The Handbook of Global Shadow Banking, Volume I

Shadow banking is a house with many rooms and so we need to do some fact finding. What segments are there, how voluminous are they, do they differ per country and what do they have in common? And also what makes them problematic? Regulators and supervisors have been breaking down market segments to filter out the individual shadow banking segments to be regulated. Starting point is the overall idea that shadow banking in one way or the other is involved in traditional financial intermediary activities without being regulated as traditional banks. Different analyses and models are reviewed as well as how these models evolved over time. Experience showed that it is better to trace certain economic functions and their associated risks rather than certain legal entities or structures. Not only because a structure in itself doesn’t cause risk but also because the next crisis will be different than the previous one, we ultimately want regulation and supervision to hold some predictive value as well.

Retaking what was identified in Chap. 1, five key topics become paramount when defining shadow banking activities: credit transformation, maturity transformation, liquidity transformation, imperfect transfer of credit risk and leverage. With a good understanding of those five concepts and deeply documented in how shadow banking activities historically emerged, we are armed to start the actual analysis. Shadow banking activities are always the result of regulation combined with demand for something. That has implications. Both items are evolving and dynamics features which imply that shadow banking will also evolve over time and the underlying business models applied will undeniably change. And so does the way we measure, analyze and regulate those activities. History will and should be our guide when looking at the wide variety of shadow banking measurement models.

Securitization is most likely the most visible part of the shadow banking industry. That is mostly due to its alleged involvement of the 2007–2009 financial crisis. Born as a tool to reduce capital charges for banks, securitization became an industry in its own right. Also here a combination of regulation and demand triggered the emergence of shadow banking. The crisis learned that adjustments were needed to reduce the unanticipated consequences and unregulated business practices. Both the (inter)national regulators and supervisory bodies introduced an avalanche of changes to make the industry safer while maintaining the capital reduction benefits for banks. Risk retention, different techniques of tranching, selection at the gate (STS) and all sorts of compliance rules were introduced. After reviewing all efforts involved and despite all improvements realized, Nijs is still not convinced that it has made the industry effectively safer and many questions are still unanswered. NOTE: the chapter does not provide a full analysis related to securitization. Other chapters will delve deeper into certain securitization-related topics or resurface certain (new) features.

Securities lending and the repo market are often seen as opaque and un-transparent. They are however both key in the functioning of our financial system as it exists today. The 2007–2009 financial crisis demonstrated how sensitive they are and how liquidity almost overnight can dry up. The segments have seen material reforms in recent years which the industry is still digesting. After having reviewed them, there is a sense that the segment might have been prone to multi-layered overregulation also in spaces where no real action was needed. Part of that can be explained by the fact that often different financial techniques and risks come together in these segments. But overregulating complex markets triggers its own set of complications. Introducing haircuts on and demanding higher quality collateral puts (or might put) strain on the collateral supply in the market. Reducing leverage in itself is a good thing, but where does that liquidity go? Like in most cases, there are many ways to get it wrong and one or very few ways to get it right.

The global financial infrastructure is a network of players and transactions. And a large set of transactions runs through a distinct number of financial players. A material part of these transactions is cleared through a central clearing party (CCP). Triggering uniformity of transactions, those CCPs also take out counterparty risk for its members. But a very material part of market transactions aren’t cleared and processed in the private market (over the counter [OTC]). The financial crisis documented that the counterparty risk can then be substantial, particularly in the derivatives markets. And so more transactions needed to be cleared was the regulator’s view. But that is not without complications. Besides the fact that the number of CCPs is limited and are now processing more transactions making them potentially systemically relevant, there are many open and problematic questions. How should they be regulated and supervised? What kind of balance sheet should they hold and should they be regulated like banks although they are not? What if one or more of their clients default? What does it mean for the CCP and its remaining clients? And which capital and other buffers should be built in? And what if the CCP itself defaults? How will members be protected? The choices made to answer these questions will be critical for the functioning of the industry and the stability of the entire financial system. But the jury is still out on many of them.

This short chapter tables the question about the qualification of which financial institutions (FI) are ‘systemically important’ (SIFI). Given the high concentration of transactions engaged in by a limited number of market participants, those entities require additional supervision and often additional capital charges simply for being that omnipresent in the global financial network. Some banks and insurers are domestically important and others are so on a global level. For those that don’t qualify as a bank or insurers, they created the designation non-bank non-insurance company (NBNI SIFI). And so criteria were developed to identify them and treat them accordingly. That is harder than it sounds as size and the nature of the transactions engaged in often says very little about the systemic nature of an institution. And so were the initial 2014 rules already revised in 2016. It will stay an ongoing effort with no guarantee of completeness or ultimate accuracy. But where does it leave shadow banking? Most shadow banking entities are not labeled as a bank or insurance company. But most shadow banking activities occur within larger financial groups designated as banks. And with business models changing constantly and being spread out over a variety of (inter)national entities, qualification and treatment need to be continuously revisited.

This chapter takes a step back and asks the question what happened when the dust settled after the financial crisis of 2007–2009. There was time for analysis and reflection. But then it was time to take action based on those findings and experiences. But where to start in a complex domain with many issues that require attention? And does dealing with the 2007–2009 issues solve the deeper root-cause problems? If we don’t want to go down the road of fixing the symptoms, what are then the underlying objectives? Financial stability, liquidity, risk neutralization, keep credit flowing at all times and so on. And what are the best tools to achieve those objectives? Ex ante regulation is needed but inherently insufficient; ex post regulation is to ensure that things are cleaned up as soon as possible and markets don’t stay instable longer then absolutely needed. And how does regulation relate to macroprudential and monetary policies that carry the same objective? And can supervision and stress testing contribute to those joint objectives? An analysis of what happened and the decisions made in the financial industry and the different shadow banking segments is the subject of this chapter.

This chapter, which builds on the insights generated in Chap. 7, takes the discussion a couple of notches up. Starting from how shadow banking emerged, the analysis focuses on the question how regulation can help manage an industry it helped creating itself. Two concepts are central in the analysis: regulatory arbitrage (the technique through which simply put one can achieve the same economic outcome by using a different legal technique or transaction and often subject to different (i.e. lower) capital requirements) and second the creation of private safe assets. What exactly is a safe asset and can safe assets be produced privately or is that only possible by sovereigns in the current financial system? If privately created safe assets are inherently instable, the central bank and the taxpayer essentially underwrite the shadow banking industry on an ongoing basis. Contract imperfection, director liability, limited liability for corporations, bankruptcy laws and moral hazard are then topics that need to be brought into the discussion.

Ex ante legislation is needed but inherently insufficient, and thus ex post regulation is part of any possible holistic solution. There are bankruptcy laws in many countries and not all are the poster child of optimal regulation. But even if they were, a framework is needed to address the specifics of the financial industry. From multijurisdictional monitoring to forcing banks to develop their own resolution and recovery scenarios are all building blocks of a comprehensive framework and so are stress tests. But questions are asked about how this all should work together in an efficient way under conditions that typically qualify as ‘distress’. And if ultimately it becomes clear the sovereign needs to step in to rescue a bank or financial conglomerate (bail-in or bailout), an avalanche of questions emerge as to which sovereign(s) need(s) to step in, which of the parties involved (shareholders, unsecured lenders and/or deposit holders) take a haircut and in what order. Very problematic still is the EU situation despite the bank recovery and resolution directive and single resolution mechanism put in place in recent years.

Born out of the US Q regulation (which capped the interest one could earn on deposit accounts) in the 1970s in the US, the contemporary money market fund/UCITS industry is one of the largest and prominent segments of the shadow banking market globally. They fund large volumes of treasury paper, commercial paper and corporate bonds globally. The idea of those funds was and is to earn to (slightly) higher return than on a deposit account, with no risk and full and continuous liquidity. That has proven problematic and liquidity dried up in the early parts of the 2007–2009 crisis. These funds are subject to a ‘first-mover advantage’, that is, those that exit first leave possible value distortions or capital destruction for remaining investors. Possible solutions and decisions taken vary quite a bit across the world but every single possible technique in the playbook has been implemented to avoid the market instability that leads to run on those funds. But doubt still very much exists among scholars as to whether the right decisions were taken to keep these funds going under severe forms of market distress as they continue to be prone to market contagion. It is time for a comprehensive analysis.

This lengthy chapter brings home a critical question regarding an adequate tax model for financial institutions (FIs) and shadow banking entities. Given that leverage is a constitutive factor of the shadow banking business model, corporate tax systems have an embedded debt bias and credit-, maturity- and liquidity transformation occur outside the regulated banking sphere in the shadow banking segments, the author wonders if a Pigovian tax model, whereby the negative externalities caused would trigger tax liabilities, would be more appropriate to neutralize possible shadow banking exposures. Starting from the contemporary tax system, the older and more recent literature on Pigovian taxes, he expands his Pigovian tax model designed initially in 2015 for the financial sector and shadow banking entities, in particular using the aforementioned constitutive elements as drivers for the design of the model. But Pigovian taxes are politically a difficult topic whether it is for environmental purposes, reducing obesity (sugar tax) or reducing systemic risk in the financial markets.

Nijs formulates some interim conclusions on the shadow banking sector and the segments discussed in previous chapters. More importantly he addresses the question regarding the legitimacy of the trend initiated by regulators and supervisors in 2015 to reframe shadow banking into market-based finance. The positive reformulation should help to embrace shadow banking as part of the global financial infrastructure and a complement to traditional banking, which admittedly can under distress bring an economy down. But renaming the sector changes nothing intrinsically, unless one tends to believe that the shadow banking segments are now properly regulated, which is the dominant self-serving opinion of many regulators and supervisors around the world. But a lot still needs to happen to go in a safe way from shadow banking to market-based finance. And even if we do, it will not be without implications, as the taxpayer will then underwrite the market as such rather than the shadow banking segments and their activities, a topic important enough to spill over into volume II of the handbook.