by Don Alexander, MBA
Associate, RSD Solutions Inc.
The role of alternative investments in the financial intermediation process has moved into the background as Basel III, Dodd-Frank and other proposed reforms are thought to solve all problems. However, these reforms do not address all the issues, in particular the role of asset managers in the intermediation process and the role of derivatives. Zoltan Pozsar & Manmohan Singh, two IMF economists, in The Nonbank-Bank Nexus and the Shadow Banking System (IMF Working Paper WP/11/289, December 2011) look at the role of asset managers.
The current view of financial regulation does not incorporate the rise of asset managers as a source of funding through the shadow banking system. Asset managers are sources of demand for non-M2 types of money and serve as source collateral “mines” for the shadow banking system. Banks receive funding through the re-use of pledged collateral “mined” from asset managers. This has allowed asset managers to replace traditional creditors, primarily household retail deposits, as a key funding source to the banking system.
In this process, asset managers, normally long-term investors, transform the maturity of the long-term assets into short-term liabilities (similar to bank retail deposits). This follows the tendency to use these short-term liabilities to boost returns. Asset managers receive cash collateral in return for the securities they loan. It’s a gain for both parties since the cash they receive helps them to manage their funds liquidity needs (however they act like wholesale funds).
Using this methodology, the US shadow banking system reached $25 trillion in 2007 and declined to $18 trillion in 2010, higher than earlier estimates. The authors suggest regulators incorporate the re-use of pledged collateral when defining prudent bank liquidity and leverage position ratios.
The lack of sufficient disclosure will become apparent during a period of a collateral crunch to the financial system (lack of acceptable collateral). This will lead to greater funding stresses during a credit squeeze. According to the authors, there was approximately US$ 5.8 trillion in off-balance sheet items of banks used for collateral mining and collateral re-use. This is down from nearly US$ 10 trillion at the end of 2007. The size of the number should be of concern, especially with events in Europe.
Monitoring the shadow banking system will warrant closer attention beyond current regulatory parameters. Regulatory reform is focused on fortifying the equity base of the banking system and limit leverage through caps and capital adequacy requirements. Pozsar and Singh note that the present framework of financial intermediation and data collection does not fully incorporate asset managers as funding sources for banks through the shadow banking system. Non-bank sources of funding are thought to be sticky like retail deposits. They note a number of weaknesses in current data availability: a broader definition of bank leverage, a breakdown of non-bank funding sources and a closer look at dealer’s ability to borrow and re-pledge collateral from various sources.
They suggest an improvement in the current regulatory framework by increasing incentives for banks to move away from wholesale short-term funds into retail deposits and term funds. Otherwise, the shadow banking system will fill the role, especially for riskier activities. Other changes they suggest incorporating the unregulated shadow banking system more into Basel III and Dodd-Frank. Lastly, making changes in the flow of funds data to incorporate derivatives, off-balance sheet transactions and breaking down short-term funding sources for better monitoring. The use of off-balance sheet sources of funding should be included in risk management monitoring.
For more on this follow the link: http://www.imf.org/external/pubs/ft/wp/2011/wp11289.pdf
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