| 2013 |
||ADDITIONAL SUPPORTING MATERIALS IN 2013
SHADOW BANKING - Safe Harbor Privileges
The roots of shadow banking 01-16-14 Enrico Perotti
The ‘shadow banking’ sector is an ill-defined financial segment that expands and contracts credit outside the regulatory perimeter.
- It was critical in the build up and demise of the credit boom.
- Shadow banking operates outside the regulatory perimeter,
- It replicates the structure of banking in many ways.
- Even proper banks use them to avoid stricter capital requirements,
- Shadow banking assets at the time of the crisis had grown larger than the banking sector proper.
- While much reduced since 2008, in the US its size still exceeded bank assets in 2011.
- The rapid withdrawal of funding to this segment played a major role in the credit crunch of 2007-2008.
- As such, its prudential standards should be brought into alignment to avoid further regulatory arbitrage.
- The decision by the Basel committee in these days to accept a relaxed definition of the leverage ratio, for which banks lobbied fiercely, appears a serious setback.
Defining shadow banking by function
By definition, shadow banking is not a precise category. In this column, I focus on financial intermediaries that take credit risk.
Banks acquire illiquid risky assets, funding them with inexpensive, demandable debt.
- Most investors prefer safe, short term and liquid assets, so banks can use cheap funding, by promising liquidity on demand.
- This is made credible by deposit insurance and access to central bank refinancing.
Confidence on immediacy ensures that demandable debt is routinely rolled over, thus supporting long-term lending and high leverage.1
As bank credit volume is constrained by capital ratios and deposit base, financial markets have thought of new ways to carry risky assets on inexpensive funding. Shadow banking requires creating a variant of demandable debt, credibly backed by a direct claim on liquidity.
But the dominant funding channel is issuing collateralised financial credit, such as repos or derivative-based claims.2 This is the source of shadow banks’ very short-term, inexpensive funding source.
How can these liabilities deliver investors credible liquidity upon demand?
Jump the running queue: Superior bankruptcy rights
Security-pledging (the collateral part of collateralised financial credit) grants access to easy and cheap funding thanks to the steady expansion in the EU and US of “safe harbour status” – the so-called bankruptcy privileges for lenders secured on financial collateral.
Critically, lenders in this collateralised financial credit transaction can immediately repossess and resell pledged collateral. They also escape most other bankruptcy restrictions such as cross default, netting, eve-of-bankruptcy and preference rules (see Perotti 2010).
- These privileges ensure immediacy for their holders.
- Unfortunately, they do so by undermining orderly liquidation, the foundation of bankruptcy law.
The consequences became visible upon Lehmann’s default, when its massive stock of repo and derivative collateral was taken and resold within hours. This produced a shock wave of fire sales of ABS holdings by safe harbour lenders. While these lenders broke even,3 their rapid sales spread losses to all others, forcing public intervention.
When the safe harbour provisions were massively expanded in a coordinated legislative push in the US and EU (Perotti 2011),4 they supported an extraordinary expansion of shadow banking credit and mortgage risk taking. The guaranteed ease of escape fed the final burst in maturity and liquidity mismatch in the 2004-2007 subprime boom, where credit standards fell through the floor.
Borrowing securities to generate collateralised financial credit
While shadow banks expanded with securitisation, they can also rely on the liquidity of assets they do not own. They do this by borrowing securities from insurers, pension and mutual funds, custodians, and collateral reinvestment programmes.5 In exchange, the beneficial (i.e. real) owners of such securities receive fees for lending the assets and they book these as yield enhancement. Borrowed securities are then pledged to ‘repo lenders’ (the short name for credit grantors in a collateralised financial credit transaction) or posted as margins on derivative transactions.
Experienced asset managers who lend securities in this way protect themselves via collateral swaps, i.e. a related transaction where the security borrower pledges collateral of lower liquidity. This so-called ‘liquidity risk transformation chain’ (which transforms illiquid assets into short term credit) may have more links.
The financial logic behind the liquidity risk transformation chain is clear. Security pledging activates the liquidity value of assets from long-term holders who do not need it. Such extraction of unused liquidity value may be seen as enhancing “financial productivity”. It certainly increase asset liquidity, and boosts securitisation. Yet this can be an illusory gain, flattering market depth in normal times, at the cost of greater illiquidity at times of distress.
The repo lenders and security lenders typically require a more than one-to-one exchange to protect themselves against the possibility of the collateral losing value. These ratios are called ‘haircuts’ since each $1 of collateral generates less than $1 of credit.
Shadow banking runs: Rising haircuts
A jump in market haircuts, and ultimately a refusal to roll over security loans or repos, is the classic shadow bank run.
- As a security borrower cannot raise as much funding from its own illiquid assets, it is forced to deleverage fast or goes bust.
In both cases this triggers fire sales.
- Once repo lenders seize collateral, they have all reasons to wish to sell fast.
First, they are not natural holders. Second, they do not suffer from a fire sale as long as the price drop is less than their haircut. Third, they are aware that others are repossessing similar collateral at the same time, so they have an incentive to front sell.
- In addition, real money investors that lost their original holdings are likely to sell the repossessed, less liquid collateral.
First, they may wish to re-establish their portfolio profile. More critically, they legally need to sell within days to be able to claim any shortfall in bankruptcy court.
- This leads to a dramatic acceleration of sales for assets originally committed to a long holding period.
While central banks are not in charge of shadow banks, they do come under pressure to stop fire sales and create outside liquidity. This completes the banking analogy.
The safe harbour debate
It is now evident that shadow banks need the safe harbour privileges to replicate banking. No financial innovation to secure escape from distress can match the proprietary rights granted by the safe harbour status, which ensure immediate access to sellable assets. Traditional unsecured lenders have taken notice, and now request more collateral, squeezing bank funding capacity and limiting future flexibility.
Many attentive observers find such an unconditional assignment of superpriority to repo and derivative claimants excessive.6 Duffie and Skeel (2012) discuss in an excellent summary the merit of safe harbour. In their words:
“Safe harbours could potentially raise social costs through five channels: (1) lowering the incentives of counterparties to monitor the firm; (2) increasing the ability of, or incentive for, the firm to become too big to fail; (3) inefficient substitution away from more traditional forms of financing; (4) increasing the market impact of collateral fire sales; and (5) lowering the incentives of a distressed firm to file for bankruptcy in a timely manner.”
All these arguments demand attention. Repo lenders and derivative counterparties enjoy not just immediacy in default, but also reset margins daily. By construction, this produces a unique safe claim. Just as insured depositors, these claimants can afford to neglect credit risk, and perform no monitoring role.
Collateral lending, by splitting up liquidity transformation, lengthens credit chains and expands the number of connections among intermediaries, contributing to systemic risk (Gai et al. 2011).
What should happen to the safe harbour privileges?
The main proposals aim at restricting eligibility. Tuckman (2010) suggested only cleared derivatives should enjoy the status. Duffie and Skeel argue it may be limited to appropriately liquid collateral (thus not ABS!) and only transparent uses (derivatives listed on proper clearing exchanges).
In recent research (Perotti 2011), I suggest that claims be publicly registered (just as secured real credit is) as a precondition for safe harbour status. This will ensure proper disclosure, essential to macro prudential regulators, and avoids unauthorised or misunderstood (re)hypothecation.
Investors who wish to claim superpriority in distress seek a scarce resource. They should be paying for the privilege, and for any risk externality it creates. In normal times, a low charge should be levied on registered claims. Charges should be adjusted countercyclically, lowered in difficult times, and raised when aggregate liquidity risk builds up, to brake an otherwise uncontrollable expansion.
Other approaches involve limiting the stock of safe harbour claims directly (Stein 2012) by a cap and trade model, which a registry receiving fees could support.
A critical issue is the treatment of collateral posted for central bank refinancing. For central banks to operate as ultimate liquidity providers, their claims should not be undermined. A specific privilege for eligible collateral is justified, as central banks are by definition not likely to create fire sales.
Thanks to the safe harbour rules, a shadow bank can hold risky illiquid assets and earn full risk premia with funding at the overnight repo rate. In what is essentially a synthetic bank, repo and collateral swap haircuts act as market-defined capital ratios.
Liquidity transformation across states and entities has procyclical effects.
It enhances credit and asset liquidity in normal or boom times, at the cost of accelerating fire sales in distress. While any reform to the shadow banking funding model should take into account its favourable effects on asset liquidity and credit in normal times, the associated contingent liquidity risk is not at present controllable (nor is it well measured!). There is an academic consensus that a balance has to be struck (Acharya et al. 2011; Brunnermeier et al. 2011; Gorton and Metrick 2010; Shin 2010).
Appropriate tools are also necessary to align capital and risk incentives in banks and shadow banks (Haldane 2010). Security lending may also undermine Basel III liquidity (LCR) rules.
At a time when all lenders seek security, questioning the logic of safe harbour provisions may seem unwise. Yet at the system level, it is simply impossible to promise security and liquidity to all. Uncertainty on the stock of pledged assets may create a self-reinforcing effect, feeding a frenzy among lenders to all seek ever-higher priority. This is already taking place, and is ultimately unsustainable at the individual and aggregate level.
Finally, it is questionable whether the highest level of protection should be granted to collateralised lenders, and to shadow bank funding, over all other investors. For all these reasons, regulators and the wider society need to make an informed decision.
Acharya, Viral, Arvind Krishnamurthy, and Enrico Perotti (2011), “A consensus view on liquidity risk”, VoxEU.org, 14 September.
Acharya, Viral and Sabri Öncü (2012), “A proposal for the resolution of systemically important assets and liabilities: the case of the repo market”, CEPR DP 8927, April.
Brunnermeier, Markus, Gary Gorton, and Arvind Krishnamurthy (2011), “Risk Topography”, NBER Macroannual 2011.
Duffie, Darrell and David Skeel (2012), A Dialogue on the Costs and Benefits of Automatic Stays for Derivatives and Repurchase Agreements, Stanford University, March.
Haldane, Andrew (2010), “The $100 Billion Question”, Bank of England, March.
Gai, Prasanna, Andrew Haldane, and Sujit Kapadia (2011), “Complexity, Concentration and Contagion”, Bank of England discussion paper.
Gorton, Gary, and Andrew Metrick (2010), “Regulating the Shadow Banking System”, Brookings Papers on Economic Activity, (2):261-297.
Perotti, Enrico (2010), “Systemic liquidity risk and bankruptcy exceptions”, VoxEU.org, 13 October.
Perotti, Enrico (2011), “Targeting the Systemic Effect of Bankruptcy Exceptions”, CEPR Policy Insight No. 52 and Journal of International Banking and Financial Law (2011)
Shin, Hyun Song (2010), “Macroprudential Policies Beyond Basel III”, Policy memo.
Stein, Jeremy (2010), “Monetary Policy as Financial-Stability Regulation”, Quarterly Journal of Economics, 127(1):57-95.
Tucker, Paul (2012), “Shadow Banking: Thoughts for a Reform Agenda”, Speech at the European Commission High Level Conference, 27 April, Brussels.
Tuckman, Bruce (2010), Amending Safe Harbors to Reduce Systemic Risk in OTC Derivatives Markets, Centre for Financial Stability, New York.
1Historically, confidence was supported by high capital, reputation and limited competition. As competition increased and capital fell, central banks’ emergency liquidity transformation and deposit insurance allowed steadily higher credit and bank leverage.
2Trivially, shadow banks may also access bank credit lines (as SIVs did).
3The rest of the creditors had to wait years to get less than 20 cents on the dollar.
4Limited safe harbour status was granted as exceptions in the 1978 US Bankruptcy code, limited to Treasury repos and margins on futures exchanges for qualifying intermediaries. They were broadened progressively to include margins on OTC swaps. The massive changes took place in 2004, when any financial collateral pledged under repo or derivative contracts, whether OTC or listed, by any financial counterparty, came to enjoy the bankruptcy privileges (Perotti 2011).
5According to Poszar and Singh (2011): “At the end of 2010.. about $5.8 trillion in off-balance sheet items of banks related to the mining and re-use of source collateral… down from about $10 trillion at year end-2007”.
6Creation of new proprietary rights is exceedingly rare. Limited liability is the last main case.
SHADOW BANKING - $71T and Now Bigger than the Global Economy
SIZING THE GLOBAL SHADOW BANKING SYSTEM
FSB's Global Shadow Banking Monitoring Report 2013 11-14-13 BIS
The main findings from the 2013 exercise are as follows :
- According to the ‘ macro mapping ’ measure , based on ‘ Other Financial Intermediaries ’(OFIs), non-bank financial intermediation grew by $5 trillion in 2012 to reach $71 trillion.
- By absolute size, advanced economies remain the ones with the largest non-bank financial systems.
- Globally OFI assets represent on average about 24% of total financial assets, about half of banking system assets and 117% of GDP. These patterns have been relatively stable since the crisis.
- OFI assets grew by +8.1% in 2012, helped by a general increase in valuation of global financial markets while bank assets were relatively stable as valuation effects were counterbalanced by shrinking balance sheets.
- The global growth trend of OFI assets masks considerable differences across jurisdictions, with growth rates ranging from -11% in Spain to +42 % in China.
- Emerging market jurisdictions showed the most rapid increases in non-bank financial system assets.
- Four emerging market jurisdictions had 2012 growth rates for non-bank financial intermediation above 20%. However, this rapid growth is from a relatively small base.
- While the non-bank financial system may contribute to financial deepening in these jurisdictions, careful monitoring is still required to detect any increases in risk factors (e.g. maturity transformation or leverage) that could arise from the rapid expansion of credit provided by the non-bank sector.
- Among the OFI sub-sectors that showed the most rapid growth in 2012 are real estate investment trusts (REITs) and funds (+30 %), other investment funds (+16%) and hedge funds (+11%).
- Of note that the growth rate for hedge funds should be interpreted with caution as the FSB macro-mapping exercise significantly underestimates the size of the hedge fund sector. The results of the recent IOSCO hedge fund survey provide a more accurate picture of the size of the hedge fund sector but do not provide an estimate of its growth
SHADOW BANKING: Why the Fed Can't Stop Fueling The Shadow Bank
Why the Fed Can't Stop Fueling The Shadow Bank Kiting Machine 06-03-13 Bill Frezza via Menckenism blog
Fractional reserve banking is unlike most other businesses. It's not just because its product is money. It's because banks can manufacture their product out of thin air. Traditional commercial banks essentially create money through a well understood and time honored pyramiding of loans. Depositors who understand that their deposits are thereby placed at risk choose their banks accordingly.
Under the bygone rules of free market capitalism, only one thing kept banks from creating an infinite amount of money, and that was fear of failure. Failure occurs when depositors come to believe that their bank has lent out too much manufactured money to too many dodgy borrowers and may not be able to cover depositors’ withdrawals. When this happens, depositors rush to reclaim their money while there is still some left, leading to the bank’s collapse.
Under free market capitalism, banks compete along a spectrum of risk and reward. Conservative banks offer a higher degree of safety by maintaining larger reserves, thereby manufacturing and lending out less money. Through word and deed they let depositors know that they lend to only the most creditworthy borrowers, who generally must post valuable collateral. These banks remain profitable because they successfully attract prudent depositors willing to accept lower rates of interest.
Banks of a more speculative bent offer a lower degree of safety, maintaining smaller reserves to create and lend out more money. Seeking higher returns, they often lend to less creditworthy borrowers who may put up poor quality collateral or none at all. These banks attract risk-taking depositors looking for a higher rate of interest. They can be very profitable during periods of economic expansion but often fall into distress during economic downturns.
Periodic bank failures remind depositors of the connection between risk and reward. When caveat emptor rules, smart depositors who pay attention make money and dumb depositors who don't lose theirs.
Because the latter outcome is intolerable in a democracy, we have government-provided deposit insurance and other taxpayer-financed backstops that shield most depositors from the risk of loss. In theory banks pay premiums to fund this insurance. In practice these premiums are not risk-based. Banks are not penalized for making riskier loans, in turn often leaving the premiums too low to finance payouts. This creates a huge moral hazard, as it frees depositors to seek the highest return without regard for safety.
Worse, it removes conservative banks’ competitive advantage. Under a government-guaranteed deposit insurance regime, conservative bankers who want to stay in business must take on more risk in order to pay the higher interest rates necessary to attract depositors. This often sets off a race to the bottom, which results in periodic banking crises.
After each of these crises, politicians promise taxpayers that it will never happen again. And each time it does, the government creates a new set of labyrinthine regulations that attempt to mimic the business judgment of conservative bankers. Minimum reserve requirements are established, which normally become the maximum as there is little advantage in exceeding them. And both depositors and the bankers themselves become complacent about the banks’ investments because it is so easy to privatize gains and socialize losses.
Banks also learn that competitive advantage can be obtained by either gaming the regulations or having cronies write them. As regulations get more intrusive and complex, politicians discover that they can be used to advance social policies, such as increasing home ownership among voters with poor credit, thereby increasing the risk on banks’ loan books.
This mixed economic system is the one that replaced free market capitalism in hopes that it would prevent bank failures. Despite, and some even say because of, a regulatory regime that discouraged conservative banking and rewarded reckless mortgage lending, the banking system crashed - again - in 2007-2008.
What is not widely appreciated is that the ensuing government bailouts allowed an underlying shadow banking system to not only survive but grow even larger. It is called the shadow banking system because it operates outside most government-regulated banking laws. This is primarily because regulations and accounting standards haven’t caught up with the practices of these banks, which are relatively new and poorly understood.
It was the seizing up of the commercial paper and repo markets that funds the shadow banking system that abruptly halted the flow of liquidity that kept the mortgage bubble propped up. This revealed the underlying insolvency of Fannie Mae, Freddie Mac, and many commercial banks stuffed with subprime mortgage securities accumulated under the mixed economic system described above.
Powered by an exclusive club of primary reserve dealers, a group that once included high flyers like Lehman Brothers, MF Global, and Countrywide Securities, these shadow banks work hand in glove with the Federal Reserve to manufacture money by pyramiding loans atop the base money deposits held in their Federal Reserve accounts.
To the frustration of Keynesians, and despite an unprecedented Quantitative Easing (QE) by the Federal Reserve, conventional commercial banks have broken with custom and have amassed almost $2 trillion in excess reserves they are reluctant to lend as they scramble to digest all the bad loans still on their books. So most of the money manufactured today is actually being created by the shadow banks. But shadow banks do not generally make commercial loans. Rather, they use the money they manufacture to fund proprietary trading operations in repos and derivatives.
EMERGING WORLD: COLLATERAL TRANSFORMATIONS, REHYPOTHECATION & SFV's
ABOVE SCHEMATIC FROM : GLOBALIZATION TRAP by GordonTLong.com
It is critically important to distinguish the interconnectedness between banks and different types of shadow banking entities. Different shadow banking entities are associated with different risk factors such as credit intermediation, maturity transformation, and leverage.
Excerpt below taken from: Why the Fed Can't Stop Fueling The Shadow Bank Kiting Machine Bill Frezza via Menckenism blog
Where does the pyramiding come from if shadow banks aren’t making loans that get redeposited to fuel the cycle? Securities held as collateral by counterparties in a repo contract can be rehypothecated by the lender to obtain additional loans. (So can securities held in customer accounts, unless their brokerage agreements expressly prohibit it. This was an unwelcome discovery by MF Global’s hapless clients, who saw their assets whooshed off to London where different brokerage rules allow such hypothecation.) Loans made against securities held as collateral can then be used to either buy more securities, which can be fed back into the repo market, or trade a bewildering array of complex synthetic derivatives.
If this sounds like circular check kiting that’s because it is, especially when you add in the issuance of commercial paper required to grease the wheels. The biggest difference is that an embezzler kiting checks does not have the support of a central bank providing steady injections of liquidity, beefing up balance sheets that create confidence in their debt instruments.
How much of the original high quality collateral must shadow banks hold in reserve should some of their derivatives implode, as many did during the last crisis? Zero. By repeatedly spinning the wheel, the top 25 U.S. banks have piled up over $200 trillion in leveraged bets atop a thinning wedge of collateral, claims to which are spread across an opaque and complex chain of counterparties residing in multiple legal jurisdictions. These collateral claims are co-mingled with an estimated $400 trillion to $1.3 quadrillion in notional outstanding derivatives made by other banks around the world, altogether amounting to more than 20 times global GDP.
Due to the fact that accounting standards have not kept up with these innovative practices, banks are not required to report the gross notional value of the outstanding derivative contracts on their books, only their net asset positions. These theoretical Value at Risk positions, which would only be netted out if all the contracts were unwound in an orderly manner—as one might unwind a check kiting scheme before getting caught—can only be realized in a liquidity crisis if the counterparty chains across which these contracts are hedged hold up.
These counterparty chains froze in spectacular fashion during the last financial crisis. After the collapse of Lehman Brothers and with the insolvency of AIG looming, a chorus of politicians, bankers, and bureaucrats browbeat the government into delivering a system-wide bailout. As a result, many reckless banks and bankers that should have been driven out of the market are back doing business as usual.
The largest banks learned that they need not worry about the possibility of bankruptcy. When the next crisis hits, all they have to do is shout “systemic collapse” and another bailout will appear. Being Too Big To Fail, they can maximize profits without having to hold reserves against the risk of counterparty failure, knowing that the taxpayer will always be there to make them whole.
The solution is not more regulations, which will never keep up with the financial wizards whose lobbyists end up writing these rules anyway. In addition, trades can be made anywhere in the world, so to be effective the regulations would have to be global. As long as governments continue to prop up failing banks, regulation will always be inadequate to mitigate the moral hazard that accompanies bailouts. And, ironically, the added costs of regulatory compliance will make it harder still for smaller and more prudent banks to compete.
True to form, Congress has not solved the TBTF problem but has actually made it worse, loading ever more regulations on commercial banks through Dodd-Frank. Meanwhile, taxpayer exposure to the banking system has grown even larger.
Optimists believe that as long as everyone remains calm and keeps believing everything is fine, then everything will be. Central planning advocates hope that the kiting scheme can be unwound by extending banking regulations to cover the shadow banks while the Fed somehow weans them off of Quantitative Easing. Cynics believe that asking Washington to get the situation under control is a hopeless quest, especially since few Congressmen have a clue what is really going on.
Meanwhile uncertainty hangs over the system since bankruptcy laws, which differ from country to country, have not kept up with hyper-hypothecation. Moreover, the government’s handling of the auto bailout shows that investors cannot rely on existing bankruptcy law even when it speaks clearly on an issue. Therefore, no one really knows who will have first dibs on the collateral when the music stops. And just what are those high quality assets? Sovereign bonds and mortgage CDOs, which are themselves subject to precipitous losses.
As the debate drags on and global economic conditions worsen, the growing pyramid is being kept afloat by the easy money policies of central banks too frightened to withdraw their support lest a stock market correction trigger a cascade of margin calls that brings down the whole system—much like last time.
All this money creation has not yet generated much visible consumer price inflation. This is partly because official inflation measures are suspect but mostly because the bulk of the new money being created is flowing into financial assets and not the consumer economy. This has inflated asset bubbles to levels impossible to justify based on underlying economic conditions, in particular the stock market where investors have fled in search of yield. No one knows when the bubble will pop, but when it does a donnybrook is going to break out over that thin wedge of collateral whose ownership is spread across counterparties around the world, each looking for relief from their own judges, politicians, bureaucrats, and taxpayers.
When that happens and the clamor for regulation, nationalization, confiscation, and demonization arises there is only one thing we can be sure of. The disaster will once again be blamed on a free market capitalism that has not existed in this country for over 100 years.
SHADOW BANKING - NEW YORK FEDERAL RESERVE - The Definitive Work on Shadow Banking & The Financial Crisis
Shadow banks are best thought along a spectrum. Each of the seven steps involved in the shadow credit intermediation process were performed by many different types of shadow banks, with varying asset mixes, funding strategies, amounts of capital and degrees of leverage.
CLICK TO ENLARGE
The Post-Crisis Backstop of the Shadow Banking System - Pozsar, Adrian, Ashcraft, Boesky (2010)
Once private sector credit and liquidity put providers' ability to make good on their "promised" puts came into question, a run began on the shadow banking system. Central banks generally ignored the impairment of such important pillars of the shadow banking system as mortgage insurers or monoline insurers. Once the crisis gathered momentum, however, central banks became more engaged.
The series of 13 liquidity facilities implemented by the Federal Reserve and the guarantee schemes of other government agencies essentially amount to a 360º backstop of the shadow banking system. The 13 facilities can be interpreted as functional backstops of the shadow credit intermediation process. Thus,
- CPFF is a backstop of loan origination and warehousing;
- TALF is a backstop of ABS issuance;
- TSLF and Maiden Lane, LLC are backstops of th e system's securities w arehouses (broadly speaking);
- Maiden Lane III, LLC is a backstop of the credit puts sold by AIG-FP on AB S CDOs;
- TAF and FX sw aps are backstops of and facilitated the orderly "on-boarding" of formerly off-balance sheet ABS intermediaries (many of them run by European banks who found it hard to swap FX for dollars); and finally,
On the funding side,
- PDCF is a backstop of the tri-party repo system (a "platofrm" where MMMFs (and other funds) fund broker-dealers and large hedge-funds) and the
- AMLF, MMIFF and Maiden Lane II, LLC are backstops of various forms of regulated and undregulated money market intermediaries.
- Furthermore, the Treasury Department's Temporary Guarantee Program of MMMFs was an additional form of backstop for money market intermediaries. This program, together with the FDIC's TLGP can be considered modern day equivalents of deposit insurance.
Only a few types of entities were not backstopped by the crisis, and some attempts to fix problems might have exacerbated the crisis . Examples include not backstopping the monolines early on in the crisis (this might have tamed the destructiveness of delevera ging) and the failed M-LEC which ultimately led to a demarcation line between bank-affiliated and standalone ABS intermediaries (such as LPFCs or credit hedge funds) as recipients and non-recipients of official liquidity. These entities failed too early on in the crisis to benefit from the liquidity facilities rolled out in the wake of the bankruptcy of Lehman Brothers, and their demise may well have accelerated and deepened the crisis, while also necessitating the creation of TALF to offset the shrinkage in balance sheet capacity for ABS from their demise.
CLICK TO ENLARGE
These appendixes, which depict graphically the processes described in the article, offer a comprehensive look at the shadow banking system and its many components.
- Map : The Shadow Banking System www.newyorkfed.org/research/economists/adrian/1306adri_map.pdf
- Appendix 1 : The Government-Sponsored Shadow Banking System www.newyorkfed.org/research/economists/adrian/1306adri_A1.pdf
- Appendix 2 : The Credit Intermediation Process of Bank Holding Companies www.newyorkfed.org/research/economists/adrian/1306adri_A2.pdf
- Appendix 3 : The Credit Intermediation Proc ess of Diversified Broker-Dealers www.newyorkfed.org/research/economists/adrian/1306adri_A3.pdf
- Appendix 4 : The Independent Specialists-Base d Credit Intermediation Process www.newyorkfed.org/research/economists/adrian/1306adri_A4.pdf
- Appendix 5 : The Independent Specialists-Base d Credit Intermediation Process www.newyorkfed.org/research/economists/adrian/1306adri_A5.pdf
- Appendix 6 : The Spectrum of Shadow Banks within a Spectrum of Shadow Credit Intermediation www.newyorkfed.org/research/economists/adrian/1306adri_A6.pdf
- Appendix 7 : The Pre-Crisis Backstop of the Sh adow Credit Intermediation Process www.newyorkfed.org/research/economists/adrian/1306adri_A7.pdf
- Appendix 8 : The Post-Crisis Backstop of the Shadow Banking System www.newyorkfed.org/research/economists/adrian/1306adri_A8.pdf
SHADOW BANKING - Self Securitization
The Unspoken, Festering Secret At The Heart Of Shadow Banking: "Self-Securitization" ... With Central Banks 11-15-13 Zero Hedge
SECURITIZATION (for the Layman):
The process whereby banks take risky assets on their books, package, tranche them, and then re-sell them to yield chasing fiduciaries of widows and orphans. The conversion process can be nebulous, usually involving a 20 year-old evil French mastermind working for Goldman, and a billionaire hedge fund manager, who select the worthless securities put into the weakest tranche, just so the abovementioned two parties can short it while misrepresenting their conflicts of interest, and make a boatload of money when the whole securitized structure implodes. The process usually takes place "off balance sheet" via Special Purpose Vehicles so it is completely unregulated, and as such allows massive leverage.
According to many, the hidden leverage embedded in the securitization pipeline is what catalyzed the 2008 near-death experience of the financial markets. All of this is well-known to most. What however is certainly not known, because until a few days ago the concept did not technically exist, is what emerged deep from the bowels of the FSB's 2013 "Global Shadow Banking report", and what is barely even defined anywhere in popular literature, which thus we have defined as the "unspoken, festering secret at the heart of shadow banking."
What is "self-securitization"? Go ahead and Google it: there doesn't exist any technical definition of this heretofore unheard of phrase. Rather the term, conceived by the FSB as a means of making the total size of the $71 trillion shadow banking sector somewhat more palatable, is defined as follows:
Self-securitisation (retained securitisation) is defined as those securitisation transactions done solely for the purpose of using the securities created as collateral with the central bank in order to obtain funding, with no intent to sell them to third-party investors. All of the securities issued by the Structured Finance Vehicle (SFV) for all tranches are owned by the originating bank and remain on its balance sheet.
At this point alarm bells should be going off. And if they aren't, here is some more color.
The numbers for OFIs presented in sections 2 to 4 of this report include all financial assets of Structured Finance Vehicles (SFVs), regardless of who holds the securitised products. However, in a number of jurisdictions, some of these products are returned back onto the balance sheet of the bank that originally provided the asset to be securitised. This so called self-securitisation, or retained securitisation, is defined as those securitisation transactions done solely for the purpose of using the securities created as collateral with the central bank in order to obtain funding, with no intent to sell them to third-party investors. All of the securities issued by the SFV for all tranches are owned by the originating bank and remain on the bank’s balance sheet, so that third-party investors do not own any of the securities issued by the SFV. These assets should not be included in the shadow banking figure, as prudential consolidation rules consider them as banks’ own assets and as such subject to consolidated supervision and capital requirements.
... some of the assets that are currently ‘self-securitised’ by banks may at some point be sold to third parties when financial conditions improve.
Wait a minute: a company is "securitizing" assets.... which it then keeps, but only after it has "obtained funding with a central bank"? What?
Judging by the countries whose shadow bank institutions are the most aggressive participants in "self-securitization", it gets clearer just what is going on here:
While Italy and Spain are clear, why is Australia on this list?
While the large increase in Australian banks’ self-securitisation of residential mortgage-backed securities (RMBS) started in 2008 (i.e. before Basel III was developed), the amount of self-securitisation is expected to stay high going forward as these securities are eligible as collateral for the Reserve Bank of Australia’s Committed Liquidity Facility (CLF). Indeed some banks are gearing up already for the CLF. Given the low level of government debt in Australia, the Australian prudential regulator has adopted elements of the Basel rules that allow banks to count a committed liquidity facility provided by the central banks as part of their Basel III liquidity requirements.
So that very strict Basel III requirements are permissive enough to allow... shadow "banks" to engage in self-securitization with their central bank? Just brilliant.
Finally, what amount of circularly (non) securitized, central-bank backstopped securities are we talking here?
That is the amount of unlevered notional that shadow (and regular) banks engage in circular check-kiting games with central banks for, and in the process obtaing "funding." As one trading desk explained it:
you take yr worst assets... package up in an spv (which removes em from yr gaap balance sheet) then flip to central bank for cash at modest haircut and boom revenues...
And presto: magic balance sheet clean up and even more magical "revenues."
But wait, there's more (spoiler preview: take the above quote and put in on constant rewind)
Where this mindblowing, circular scheme in which riskless central banks serve as secret sources of incremental bank funding, i.e., free money, gets completely insane, is the realization that these self-securitized assets can also participate in rehypothecation chains. Recall from our exposition yesterday on the permitted leverage resulting from collateral reuse in a repo chain which is fundamentally what shadow banking is all about: unregulated, stratospheric leverage.
So... three participants result in 4x leverage; four: in roughly 6x, and so on. Of course, these are conservative estimates: in the real, collateral-strapped world, the amount of collateral reuse, and thus the number of participants is orders of magnitude higher. Which means that after just a few turns of rehypothecation, leverage approaches infinity.
Which means that should these same banks that self-securitize with Central Bank X, then proceed to re-use the same security with the same counterparty - i.e., their host central bank, or the Fed of course - then this $1.2 trillion in assets, already carried off-balance sheet with Basel III's blessings, can get 2x, 3x, 5x, 8x, 13x or more turns of leverage on them, as for the shadow bank it is the central bank that is the (up to infinity) levered counterparty. And the central bank, as everyone knows, can always just print money if and when the worthless collateral backing the bank's self securitization ends up worthless.
The implication of this unprecedented shadow banking circle jerk, which could very easily make even the direct wealth transfer resulting from trillions in QE pale by comparison, is so stunning that we leave it up to the reader to come to their own conclusion.
SHADOW BANKING -Unfractional Repo
Unfractional Repo Banking: When Leverage Is "Limited" By Infinity 11-14-13 Zero Hedge
Today's release of the 2013 edition of the Global Shadow Banking Monitoring Report by the Financial Stability Board doesn't contain anything that frequent readers of this site don't know already on a topic we have covered since 2009. It does however have a notable sidebar which explains the magic of "(un)fractional repo banking" - a topic made popular in late 2011 following the collapse of MF Global - when it was revealed that as part of the Primary Dealer's operating model, a core part of the business was participating in UK-based repo chains in which the collateral could be recycled effectively without limit and without a haircut, affording Jon Corzine's organization virtually unlimited leverage starting with a tiny initial margin.
Naturally, any product that can allow participants infinite leverage is something that all "sophisticated" market participants not only know about, but abuse on a regular basis. The fact that this "unfractional repo banking" is at the heart of the unregulated $71.2 trillion shadow banking system, the less the general public knows about it the better.
Which is why we were happy that the FSB was kind enough to explain in two short paragraphs and one even simpler chart, just how the aggregate leverage for the participants in even the simplest repo chain promptly becomes exponential, far above the "sum of the parts", and approaches infinity in virtually no time.
From the FSB:
As a simple illustration of the way in which repo transactions can combine to produce adverse effects on the system that can be larger than the sum of their parts, suppose that investor A borrows cash for a short period of time from investor B and posts securities as collateral. Investor A could use some of that cash to purchase additional securities, post those as further collateral with investor B to receive more cash, and so on multiple times. The result of this series of ‘leveraging transactions’ is that investor A ends up posting more collateral in total with investor B than they initially owned outright. Consequently, small changes in the value of those securities have a larger effect on the resilience of both counterparties. In turn, investor B could undertake a similar series of financing transactions with investor C, re-using the collateral it has taken from investor A, and so on.
Exhibit A2-5 mechanically traces out the aggregate leverage that can arise in this example. Even with relatively conservative assumptions, some configurations of repo transactions boost aggregate leverage alongside the stock of money-like liabilities and interconnectedness in ways that might materially increase systemic risk. For example, even with a relatively high collateral haircut of 10%, a three-investor chain can achieve a leverage multiplier of roughly 2-4, which is in the same ball park as the financial leverage of the hedge fund sector globally. It is therefore imperative from a risk assessment perspective that adequate data are available. Trade repositories, as proposed by FSB Workstream 5, could be very helpful in this regard.
So... three participants result in 4x leverage; four: in roughly 6x, and so on. Of course, these are conservative estimates: in the real, collateral-strapped world, the amount of collateral reuse, and thus the number of participants is orders of magnitude higher. Which means that after just a few turns of rehypothecation, leverage approaches infinity. Needless to say, with infinite leverage, even the tiniest decline in asset values would result in a full wipe out of one collateral chain member, which then spreads like contagion, and destroys everyone else who has reused that particular collateral.
All of this, incidentally, explains why down days are now prohibited. Because with every risk increase, there is an additional turn of collateral re-use, and even more participants for whom the Mutual Assured Destruction of complete obliteration should the weakest link implode, becomes all too real.
That, in a nutshell, are the mechanics. As to the common sense implications of having an unregulated funding market which explicitly allows infinite leverage, we doubt we have to explain those to the non-Econ PhD readers out there.
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