Shadow Banking System - Credit Derivatives Facilitate Extension of Credit

Credit Derivatives Facilitate Extension of Credit

The shadow banking system also conducts an enormous amount of trading activity in the OTC derivatives market, which grew rapidly in the decade up to the 2008 financial crisis, reaching over US$650 trillion in notional contracts traded. This rapid growth mainly arose from credit derivatives. In particular these included:

• interest rate obligations derived from bundles of mortgage securities
• collateralised debt obligations (CDO)
• credit default swaps (CDS), a form of insurance against the default risk inherent in the assets underlying a CDO; and
• a variety of customized innovations on the CDO model, collectively known as synthetic CDOs

The market in CDS, for example, was insignificant in 2004 but rose to over $60 trillion in a few years. 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. Despite the prevalence and volume of this activity, it attracted little outside attention before 2007, and much of it was off the balance sheets of the contracting parties' affiliated banks. The uncertainty this created among counterparties contributed to the deterioration of credit conditions.

Since then the shadow banking system has been blamed for aggravating the subprime mortgage crisis and helping to transform it into a global credit crunch.