In the wake of the 2008 financial crisis, which arguably constituted one of the most sweeping troubles in the financial sector to date, economists, banking experts and others struggled to find a satisfactory answer to a most exigent question: What, eventually, had caused the enormous breakdown to spread globally and shake the financial system.
Albeit many approaches to sufficiently rationalize the events have been conceived over the years, the most plausible causes being supposedly well-known, answering the question of “How?” or “Why?” still triggers controversy and a variety of opinions, mostly due to the sheer complexity of the financial system that renders it very difficult to give simple, clear explanations. There are, however, plenty of causes which many renowned and appraised experts regard as the main drivers of the financial crisis. One of the frequently mentioned ‘culprits’ is the market for securitized lending and shadow banking.
It is therefore the purpose of this essay to expound the role of this specific financial sector during the 2008 crisis in the attempt to explore the roots of the eventual turmoil on the financial market. To that end, the essay will follow a clear agenda: Firstly, the concept of securitized lending and shadow banking will be dealt with. The paragraph is devoted to a basic definition of both terms and a short outline of the underlying mechanisms and functions which the market is based on. A relatively brief analysis of the current market situation and its inherent weaknesses serve to refine the impression of this specific sector, however, the latter evaluation will have a rather general focus on the comparison with other financial instruments rather than drawing a direct line to the financial crisis.
The main body of this assignment embodies a thorough analysis of the eventual impact of shadow banking in the financial crisis, which will mostly consist of the discussion of two supposedly major contributing factors of the sector – the opacity of financial instruments and the lack of regulation. Lastly, a consideration of the consequences, e.g. reinforced financial regulation, is intended to conclude the analysis.
A final conclusion then will attempt to appropriately summarize and assess the findings of the essay.
2. The Concept of Shadow Banking and Securitized Lending
2.1. Overview
Although the term of “shadow-banking” has appeared abundantly ever since the financial crisis took place and has been subject to rather negative, accusative assessment for its supposed crucial role in the process, there are plenty of different, relatively vague definitions aiming to characterise the sector.
One of the definitions that frequently appears in several quotations on this matter was contrived by the Financial Stability Board (FSB), describing shadow-banking as “a system of credit intermediation that involves entities and activities outside the regular banking system”. (FSB 2011) According to this definition, shadow-banking therefore bears a few distinctive characteristics as part of the overall financial system:
– As with traditional banks, shadow banks do also offer credit and maturity transformation to their clients. Hence, they generally fulfil the function of credit intermediation just as their conventional counterparts, i.e. they serve as intermediaries between borrowers and lenders.
– However, the approach to funding in traditional banking and shadow banking is quite different. While the loanable fund model is prevailing in the former system, where in theory, banks use received deposits to create loans, shadow banks enable funding through non-depository channels such as securitized lending. This involves the use of financial instruments such as repurchase agreements, also known as “repos”.
– Furthermore, unlike depository financial intermediaries (i.e. traditional banks), shadow-banking institutions do operate outwith the realm of financial regulation, that is to say shadow-banks are generally neither supervised nor can they access liquidity through central bank funding, e.g. the discount window of the Federal Reserve. (Greenbaum 2016)
To conclude, shadow banks fulfil a purpose similar to traditional formal banks, however, their approach to intermediation is a vastly different one, relying primarily on securing loans with non-depository assets, while also lacking the regulation that other banks endure.
Shadow banking as a term entails a large variety of financial activities and entities, most notably securitization vehicles, money market funds, markets for repurchase agreements, investment banks, and mortgage companies. (Bernanke, 2012) As a rather broad and relatively complex system, we will focus primarily on the role that securitization and repo activities had to play in the crisis and refer to these as the shadow banking system, while being aware that the term is in fact more encompassing. In order to further understand the underlying mechanism of shadow banking, we will firstly explore on the concept of securitization, being a key element of the shadow banking system and a significant contributing factor in the crisis.
The term securitization denotes “the process by which tradable securities are created and introduced into capital markets. Such a process generally involves, typically, the isolation of a pool of assets and their repackaging into securities.” (Barrieu 2010) Evidently, the main purpose of such a pooling and tranching of assets is to basically categorize them by risk and transform them into usable securities. Securitization normally involves repackaging securities according to the inherent (default) risk associated with the underlying assets. According to Barrieu (2010), this allows investors to properly diversify their portfolio and to increase their return on investment.
Although the matter of securitization is quite expansive, we will nevertheless touch on the basic process and the participants involved.
As with many financing processes, borrower and lender partake in an exchange of cash and assets. The process itself begins with an originator that wishes to divest assets. These may include contracts which yield future payments, e.g. mortgage loans which in this way represent an asset on the balance sheet of the originator. Such assets can now be converted into securities through the creation of a so-called special purpose vehicle (SPV), a passive, legally constituted entity (Bannock, Manser 2003). In essence, this vehicle fulfils two major functions:
1) After the assets are transferred to the SPV, the latter then issues securities to investors which are, in turn, secured by the transferred assets. This step embodies the epitome of securitization, the transformation of assets into tradable bonds, being a primary responsibility of the SPV.
2) The investors, in return, pay a price to buy these securities. The proceeds from the securities sales will then be passed through the SPV to the originator, while the latter is responsible to transfer all cash flows related to the asset to the SPV. Ultimately, the SPV transfers these cash flows to the investors. Therefore, this entity more or less assumes the role of an intermediary between the borrower (originator) and the lender (investor).
The securities generated in the process may differ with respect to the underlying asset respectively collateral. If general assets back securities, they are referred to as asset-backed securities (ABS), although the probably most notorious of these are called mortgage-backed securities (MBS), collateralized by mortgage loans, which played an incontestable role during the financial crisis.
Contrary to the simple explanation above, securitization does not commonly transform a single asset into securities. Instead, several assets associated with different risk levels or ratings (e.g. AAA for high-quality assets) are pooled in the SPV before being repackaged into securities. Gorton and Metrick (2010) denote this step as the creation of a capital structure, by which the assets are channelled into different tranches according to their underlying risk.
In order to comprehend the actual trouble fuelled by securitization, it is important to note that this process may again be repetitive. Once assets have been transformed into tradable ABS and sliced into respective risk-related tranches, these securities are eligible for another pooling and repackaging, leading to the creation of yet another layer of securities. In the case of ABS, these securitizations are generally referred to as collateralized debt obligations (CDOs) which can again be sold to investors or, not unusual during the crisis, undergo further re-securitization. This series of slicing and recombining was, according to Gorton and Metrick (2012), contributing to the growing opacity of these financial instruments prior to 2008 which in turn they regard as a major root cause of the crisis to follow.
The shadow banking system does, in fact, rely on securitization in order to enable non-depository lending as suggested above. Those securities created by SPVs – being part of the shadow banking system themselves – are used by such institutions as collateral in loans to investors and therefore serve as an important basis for the funding and lending mechanism underneath.
2.2. The Rise of Shadow Banking
Before dealing with the actual causes of the crisis related to shadow banking, additional light will be shed on the market development over the last decades. This outline is intended to provide an impression of the undoubtedly growing significance of this sector in comparison with traditional banking.
Despite the vague definition and general difficulty regarding data access, as shadow banks are not subject to formal regulatory policies, literature suggests that the shadow banking system has experienced vast growth over time. According to Poszar et al (2010), the fraction of shadow banking in total financial intermediation rose from 10% in 1980 to approximately 60% in 2008. The following chart provides support to this claim, depicting the increase of shadow liabilities, related to securitization activity (ABS, MBS) as well as short-term money market funding (such as repo) prior to and after the financial crisis.
A look at the development of the U.S. shadow banking activities indicates two major findings: Firstly, the shadow banking system has continuously experienced an expansion in volume, surpassing that of the traditional banking sector in the early 1990s. Secondly, despite its incessant growth, there is a clearly visible surge of shadow banking in the years preceding the crisis, leading to a peak in shadow banking-related liabilities in the year of 2008. In the aftermath, a sharp decline can be observed.
Although the mere size hardly serves as an actual cause of the events in the subprime mortgage market and the ensuing financial crisis, it still points out how deeply embedded these activities were and how far their eventual impact would reach. Hence, alongside the foregoing hints at the fragility of the system, this point serves to support the claim that shadow banking played a significant role in the financial crisis.
2.3. Inherent risks of shadow banking
As with traditional banks, their shadow counterparts face a series of similar risks, including credit, maturity and liquidity risk. The probably most significant difference to conventional, regulated banks, however, is their lack of several safety measures implemented by a regulatory body such as deposit insurance or the aforementioned discount window of the Federal Reserve. While traditional banks can address their central banks in times of financial distress in which they are liable to face bankruptcy, shadow banks have no access to such instruments. Accordingly, it can be inferred that these institutions are subject to greater threats from a run when, all of a sudden, investors request withdrawal of their funds. This would potentially pose them at great risk since shadow banks had to fire sell their long-term illiquid assets in order to sell off their debts. (Roubini 2008) Such ‘fire sales’ of assets may incur further losses, amplifying the risk of bankruptcy.
Another aspect of risk is found in the lack of regulatory capital requirements which do not apply to shadow institutions. While conventional banks, especially in the wake of the financial crisis, are obliged to maintain a fair amount of capital as a means of protection against bankruptcy, shadow banks have traditionally been very highly leveraged as they were not subject to such regulations.
Finally, the shadow banking system has been perceived as a source of risk for its lack of supervision and a general poor amount of information on the scale of related operations, supposedly allowing these institutions to be “veiled”. Even though there have been dissenters to this view, the essay will further elaborate on this aspect and support the claim in the following section.
1. The role of Shadow Banking in the financial crisis
Pondering on the question of how or even whether shadow banking had an impact in the run-up of the financial crisis may not be uniformly lead to a single answer. In literature, there are several very diverse opinions on the matter. Gorton and Metrick (2012), for example, regard the entire crisis as a bank run on the repo market, where, according to them, investors intended to withdraw their provided funds rather quickly or demanded ever higher values of collateral, resulting in an increase of repo haircuts. Others, such as Coval et al (2009) deem the process of securitization as major contributing factor. In the following section, we will elaborate on two themes to explore on the influence of shadow banks in the crisis: the opacity of their products and the role of regulation.
3.1. Opacity of Structured Financial Instruments:
In many ways, especially in popular views, it can be argued that the growing complexity of structured financial products and related informational deficits had a major contributing role to play in triggering the eventual crisis. Gorton and Metrick (2012), as previously said, referred to the phenomenon of securitization as employed by SPVs prior to 2008 as a “veil” that was difficult to pierce through, especially at higher levels as seen in CDOs. This position is advocated by several authors (Coval, Jurek, Stafford 2009) Coval associates several risks with securitization, especially the tendency to repackage relatively risky assets into new securities that were widely believed to be rather safe, while, in fact, the default risk of these assets was often underestimated. Adrian and Ashcraft (2012) support this view, arguing that the plentiful, subtle steps of securitization make it difficult for investors to actually understand what risk resides in the security they own. As a result, credit rating agencies rated many of the tranches created very benevolently, further amplifying the problem. Another serious related issue that may have played a role in the financial crisis was default correlation. Coval et al (2009) points out the ill-based assumption in the financial world that default risk was, for the most part, limited to the very asset itself, whereas quite the opposite was the case. Among similar lines, Claessens et al (2012) identifies a build-up in so-called “tail risks” on account of the tranching process, exposing seemingly safe AAA tranches to considerable risk in case of low-probability events such as the simultaneous decline of house prices in the United States. Poszar et al (2010) ultimately connect the widespread belief in the safety of these securities with an inclination of financial institutions to hold back little capital as means of protection. A lack of transparency and the inability to look behind this “veil” may furthermore cause investors to flee potentially risky investments. This is particularly likely to happen in periods of distress and when the value of the underlying asset is in question. (Caballero and Simsek 2009)
Although this position appears rather intuitive, as the complexity of several financial securities during the subprime crisis might have sparked uncertainty about the true value of the underlying asset, there is no consensus in literature on this matter. In fact, some authors argue against this assertion, instead absolving the opaqueness of such instruments as the actual “culprit to be blamed”.
Holmstrom (2015) deems opaqueness of debt securities as a key feature of the related money market, describing the complex and intransparent nature of debt contracts as a inherent trait, where – in contrast to stock markets – price discovery is rendered insignificant due to the over-collateralization of debt. The resulting opacity of such instruments therefore minimizes the urge of investors to collect information which in turn may justify the rise of opaque financial products until the crisis. (Adrian and Ashcraft, 2012) Holmstrom refers to the confidence of investors in the value of the underlying asset as the most crucial aspect in keeping debt markets stable.
In any way, while there are definitely dissenters to the predominant view, I very much consider the issue of complexity in structured financial products to have at least contributed to the happenings of the financial crisis. The inability to directly ‘see’ the asset linked to several securities, further compounded by the repetitive securitization of those into CDO or CDO square, may have raised difficulty in evaluating these products. Shadow banking institutions such as SPVs accordingly might have caused fragilities in the market due to the intransparency of some of their concoctions.
3.2. The absence of regulation
Popular views often deemed, and in fact still do, the failure of sufficiently supervising and controlling the entirety of the financial sector largely responsible for the critical occurrences in the financial crisis. However, as we find such views to run regrettably frequently on impulsive emotions rather than rationality, we shall thoroughly explore on the lack of regulation in the shadow banking sector in an attempt to rationalize its unregulated nature.
Valckx et al (2014) regards tight banking regulation as well as the opportunity to facilitate financial intermediation as the main drivers conducive to the shadow banking system. Other sources back the impression of a growing demand this sector was intended to satisfy.
Albeit various approaches as how to address this problem have been put forward, a consensus has been reached on the issue of whether a reinforced regulation of the shadow banking system is vital. In fact, many authors (Claessens et al 2012, Valckx et al 2014, Gorton, Metrick 2012) agree on the matter that the events of the financial crisis call for a more attentive recognition of non-commercial financial activities.
The absence of regulation may pose problems in the following dimensions:
1) Difficulties in measuring the size, composition and growth of shadow banking activities
As most institutions of the sector operate outwith the realm of conventional banking regulation such as the Basel principles and therefore are not subject to the same close scrutiny as traditional banks, shadow banking activities, especially those until 2008, are perceived to be difficult to measure uniformly, as suggested by Claessens (2012). A more general problem associated with this seemed to be the overall poor recognition of the shadow banking sector as a whole until the crisis. The Association of German Banks (2014) hints in this direction, pointing out how late the FSB started to actually cope with this area of the financial market and contrived a definition no earlier than 2007.
2) Specific risks
It has been noted in 2.3. how non-bank financial institutions do not face the same capital requirements commercial which banks must adhere to, e.g. the regulatory framework of the Basel II/III principles. Valckx et al (2014) notes the increased risk of bankruptcy of these institutions on account of their high leveraging and illiquidity of assets, pointing at the aforementioned resulting phenomenon of fire sales of these assets as a compounding contributing factor in the crisis. This fast-paced deleveraging eventually led to the bankruptcy of the sector in late 2008.
Another significant inherent trait of the shadow-banking system that was mentioned in the introductory overview is the non-existent access to a general safety net in case of a run. Adrian and Ashcraft (2012) denote the existence of deposit insurance and the discount window of the Federal Reserve as such a net, the latter allowing depository banks to access liquidity from a central bank as a lender of last resort. The lack of these options arguably renders shadow banks more fragile in times of financial distress and panics as their inability to gain liquidity requires them to fire sell their assets instead.
4. Concluding remarks
All things considered, we can conclude that the shadow banking system, in all its sophisticated variety, has indeed left remarkable traces on the financial world since the crisis of 2008. This assignment has given a brief account of the role these institutions played and, to that end, incorporated the views of several authors on the matter. In this regard, it can be argued that shadow banks have contributed significantly to the run-up of the crisis in several dimensions, even though the sector is broad and the identified root causes are not the same, as some authors such as Coval et al refer to the role of securitization while others such as Gorton and Metrick spot the breakdown of the repo market as primary manifestation in the financial crisis. Most importantly, as we saw in the foregoing section, the impact of opacity of the related financial instruments and the inherent vulnerabilities of this area may have served as driving forces. While the complexity of shadow banking intermediation and its products apparently gave rise to complications regarding the appropriate evaluation of risk, the ‘natural’ weaknesses of the sector, such as the absence of supervision and operations outwith a general safety net, exacerbated the situation, as, to put it in simple terms, nobody really ‘saw’ the rise of non-banking activities or paid too little attention to their growth, which was, in fact, considerable.
In spite of these drawbacks, however, there are still few reasons to outright demonize the concept of shadow banking intermediation since these activities eventually have been established to satisfy a need.