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By David Friedman

A new paper argues that the so-called “shadow banking” system is partially to blame for the recession, and it proposes some regulatory reforms not presently addressed in the Dodd-Frank legislation.

Given the complex nature of the topic, this blog post will be the first in a series of three posts examining the various issues the paper raises. This post will focus on what the shadow banking system is and how it came to be, the second post will focus on why we should care about the shadow banking system, and the third will focus on proposed regulatory reforms.

The paper is written by two Yale School of Management professors, Gary Gorton and Andrew Metrick. Its principal claim is that there are certain features of the shadow banking system which caused problems in the financial markets over the past three years, but which have not been addressed by any current legislation, and therefore need attention. They write:

In its broadest definition, shadow banking includes familiar institutions [such] as investment banks, money-market mutual funds, and mortgage brokers; rather old contracts, such as sale and repurchase agreements (“repo”); and more esoteric instruments such as asset-backed securities (ABS), collateralized-debt obligations (CDOs), and asset-backed commercial paper (ABCP).

They further explain the reasons for the rise in shadow banking:

One force came from the supply side, where a series of innovations and regulatory changes eroded the competitive advantages of banks and bank deposits. A second force came from the demand side, where demands for collateral for financial transactions gave impetus to the development of securitization and the use of repo as a money-like instrument. Both of these forces were aided by court decisions and regulatory rules that allows securitization and repo special treatment under the bankruptcy code.

So, there are three main components of the shadow banking system, which I will briefly review below: money market mutual funds (MMMFs), securitization, and the repo market.

Money market mutual funds provide short-term liquidity to financial intermediaries, but are not regulated in the same way as banks are regulated. Money market mutual funds seek to maintain a net asset value of $1.00 per share; prior to September 2008, no money market mutual fund, save one, “broke the buck.”

Gorton and Metrick note that “MMMFs were a response to interest-rate ceilings on demand deposits (Regulation Q).” More information on Regulation Q, which has since been repealed, can be found here. In short, since banks were prohibited by law from paying interest rates above a certain ceiling, the private market developed alternative vehicles for large investors to manage short-term liquidity needs, namely, money market mutual funds, and so these vehicles operated outside the regulatory purview of the FDIC and other banking regulators. Further, the government’s response in the midst of the crisis was to guarantee these unregulated investment vehicles:

The government made good on the implicit promise [of MMMFs maintaining their $1.000 per share value] by explicitly guaranteeing MMMFs, and it may not be credible for the government to commit to any other strategy in the future. As long as MMMFs have implicit and free government backing, they will have a cost advantage over other insured deposits.

The paper defines securitization as:

The process by which traditionally illiquid loans are sold into the capital markets. This is accomplished by selling large portfolios of loans to special purpose vehicles (SPVs), legal entities that issue rated securities in the capital markets, securities that are linked to the loan portfolios.

An originating firm lends money to a number of borrowers….[Then] a portfolio of loans is selected for the purpose of securitization. This step is the “pooling” of the loans into a portfolio. The portfolio is then sold to an SPV….The SPV finances the purchases of these loans by selling rated securities in the capital markets. These securities, called tranches, are ranked by seniority and have ratings reflecting that. The whole process takes the loans that traditionally would have been held on-balance sheet by the originating firm and creates marketable securities that can be sold and traded via the off-balance sheet SPV.

As with MMMFs, securitization is a process that occurs outside of the regulatory purview of the banks’ regulators, yet is essentially a banking function, in that it provides a source of liquidity to the entity which previously had the loans (assets) on its balance sheet.

Finally, repurchase agreements, colloquially called “repo” are agreements which allow borrowers to use a financial security as collateral in order to get a loan at a fixed rate; it is another source of liquidity and is, again, outside the purview of banking regulators. The paper notes that the repo market grew because of

the rapid growth of money under management by institutional investors, pension funds, mutual funds, state and municipalities, and nonfinancial firms. These entities hold cash for various reasons, but would like to have a safe investment, which earns interest, while retaining the flexibility to use the cash, in short, a demand deposit-like product. In the last thirty years these entities have grown in size and become an important feature of the financial landscape.

In short, these three products–money market mutual funds, securitized investment vehicles, and repurchase agreements–have become sources of liquidity for holders of large amounts of cash and they occur outside of the “normal” banking system, and so are more or less unregulated by traditional banking regulators. The amount of leverage used and the opacity of the various transactions have been implicated in the financial crisis.

The next blog post in this series will investigate why regulators, and, more pertinently, individual investors, should care about the shadow banking system. Finally, the third and last post will examine proposed regulatory reforms.

Source: Why We Must Care About the Shadow Banking System