By FS Staff
Shadow banking is back in the news. First there are ongoing problems in China where bad loans outside of the traditional banking system are causing increasing financial strain. Then, here in the U.S., regulators are also becoming more concerned about the rising use of leveraged loans by non-bank intermediaries or things like peer-to-peer lending, where the largest such company in this space, Lending Club, just filed for an IPO.
In order to gain a better understanding of these potential risks and how they come to pose a threat, shadow banking expert Laura Kodres from the IMF tells Financial Sense Newshour that forms of shadow banking are "definitely picking up." Although we're not yet back to the same levels reached in the last financial crisis, she warned "it's certainly in that upward direction."
Since shadow banking activities are also closely tied to low rates and the search for yield, in order to prevent financial disruption going forward, Laura explains below that it will be very important that Fed rate hikes are done gradually and communicated in a clear manner. Of course, the longer we stay at these levels, the greater the risks become.
Here's everything you ever wanted to know about this subject and more:
Financial Sense Newshour: Laura, do you mind explaining how the IMF or other institutions define shadow banking?
Laura Kodres: The definition that I find most useful is one that the Financial Stability Board uses, which basically defines shadow banking as credit intermediation involving entities and activities outside of the regular banking system. I think embedded in this definition there are three risks that can make shadow banking problematic: maturity risk transformation, credit risk transformation, and liquidity risk transformation. And since shadow banking is by definition outside the banking system, it's usually not subject to the same oversight of these risks and generally doesn't have a public backstop when these risks materialize in an outsized way. Some of these definitions of shadow banking rely expressly on this notion of an absence of a public sector backstop…although, to be frank, some of them were backstopped during the crisis so it's not a never-never type of deal. So, the typical shadow banks in the United States would be considered things like money market mutual funds, private label securitization, tri-party and bi-lateral repo arrangements, some types of special purpose vehicles that can be off the balance sheet of banks or off-balance sheet of other types of financial entities: finance companies and mortgage brokers. Those would be the most typical type.
FSN: Can you quickly explain the role shadow banking played in the prior financial crisis?
LK: It's pretty clear that shadow banking did play a very large role in the last financial crisis and, to be fair though, the root cause of that event really was what I would call poor loan origination… We could talk probably 20 minutes on this topic alone but let me just sort of give you a very small snapshot of the elements of shadow banking that occurred in the crisis. Clearly, what was going on was there was a credit extension to households that in many cases probably shouldn't have happened and they were offered very advantageous loans. But then those loans were packaged and distributed both in the United States and abroad and that aggravated what would've otherwise have been probably a fairly isolated problem. And why were those loans able to be originated? Well one is that it was spurred on by an abundance of funds that came from the shadow banking system. A lot of them came through wholesale types of arrangements, most notably money market mutual funds where they were originated by large cash pools… So, what ultimately happened is there were a set of events where there was a lot of liquidity going for relatively low quality loans, not just in this country but in other counties as well-Spain and Ireland are classic examples. But what occurred was that this collapsed when people started to question the true value of this underlying collateral both for the repos and for what were then well-used asset-backed commercial paper and that was used mainly by the money market mutual funds. And some of that asset-backed paper was actually being backed by the securitized products that were being produced in these chains. So it became unclear who was holding the asset. It became unclear who was supplying the liquidity. It was unclear whether or not those people or institutions supplying the liquidity would continue to do so. And that just led to a complete freeze in wholesale funding markets, which then led to fire-sales of a lot of assets to generate the needed liquidity. This implied of course that there were losses on some of these balance sheets that became more commonly known and then we ended up with retail runs on money market mutual funds, certain banks, and the general undercapitalization of a lot of major institutions.
FSN: Focusing on some of the regulatory efforts that have been done since the financial crisis, what have been some of the intended and unintended consequences of these efforts?
LK: Well, I think the intended consequences are pretty easy and we can point to just a couple of them to make our lives simple. Money market mutual funds are clearly less risky than they were pre-crisis. And that's largely because they are now limiting the amount of maturity transformation they can take on. Banks are less exposed to shadow banks partly because if they are engaged with them then they are holding more capital against the types of activities that are present there. Certainly there's a lot more transparency in a lot of dimensions. Credit rating agencies are much more transparent. Bank stress tests are routinely done and available. Information on repo transactions and the underlying collateral is now posted at the NY Fed. Financing costs are now more transparent. And clearly the amount of leverage in the system is somewhat less. Banks have been forced to really de-lever. And shadow banks have not re-levered in complete opposition to the banks deleveraging. So, those are all intended consequences. On the unintended consequences, those are a little less obvious. But I would point to the lack of private sector securitization of mortgages as an unintended consequence. I think the market is basically defunct. It hasn't taken off. There are a few of these securitized products on residential mortgages coming out now but they are relatively few and far between. There are probably at least two reasons for that: one is that investors are quite skeptical about the products now so they are very careful about the types of securitized products they are willing to purchase and most of those are now being done by Freddie and Fannie. And so with that public backstop sitting behind them-really public ownership at this point-those are very safe entities; they are very safe instruments to invest in. But the other side I think is maybe not attended to enough and the other side is the supply side. Securitized products are now very costly to produce. There's a lot of this new regulation that's in play and my personal view is that it ended up being overregulated. And why did that occur? Well, it occurred because each of the regulators saw a separate problem that they needed to attend to. So accountants said, "Oh, well this is because these things are off-balance sheet. Let's put them back on the balance sheet." Others said that banks need to hold more capital against these securitized products. Securities regulators said we need more skin in the game so we need to put in these higher retention rules. Then, lastly, others said, "You know, maybe the problem was with ratings agencies," so there's been a host of rating agency regulations about transparency and observing what's in these things and how they're rated and exactly how they're priced. And so with this panoply of regulation you've found that it's sort of made this too costly to engage in and if you talk to the private sector individuals that have been doing this activity, they're looking at it saying, "Well, I'm not sure it's worth it." So, I think we should've taken a step back and considered how all these regulations fitted together as they were being formed rather than simply putting them all on the books in order to attack one or a few of these problems in an isolated manner.
FSN: So, a lot of regulation has been passed in the U.S. since then and, like you say, there's been an element of overregulation since each of them are trying to attack it from a different angle. Now, with that said, has the growth in shadow banking in recent years and even the increased use of leverage, which you touched upon a little bit, has that become a concern once again and what are some of the best ways we can prevent a rerun of the last financial crisis?
LK: Certainly this notion of are we back to where we were then is a tough question. Data show that some forms of shadow banking are definitely picking up. Repo activity for instance is definitely on the rise again. In the U.S. it's not quite where it was at the peak of the last crisis but it's certainly in that upward direction. And leverage is being taken on in different forms. Leveraged loans are an example where we are concerned that the criteria underneath them are now again a little bit looser than they've been in the past and that's a concern. Some new intermediaries are rising to replace banks in the loan business itself. You mentioned earlier KKR. There are a number of entities, be they hedge funds, private equity, insurance companies, and we're seeing peer-to-peer lending schemes come to play. Some ETFs are now holding loans as their underlying collateral. So we're seeing a number of new players, or maybe old players taking on these new roles in the lending business itself, and that deserves a careful examination going forward to see how much lending is being done through these channels and whether the risks are being appropriately priced. In other countries we do see more lending through non-bank channels as well. And let me point to China, which is probably the most worrisome case of this. For a while now we've been able to identify that the shadow banking going on there has been going through what are called wealth management products. And these products are sometimes associated with banks, sometimes not, but they offer much higher returns to investors than do the regular deposits which are limited to about 75 basis points of interest. Now there's even a newer concern that they have an electronic payment system much like PayPal in the United States and by the press of a button you can take all of the money sitting in the equivalent of a PayPal account and sweep it into a money market mutual fund. And it's a little bit unclear what these money market mutual funds are investing in. Some of them appear to be investing in relatively short-term paper like commercial paper as in the United States and other places that have money market mutual funds. But some of that commercial paper is really backing longer-term loans, some of it public loans. And so it's a little bit unclear whether or not the on-a-dime redemption ability to put your money back into your PayPal account or your equivalent will be a problem. So that's one area of concern when it comes to run-risk where you have this maturity transformation and perhaps not good transparency of the risks being undertaken. Other countries in Asia for example have finance companies that are now lending a lot of money to usually small- and medium-sized enterprises and households that are perhaps not able to go to a regular bank. Much of this is a natural progression of development in these countries. On the other hand, in many cases there's less oversight and the data of how much of this activity is really going on is lacking and so there are inherent uncertainties about what risks these potential avenues pose.
FSN: Many say that one of the root causes for shadow banking, or for growth in the shadow banking market, is the search for yield in a very low interest rate environment like we have currently. How should we expect this to evolve should interest rates stay low for much longer and is it really just simply a matter of raising interest rates at this point?
LK: That's the big question that's facing many people. The first question is, "When will the Fed raise rates?" and the other one is, "What will the effects be?" And clearly this is a thorny issue, but before we delve into that let me point out two things about the rise of shadow banking. One is that it's not new. We've had shadow banking around for a very long period of time. We may have not named it that but we've certainly seen non-bank credit intermediation going back decades. And certainly if we look at the development of countries overall, what we observe is they mostly start out as bank based financial institutions and financial markets and then they move into non-banks and there's a natural progression in which non-banks provide credit to the society at large. So there's a natural developmental issue here that goes on in most countries. Another sort of driver of shadow banking if you will is what I would call regulatory arbitrage or the notion that banks are more highly regulated than non-banks. And the differential regulation often pulls some types of intermediation into the non-banking area. The rise of money market mutual funds in the 1980s was really the result of Regulation Q, which limited the interest that savings banks could pay on deposits in the United States. Exactly that same restriction in China is what's driving its shadow banking system now. They've loosened the lending rate but they still have a regulatory constraint on the deposit rate. So there are some of these more structural issues going on in the background. I would also point to a demographic issue. In many aging populations of which there are many, not just in the United States...but even in China and India they are having an aging demographic issue; and in many cases there's either not a safety net or people haven't saved enough so there's a natural inclination to search for yield even without having a low interest rate environment. So we have a bunch of things underpinning the rise of shadow banking, which I think is a secular trend not a cyclical trend. At the same time, certainly a cyclical component of a very low interest rate environment is also relevant. We see that there is a growth in various types of instruments during a low interest rate environment and we're experiencing that now with for example these higher yielding ways of making money through loans by having them in private equity funds and so on. How much of the growth would be slowed if rates were to rise? Well, certainly some of the incentives to go outside of the banking system would be lessened if rates were higher and I think we could all agree that the direction would be toward money flowing back into the banking system out of the shadow banking system. How much? I really don't have a very good feel for how much. I would suggest that this rise in rates would be less disruptive to the financial system as a whole, not just the non-banking system, but the traditional banking system if the rise is communicated clearly, if it's gradual, and especially if it's against a backdrop of rising economic growth and a healthier housing and labor market. So depending on how it happens will depend a lot on whether or not this ends up being disruptive for the shadow banking area or the banking area as well. My hope is that this will unwind in a nice and safe and sound manner. The opposite would be that we continue to see very very low rates and people taking higher risk as this low rate environment remains in place. We are seeing that in pockets of the U.S. economy and pockets in various countries of the world. So I can't give you a complete answer for that but I would expect that the search for yield and the cyclical component is one component of several components that are driving the shadow banking area.
FSN: If you were to summarize the situation that we are facing with shadow banking currently, what would be the main message that you think investors and listeners to our show should come away with?
LK: Well, the first thing that I would want to emphasize is that shadow banking is not a pejorative word in our financial lexicon. There are certainly positive aspects of shadow banking. Credit intermediation outside of the banking system is a perfectly acceptable method of doing credit intermediation assuming that the risks associated with it-and those are those three risks: maturity transformation, credit transformation, and liquidity transformation-are appropriately understood, they are risk managed properly and they're priced properly. If we go back, many people wouldn't own cars in this country if it weren't for a financial arm like GM and Ford have or they wouldn't own refrigerators if Sears didn't exist with their credit cards. So it's pretty obvious that a non-bank credit extending arm of our financial system is an important element of just general growth. The issue that we'll need to pay close attention to is whether or not the risks of shadow banking are dangerous when they contribute to excessive credit growth or when there are uncertain ownerships of that risk, including their connection to the regulated and backstopped banks. And hence those sorts of uncertainties and those sorts of credit extensions can lead to disruptive financial behaviors such as runs. Those risks are real. And it's true that they have the capacity to reach the levels that they reached in the last crisis if they're allowed to play out to their fullest extent. I think we already have in place things that will limit the amount of credit extension in the banking system and I think we are paying more careful attention to how risks arise and how to mitigate them in the shadow banking system as well. I would have a slight cautionary note here and that is that it's really easy for non-banking institutions to morph into different kinds of institutions and exactly the way that leverage is undertaken and how it's manifested is different in every crisis. And so, one needs to be very flexible and consistent about monitoring the actual products that are being innovated or coming out of these institutions, how they're being used, why they're being used, and who they're being used by. And that's not the kind of information that you normally have in the data reports-that's the information you get from interviews and sort of the soft side of oversight. Often we get tired of learning from our mistakes and somehow we need to instill diligence in this process of monitoring. And I would also leave your listeners with the notion that I think it's really important to pay attention to people who have lived through past crises. It's amazing how many pieces of wisdom and knowledge they have having lived through earlier crises and they can see the connections between what happened this time and what happened in 1998 or what happened in 1994 and so on. So keeping these people in the room and keeping their histories and their insights alive are an important element in preventing future mistakes from happening.
FSN: Thank you for coming on and providing your insights for our listeners. I do know that the IMF produces a Global Financial Stability Report. Would you mind giving our listeners a little more information on that?
LK: Sure. We've been doing this for a very long time. I think when I first came to the Fund in 1994 it was called the International Capital Markets Report and that was the unit I worked in and then recently I oversaw the more current version of it called the Global Financial Stability Report. It comes out twice a year: usually in the spring sometime in April and usually in the fall sometime in October. It's associated with our annual meetings so it's usually released the week before the annual meeting. Just as a plug, the next GFSR will in this fall have an entire chapter on shadow banking and it will even look at how to think about the respective factors that go into the rise and fall of shadow banking in a more empirical fashion, so I think some of the questions you posed might be better answered in that forthcoming chapter.
FSN: Where can they find the IMF's next Global Financial Stability Report?
LK: You can find it at www.imf.org and if you just scroll a little bit down on the right hand side we have three flagships: the World Economic Outlook, the Global Financial Stability Report, and the Fiscal Monitor.
FSN: Thank you again for coming onto Financial Sense Newshour and speaking with us.