Shadow Banking Failure of Regulation During the Sub-Prime Crisis Research Paper

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shadow banking system, its role in the subprime mortgage crisis, and failures of regulation within the shadow banking system. The term "shadow banking system" was coined by PIMCO's Paul McCulley in 2007 (Spanos, 2012) and refers to a banking system that includes financial intermediaries that are involved in creating credit across the global financial system, whose functions are not subject to regulatory oversight (Investopedia, 2012). The question has been debated as to whether shadow banking meets the definition of true banking. Given that the two systems perform similar functions, including credit intermediation and maturity transformation, the two should be considered parallel systems (Noeth and Sengupta, 2011).

The term shadow banking is used to describe any provision of credit taking place outside of the traditional deposit-funded lending system. This definition includes institutions that range from pawnbrokers and consumer finance companies to securities dealers as well as firms that issue corporate bonds. Regulators, however are most concerned with the system of institutions, instruments and markets that mirror commercial banking. Shadow banking does this by enabling funds borrowed from short-term sources, such as the money markets, to be invested in longer-term, less liquid assets. Institutions engaged in this form of shadow banking include investment banks, hedge funds, structured investment vehicles and issuers of asset backed commercial paper (ABCP) (Armstrong, 2010). Shadow banks also provide securitization and secured funding techniques through the use of collateral debt obligations (CDOs) and repurchase agreements (repos).

The shadow banking system provided sources of funding for credit by converting opaque, risky long-term assets into money-like, short-term liabilities. Pozsar, Adrian, Ashcraft, and Boesky (2012) argue that maturity and transformation in the shadow banking system contributed to the asset price appreciation in residential and commercial real estate markets in advance of the 2007-2009 financial crisis. In the course of the financial crisis, the shadow banking system was severely strained; in fact many parts of the system collapsed. This failure occurred because of credit intermediaries' reliance on short-term liabilities to fund illiquid long-term assets in what is an inherently fragile activity that is prone to runs. Shadow banking vulnerability is due in large part to its inability to access public sources of liquidity such as the Federal Reserve's discount window, or public sources of insurance such as Federal Deposit Insurance.

In the past, the shadow banking system has not been subject to regulation primarily because it did not accept traditional bank deposits. Consequently, many shadow banking institutions and instruments operated with higher credit, liquidity and market risks; at the same time they lacked capital requirements proportionate with those risks. Following the subprime mortgage meltdown in 2008, shadow banking activities have come under increasing scrutiny and demand for regulation (Investopedia, 2012). However, with regulated banks facing tighter supervision and stricter new capital rules, regulators fear that even more credit will move out of the regulated banking industry to the shadow system (Armstrong, 2010).

The shadow banking system functions to create credit through a complex process of securitization, the use of commercial paper, and the repo market, as opposed to the traditional bank model that uses deposits to fund loans. Securitization allows illiquid assets like mortgages to be converted into tradable asset-backed securities. Once these assets are converted to securities, shadow banks can then use them as collateral to borrow short-term money from money market funds or in the repo market, with the resulting cash used to fund other lending activities (Armstrong, 2010).

The functioning of shadow banking is significant in part dues to its size. Precise estimates are not available, but research from the Federal Reserve Bank of New York estimated the size of the shadow banking system to be around $16 trillion in liabilities during the first quarter of 2010. This amount exceeded the size of the traditional banking system, which was estimated to have about $13 trillion over the same period. The $16 trillion figure represents a decline from $20 trillion, the estimated size of the shadow banking market before the global financial crisis (Armstrong, 2010).

Many experts believe that a run on the shadow banking system triggered the global financial crisis. Regulators are therefore concerned with the safety of the shadow banking system because, unlike traditional banking, there is no safety net of deposit protection schemes to prevent bank runs. When the global crisis unfolded with U.S. subprime mortgages beginning to default in 2007, shadow banks experienced increasing difficulty in using securities linked to subprime mortgages as collateral in the repo market. This difficulty in turn meant their losing access to their primary source of funding (Armstrong, 2010).

With the failure of Lehman Brothers, investors, fearing their level of exposure, took their cash out of money market funds. In the face of stronger capital rules and tighter supervision resulting from the crisis, regulators believe that even more money will flow out of the traditional banking sector into the shadow banking system (Armstrong, 2010).

Shadow Banking and the Subprime Crisis

For a financial crisis to occur, multiple intermediaries have to fail simultaneously and thereby disrupt the operations of a particular financial market. This disruption is usually the result of a detrimental external factor that affects many institutions simultaneously, or a problem in one institution spreading to others through some internal contagion mechanism. Each individual institution may fail due to investment risk, hedging risk, counterparty risk, or liquidity risk. With liquidity risk, the institution is unable to sell assets at fair value due to time constraints (Hsu and Moroz, 2009). The shadow banking system failed due to a liquidity crisis in 2007 that resulted from bank runs.

Bank runs, which had largely been eliminated through various policy measures began to reemerge during the subprime crisis. A bank run may be defined as a swift loss by an institution of deposits or other short-term financing, which loss causes it failure from lack of liquidity. Even though the traditional bank run may be thought of as depositors lined up outside a retail bank branch, the concept of a bank run applies to other scenarios as well. Examples could include mutual fund investors who all decide to redeem their shares at once, or a hedge fund that finds no lenders willing to roll over its repos, or a conduit that finds itself unable to sell short-term commercial paper to refinance expiring obligations (Hsu and Moroz, 2009).

The contagion mechanism that fuels bank runs can be caused by an external economic problem, such as the default of a few banks causing direct losses at counterparties, or lower prices on assets held by other banks due to fire-sale liquidations. These problems reduce the amount of liquidity in the system. Most countries address the problem of bank runs by providing government guarantees for deposits up to a certain amount. Such guarantees work because once depositors do not bear the risk of a loss, they no longer have an incentive to withdraw at the first sign of trouble (Hsu and Moroz, 2009).

Bank runs on the shadow banking system were a significant factor in the spread of subprime losses to the overall financial system. Because of their illiquid assets, highly leveraged shadow banks suffered from the loss spiral effect by which they were forced to deleverage because of higher margin requirements along with falling asset prices. Deleveraging in turn increased margin requirements and reduced asset valuations, thereby fueling the next round of the loss spiral (Hsu and Moroz, 2009).

While some experts believe that the run on shadow banks caused the subprime crisis, others argue instead that it was only the trigger. That is, the subprime crisis was responsible for setting off a run in the shadow banking market, which was and is susceptible to runs. Bank runs result from crises in depositor confidence, occurring when creditors become concerned that their bank is insolvent and therefore rush to get their money back. Because of FDIC insurance, such runs do not occur with traditional banks. In the shadow banking market however, in the absence of deposit insurance, massive institutional depositors require collateral to secure their deposits, such as AAA mortgage-backed securities. The demand in shadow banking for collateral drove the escalating demand for mortgage-backed securities (Klein, 2010).

Stein (2010) argues that the subprime crisis did not so much expose a flaw in the basic concept of securitization as it did expose the "reckless and excessively complex way" in which it was applied to subprime mortgage loans (p.3). The subprime crisis also demonstrated that traditional banks use shadow banking for the purpose of regulatory arbitrage, that is, a purposeful attempt to avoid rules that dictate how much capital banks are required to hold.

Another aspect of the shadow banking system involves its effect on the money supply. Typically when one thinks about the money supply, one thinks of the Fed's measures of actual money, M1, M2 and so forth, as well as the various determinants of how money moves through the system, such as multipliers, Fed funds rates, reserve requirements etc. However debt plays a role too; if banks…

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