The Shadow Banking System

Out of the shadows: How banking’s secret system broke down
By Gillian Tett and Paul J Davies
Published: December 16 2007 18:33 Financial Times

When the New York markets open on Monday, all eyes will be on Wall Street’s banks. As the US Federal Reserve, in a bid to ease the liquidity crisis, holds a novel type of money market auction to inject some $20bn of funds into financial institutions, investors and policymakers will be watching closely to see how many large banks bid for how much cash – and what that, in turn, indicates about their state of health.

Yet while investors are scrutinising some of the industry’s best-known names, a spectre will be silently haunting events: the state of the little-known, so-called “shadow” banking system.

A plethora of opaque institutions and vehicles have sprung up in American and European markets this decade, and they have come to play an important role in providing credit across the financial system. Until the summer, structured investment vehicles (SIVs) and collateralised debt obligations (CDOs) attracted little attention outside specialist financial circles. Though often affiliated to major banks, they were not always fully recognised on balance sheets. These institutions, moreover, have never been part of the “official” banking system: they are unable, for example, to participate in Monday’s Fed auction.

But as the credit crisis enters its fifth month, it has become clear that one of the key causes of the turmoil is that parts of this hidden world are imploding. This in turn is creating huge instability for “real” banks – not least because regulators and bankers alike have been badly wrong-footed by the degree to which the two are entwined.

“What we are witnessing is essentially the breakdown of our modern-day banking system, a complex of leveraged lending [that is] so hard to understand,” Bill Gross, head of Pimco asset management group recently wrote. “Colleagues call it the ‘shadow banking system’ because it has lain hidden for years, untouched by regulation yet free to magically and mystically create and then package subprime loans in [ways] that only Wall Street wizards could explain.”

By any standards, the activities of this shadow realm have become startling. Traditionally, the main source of credit in the financial world was the official banks, which typically forged business by making loans to companies or consumers. They retained this credit risk on their books, meaning that they were on the hook if loans turned sour.

However, in the past decade, this financial model has changed radically. On the one hand, banks have increasingly started to sell their credit risk to other investment groups, either via direct loan sales or by repackaging loans into bonds; at the same time, regulatory reforms have permitted the banks to reduce the amount of capital that they need to hold against the danger that borrowers default.

The net consequence is that the western financial system embraced what Paul Tucker, head of markets at the Bank of England, has described as the age of “vehicular finance”. This system has given banks huge incentives to pass on their loans to new vehicles, either by creating these themselves or by sponsoring outside fund managers to run them.

The role of such entities in creating credit has increased vastly in the past three years. For example, the asset-backed commercial paper market, which supplies the lion’s share of funding to SIVs and conduits in the form of cheap, short-term cash, saw a step-change in growth at the end of 2004. The volumes of such paper in issue had fluctuated between $600bn and $700bn for at least four years; at the market’s peak this summer they stood at almost $1,200bn.

“The shadow banking world has expanded at an amazing rate,” says Bob Janjuah, credit analyst at Royal Bank of Scotland, who estimates that these shadow banks could have accounted for half of all net new credit creation in the past two years in the US.

Because these vehicles typically borrow heavily to finance their activities, they have also been a key reason why leverage – or debt levels – across the financial world has risen so fast without regulators, or ordinary investors, being fully aware of this boom.

The involvement of hedge funds, themselves highly geared, as providers of the equity at the foundations of this system illustrates why shadow banking can have such an outsized impact on the supply of credit. Satyajit Das, an author and derivatives industry expert, cites an example where just $10m of real, unlevered hedge fund money supports an $850m mortgage-backed deal. This means $1 of real money is being used to create $85 of mortgage lending – credit creation far beyond the wildest dreams of high-street bankers.

Since SIVs and CDOs have never been in the business of gathering deposits from customers, their significance to the economic and financial system has not been widely recognised by regulators and policymakers. However, the huge expansion of the SIV and conduit industries in particular was fuelled by short-term debt bought by so-called money-market funds. Retail investors, schools, hospitals and pension funds have placed billions of dollars in such funds, yet none of this system comes under bank regulations.

The problem now is that the business model behind parts of this shadow banking world looks increasingly shaky, particularly among the SIVs. There is huge concern in the US that some of these money-market funds might not return all the money people have entrusted to them. “You have a whole pool of investors who have been putting their money into SIVs thinking that they were as safe, or even safer, than real banks,” says the head of investment banking at one big financial institution.

The role of regulators in this world was to a great degree replaced by the credit rating agencies, which awarded high, ultra-safe ratings to the debt issued by SIVs and other vehicles on the basis of historical analysis of the probabilities of defaults and losses across the shadow banking system.

However, this year’s credit turmoil has brought ratings downgrades to many of these instruments. “It’s clear that we can no longer solely rely on an investment’s credit rating when making management decisions,” says Alex Fink, chief financial officer of a state fund in Florida that was recently forced to freeze withdrawals after investors pulled out $13bn amid concerns over its exposure to securities backed by subprime mortgages. The securities had held top-notch ratings.

But it is not just in Florida or even the US where such pain has been felt – money-market funds run by BNP Paribas and Axa of France were among the first to freeze withdrawals back in August. It is a process that some regulators, such as Axel Weber, the Bundesbank president, liken to an old-fashioned “bank run” – albeit one that is now happening in the shadow bank sector rather than at visible high-street names.

The result of this is that the shadow banking sector is now shrinking at an even faster rate than it grew. The SIV sector has seen assets fall in value by as much as $150bn from a peak of more than $400bn, while the asset-backed commercial paper market itself is almost $400bn off its peak in July.

T he almost inevitable demise of the SIV is unlikely to trouble many regulators in the long term, but in the short term it leaves policymakers and bankers with a big problem.

Precisely because the sector has been so widely ignored in recent years, there has been relatively little debate about who might be responsible if it ever ran into problems. After all, SIVs – like other parts of the “vehicular finance” world – do not have any right to call on central banks as lenders of last resort, since they are not part of the official banking system.

Most of these vehicles, and the shadow banking sector as a whole, is supported by back-up liquidity lines with “real” banks – promises to lend money that bankers never imagined they would have to deliver on. Only now are these private-sector “lenders of last resort” being fully tested, as can be seen in the moves by HSBC and Citigroup, among others, to take tens of billions of dollars of lending back on to their balance sheets. Such rescues are taking place in spite of banks’ continued protestations that they have no legal responsibility to act.

This illustrates the huge level of uncertainty about exactly what banks will do and when – uncertainty that is compounded by the opaque nature of the vehicles themselves. For investors, regulators and central bankers – let alone for politicians – it is impossible to predict how this process will play out.

“As 2007 comes to a close, banks are having to deal with an expansion of their balance sheets, via an unwinding of SIV assets or retention of loans that banks are currently unable to sell,” says David Brickman, analyst at Lehman Brothers.

T his uncertainty has sparked money markets tensions – prompting the Fed’s action on Monday. But it is also creating concern about whether banks will soon cut their lending to the real economy – thus hurting growth.

Some investment bankers insist that the outlook is not so dire. After all, while the subprime mortgage-linked world has seized up – in Europe as much as the US – activity in other parts of corporate lending remains relatively robust. Indeed, investment vehicles linked to corporate debt, such as collateralised loan obligations (CLOs), remain a bright spot in the broader securitisation markets.

But central bankers are clearly concerned. The BoE’s Mr Tucker referred in a speech last week to a series of recent papers by the US economists Adrian Tobias and Hyun Shin, which argue that the credit cycle will be amplified by the kind of balance-sheet management employed by the shadow banking sector and modern banks themselves. “When the music stops, the process [of credit expansion] can be reversed as falls in asset values, leverage and liquidity feed on each other,” said Mr Tucker.

One thing that is clear is that regulators are facing mounting pressure to change their attitude towards these “shadow” banks. Hector Sants, chief executive of the UK’s financial watchdog, said last week that regulators’ ability to monitor the financial system had been hampered by banks’ use of “opaque” off-balance sheet financing and that this “needs to be addressed”.

There is also growing debate about whether a system that relies so heavily on non-bank lenders should also have some kind of “buyer of last resort” to stand behind the markets, much as central banks do for the banking system.

“Lending has become disintermediated to the extent that in many sectors the majority of lending is done not by banks but by investors. So if there is a run on the markets through the evaporations of liquidity, who is there to step in and provide that liquidity?” asks Alexander Batchvarov, head of structured product research at Merrill Lynch. “Previously we saw a similar situation with the collapse of LTCM. Today it is structured finance. Tomorrow it will be something else. Maybe we can study this crisis and come up with some form of structure that in future can perform that liquidity-providing, buyer-of-last-resort role.”

In some ways, the co-ordinated actions of the central banks in coming days are already supplying funds for this – but on a very modest scale given the size of the problem. Consequently, in the months ahead regulators and financiers will face mounting pressure to make the system of “vehicular finance” less complex and opaque. One result of the 2007 credit shock, in other words, is that the shadow banks will become less shadowy in the future.

As Pimco’s Mr Gross notes: “Investors should anticipate that the shadow’s successor will be a more conservative, less risk-oriented banking system.”

Copyright The Financial Times Limited 2007