Banking and Finance Law Daily Wrap Up, BANKING OPERATIONS–Federal Reserve Bank of New York Staff Report on shadow bank monitoring, (Sep 30, 2013)

By Colleen Svelnis, J.D.

The Federal Reserve Bank of New York has issued a staff report providing an overview of recent developments in shadow credit markets. Their preliminary findings include a definition of shadow banking and reasons why it exists and discusses why regulators and academics should care about shadow banking. The shadow banking system consists of a web of specialized financial institutions that conduct credit, maturity, and liquidity transformation without direct access to public backstops. The lack of such access to sources of government liquidity makes shadow banks inherently fragile. Shadow banking activities are often intertwined with core regulated institutions such as bank holding companies, security brokers and dealers, and insurance companies. The report discusses how these interconnections of shadow banks with other financial institutions create sources of systemic risk for the broader financial system. The official sector has attempted to minimize this systemic risk through the use of its own balance sheet by providing credit guarantees on the liabilities of these intermediaries, as well as by providing contingent liquidity to these institutions from the lender of last resort. However, the risk-insensitive provision of credit guarantees and liquidity backstops creates well-known incentives for excessive risk-taking, leverage, and maturity transformation, motivating the need for enhanced supervision and prudential regulation.

An official definition of shadow banking was recently formulated by the Financial Stability Board (FSB) as “the system of credit intermediation that involves entities and activities outside the regular banking system.” Over time, financial innovation has transformed intermediation from a process involving a single financial institution to a process now broken down among several institutions, each with their own role in manufacturing the intermediation of credit. The motive to reduce costs has also pushed financial activity into the shadows in order to reduce or eliminate the cost associated with prudential supervision and regulation, investor disclosure, and taxes. Regulation typically forces private actors to do something that they would otherwise not do: pay taxes to the official sector, disclose additional information to investors, or hold more capital against financial exposures. Financial activity which has been re-structured to avoid taxes, disclosure, and/or capital requirements, is referred to as arbitrage activity. While high corporate taxes can have adverse effects on financial stability, it appears that low corporate taxes can also have adverse effects. According to the staff report, academic literature suggests that shadow credit intermediation is largely motivated by the confluence of specialization by financial intermediaries, financial innovation in the composition of money supply, and regulatory cost avoidance.

Monitoring risks. The FSB(2012) identified five broad economic functions that are supposed to capture the broad spectrum of intermediation activities:

1. Management of client cash pools with features that make them susceptible to runs such as credit investment funds, credit mutual funds, and mortgage REITs.

2. Loan provisions that depend on short-term funding such as finance companies.

3. Intermediation of market activities that depend on short-term funding or on secured funding of client assets.

4. Facilitation of credit creation such as insurance guarantors.

5. Securitization-based credit intermediation and funding of financial entities such as securitization vehicles.

Agency Mortgage REITs. While U.S. REITs are regulated by the SEC, agency REITs structure their operations in a way to be excluded from specific regulations in the Investment Company Act. As a result, agency REITs have virtually no prudential regulation, though, as publicly listed entities, they are subject to the SEC’s investor protection rules and have to file reports such as 10Qs. The agency REIT market consists of only a handful of companies, the majority of which were created since the financial crisis. The size of agency REIT holdings has been growing rapidly in recent years. The rapid growth of agency REITs since the financial crisis can be primarily attributed to the interest rate environment.

Leveraged finance. Loans to firms with non-investment grade credit ratings are generally referred to as leveraged lending, and include two broad loan purposes. The first is regular corporate lending. The second is event-driven financing. Leveraged loans are typically structured as five to seven year floating-rate balloon loans with limited amortization, which makes their performance highly dependent on refinancing conditions and the state of equity markets. While leveraged lending collapsed in 2008 from a peak of $680 billion in 2007, it has rebounded very quickly, and is now at record levels of volume, projected to be larger than $1 trillion in 2013. However, as of this writing, NAthe total amount of leveraged loans outstanding has remained flat since 2007, suggesting that the flow is largely related to refinancing of loans, in part due to lower interest rates, but also due to maturities.

Reinsurance. Reinsurance is the sale of risk from an insurance company to a reinsurance company. There are several motivations for reinsurance. First, reinsurance helps an insurer avoid concentrations in its own portfolio, permitting it to underwrite larger insurance policies by relaxing regulatory and economic capital constraints. Second, solicitation of third-party evaluation and pricing of risk can supplement the insurer’s own evaluation and pricing, reducing uncertainty about the risk. Third, when markets are segmented, the insurer can earn arbitrage profits. Segmentation can be driven by reinsurers who have more expertise or better diversification, permitting them to have better pricing. However, reinsurers can have a cost advantage for other reasons, including lower taxes and/or regulatory costs, as well as a greater risk appetite

Tri-party repo. A repurchase agreement (repo) is the sale of securities together with an agreement that the seller will buy back the securities at a later date. The distinguishing feature of a tri-party repo is that a clearing bank acts as an intermediary between the two parties to the repo. The clearing bank is responsible for the administration of the transaction.

Money market mutual funds. Money market funds are regulated by the SEC and have represented an alternative to bank deposits from investors’ point of view, with yields that are typically more attractive than bank deposits. The report investigates their history and the role of investment flows into and out of money market mutual funds, especially around the financial crisis.

Shadow banking in China. One area where shadow banking has been growing significantly is in China. In response to rapid growth in bank credit and concerns about inflation, the Chinese government put in place significant restrictions in 2010 on the traditional banking system through higher interest rates, tougher reserve requirements, and more conservative credit quotas.

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