Another Federal Reserve paper on shadow banking emphasizes its systemic risks. In particular, shadow banking seems to have a tendency to accumulate tail risks, relies on fragile funding conditions (without official backstop), and is subject to pronounced pro-cyclicality. Shadow banking activity is tied to core regulated institutions and, hence, is a valid concern for broad financial stability.

“Shadow Bank Monitoring”, Federal Reserve Bank of New York Staff Reports, No. 638, September 2013
 http://www.newyorkfed.org/research/staff_reports/sr638.pdf

For the basics on shadow banking view post here. 

The below are excerpts from the report. Cursive text and emphasis has been added.

The case in a nutshell

“The shadow banking system consists of a web of specialized financial institutions that conduct credit, maturity, and liquidity transformation without direct, explicit access to public backstops. The lack of such access to sources of government liquidity and credit backstops makes shadow banks inherently fragile. Shadow banking activities are often intertwined with core regulated institutions such as bank holding companies, security brokers and dealers, and insurance companies. These interconnections of shadow banks with other financial institutions create sources of systemic risk for the broader financial system.”

The rise of shadow banking

“The official definition of shadow banking was recently formulated by the Financial Stability Board (FSB) as ‘the system of credit intermediation that involves entities and activities outside the regular banking system’

“[The] traditional form of financial intermediation, with credit being intermediated through banks and insurance companies, but with the public sector standing close by to prevent destabilizing runs, dominated other forms of financial intermediation from the Great Depression well into the 1990s…Over time, financial innovation has transformed intermediation from a process involving a single financial institution to a process now broken down among several institutions, each with their own role in manufacturing the intermediation of credit. With specialization has come significant reductions in the cost of intermediation, but the motive to reduce costs has also pushed financial activity into the shadows in order to reduce or eliminate the cost associated with prudential supervision and regulation, investor disclosure, and taxes.”

“According to the FSB exercise, the global shadow banking system…grew exponentially in the years prior to the crisis, rising from $26 trillion in 2002 to $62 trillion in 2007. The system shrunk during the crisis, but it is reported at $67 trillion in 2011. Moreover, the data indicates that the shadow banking system represents about 25% of total financial intermediation, down from its peak at 27% in 2007.”

The relation between regulated banks and shadow banking

“The standard narrative of shadow banking is that traditional banks lose their centrality in the process of intermediation, and they get replaced by specialized providers of intermediation services along the chain… if modern intermediation requires an enhanced role for, say, specialty lenders, underwriters, asset managers, money market funds, insurance companies, etc., then an existing banking organization may adapt by incorporating such entity types under common ownership and control… Consequently, the locus of intermediation activity is not confined within the balance sheet of a commercial bank, but it is to be found within the broader footprint of more complex bank holding company organizations.”

Regulated bank entities also maintained an important role in ‘feeding’ the shadow banking systems, in their role at loan origination. Bord and Santos (2012) show this in their study of the role of banks in the originate-to-distribute model of credit intermediation. The authors document that more than 75 percent of syndicated credit lines are bought by syndicate participant banks and that they stay with those banks after three years.”

The inherent fragilities of shadow banking

“Because they are tailored to take advantage of mispriced tail risk, shadow banking institutions accumulate assets that are particularly sensitive to tail events…Evidence from psychology and behavioral finance argues that market participants are fundamentally biased against the rational assessment of tail risk… Neglected risks are one way to interpret the widely perceived risk-free nature of highly rated structured credit products, such as the AAA tranches of ABS.”

“The financial frictions that lead to excessive risk taking and exacerbated credit losses during downturns also interact with the fragility of funding. Per definition, funding sources for shadow banking activities are uninsured and thus runnable. In many ways, the fragility of shadow banks due to the run-ability of liabilities resembles the banking system of the 19th century, prior to the creation of the Federal Reserve and the FDIC.”

Shadow bank leverage tends to be high when balance sheets are large and credit intermediation is expanding. Furthermore, equity is countercyclical, both in the theory and in the data, as intermediaries tend to hold as little equity as possible during booms, but are forced to raise equity during downturns when the market risk increases. Adrian and Boyarchenko (2012) also document the close link between intermediary balance sheets and asset prices. Over time, expanding leverage tends to coincide with compressed risk premia and inflated asset prices. In busts, risk premia widen, generating asset price busts. In addition, market volatility is countercyclical. As a result, the funding of intermediaries tends to collapse during times of crisis.”

“The splitting up of intermediation activity across multiple institutions, as is done in the shadow banking system, has the potential to aggravate underlying agency problems. In particular, it is typically costly to convey complete and accurate private information about the credit quality of a borrower between financial institutions.”