We define shadow banking as the system of finance that exists outside regulated depositories, investment banks, or bond funds. It includes bank-sponsored intermediaries such as asset-backed commercial paper (ABCP) conduits,money-market funds, collateralized loan obligations (CLOs), finance companies, private investment funds, business development corporations (BDCs), asset managers, and hedge funds. The market determines the level of leverage and access to funding for participants in the shadow-banking system, which results in market-driven cost of funds.Given that, in our view, shadow-banking players differ from traditional banks in three important ways. They don't typically operate under bank regulatory supervision and thus often operate under differing capital, leverage, and liquidity guidelines. They don't normally benefit from government capital support, such as deposit insurance. And they don't benefit from the liquidity support available to regulated banks, such as the ability to borrow from the Fed. This lack of oversight and support was a factor in the difficulties some shadow-banking players experienced during the financial crisis.
The recent financial crisis shined a light on shadow banking that has grown brighter as the economic and political after shocks of the crisis reshape the banking industry. In the absence of one financial regulator harmonizing the shadow-banking and traditional-banking sectors, Standard & Poor's Ratings Services believes shadow banking maybe well positioned to take on a greater role in lending vis-à-vis the banking sector; it may try to advance theemerging opportunity to finance more assets that banks either can't or won't fund because of new regulation. This regulation includes the Dodd-Frank Act, the Basel III capital guidelines, and yet-to-emerge governance for thegovernment-sponsored entities (GSEs) Fannie Mae and Freddie Mac. Here, we focus primarily on the U.S., but the two-tier system of banking and shadow banking is a global condition.
ReplyDeleteWe define shadow banking as the system of finance that exists outside regulated depositories, investment banks, or bond funds. It includes bank-sponsored intermediaries such as asset-backed commercial paper (ABCP) conduits,money-market funds, collateralized loan obligations (CLOs), finance companies, private investment funds, business development corporations (BDCs), asset managers, and hedge funds. The market determines the level of leverage and access to funding for participants in the shadow-banking system, which results in market-driven cost of funds.Given that, in our view, shadow-banking players differ from traditional banks in three important ways. They don't typically operate under bank regulatory supervision and thus often operate under differing capital, leverage, and liquidity guidelines. They don't normally benefit from government capital support, such as deposit insurance. And they don't benefit from the liquidity support available to regulated banks, such as the ability to borrow from the Fed. This lack of oversight and support was a factor in the difficulties some shadow-banking players experienced during the financial crisis.
The trade-offs between shadow banking and traditional banking lending occur in areas of capital requirements,liquidity requirements, and reporting transparency. These differences create opportunities for borrowers and lenders to pursue the cheapest-cost, least transparent source of capital, and results in incentives to concentrate debt leverage that has led and may lead again to systemic events. Because traditional bank lenders have been busy building and maintaining capital, other funding avenues, including the public and private capital markets and the shadow-banking system, have begun to fill the void and may continue to do so. We also believe the shadow-banking system will grow because we expect some investors to continue to seek high returns by backing shadow-banking lenders. Some of that growth may be tied to capital sizing being focused on specific portfolios of assets, which we believe can be a positive if it is transparent to investors and regulators. Some of that growth may be tied to innovation that may focus more on regulatory arbitrage of capital, liquidity, or transparency as opposed to enhanced asset-and-liability management.
Although there may be some benefits from growth in the shadow-banking system, such as financial innovation and lower-cost financing to corporate borrowers, we also see potential risks in this trend: If shadow banking isn't monitored rigorously, consistently, and transparently, the global financial system, in our view, could perpetuate the already entrenched two-tiered approach, with different regulatory, capital, and reporting requirements for traditional commercial banks and the components of the shadow-banking system. Under certain circumstances, that might destabilize the financial system. In addition, we believe shadow banks will likely have to overcome investor concerns about their access to capital, liquidity support, and transparency.
ReplyDeleteA two-tier environment encourages regulatory and capital arbitrage, as borrowers compare and seek out the best possible terms. Shadow banks can have a low cost of funding that compares with banks'. For example, when shadow banks borrow in the commercial paper market, their cost of financing is comparable to banks' costs. In addition, shadow banks' capital may be less than bank requirements because of regulatory differences or market-driven differences in capital requirements. Traditionally, for instance, banks have had a lower cost of funding thanks to their base of deposits. The shadow-banking system can sometimes lend more cheaply at certain risk levels when it has less-stringent capital and regulatory requirements or lower market-driven capital requirements. This is what we observed leading up to the 2008 financial crisis. When the crisis was at its worst and asset values began to tumble, some large funds and investment vehicles could only stay in business by selling assets at steep discounts. At the same time, a number of banks that had warehoused billions of dollars worth of assets in various segments of the shadow-banking system found those assets hard to sell. But many banks globally ultimately received liquidity support from central bankers, including the Federal Reserve, while some shadow-bank players,ineligible for this support, collapsed. The danger, in our view, is that a two-tier regulatory system could, under similar conditions, lead to another cycle of failed financial institutions, depreciating asset prices, and losses.
The share of corporate lending from the shadow-banking system is, we understand, still low relative to that coming from banks and when compared to the universe of shadow banking. Nevertheless, parts of the shadow-banking system will, we believe, continue to play a role in the fixed-income securities markets.