Shadow Banking System - Risks or Vulnerability

Risks or Vulnerability

Shadow institutions are not subject to the same prudential regulations as depository banks, so that they do not have to keep as high financial reserves relative to their market exposure. Thus they can have a very high level of financial leverage, with a high ratio of debt relative to the liquid assets available to pay immediate claims. High leverage magnifies profits during boom periods and losses during downturns. This high leverage will also not be readily apparent to investors, and shadow institutions may therefore be able to create the appearance of superior performance during boom times by simply taking greater pro-cyclical risks. Money market funds have zero leverage and thus do not pose this risk feature of shadow banks.

Shadow institutions like SIVs and conduits, typically sponsored and guaranteed by commercial banks, borrowed from investors in short-term, liquid markets (such as the money market and commercial paper markets), so that they would have to repay and borrow again from these investors at frequent intervals. On the other hand, they used the funds to lend to corporations or to invest in longer-term, less liquid (i.e. harder to sell) assets. In many cases, the long-term assets purchased were mortgage-backed securities, sometimes called "toxic assets" or "legacy assets" in the press. These assets declined significantly in value as housing prices declined and foreclosures increased during 2007–2009.

In the case of investment banks, this reliance on short-term financing required them to return frequently to investors in the capital markets to refinance their operations. When the housing market began to deteriorate and their ability to obtain funds from investors through investments such as mortgage-backed securities declined, these investment banks could not refinance themselves. Investor refusal or inability to provide funds via the short-term markets was a primary cause of the failure of Bear Stearns and Lehman Brothers during 2008.

From a technical standpoint, these institutions are subject to market risk, credit risk and especially liquidity risk, since their liabilities are short term while their assets are more long term and illiquid. This creates a problem, as they are not depositary institutions and do not have direct or indirect access to the support of their central bank in its role as lender of last resort. Therefore, during periods of market illiquidity, they could go bankrupt if unable to refinance their short-term liabilities. They were also highly leveraged. This meant that disruptions in credit markets would make them subject to rapid deleveraging, meaning they would have to pay off their debts by selling their long-term assets. A sell off of assets could cause further price declines of those assets and further losses and selloffs. In contrast to investment banks, money market funds do not go bankrupt—they distribute their assets (which are mainly short-term) pro rata to shareholders if their net asset value falls below $.9995 per share. Only two funds ever have failed to pay investors $1.00 per share. The Reserve Primary Fund paid $.99 per share to its shareholders and another fund paid its shareholders $.96 per share in 1994.

The securitization markets frequently tapped by the shadow banking system started to close down in the spring of 2007, with the first failure of auction-rate offerings to attract bids. As excesses associated with the U.S. housing bubble became widely understood and borrower default rates rose, residential mortgage-backed securities (RMBS) deflated. Tranched collateralized debt obligations (CDOs) lost value as default rates increased beyond the levels projected by their associated agency credit ratings. Commercial mortgage-backed securities suffered from association and from a general decline in economic activity, and the entire complex nearly shut down in the fall of 2008. More than a third of the private credit markets thus became unavailable as a source of funds. In February 2009, Ben Bernanke stated that securitization markets remained effectively shut, with the exception of conforming mortgages, which could be sold to Fannie Mae and Freddie Mac.

U.S. Treasury Secretary Timothy Geithner has stated that the "combined effect of these factors was a financial system vulnerable to self-reinforcing asset price and credit cycles."

In January 2012, the global Financial Stability Board announced its intention to further regulate the shadow banking system, in the interests of the real economy.