Shadow banking system
For example, before the 2007–2008 financial crisis, investment banks financed mortgages through off-balance-sheet (OBS) securitizations (e.g., asset-backed commercial paper programs) and hedged risk through off-balance sheet credit default swaps.
Yet unlike their more regulated competitors, they lack access to central bank funding or safety nets such as deposit insurance and debt guarantees.
[27] A headline study by the International Monetary Fund defines the two key functions of the shadow banking system as securitization – to create safe assets, and collateral intermediation – to help reduce counterparty risks and facilitate secured transactions.
[32] The G20 leaders meeting in Russia in September 2013, will endorse the new Financial Stability Board (FSB) global regulations for the shadow banking systems which will come into effect by 2015.
[11] Many "shadow bank"-like institutions and vehicles have emerged in American and European markets, between the years 2000 and 2008, and have come to play an important role in providing credit across the global financial system.
[34] In a June 2008 speech, Timothy Geithner, then president and CEO of the Federal Reserve Bank of New York, described the growing importance of what he called the "non-bank financial system": "In early 2007, asset-backed commercial paper conduits, in structured investment vehicles, in auction-rate preferred securities, tender option bonds and variable rate demand notes, had a combined asset size of roughly $2.2 trillion.
[3] Shadow institutions are not subject to the same prudential regulations as depository banks, so that they do not have to keep as high financial reserves relative to their market exposure.
This high leverage will also not be readily apparent to investors, and shadow institutions may therefore be able to create the appearance of superior performance during boom times by simply taking greater pro-cyclical risks.
In the case of investment banks, this reliance on short-term financing required them to return frequently to investors in the capital markets to refinance their operations.
Investor refusal or inability to provide funds via the short-term markets was a primary cause of the failure of Bear Stearns and Lehman Brothers during 2008.
This creates a problem, as they are not depositary institutions and do not have direct or indirect access to the support of their central bank in its role as lender of last resort.
This meant that disruptions in credit markets would make them subject to rapid deleveraging, meaning they would have to pay off their debts by selling their long-term assets.
[citation needed] The securitization markets frequently tapped by the shadow banking system started to close down in the spring of 2007, with the first failure of auction-rate offerings to attract bids.
As excesses associated with the U.S. housing bubble became widely understood and borrower default rates rose, residential mortgage-backed securities (RMBS) deflated.
Commercial mortgage-backed securities suffered from association and from a general decline in economic activity, and the entire complex nearly shut down in the fall of 2008.
[38] In February 2009, Ben Bernanke stated that securitization markets remained effectively shut, with the exception of conforming mortgages, which could be sold to Fannie Mae and Freddie Mac.
[39] U.S. Treasury Secretary Timothy Geithner has stated that the "combined effect of these factors was a financial system vulnerable to self-reinforcing asset price and credit cycles.
"[35] In January 2012, the global Financial Stability Board announced its intention to further regulate the shadow banking system, in the interests of the real economy.
[44] The concept of hidden high priority debt dates back at least 400 years to Twyne's Case and the Statute of Bankrupts (1542) in the UK, and to Clow v. Woods[45] in the U.S.
The concept of credit growth by unregulated institutions, though not the term "shadow banking system", dates at least to 1935, when Friedrich Hayek stated: There can be no doubt that besides the regular types of the circulating medium, such as coin, notes and bank deposits, which are generally recognised to be money or currency, and the quantity of which is regulated by some central authority or can at least be imagined to be so regulated, there exist still other forms of media of exchange which occasionally or permanently do the service of money....
[46]The full extent of the shadow banking system was not widely recognised until work was published in 2010 by Manmohan Singh and James Aitken of the International Monetary Fund, showing that when the role of rehypothecation was considered, in the U.S. the SBS had grown to over $10 trillion, about twice as much as previous estimates.
[47][48] During 1998, the highly leveraged and unregulated hedge fund Long-Term Capital Management failed and was bailed out by several major banks at the request of the government, which was concerned about possible damage to the broader financial system.
In the years leading up to the crisis, the top four U.S. depository banks moved an estimated $5.2 trillion in assets and liabilities off their balance sheets into special purpose vehicles (SPEs) or similar entities.
[51] Because credit default swaps were not regulated as insurance contracts, companies selling them were not required to maintain sufficient capital reserves to pay potential claims.
Demands for settlement of hundreds of billions of dollars of credit default swaps contracts issued by AIG, the largest insurance company in the world, led to its financial collapse.
Since then the shadow banking system has been blamed[34] for aggravating the subprime mortgage crisis and helping to transform it into a global credit crunch.
[15][57] The Chinese shadow banks, such as Sichuan Trust, have been greatly affected by the property sector crisis due to over lending and a crackdown on regulations.
