Shadow Banking - Federal Reserve Bank of New York
Federal Reserve Bank of New York Staff Reports
Shadow Banking
Zoltan Pozsar Tobias Adrian Adam Ashcraft Hayley Boesky
Staff Report No. 458 July 2010
Revised February 2012
FRBNY
Staff
REPORTS
This paper presents preliminary findings and is being distributed to economists and other interested readers solely to stimulate discussion and elicit comments. The views expressed in this paper are those of the authors and are not necessarily reflective of views at the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.
Shadow Banking Zoltan Pozsar, Tobias Adrian, Adam Ashcraft, and Hayley Boesky Federal Reserve Bank of New York Staff Reports, no. 458 July 2010: revised February 2012 JEL classification: G20, G28, G01
Abstract The rapid growth of the market-based financial system since the mid-1980s changed the nature of financial intermediation. Within the market-based financial system, "shadow banks" have served a critical role. Shadow banks are financial intermediaries that conduct maturity, credit, and liquidity transformation without explicit access to central bank liquidity or public sector credit guarantees. Examples of shadow banks include finance companies, asset-backed commercial paper (ABCP) conduits, structured investment vehicles (SIVs), credit hedge funds, money market mutual funds, securities lenders, limited-purpose finance companies (LPFCs), and the government-sponsored enterprises (GSEs). Our paper documents the institutional features of shadow banks, discusses their economic roles, and analyzes their relation to the traditional banking system. Our description and taxonomy of shadow bank entities and shadow bank activities are accompanied by "shadow banking maps" that schematically represent the funding flows of the shadow banking system. Key words: shadow banking, financial intermediation
Adrian, Ashcraft: Federal Reserve Bank of New York. Pozsar: International Monetary Fund. Boesky: Bank of America Merrill Lynch. Address correspondence to Tobias Adrian (e-mail: tobias.adrian@ny.). The views expressed in this paper are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System.
The Shadow Banking System
Conceptualized, designed and created by Zoltan Pozsar (zoltan.pozsar@ny.) The Federal Reserve Bank of New York, November, 2009
The Traditional Banking System
Ultimate Borrowers
Households, Businesses, Governments
Assets
Loans
Bonds Equity
Borrowers
Assets
Loans
Commercial Banks
Loans
Dollar Deposits
Equity
`
The "Cash" Shadow Banking System
Ultimate Borrowers
Households
Assets
Loans
Equity
"Prime" Homeowners
Home
1st Lien Equity
Subprime Homeowners
Home
1st Lien 2nd Lien
Consumers
Goods &
Services
Loans
Nonfinancial Businesses
Assets
Loans
Bonds Equity
Businesses
Investments
C&I Loans
Businesses
CRE
CRE Loans
Private Equity Portfolio Companies
Firms
LBO Loans
Governments
Tax Revenues
Bonds
Federal Government
Tax Revenues
Treasury Bonds
State Governments
Tax Revenues
State Bonds
Local Governments
Tax Revenues
Muni Bonds
Credit "References"
Discount Window
Loan Collateral
Reserves
Deposit Insurance (FDIC)
Agency Debt Purchases
Agency Debt
Reserves
11/25/2008
FDIC
Insurance Premia
Deposit Insurance
Equity
Federal Government
No Explicit
Fees
Implicit Insurance
Deposit Insurance (FDIC)
Step (1): Loan Origination
Liability Insurance (Federal Government)
Step (2): Loan Warehousing
FH LBs Discount Notes
Loans
Agency Debt
Equity
Commercial Bank*
Dollar
Loans
Deposits
ABCP
Repo
Securities
LTD
Equity
*FHC affiliate
Finance Company*
CP
ABCP
Loans
BDP
MTNs
Equity *FHC affiliate
Single-Seller Conduit
Loans
ABCP
O/C
Single-Seller Conduit
Loans
ABCP
O/C
Multi-Seller Conduit* (Warehouse and Term)
Loans
ABCP
O/C *FHC affiliated
Multi-Seller Conduit* (Warehouse and Term)
Loans
ABCP
O/C *European bank affiliated
Finance Company* CP
ABCP BDP Loans MTNs
Equity *Broker-dealer affiliate
Industrial Loan Company*
Loans
Brokered Deposits
Equity *Broker-dealer affiliate
Standalone Finance Company CP
Loans
ABCP MTNs
Equity
Captive Finance Company
CP
ABCP
Loans
BDP MTN
LTD
Equity
TLGP
MTNs
Debt Insurance
Single-Seller Conduit
Loans
ABCP
O/C
Broker Sweep Accounts
Brokerage
Brokered Clients'
Deposits
Cash Balances
Single-Seller Conduit
Loans
ABCP
O/C
Industrial Loan Company*
Loans
Brokered Deposits
Equity *Finance company affiliate
Multi-Seller Conduit* ("Rent-a-Conduit")
Loans
ABCP
O/C *Independent conduit
Credit Insurance (Mortgage Insurers)
Mortgage Insurers*
Premia
Credit Insurance
Equity *Unaffiliated with originators!
Agency MBS Purchases
Agency MBS
Reserves
11/25/2008
Agency Debt Purchases
Agency Debt
Reserves
11/25/2008
GSEs, DoE, SBA
No Explicit
Fees
Implicit Insurance
Step (3): ABS Issuance
Fannie and Freddie*
TBA Market
Broker-Dealer* *FHC affiliate
Structuring and
Syndication
Credit Insurance (GSEs, DoE, SBA)
Agency MBS
Agency
Loans*
PassThrough
s *Conforming mortgages
FFELP ABS
A1
Loans*
AAA AA-BBB
Equity
*Conforming student loans
SBA ABS
A1
Loans*
AAA AA-BBB
Equity
*Conforming SBA loans
Subprime, RMBS, CMBS
A1
Loans
AAA AA-BBB
Equity
High-Yield CLOs
(LBO Loans)
A1
Loans
AAA AA-BBB
Equity
Consumer ABS
(Credit Card ABS)
A1
Loans
AAA AA-BBB
Equity
Broker-Dealer* *DBD affiliate
Structuring and
Syndication
RMBS
(1st lien, private label)
A1
Loans
AAA AA-BBB
Equity
Subprime ABS
(2nd lien, subprime, HELOCs)
A1
Loans
AAA AA-BBB
Equity
CMBS and High-Yield CLOs
(LBO Loans)
A1
Loans
AAA AA-BBB
Equity
Consumer ABS
(Card, Auto, Student Loan)
A1
Loans
AAA AA-BBB
Equity
Other ABS
(Floorplan, Equipment, Fleets)
A1
Loans
AAA AA-BBB
Equity
Middle-Market CLOs
(Loans to SMEs)
A1
Loans
AAA AA-BBB
Equity
Credit Insurance (Monolines)
Monoline Insurers*
Premia
Credit Insurance
Equity *Unaffiliated with originators!
Federal Government
No Explicit
Fees
Implicit Insurance
European Sovereign and Quasi-Sovereign States
No Explicit
Fees
Implicit Insurance
Step (4): ABS Warehousing
Step (5): ABS CDO Issuance
Trading Books
AA-BBB Repos
Haircuts
Repo Conduits
Reverse Repos*
ABCP
O/C
Hybrid Conduits
AA-BBB ABCP
O/C
High-Grade CDOs
Supers
AA-A
AAA AA-BBB
Equity
Mezzanine CDOs
Supers
BBB
AAA
AA-BBB
Equity
Hybrid Conduits (ABS Warehouse Conduits)
AA-BBB ABCP
O/C
Trading Books AA-BBB Repos Haircuts
High-Grade CDOs
Supers
AA-A
AAA AA-BBB
Equity
Mezzanine CDOs Supers AAA
BBB AA-BBB Equity
Liability Insurance (Federal Government)
Liability Insurance (EU Government)
Step (6): ABS "Intermediation"
Off -Balance Sheet ABS Intermediation
On -Balance Sheet ABS Intermediation
CMOs (Time-Tranched Agency MBS)
Agency MBS
CMO Tranches
Fannie and Freddie
(Retained Portfolios)
Agency Discount
MBS
Notes
Private
Agency
ABS
Debt
FHLBs
(Retained Portfolios)
Agency Discount
MBS
Notes
Private
Agency
ABS
Debt
Federal Government
Off-Balance Sheet Off-Balance Sheet
Off-Balance Sheet Off-Balance Sheet Off-Balance Sheet
SIV, SIV-Lite
AAA
CP
AA-BBB
LTD
MTNs
Supers
CNs*
*Capital Notes
Arbitrage Conduit
AAA AA-BBB
ABCP
O/C
Liquidity Puts*
LongTerm Munis
ShortTerm Munis
*ARSs, TOBs, VRDOs
SIV
AAA
CP
AA-BBB
LTD
MTNs
Supers
CNs*
*Capital Notes
Off-Balance Sheet
Asset Manager* *BHC affiliate
Europe an Banks
[...]
Mezz ABS Mezz CDO
Euro Deposits
Equity
Arbitrage Conduit
AAA AA-BBB
ABCP
O/C
Off-Balance Sheet
Europe an Banks
[...]
Mezz ABS Mezz CDO
Euro Deposits
Equity
Off-Balance Sheet
Credit Hedge Fund*
AAA AA-BBB
Repos
*Broker-dealer affiliate
Trading Book
Super
Seniors Super
Repos
Seniors
Liquidity Puts*
LongTerm Munis
ShortTerm Munis
*ARSs, TOBs, VRDOs
Credit Hedge Fund
AAA AA-BBB
Repos
Haircuts
LPFCs
AAA AA-BBB
CP
LTD
MTNs
CNs*
*Capital Notes
REITs
[...]
[...]
Off-Balance Sheet
Asset Manager, Prime Broker
*Broker-dealer affiliate
Credit Insurance (AIG FP)
Diversified Insurance Co.
Premia
Credit Insurance (Par Puts)
Equity *Unaffiliated with originators!
Credit Insurance (AIG FP)
The "Synthetic" Shadow Banking System
Ultimate Borrowers
Single-Name and Index Corporate CDS
Bond(s)
CDS
Households, Businesses, Governments
Assets
Loans
Bonds Equity
Single-Name and Index Sovereign CDS
Bond(s)
CDS
Structured Credit and Loan CDS Indices
Loan(s)
CDS
CDPCs
Unfunded Protection
Funded Protection
Protection Sold
Equity
Credit Hedge Funds
Unfunded Protection
Funded Protection
Protection Sold
Equity
Source: Shadow Banking (Pozsar, Adrian, Ashcraft, Boesky (2010))
CPFF
CP ABCP
Reserves
10/7/2008
Counterparty Hedges
Warehouse Hedges
Counterparty Hedges
Warehouse Hedges
Broker-Dealers*
Protection Protection
Bought
Sold
*Market Makers
TALF
AAA
Reserves
11/25/2008
Counterparty Hedges
Counterparty Hedges
Maiden Lane LLC
Warehou sed ABS
Reserves
3/24/2008
Warehouse Hedges
Maiden Lane III LLC
CDS on CDOs
Reserves
10/11/2008
Warehouse and Counterparty Hedges
TAF
ABS
Reserves
12/12/2007
FX Swaps
$
FX
12/12/2007
Warehouse Hedges
CPDOs*
[...]
AAA
Equity *Referencing corporate loan indices, etc.
Warehouse Hedges
Funded Synthetic CDOs* (Credit-Linked Notes)
AAA
AAA
Treasurys
AA-BBB Equity
Referencing ABS and single-name CDS
indices, etc.
Unfunded Synthetic CDOs*
AAA [...]
AA-BBB Equity *Referencing single-name CDS indices, etc.
Private Risk Repositories The "Synthetic" Shadow Banking System
(Derivatives-Based Risk Repositories)
Private Risk Repositories Private Credit Transformation
(Tail Risk Absorption)
Independent Specialists' Credit Intermediation Process
DBDs' Credit Intermediation Process
European Banks' Shadow Banking Activites
FHCs' Credit Intermediation Process
The GSEs' Credit Intermediation Process The Government-Sponsored Shadow Banking System
(Public Originate-to-Distribute Model)
Public Risk Repositories Public Credit Transformation
(Tail Risk Absorption)
Traditional Banks' Lending Process The Traditional Banking System
("Originate-to-Hold-to-Maturity-and-Fund-with-Deposits")
The "External" Shadow Banking System (DBDs: Originate-to-Distribute Model | Independent Specialists: Originate-to-Fund Model)
The "Internal" Shadow Banking System (Private Originate-to-Distribute Model)
`
Short-Term Funding
Deposits
Checking
Loans
Accounts
CDs
Equity Funding
Bank Equity
Loans
Bank Equity
Equity Funding
Debt Funding (Short and Long-Term Deposits
Depositors Deposits Equity
Real Money Accounts*
Bank Equity
Client Funds
*Asset Managers, Insurance Companies and Pension Funds
Short- to Long-Term Cash
Money Market "Portfolios"
Checking Account MMDAs
CDs
ShortTerm Savings
Long-Term Investments
Equity Portfolios
Bank Equity
Term Savings
Ultimate Creditors
Households, Businesses and the Rest of the World
Public Risk Repositories (Tail Risk Absorption)
Catalogue:, Shadow Bank Liabilities
Short-Term Debt Instruments
Agency Discount Notes
Loans ABS
Agency Bills
Liquidity Puts
Munis
ARSs TOBs
ABS
or VRDOs
A1 (AAA) ABS Tranches
Loans
A1
CP
Loans
CP
ABCP
Loans ABS
ABCP
BDPs
Loans
BDPs
Tri-Party Repo System Tri-Party Clearing Banks*
Reverse Repos
ABS Collateral
*BoNY and JP Morgan Chase
Medium-Term Instruments
MTNs
Loans ABS
Private MTNs
A2 & A3 (AAA) ABS Tranches
Loans
AAA (A2-A3)
Agency Debt*
Loans ABS
Agency Debt
*Medium-term debt
Long-Term nstruments (LTD)
Long-Term Debt
Loans
Private LTD
ABS
Agency LTD
A4 and AA-BBB ABS Tranches AAA (A4)
Loans AA-BBB
CDOs
HG
Super
ABS
Senior
Mezz
Super
ABS
Senior
Public Equity
Loans ABS
Equity
Structured Credit Equity
Loans
ABS
and
ABS
CDO
Equity
TSLF/PDCF
Tri-Party Collatera
l
Reserves
3/11/08 and 3/16/08, respectively
Synthetic Credit Liabilities
Short-Term Synthetic Liabilities
Loans,
ABS
Funded
and
Protection
CDOs
Long-Term Synthetic Liabilities
Loans,
ABS
Funded
and
Protection
CDOs
Counterparty Risks*
Loans,
ABS
Unfunded
and
Protection
CDOs
*Inability to meet
unfunded liabilities, etc.
Provision of Risk Capital
Wholesale Funding (Term Debt Funding)
Wholesale Funding (Medium-Term Funding)
Wholesale Funding (Overnight Funding)
Wholesale Funding (Short-Term Funding)
Temporary MMMF Guarantee
No Explicit
Fees
MMMF Insurance
9/18/2008 *Funded by UST's $50 billion Exchange Stabilization Fund
Regulated Money Market Intermediaries
Step (7): Wholesale Funding (Shadow Bank "Depositors")
Unregulated Money Market Intermediaries
2a-7 MMMFs
A1
CP
ABCP $1 NAV
BDP
Shares
RRs
Other*
*TOBs and VRDOs
Offshore (non-2a-7) MMMFs
A1
CP
ABCP $1 NAV
BDP
Shares
RRs
Other*
*TOBs and VRDOs
Cash "Plus" Funds
A1
CP
ABCP $1 NAV
BDP
Shares
RRs
Other*
*ARS, MMMFs, as well as
MTNs and term ABS
Enhanced Cash Funds
A1
CP
ABCP $1 NAV
BDP
Shares
RRs
Other*
*ARS, MMMFs, as well as
MTNs and term ABS
Ultra-Short Bond Funds
A1
CP
ABCP
$1 NAV
BDP
Shares
RRs
Other*
*ARS, MMMFs, as well as
MTNs and term ABS
PBGC
Insurance Premia
Implicit Insurance
Insurance Guarantees
Direct Money Market Investors Corporate Treasurers
A1
CP ABCP RRs
$1 NAV Shares
Other* *ARS, MMMFs
Bank Treasurers
A1
CP
ABCP $1 NAV
BDP
Shares
RRs
Other*
*ARS, MMMFs
LGIPs
A1
CP
ABCP $1 NAV
BDP
Shares
RRs
Other*
*MMMFs
Sweep Accounts
A1
CP
ABCP $1 NAV
BDP
Shares
RRs
Other*
*ARS, MMMFs
Cash lending for
securities collateral
Agent Securities Lending
Cash Reinvestment Accounts
A1
CP
ABCP
Cash
BDP
Collateral
RRs
Other*
*MMMFs, MTNs, term ABS and
TOBs and VRDOs
Securities Lending*
Cash Collateral
Securities Lent
*Done by custodian banks on an agent basis.
Principal Securities Lending
Cash Reinvestment Accounts
A1
CP
ABCP
Cash
BDP
Collateral
RRs
Other*
*MMMFs, MTNs, term ABS and
TOBs and VRDOs
Securities Lending*
Cash Collateral
Securities Lent
*Done by real money accounts on a principal basis.
Asset Managers*
Cash
MTNs
LTD
Client
Equity
Funds
Structured
Credit
*Mutual Funds, ETFs, Separate Accounts
Pension Funds, Insurance Companies*
Cash
MTNs
LTD
Pension
Equity
Liabilities
Structured
Credit
*Public and Private Pension Funds,
and Life and P&C Insurance Companies
Ultimate Creditors
Short-Term Savings
Money Market Portfolios
Direct Investmen $1 NAV
Shares
ShortTerm Savings
Long-Term Savings
Fixed Income Portfolios*
MTNs
LTDs
Term Savings
CNs
*Bank, Shadow Bank
and Corporate Debt
Equity Portfolios*
Public Equity
Term Savings
*Bank and Corporate Debt
Structured Credit Portfolios*
Debt Tranches
Equity Tranches
Term Savings
*Term ABS and CDO debt and equity tranches
Households and Nonprofits
Savings: Excess Cash
"Equity"
Nonfinancial Corporates
Savings: Excess Cash
"Equity"
Federal, State and Local Governments
Savings: Excess Cash
"Equity"
RoW (Foreign Central Banks)
Savings: FX
Reserves
Local Currency
RoW (Sovereign Wealth Funds)
Savings: Export "Equity" Revenue
FX Reserves
Bonds*
*Issued to central banks in exchange for investibe FX
Federal Reserve
DW
TAF
FX Swaps
TSLF
TSLF
PDCF
CPFF
TALF AMLF
Reserves
MMIFF ML, LLC
ML II, LLC
ML III, LLC
LSAPs
OMO Collatera
l
Equity
Credit Hedges
Alternative Asset Managers*
Cash
MTNs
LTD
Client
Funds
Equity
*Hedge Funds and Private Equity (only credit exposures)
AMLF ABCP Reserves
9/19/2008
MMIFF
Non-
repo MM instrume
Reserves
nts
10/21/2008
Maiden Lane II LLC
Subprim
e ABS
Reserves
RMBS
11/10/2008
Hedgers*
Insured Assets
Broker-dealer CVA desks, ABS pipeline hedges, negative basis traders, real money accounts, etc.
Speculators*
"Naked" Positions
Proprietary trading desks, credit hedge funds, etc.
Portfolio Protection*
Hedges
Term Savings
*Hedging Motives
Synthetic Exposures*
Credit Bets
Term Savings
*Speculative Motives
Ultimate Creditors
Households, Businesses, Governments and the Rest of the World (RoW)
1. Introduction
Shadow banks intermediate credit through a wide range of securitization and secured funding techniques such as asset-backed commercial paper (ABCP), asset-backed securities (ABS), collateralized debt obligations (CDOs) and repurchase agreements (repos). These securities are used by specialized shadow bank intermediaries that are bound together along an intermediation chain. We refer to the network of shadow banks in this intermediation chain as the shadow banking system. While we believe that shadow banking is a somewhat pejorative name for such a large and important part of the financial system, we adopt it in this paper.
Over the past decade, the shadow banking system provided sources of funding for credit by converting opaque, risky, long-term assets into money-like, short-term liabilities. Arguably, maturity and credit transformation in the shadow banking system contributed to the asset price appreciation in residential and commercial real estate markets prior to the 2007-09 financial crisis. During the financial crisis, the shadow banking system became severely strained and many parts of the system collapsed. Credit creation through maturity, credit, and liquidity transformation can significantly reduce the cost of credit relative to direct lending. However, credit intermediaries' reliance on shortterm liabilities to fund illiquid long-term assets is an inherently fragile activity and may be prone to runs.1 As the failure of credit intermediaries can have large, adverse effects on the real economy (see Bernanke (1983) and Ashcraft (2005)), governments chose to shield them from the risks inherent in reliance on short-term funding by granting them access to liquidity and credit put options in the form of discount window access and deposit insurance, respectively.
1 There is a large literature on bank runs modeled as multiple equilibria initiated by Diamond and Dybvig (1983). Morris and Shin (2004) provide a model of funding fragility with a unique equilibrium in a setting with higher order beliefs. Martin, Skeie and von Thadden (2011) provide a theory of runs in the repo market.
1
Shadow banks conduct credit, maturity and liquidity transformation similar to traditional banks. However, what distinguishes shadow banks from traditional banks is their lack of access to public sources of liquidity such as the Federal Reserve's discount window, or public sources of insurance such as Federal Deposit Insurance. The emergency liquidity facilities launched by the Federal Reserve and other government agencies' guarantee schemes created during the financial crisis were direct responses to the liquidity and capital shortfalls of shadow banks. These facilities effectively provided a backstop to credit intermediation by the shadow banking system and to traditional banks for their exposure to shadow banks.
In contrast to public-sector guarantees of the traditional banking system, prior to the onset of the financial crisis of 2007-2009, the shadow banking system was presumed to be safe due to liquidity and credit puts provided by the private sector. These puts underpinned the perceived risk-free, highly liquid nature of most AAA-rated assets that collateralized credit repos and shadow banks' liabilities more broadly. However, once private sector put providers' solvency was questioned, even if solvency was perfectly satisfactory in some cases, the confidence that underpinned the stability of the shadow banking system vanished. The run on the shadow banking system, which began in the summer of 2007 and peaked following the failure of Lehman in September and October 2008, was stabilized only after the creation of a series of official liquidity facilities and credit guarantees that replaced private sector guarantees entirely. In the interim, large portions of the shadow banking system were eroded.
The failure of private sector guarantees to support the shadow banking system stemmed largely from the underestimation of asset price correlations by every relevant party: credit rating agencies, risk managers, investors, and regulators. Specifically, they did not account for the fact that the prices of highly rated structured securities become much more correlated in extreme environments than in
2
normal times. In a major systemic event, the price behavior of diverse assets become highly correlated as investors and levered institutions are forced to shed assets in order to generate the liquidity necessary to meet margin calls (see Coval, Jurek and Stafford (2009)). Mark-to-market leverage constraints result in pressure on market-based balance sheets (see Adrian and Shin (2010a), and Geanakoplos (2010)). The underestimation of correlation enabled financial institutions to hold insufficient amounts of liquidity and capital against the puts that underpinned the stability of the shadow banking system, which made these puts unduly cheap to sell. As investors also overestimated the value of private credit and liquidity enhancement purchased through these puts, the result was an excess supply of cheap credit.
The AAA assets and liabilities that collateralized and funded the shadow banking system were the product of a range of securitization and secured lending techniques. Securitization-based credit intermediation process has the potential to increase the efficiency of credit intermediation. However, securitization-based credit intermediation also creates agency problems which do not exist when these activities are conducted within a bank. In fact, Ashcraft and Schuermann (2007) document seven agency problems that arise in the securitization markets. If these agency problems are not adequately mitigated with effective mechanisms, the financial system has weaker defenses against the supply of poorly underwritten loans and aggressively structured securities.
Overviews of the shadow banking system are provided by Pozsar (2008) and Adrian and Shin (2009). Pozsar (2008) catalogues different types of shadow banks and describes the asset and funding flows within the shadow banking system. Adrian and Shin (2009) focus on the role of security brokers and dealers in the shadow banking system, and discuss implications for financial regulation. The term "shadow banking" was coined by McCulley (2007). Gertler and Boyd (1993)
3
and Corrigan (2000) are early discussions of the role of commercial banks and the market based financial system in financial intermediation. The contribution of the current paper is to focus on institutional details of the shadow banking system, complementing a rapidly growing literature on the system's collapse.. As such, our paper is primarily descriptive, and focuses on funding flows in a somewhat mechanical manner. We believe that the understanding of the plumbing of the shadow banking system is an important underpinning of any study of systemic interlinkages within the financial system. The remainder of the paper is organized as follows. Section 2 provides a definition of shadow banking, and an estimate of the size of shadow banking activity. Section 3 discusses the seven steps of the shadow credit intermediation process. Section 4 is by far the longest section of the paper, describing the interaction of the shadow banking system with institutions such as bank holding companies and broker dealers. Finally, section 5 concludes.
2. WHAT IS SHADOW CREDIT INTERMEDIATION? 2.1 Defining Shadow Banking In the traditional banking system, intermediation between savers and borrowers occurs in a single entity. Savers entrust their savings to banks in the form of deposits, which banks use to fund the extension of loans to borrowers. Savers furthermore own the equity and debt issuance of the banks. Relative to direct lending (that is, savers lending directly to borrowers), credit intermediation provides savers with information and risk economies of scale by reducing the costs involved in screening and monitoring borrowers and by facilitating investments in a more diverse loan portfolio.
4
Credit intermediation involves credit, maturity, and liquidity transformation. Credit transformation refers to the enhancement of the credit quality of debt issued by the intermediary through the use of priority of claims. For example, the credit quality of senior deposits is better than the credit quality of the underlying loan portfolio due to the presence of junior equity. Maturity transformation refers to the use of short-term deposits to fund long-term loans, which creates liquidity for the saver but exposes the intermediary to rollover and duration risks. Liquidity transformation refers to the use of liquid instruments to fund illiquid assets. For example, a pool of illiquid whole loans might trade at a lower price than a liquid rated security secured by the same loan pool, as certification by a credible rating agency would reduce information asymmetries between borrowers and savers.
Credit intermediation is frequently enhanced through the use of third-party liquidity and credit guarantees, generally in the form of liquidity or credit put options. When these guarantees are provided by the public sector, credit intermediation is said to be officially enhanced. For example, credit intermediation performed by depository institutions is enhanced by credit and liquidity put options provided through deposit insurance and access to central bank liquidity, respectively. Exhibit 1 lays out the framework by which we analyze official enhancements.2 Thus, official enhancements to credit intermediation activities have four levels of "strength" and can be classified as either direct or indirect, and either explicit or implicit.
1. A liability with direct official enhancement must reside on a financial institution's balance sheet, while off-balance sheet liabilities of financial institutions are indirectly enhanced by the public sector. Activities with direct and explicit official enhancement include on-balance sheet funding
2 The analysis of deposit insurance was formally analyzed by Merton (1977) and Merton and Bodie (1993). 5
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