May 18, 2011

Shadows No More: The Shadow Banking System Steps Into The Spotlight
Primary Credit Analysts: Nik Khakee, New York (1) 212-438-2473; nik_khakee@standardandpoors.com Jeffrey Zaun, New York (1) 212-438-2739; jeffrey_zaun@standardandpoors.com Joel C Friedman, New York (1) 212-438-5043; joel_friedman@standardandpoors.com Rian M Pressman, CFA, New York (1) 212-438-2574; rian_pressman@standardandpoors.com Robert Chiriani, New York (1) 212-438-1271; robert_chiriani@standardandpoors.com Chris C Cary, New York (1) 212-438-1894; chris_cary@standardandpoors.com

Table Of Contents
What Could Fuel Shadow-Banking Growth? Regulatory Changes Create New Opportunities Differences In Liquidity Support Transparency Is Uneven In The Shadow Sector

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The recent financial crisis shined a light on shadow banking that has grown brighter as the economic and political aftershocks of the crisis reshape the banking industry. In the absence of one financial regulator harmonizing the shadow-banking and traditional-banking sectors, Standard & Poor's Ratings Services believes shadow banking may be well positioned to take on a greater role in lending vis-à-vis the banking sector; it may try to advance the emerging opportunity to finance more assets that banks either can't or won't fund because of new regulation. This regulation includes the Dodd-Frank Act, the Basel III capital guidelines, and yet-to-emerge governance for the government-sponsored entities (GSEs) Fannie Mae and Freddie Mac. Here, we focus primarily on the U.S., but the two-tier system of banking and shadow banking is a global condition. We define shadow banking as the system of finance that exists outside regulated depositories, investment banks, or bond funds. It includes bank-sponsored intermediaries such as asset-backed commercial paper (ABCP) conduits, money-market funds, collateralized loan obligations (CLOs), finance companies, private investment funds, business development corporations (BDCs), asset managers, and hedge funds. The market determines the level of leverage and access to funding for participants in the shadow-banking system, which results in market-driven cost of funds. Given that, in our view, shadow-banking players differ from traditional banks in three important ways. They don't typically operate under bank regulatory supervision and thus often operate under differing capital, leverage, and liquidity guidelines. They don't normally benefit from government capital support, such as deposit insurance. And they don't benefit from the liquidity support available to regulated banks, such as the ability to borrow from the Fed. This lack of oversight and support was a factor in the difficulties some shadow-banking players experienced during the financial crisis. The trade-offs between shadow banking and traditional banking lending occur in areas of capital requirements, liquidity requirements, and reporting transparency. These differences create opportunities for borrowers and lenders to pursue the cheapest-cost, least transparent source of capital, and results in incentives to concentrate debt leverage that has led and may lead again to systemic events. Because traditional bank lenders have been busy building and maintaining capital, other funding avenues, including the public and private capital markets and the shadow-banking system, have begun to fill the void and may continue to do so. We also believe the shadow-banking system will grow because we expect some investors to continue to seek high returns by backing shadow-banking lenders. Some of that growth may be tied to capital sizing being focused on specific portfolios of assets, which we believe can be a positive if it is transparent to investors and regulators. Some of that growth may be tied to innovation that may focus more on regulatory arbitrage of capital, liquidity, or transparency as opposed to enhanced asset-and-liability management. Although there may be some benefits from growth in the shadow-banking system, such as financial innovation and lower-cost financing to corporate borrowers, we also see potential risks in this trend: If shadow banking isn't monitored rigorously, consistently, and transparently, the global financial system, in our view, could perpetuate the already entrenched two-tiered approach, with different regulatory, capital, and reporting requirements for traditional commercial banks and the components of the shadow-banking system. Under certain circumstances, that might destabilize the financial system. In addition, we believe shadow banks will likely have to overcome investor concerns about their access to capital, liquidity support, and transparency.

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A two-tier environment encourages regulatory and capital arbitrage, as borrowers compare and seek out the best possible terms. Shadow banks can have a low cost of funding that compares with banks'. For example, when shadow banks borrow in the commercial paper market, their cost of financing is comparable to banks' costs. In addition, shadow banks' capital may be less than bank requirements because of regulatory differences or market-driven differences in capital requirements. Traditionally, for instance, banks have had a lower cost of funding thanks to their base of deposits. The shadow-banking system can sometimes lend more cheaply at certain risk levels when it has less-stringent capital and regulatory requirements or lower market-driven capital requirements. This is what we observed leading up to the 2008 financial crisis. When the crisis was at its worst and asset values began to tumble, some large funds and investment vehicles could only stay in business by selling assets at steep discounts. At the same time, a number of banks that had warehoused billions of dollars worth of assets in various segments of the shadow-banking system found those assets hard to sell. But many banks globally ultimately received liquidity support from central bankers, including the Federal Reserve, while some shadow-bank players, ineligible for this support, collapsed. The danger, in our view, is that a two-tier regulatory system could, under similar conditions, lead to another cycle of failed financial institutions, depreciating asset prices, and losses. The share of corporate lending from the shadow-banking system is, we understand, still low relative to that coming from banks and when compared to the universe of shadow banking. Nevertheless, parts of the shadow-banking system will, we believe, continue to play a role in the fixed-income securities markets.

What Could Fuel Shadow-Banking Growth?
The Dodd-Frank legislation aims to strengthen traditional banks and help protect the U.S. financial system by boosting capital-adequacy standards, restricting certain of the more-risky bank activities, and increasing consumer protections and transparency. These regulations are likely to influence lenders (banks) heavily as they decide which activities they'll continue to finance. We believe that banks will seek to measure the profitability of noninvestment-grade corporate loans, other high-risk or complex loans, and financial contracts such as derivatives, and consider the evolving capital, liquidity, and transparency standards before deciding whether to continue these business lines. This may perpetuate the existing two-tier regulation, as some of this activity is likely to move into the shadow-banking system. Thus, we believe disintermediation of the banking system, which began decades ago, is likely to resume as resurgent shadow-banking firms bolster their balance sheets to take on business that the banks discontinue. Nobody yet knows what the new "normal" returns for traditional banks will be--just that they are likely to be lower than they are today. We believe investor appetite for higher risk-adjusted returns will likely spur growth in the shadow-banking system. A BDC, for example, is limited by regulation to no more than 50% debt leverage and typically operates with less leverage than banks do. A commercial bank typically can leverage assets up to 90% or 95% with debt financing (which for a bank is in the form of deposits). The amount of leverage available in other shadow-banking segments typically runs between these extremes. But shadow-banking participants could benefit from tougher bank capital requirements if their capital guidelines are less stringent than banks' and if they can generate higher risk-adjusted returns (reflecting the higher risk levels) for their investors. A limited number of BDCs, for example (see chart 1), and distressed-debt investment funds were able to expand their balance sheets during the financial crisis while many banks were shrinking theirs. That growth allowed them to diversify their investments and typically earn higher risk-adjusted returns for their investors than banks did, despite

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employing lower leverage. BDCs provided their investors with one of the few opportunities to be a part of a conservatively leveraged lending strategy during this period. Now that banks have started to lend once again, the competition between regulated and unregulated lenders has heated up and begun to help reduce borrowing rates on high-yield loans, which in turn makes them less attractive to firms outside of the traditional banking system unless such entities 'innovate' a way to be more cost efficient.
Chart 1

During the financial crisis, banks' balance sheets made lending a secondary objective to rebuilding capital, thus lowering firm-wide leverage. Loan demand has also been weaker during the crisis. In the absence of a supply of loans from banks and in the weakened economic environment, the yield on corporate loans climbed between 2008 and 2009. In that environment, we understand that shadow lenders were able to increase lending. However, in 2011, bank lending has resumed and lending in the shadow-banking system has slowed. In our view, one implication is that banks are able, once again, to lend at rates that start to crowd out shadow lending, while pricing that risk differently. However, despite the potentially tougher competition from banks, we have observed that some segments of the shadow-banking system have been growing recently, reflecting, in our view, a demand for certain levels of credit risk that banks aren't willing to fill. In addition, rising investor demand for higher yields has spurred rapid growth in various nonbank credit investment vehicles. In particular, private equity companies such as Blackstone/GSO, Fortress, and KKR have been aggressively growing credit-related business segments. Nonbank credit has met the general financing needs of corporations and specialty projects in the energy and pharmaceutical industries, among others. Many shadow-banking players are still smaller than they were before the financial crisis--notably the

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money-market funds, whose assets fell to $2.7 trillion at the end of 2010, from a high of $3.8 trillion in December 2008, as their low yields have made them less attractive to investors. But other components of the shadow-banking system that shrank during the crisis have begun growing in line with the economic recovery. For example: • BDC assets under management are still lower than they were in 2007, but are growing and neared $12 billion by year-end 2010. • CLO origination is much less than in 2007 but has resumed, and the prices of existing securities are recovering. • Banks have sold billions of dollars in assets they warehoused when structured finance markets seized in 2007, and have started again to finance asset-backed securities (ABS) receivables. • ABS issuance has increased since the credit crunch, though it's at lower levels than in 2007. • Finance companies are slowly starting to lend--and some have returned to the ABS markets to finance assets such as auto and credit card receivables. • Global hedge fund assets, which fell about 25% from their peak to $1.4 trillion in 2008, rebounded to $2 trillion in first-quarter 2011, mostly because of gains and inflows from credit funds. At the height of the financial crisis, the aggregate shadow-banking sector ("Other" in chart 1) accounted for almost 40% of total financial assets (as measured by the Federal Reserve). By December 2010, shadow banking had started to stabilize and rebound from its low of 30% (see table 1). Commercial banks' share of total financial assets fell gradually from its peak of almost 75% in the years following World War II to its low point in 2008, and has only recently begun to recover. An uptick in the quarterly share of shadow banking from 29.91% to 29.99% as reported by the Federal Reserve as of December 2010 may be small, but it is the first increase in shadow banking market share since December 2007 (see chart 2).
Table 1

Financial Assets Of Category/Total Financial Assets
Monetary authority Commercial banking Savings institutions and credit unions Money-market mutual funds ABS Finance companies Security brokers and dealers Funding corporations Other
Data as of December 2010. Source: Federal Reserve Flow of Funds Guide

(%) 6.42 37.67 5.64 7.21 6.42 4.17 5.43 6.06 21

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Chart 2

Regulatory Changes Create New Opportunities
We believe that changes in capital and regulatory requirements will prompt some banks to restructure their existing business lines. The Volker rule, which curtails proprietary trading, hedge-fund investing, and similar activities, in our view influences the ability to service trading demand but does not necessarily curtail demand for these activities. Therefore, it is likely to cause banks to off-load these activities into the shadow system. The derivatives business, for example, where banks issue interest rate, currency, or credit-default swaps, is a high-profile area of finance in which the shadow banking system might gain at the expense of banks. If that happens, the impact of such a shift, in our view, could be counter to the regulatory objective of increasing the transparency of potentially risky financial activities. Some banks will also likely decline to make riskier loans because they are anticipating that they will have to increase the level of capital required to do so under the coming Basel III guidelines. They could decide that they prefer lending to companies with stronger credit profiles, including alternative asset managers, private equity firms, or

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other shadow-banking lenders who then, in turn, might finance the companies no longer financed by commercial banks. We can see this already happening in the bank financing of BDCs. Riskier loans are not disappearing, just moving from banks to firms in the shadow-banking system with different capital guidelines. The residential mortgage-servicing business, for example, may also be pushed farther into the shadow-banking system. For banking institutions that need to be Basel III compliant, the capital requirements for holding mortgage servicing on their balance sheets will become costly. Therefore, we believe that banks may cede this business to companies that are separately capitalized and specialize in this business, even through they might fall outside of bank regulation. In addition, regulatory pressure on the GSEs, higher guarantee fees on Federal Housing Authority loans, and the emerging requirements for banks to hold a certain share of the home loans they originate may lead some banks to reduce mortgage lending sharply. Some of this lending could end up in the shadow-banking system, with banks lending through real estate investment trusts, separate nonconsolidated subsidiaries, or utilizing repurchase agreements to place home loans in nonbanks. Dodd-Frank has already led to the creation of the Consumer Financial Protection Bureau. That new bureau may end up regulating consumer finance products that until now have been either lightly or not regulated on the federal level. These include payday and other short-term small-balance consumer loans, private student loans, subprime auto loans, money transfers, debt collection, and prepaid debit cards. Finance companies are a good example of entities that may wind up partly in and partly out of the shadow banking sector. During the financial crisis, liquidity support from the government enabled banks to avoid selling their holdings of these assets at the bottom of the market. But that support wasn't available to the shadow-banking system. Although most areas of shadow banking appear to be on the mend, the segments most closely linked to mortgage lending, such as residential mortgage-backed securities, remain depressed. We don't expect to know how the shadow-banking system will end up participating in the housing market until the future of the GSEs is clear and new bank mortgage-lending guidelines are in place.

Differences In Liquidity Support
Banks generally operate with liquidity support that the shadow banking system lacks, and in our view, this makes a big difference when the financial system comes under stress. U.S. banks having access to the discount window at the Federal Reserve enabled them to avoid realizing losses through asset liquidation that money funds or other nonbank entities without such access could not avoid. A notable example of this took place in the fall of 2008, when the Reserve Primary Fund, a money-market fund that had invested in Lehman Brothers' commercial paper only returned $0.99 of every dollar investors had put into it.
Table 2

Short-Term Financing
Private investment funds No No Structured investment vehicles No Yes Money-market funds Yes (in form of shares) No

Primarily short-term deposit financed Primarily short-term commercial paper financed (liabilities, not assets)

Banks Yes No

ABCP No Yes

Hedge funds Varies with redemption restrictions Varies, but often done using prime broker financing

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Table 3

Liquidity Support
Banks Federal Reserve Discount Window Private investment funds Liquidity facilities Limited ABCP Liquidity facilities Full Structured Money-market investment vehicles funds Liquidity facilities Cash reserves Limited None Hedge funds Cash reserves, liquidity facilities Limited

Source of liquidity support

Liquidity support All eligible assets, coverage insurance for depositors

Transparency Is Uneven In The Shadow Sector
Not all shadow-banking activities are equally transparent. How varying levels of transparency will affect the operation of these institutions and investors' willingness to buy their debt remains to be seen. There are also differences between the transparency available to investors and to regulators (see table 4).
Table 4

Reporting
Banks Quarterly No Yes No Private investment funds Quarterly Varies Yes Yes Special-purpose vehicles Monthly or Quarterly Varies Yes No Hedge Money-market funds funds Monthly Quarterly Yes Yes Yes No Yes No

Reporting period Specific portfolio assets reported to investors or depositors General asset description reported to investors Disclosure of current prices for portfolio assets

There is no one measure of transparency. Even large, complex banks, which may release tens of thousands of pages of financial reporting each year, rarely reveal every corporate exposure they have to their investors. But that can happen with some shadow-banking participants, who offer a range of transparency. Some will provide data on specific assets and their prices to every investor, while others save that level of detail for major equity investors. At the same time the level of transparency available to regulators also differs, with banks receiving the most regulatory oversight and special-purpose vehicles--trusts or other entities set up to hold assets off balance sheet--the least (see table 5).
Table 5

Regulatory Oversight
Banks Private investment funds Special-purpose vehicles Money-market funds Hedge funds FDIC Yes No No No No SEC Yes Varies No No No Yes No No Yes CFTC Yes

In our view, one factor in determining an entity's financial strength and capabilities is its level of capitalization. The transparency of capitalization in the financial system's segments can differ greatly. But we believe transparency in this area is important if regulators are to improve their understanding of the assumptions behind an institution's lending activity and investors are to better evaluate the balance of potential risk and rewards. The ability to get the

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data needed to analyze the capital position of companies in the shadow-banking system, however, remains a mixed bag to investors, regulators, and the public alike. Transparency is already a focus of the Dodd-Frank Act, and the efforts to direct over-the-counter derivatives to exchanges and clearinghouses is representative of that initiative. Money funds, too, have increased existing transparency and adopted changes in accord with SEC 2a-7 in 2010, which include monthly portfolio disclosures to investors, among other increased disclosures. The recent financial crisis caused a run on the shadow system that forced many players out of business and significantly affected the economy. We believe that fuller transparency in segments of the shadow system could alleviate the potential for this to happen again. One way we see this happening would be if financial entities were regulated by function rather than institutional charter, so that a build-up of risk in any given product is not overlooked. An example is in corporate lending: Because loans do not trade through a central exchange, there is no "place" to observe the activity. Making bank and shadow-banking corporate lending disclosure more consistent and comparable could reduce the transparency trade-off that exists in the two-tier system. We believe such a paradigm, if achieved, could help reduce the risk of major financial dislocations. Writer: Robert McNatt

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