SHADOW BANKING - Safe Harbor Privileges

The roots of shadow banking 01-16-14 Enrico Perotti

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."

SELF-SECURITIZATION

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?

Answer: $1,200,000,000,000.

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.

We added:

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.