Part I Summaries of the seminar
The workshop on "The climb of shadow bank" by Mr. Philippe Delhaise told us about some basic information of shadow bank, like definition, background, different appearances round the world, benefits and potential issues.
Definition
Before talking about shadow banking, we need to know about what's not shadow bank, or traditional finance institutions. Traditional lenders provide services like financing, payment, safekeeping of financial assets and so forth. Traditional banks have strict regulations for two significant reasons: an example may be to protect its depositors(depositors put their money in the bank rather than other place because they incapable to safeguard their investments or the business deal cost of traditional loan provider is relatively low weighed against other companies providing better service), while how much the lender can protect its depositors is determined by many factors, such as, if the loan provider itself is strong enough(whether it offers enough reserves or strong backup), the deposit guarantees plans or even if the government will provide emergency helps to the banks. Another is to control the way to obtain money, which is also employed by the central administration to keep up its monetary insurance policy. The governments want to regulate the supply of money because when loan provider lends out money, it'll develop a spiral of money. After the federal lose control of the supply of money, overheating in market or inflation might occur (for too much money supply and inadequate money supply, respectively).
Shadow banking does not mean underground banking or illegal business deal. There're different explanations about shadow bank, simply speaking, shadow banking is some companies lend money without being licensed to do so. The Financial Stability Board identified shadow bank as "credit intermediation involving entities and activities beyond the regular bank operating system". That's, shadow bank provides route without restrictions from the government, or even more market-based. The key difference between shadow bank and traditional banking institutions is which get together will need the financial risk when the borrower default.
Although shadow bank becomes a hot topic this season and the term was suggested in 2007 in the same way the financial meltdown in USA was about to explode, it's been existing for quite some time. As opposed to the word "shadow", it is visible in our daily life and legalized. The term can be used to summarized the novel financial transactions in USA, like repurchase agreements and other securities products, that happen to be also included in the services extended beyond your traditional channel by the banking institutions. Repurchase agreements deals, or "Repo" in short, is one appearance of shadow banking that are familiar in USA and Europe. Weighed against traditional commercial banking, the purchase costs is smaller and the efficiency is higher. Celebrations involved in the "Repo" specify the requirement on the security to keep the purchase efficiency. For instance, they use collateral tools that can build liquidity, value fluctuation and risk account easily in order to save time cost or do not need to set up a fresh one next time. Standard security are also urged because it will reduce the price to cope with collateral values maintaining issues and also help to reduce the threat of the lender. Change "Repo". While in China, IOU (short for "I own you") is about the most form of shadow banking. For instance, company A cannot borrow money from banking institutions easily due to its low credit while company B can borrow money from lenders without difficulties though it does not have any need to borrow money. Then company B can still borrow funds from bankers and then lend it to company A with charges. Because of this, company A can borrow money with higher interest rate but actually lower purchase costs. Although this type of loaning can help company A to build up, it still creates some dangers due to lack of regulation. Firstly, company A may default the loan, which bring costs to the lending bank or investment company and the depositors in exchange because the bank does not plan to lend the amount of money to company A with such low interest rate or exchange cost, or, the financing bank does not prepare well to deal with the default of company A with such low credit. Second of all, it may cause systemic risk. For example, using some repayment that is off-balance sheet liability like popularity draft will not be recorded to possess impacts on monetary policy. Finally, systemic risk and other effects can further result in shedding control of money resource.
In finish, shadow banking brings both benefits and potential issues. Firstly, shadow banking may lower the deal cost because in a free market, the price may lower to the equilibrium price. Second, it could help companies with little access to lend money in traditional way to raise money and develop, which improve the efficiency for your society. Thirdly, increasing needs from credit risk management and liquidity risk also requires the development of shadow banking system.
However, potential issues can't be dismissed as well. For traditional banking institutions, the rising of shadow bank actually threats their traditional services due to relative higher deal cost of traditional lenders and maturity mismatches. Shadow bank itself also bring dangers to unprofessional depositors and shareholders, especially those spend money on prosperity management products provided by traditional finance institutions because those depositors and buyers may not understand or be reminded that they have to take the financial risk themselves. Finally, government may also lose control of money resource, which has great impacts overall contemporary society as well.
Part II Analyzes and Discussions
Mr. Philippe Delhaise stands firmly that shadow bank brings more benefits than dangers and he believes that there's you don't need to put way too many regulations on shadow bank operating system because the market are designed for these types of problems. After doing some study of the huge benefits, potential risks and recommended legislation on shadow banking, I agree with Mr. Philippe Delhaise's comment that shadow bank has more benefits and it'll help the contemporary society to build up while I think that necessary rules are had a need to prevent problems brought on by potential risks.
Benefits of shadow banking
In "The Paradox of Shadow Banking"[1], Marcus Stanley listed the next benefits helped bring by the shadow bank operating system. Firstly, it allows the borrowers access to money besides regular banking institutions, which really is a much wider resource; secondly, shadow bank operating system provides different ways to convert illiquid possessions to cash, which means more easier ways are given; thirdly, investors can choose among risk-return tradeoffs products that have different opportunity and range relating to their own tastes. In this manner, more buyers will be attracted to the market, that will boost the level of available credits. Fourthly, the presence and development of shadow banking system also provides more professional services that are not (well) made by the regular banking companies. Such kind of functional diversification and specialization may help to increase the efficiency and better provide different clients. Previous however, not at least, with less rules, more complex technics may be well developed in the shadow banking system, that was also pointed out by Mr. Philippe Delhaise.
In "Shadows FORGET ABOUT: The Shadow Banking System Steps IN TO THE Spotlight"[2], Robert McNatt shown reasons behind lower purchase costs of shadow banking weighed against regular banks: lower requirement on capital due to different polices and market-driven requires.
Swati Ghosh, Ines Gonzalez del Mazo, and Inci tker-Robe brought up the idea that shadow bank also will serve as alternative money when regular bank experienced crsis, which in some way diversifies the potential risks in "Chasing the Shadows: How Significant Is Shadow Banking in Emerging Market segments?"[3].
Potential issues/risks
However, potential risks cannot be avoided so in retrospect necessary regulations are required. In [3], having less customer protection guidelines to limit rehypothecation of investments can lead to excess leverage, that may result in the surplus of money supply; procyclicality triggered by value fluctuations of possessions may amplify the instability of financial system; lack of direct formal support, the shadow banking system has difficulty in facing large-scale withdrawals; due to the complicated connection between shadow bank operating system and regular lenders, inability of either area may cause disasters to the other; since regular banking companies expands their services to shadow bank service, they may try to copy regulated service to avoid official regulation, which can make the regulation ineffective or even boost the dangers because clients or other financial areas feels that their services are under legislation.
Although the potential issues are apparent and dangerous, laws on shadow banking is still at the startup stage set alongside the fast development of shadow banking system. Here will list some legislation that are carried out in a few developed countries which were discussed in "Risk Taking, Liquidity, and Shadow Banking: Curbing Excess While Promoting Growth, Section 2"[2].
[
Current regulations
USA:
- prime institutional money market common funds will be asked to transact at a floating net advantage value and daily talk about prices float with the market-based value of the stock portfolio securities;
- Hedge against retained credit risk part are prohibited;
- Banks must calculate possessions of asset-backed commercial paper programs in their risk-weighted property;
Europe:
]
Principle of regulations
The Financial Stableness Board(FSB) proposed five general rules for regulators:
- Focus: The rules should target the potential risks that helped bring by shadow banking system. The regulator also needs to focus on if the proposed regulations will cause other risks(noticed that shadow banking system itself was fuled by complicated polices in traditional finance institutions);
- Proportionality:
- Forward-looking and flexible: Regulations should not be only made to fix the existing problem. It ought to be more versatile and able to fix the actual issues in the future. The rules system should keep rate with the fast development of shadow bank operating system;
- Effectiveness: Regulations are designed to avoid arbitrage opportunities that will take advantages of pests in legislation system like dissimilarities between financial systems. It should avoid creating new insects.
- Assessment and review: Regulators should gain access to the success and efficiency of the regulations, learn from other regulators and learn from the experience.
FSB also suggested 11 recommendations in 5 areas based on a detailed regulatory mapping exercise:
- Regulations on bank's interaction with shadow bank entities
Recommendation 1: Shadow bank services provided by banking institutions should be included in its balance sheet and this rule should be employed internationally.
Recommendation 2: Keep exposure to shadow banking under a limited portion.
Recommendation 3: Make certain the risk brought by shadow banking services can be assessed and recorded
Recommendation 4: Make sure the discussion between lenders and shadow banking services is transparent
- Regulatory reform of money market mutual funds(MMFs)
Recommendation 5: Further reform should be implemented
- Regulation of other shadow bank entities
Recommendation 6: Should bolster regulation on capital and liquidity for prudent purposes
- Regulation of securitization
Recommendation 7: Enhance transparency dependence on securitization products
- Regulation of securities lending and repos
Recommendation 8: Repos should be evaluated carefully for prudent purposes
- Other recommendation
Recommendation 9: Enhance monitoring on shadow banking activities
Recommendation 10: Enhance underwriting standards
Recommendation 11: Weakening the role of credit rating agencies
