stripping into credit, maturity and liquidity transformation components and came about due to the shortage of government-guaranteed instruments. The sovereign balance sheet plays into the emergence of shadow banking and the money claims against it. The first priority is safety as mortgage pools are securitized and placed into tranches. The tranches are put into a levered maturity transformation and funded with short-term instruments and quasi-liquidity guarantees. Short-term money market instruments are put into vehicles such as money market funds vulnerable to changing market conditions.
The FSB reform idea is to adopt measures that shorten the financial intermediation process, allowing governments to issue short-dated instruments to absorb the cash pools. Recently, the US Treasury Borrowing Advisory Committee produced the issuance of floating- rate notes to serve a similar as the issuance of t-bills as money for institutional cash pools. Regulatory approaches to design a smaller and less run-prone banking system are a key step. A more hands-on approach is required to engineer a migration of cash pools away from wholesale funding markets and toward short-term sovereign claims.
For more on this click on the link to the Voxeu article: http://www.voxeu.org/index.php?q=node/7278
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