MMAF 522 Risk and Insurance

Student name: Trang Lu Student ID: 300258197

Victoria University of Wellington Shadow banking system from the angle of hidden leverage 30 March 2012

Assignment 1: Shadow banking system and its role in the Global Financial crisis

Topic: Shadow banking system from the angle of hidden leverage Years have passed since the global financial crisis (GFC) started to unfold in mid-2007, yet
major financial markets across regions are still struggling to shrug off the mass destruction left in its wake. The crisis is not remarked by the classic failures of too big to save financial institutions, but the collapse of the entire marketi. It is not described as mere old-fashioned bank runs among strictly regulated banking institutions observed in history but a wholesale panicii that has swept through a complex and opaque web of all financial intermediaries interconnected via a myriad of innovative financial instruments, while untouched by regulationsiii. In an attempt to describe the critical role of the shadow banking system in the GFC, this paper seeks to capture, in a brief manner, shadow banks from the perspective of their hidden leverage, driven by two key financial vehicles, namely asset securitization and derivatives, by answering three critical questions: i) what shadow banking is? ii) what encourages these shadow banks to build up excessive hidden leverage and most critically iii) how these two financial vehicles, in a process of increasing leverage, have sown the seed of the banking paniciv, causing contagious distresses and unavoidable defaults across the entire global financial market.

Firstly, the relationship between banking institutions and capital markets has become remarkably
intimate in the current market conditions; while underlying economic principals remain unchanged, it is distinguished that the playing field now takes place outside the strictly regulated banking systemv. Shadow banking system comprises the instruments, structures, firms and markets whichreplicate core banking activities, but without necessarily being subject to the prudential regulations applicable for banking institutionsvi. In other words, shadow banks are generally engaged in raising short-term liquidity funds, investing in long-term illiquid assets, operating at high leverage yet having no access to deposit insurance and under no regulatory

Assignment 1

MMAF 522 Risk and Insurance Student name: Trang Lu Student ID: 300258197

Victoria University of Wellington Shadow banking system from the angle of hidden leverage 30 March 2012

framework. As Lord Tuner - chairman of the Financial Services Authority put it, non-banks are not something separate from the core banking system, but deeply intertwined with itvii.

Secondly, pressured to increase lending capacity without any struggle to raise coefficient capital,
obtain low-cost financing, enhance creditworthiness and ultimately chase after higher returns in an increasingly competitive environment, banks came to exploit the credit risk transfer mechanismviii to transfer all interest rate risks and credit risks off balance sheet to those investors who have more appetite for higher risk-adjusted returns, and in a more reckless manner, to arbitrage regulations by creating an array of AAA-rated asset-back securities and establishing a host of asset-back commercial paper vehicles in a process of effectively scaling up their leverage. However, while these unregulated/shadow players managed to hide their mounting debt obligations, risks are not mitigated but only change hands, i.e. masked and amplified in an endless circle of originate-pack-insure-distribute-purchase activities among a complex chain of interrelated financial intermediaries.

To further explain how shadow banks have become excessively leveraged while untouched by
regulators, in the third part, the paper continues to shed more lights on two key vehicles that are strongly argued to have played a critical role in causing the evaporation of the capital supply in the matter of months during the financial turmoil.

On the one hand, asset securitization reflects the originate-to-distribute modelix in which
various types of banks contractual debts such as residential/commercial mortgages, auto loans or credit card debts, etc are packaged and sold to outside investors, in the form of securities that are backed by cash-flows generated by the amortization of the installments. Capital resources freed-up from this securitization process allow banks to continue granting new credits; in the meanwhile, special purpose vehicles (SPVs), established by those banking institutions to act like warehouses of those mortgage packages use resources from the issuance of asset-backed commercial papers bought by the money mutual markets to fund those purchases. And the spiral continues. Securitized debts became such a vital and indispensable financing toolx during the period 1998-2007, largely due to their intrinsic advantages over secured loans: i) lowering
Assignment 1

MMAF 522 Risk and Insurance Student name: Trang Lu Student ID: 300258197

Victoria University of Wellington Shadow banking system from the angle of hidden leverage 30 March 2012

financing costs for ultimate borrowers, and ii) receiving higher credit ratings due to their preferential treatment (exemption from creditor-sponsored bailouts) in bankruptcy, i.e. bankruptcy-remoteiv. In addition, it is this originate-to-distribute modelix that gives way to deteriorated lending standards in the sense that low quality loans are to be passed through, hence less prudent loan screening and monitoring processes. This is how subprime mortgages sneak into the securitization process and after being flavored with all sorts of tranches and ratings, become structured productsxi purchased by financial intermediaries that inherently have too little equity as a cushion. And this is also how asset securitization enables shadow banks to raise their hidden leverage at the expense of investors/creditors who may well under-price real risks embedded in securitized assets and/or hold unrealistic expectations of asset value, making the entire system prone to run, given any remote signal of withdrawal of resources and mistrust of short-term marketsxii

On the other hand, much like asset securitization, derivatives have become a vital financial
instrument in credit markets. Described by Warren Buffet as the financial weapon of mass destructionxiii , derivatives are largely and eagerly exploited by financial institutions to diversify credit risks of their portfolio and hedge against volatilityxiv. In its simplest form, derivatives are contracts between two parties that specify conditions under which payments are to be made, with common types being futures, terms, swaps, options and credit derivatives, etc. They are treated as off-balance-sheet items, require less stringent capital, offer much less transparency due to the absence of mandatory disclosure and be even more bankruptcy-remoteiv than securitized assets, hence incentivize shadow banks to build up excessive hidden leverage. However, when combined with securities and structured products, derivatives are associated with volatility and fragility in many ways. Warren Buffet (2002) indicated that for non-collateralized derivatives, the ultimate value depends on the creditworthiness of counterpartiesxii who might have been exposed to various types of risks themselves or who get involved in large-scale mischiefs in an attempt to use mark-to-market accounting to blow up earning figures, yet end up with markto-model due to the lack of a real market and far worse with what Warren called mark-tomyth. Also, both counterparties in derivative transactions face what Warren Buffet called a
Assignment 1

MMAF 522 Risk and Insurance Student name: Trang Lu Student ID: 300258197

Victoria University of Wellington Shadow banking system from the angle of hidden leverage 30 March 2012

linkage problem in that any default by one party can cause domino effects on the other(s), resulting in serious systemic runs. In addition, what has made the entire market more fragile is the unavoidable birth of virtual assetsxi of which risks and returns replicated the original assets without any need to actually own any of them, as argued by Dwight Jaffee, Anthony W. Lynch, Matthew Richardson and Stijn Van Nieuwerburgh (2009). In this manner, derivatives-backed credit assets are moved within the system, original risks are multiplied by an unknown factor and it is no longer possible to track who bears what risk(s) in the midst of the turmoil, as Andre Capon (2007) used to call this a circularity of risksx.

In a nutshell, it is convinced that asset securitization and derivatives together created the myth
that bank credit assets can be priced and traded as low risk on secondary marketsix. On the other flip of the coin, the robust growth of these innovative financial instruments on the back of the shadow banks ample interests in hidden leverage and the regulators failure to keep pace with their complexity and opaqueness have made highly leveraged banks become extremely prone to run. The fragile fabric of trust in the short-term markets that once glued shadow banks together then started to shred when triggered by the collapse of the subprime mortgage market during 2007. Far worse, it is shadow banks hidden leverage that magnified sub-prime mortgage writedowns, wiped out bank equity before cascading fire-sales of financial assetsxv started to wreak havoc on the entire financial environment. Word count: 1,298 (Word limit approved on 29 Mar)

Jeremy C. Stein (2010), Securitization, shadow banking and financial fragility, Daedalus, 139, pp. 41-51 + Gary B. Gorton (2009), Slapped in the Face by the Invisible Hand: Banking and the Panic of 2007 , YALE and NBER. Retrieved from www.frbatlanta.org/news/CONFEREN/09fmc/gorton.pdf iii Bill Gross, Founder and Chief Investment Officer of Pimco (2007),Beware our shadow banking system, Fortune Magazine. Retrieved from (http://money.cnn.com/2007/11/27/news/newsmakers/gross_banking.fortune/) iv Michael Simkovic (2009), Secret liens and the financial crisis of 2008, American Bankruptcy Law Journal, vol. 83 v Daniel Daianu, MEP and Laurian Lungu (2008), Background paper Why is this financial crisis occurring, How to response to it, Liberals and Democrats Workshop held by Alliance of Liberals and Democrats for Europe. Retrieved from (www.alde.eu/fileadmin/webdocs/key_docs/Finance-book_EN.pdf)
ii

Assignment 1

MMAF 522 Risk and Insurance Student name: Trang Lu Student ID: 300258197

Victoria University of Wellington Shadow banking system from the angle of hidden leverage 30 March 2012

vi

Eurofi Financial Services in Europe (2011), Shadow banking Improving the consistency of banking and non- banking regulations. Retrieved from (www.eurofi.net/pdf/2011/G20/Shadow_Banking.pdf) vii Lord Tuner (2012), Shadow banking faces reform. Retrieved at (http://www.cityam.com/latest-news/shadow-banking-faces-reform) viii Viral V. Acharya and Mathew Richarson (2009) Restore financial stability How to repair a failed system, Chapter 2 of How banks played the leverage game, by Viral V. Acharya and Philipp Schnabl (2009) ix Viral Acharya, Thomas Philippon, Matthew Richardson, and Nouriel Roubini (2009) Prologue: A Birds Eye View - The Financial Crisis of 2007-2009: Causes and Remedies. Retrieved from (http://www.scribd.com/doc/16921953/The-Financial-Crisis-of-20072009-Causes-and-Remedies) x Andre Capon (2007), quoted in Securitisation: When it goes wrong, The Economist, dated 22 September 2007 xi Dwight Jaffee, Anthony W. Lynch, Matthew Richardson and Stijn Van Nieuwerburgh (2009), Mortgage origination and securitization in the financial crisis Retrieved from (http://www.scribd.com/doc/16921953/The- Financial-Crisis-of-20072009-Causes-and-Remedies) xii Maryse Farhi et Marcos Antonio Macedo Cintra, (2009) The Financial Crisis and the Global Shadow Banking System. Retrieved from http://regulation.revues.org/7473 xiii Warren Buffet (2008), Warren Buffet on Derivatives. Retrieved from www.fintools.com/docs/Warren%20Buffet%20on%20Derivatives.pdfSimilar xiv Derek Thompson (2009), A Grand Unified Theory of the Financial Crash, (http://www.theatlantic.com/business/archive/2009/09/a-grand-unified-theory-of-the-financial- crash/26939/) xv Andrei Shleifer and Robert Vishny (2010), Fire sales in finance and macroeconomics, Journal of Economic Perspectives, vol. 25, pp29-48

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