The banking system was considered to be stable before the great financial crisis of 2007. The banking system faced the worst turmoil during that period due to the evolution of the nature of banking activities. Banks started to employ diversify their sources of income. Before 2007, the one and only function of banks was to take deposits and lend money. Diversification of banking returns included many off-balance sheet activities and non-interest incomes into the features of the banks. The extra features are collectively known as shadow banking because of the lack of transparency in it. These activities increased the borrowing and lending and eventually, everyone was in a financial turmoil.
"The advent of shadow banking has fundamentally altered the nature of banking. Where once banks weremainly in the traditional business of taking deposits and making loans, they have come to rely on marketorientedand off-balance-sheet activities to generate a major share of their income."(Calmes et al. 2011, 1)
According to Calmes and Theoret, shadow banking changed the nature of the banking operations from primary lending and deposition to numerous off-balance sheet activities and non-interest methods of earning income. The trend of disintermediation has a lot to do with the advent of shadow banking. The banks started to securitize funds for people to preserve their profitability and to expand their non-traditional lines of business.(Calmes et al. 2011, 1)
As mentioned earlier, shadow banking consists of off-balance sheet activities that are non-interest income earning methods.
Off-balance Sheet Activities
"A salient feature of commercial banking over the last several decades has been the growth and evolution of off-balance sheet activities. Generally speaking, off-balance sheet activities unbundle the intermediation process. The key implication for our purposes is the on-balance sheet assets may no longer be a reliable indicator of bank's role in financial intermediation."(John. H et al. 1995, 2)
According to Boyd and Gertler, off-balance sheet activities open up the process of intermediation. In these kinds of activities, banks go beyond the traditional way of lending money to people and instead, they start giving that money to other financial institutions which give some commission to the banks. (John. H et al. 1995, 2)
In addition to that, the banks may also give backup of credit or guarantees to other financial institutions. This role of the banks is further supported by the shift of working capital lending from banks to commercial paper market. The banks are still involved in the lending but they just provide backup of credit or guarantees for the borrowers.(John. H et al. 1995, 2)
The off-balance activity that has grown more than any other activity of its kind is providingof financial derivatives. This may be considered as the conventional asset transformation task that a bank performs, but the difference here is that provision of derivatives is not recorded in a bank's balance sheet. Interest swap is an example of these derivatives.(John. H et al. 1995, 2)
Changes in non-interest income
"The behavior of non-interest income reflects the rising importance of off-balance sheet activities. Total bank income can be expressed as the sum of net interest income (earnings from balance sheet assets net of interest costs) and non-interest income (non-interest earnings from off-balance sheet activities)"(John. H et al. 1995, 2)
In the point-of-view of Boyd and Gertler, total bank income is the sum of interest-based earnings through activities that are recorded in the balance sheet and non-interest earnings through shadow banking and hidden activities.(John. H et al. 1995, 2)
The changes in the proportion of non-interest income to total income has changed significantly since the beginning of shadow banking. This ratio was stable in 1960's and 70's but went up from 20% to 33% in 1992. This shows the importance of off-balance sheet activities and how these activities increased.(John. H et al. 1995, 2)
Reasons behind the Shift to Shadow Banking
"The first cause, as mentioned previously, stems from the increased risk banks took with their new business lines; risks that were largely underestimated.The second reason was the overleveraging of banks off-balance-sheet (OBS) activities, which compounded bank risk.Under the 1988 Basel Accord, which imposed new regulatory capital standards on banks, regulatory capital arbitrageincreased, giving an incentive to financial institutions to use new conduits, such as off-balance-sheet activities thatrequired less capital than commercial loans."(Calmes et al. 2011, 1)
According to Calmes and Theoret, the first cause that propelled the banks towards shadow banking was the risks that they were beginning to take by opening up new business lines. They were unbundling the process of intermediation by lending to other financial institutions off the record rather than lending money to the people directly.(Calmes et al. 2011, 1)
Secondly, the off-balance sheet activities gave the financial institutions the incentiveto operate at lower capital. This relaxation the minimum capital requirement was seen as a prospect by the banks and they started these shadow activities. Moreover, these activities compounded the interest gained by the bank as it now included another intermediary that would be paying the bank. Thus the profitability and the lesser capital requirement of these off-balance sheet activities pushed the banks to give them a try.(Calmes et al. 2011, 1)
Effects of Off-balance Sheet Activities on Financial Stability
The off-balance sheet activities and financial stability have an inverted relationship.
"There are two complementary approaches in the literature to capturing the interaction between banking distress and the real economy. The first emphasizes how the depletion of bank capital in an economic downturn hinders banks' ability to intermediate funds. Due to agency problems (and possibly also regulatory constraints) a bank's ability to raise funds depends on its capital. Portfolios losses experienced in a downturn accordingly lead to losses of bank capital that are increasing in the degree of leverage. In equilibrium, a contraction of bank capital and bank assets raises the cost of bank credit, slows the economy and depresses asset prices and bank capital further. The second approach focuses on how liquidity mismatch in banking, i.e. The combination of short-term liabilities and partially illiquid long-term assets, opens up the possibility of bank runs. If they occur, runs lead to inefficient asset liquidation along with a general loss of banking services."(Nobuhiro et al. 2013, 2)
"Banks' off-balance sheet (OBS) activities, and in particular securitization, have fuelled the last lending boom, enabling banks to increase their operational funding. This eventually led to a standard liquidity crisis driven by maturity mismatch."(Calmes, & Theoret 2011)
"Banks' individual response to external shocks can lead to common patterns increasing systemic risks -- especially when disaster myopia is at work. For example, it is now widely admitted that the 2007 credit crisis has been severely accentuated by banking strategic complementarities in the face of regulatory constraints. Indeed, the growth in securitization, trading and cross-selling of the largest U.S. banks holdings fed a systemic risk bubble up to its breaking point."(Calmes, & Theoret 2011)
So, according to Gertler and Kiyotaki, there are two ways in which the banking distress and its relationship with the real economy can be analyzed. The first one is related to the diminishing of the capital of a bank. This makes the bank incapable of fulfilling its job as an intermediary. The lack of funds due to low capital eventually leads to losses. This raises the cost of credit and slows down the economy. The increased degree of leverage exacerbates the problem and the economy decelerates even further.(Nobuhiro et al. 2013, 2)
The second approach is how liquidity mismatch causes distress in the banking system. If the short-term liabilities and long-term assets are not combined in a correct ratio, they may lead to bank runs. Bank runs cause loss of banking activity in an economy which, in turn causes the economy to slow down due to higher…