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NYFed publishes road map for shadow banking

“The rapid growth of the market-based financial system since the mid-1980s changed the nature of financial intermediation in the United States profoundly,” begins the July 2010 study of shadow banking by four economists at the Federal Reserve Bank of New York.

It is the most complete study yet of what’s becoming known as the shadow banking system.

Its value is in its detailed and relentless documentation of an enormous but poorly-understood financial system that conducts much of its business privately, outside the view of regulators and the general public. The study’s shortcoming, in RepoWatch’s view, is that it does not show that repo is the basis for most of the leverage on the shadow system. The importance of repo gets lost in the valuable detail.

This study includes a chart of the shadow system that Financial Times columnist Gillian Tett says “should be mandatory reading for bankers, regulators, politicians and investors today.”

Also from Tett, who did some of the best reporting on credit markets prior to the crisis:

Indeed, they might do well to hang similar posters next to their desks, for at least three reasons. For one thing, this circuit board is a reminder of how clueless most investors, regulators and rating agencies were before 2007 about finance. After all, during the credit boom, there was plenty of research being conducted into the financial world; but I never saw anything remotely comparable to this road map.

That was a striking, terrible omission. …

But secondly, this poster is also a reminder that many things about the modern financial system remain mysterious – even today. On the edges of the circuit board, the NY Fed economists list all the government programmes that have supported the system since 2007 (and, in effect, replaced shadow banks when they suffered runs). This “shadow, shadow bank system” – as it might be called – looks complex and baffling too. …

Then, there is the current regulatory debate. So far this year, the Financial Stability Board and other international bodies have focused most of their reform attention on issues such as bank capital, and systems of oversight for large, systemically important banks. Next year, though, Mario Draghi, head of the FSB, wants to start discussing the shadow banking world. …

So for my money, the best thing the NY Fed could do right now is print thousands of copies of that poster – and dispatch it across the world. … After all, a key reason why that circuit board became so complex was that bankers were trying to arbitrage the last two sets of Basel rules. If shadow banking continues to be ignored (ie politicians focus just on the traditional banks) there is every chance Basel III will simply produce another complex labyrinth that will go largely ignored. Until the next crisis.

Following is the introduction to “Shadow Banking” by Zoltan Pozsar, Tobias Adrian, Adam Ashcraft, and Hayley Boesky:

The rapid growth of the market-based financial system since the mid-1980s changed the nature of financial intermediation in the United States profoundly. Within the market-based financial system, “shadow banks” are particularly important institutions. Shadow banks are financial intermediaries that conduct maturity, credit, and liquidity transformation without access to central bank liquidity or public sector credit guarantees. Examples of shadow banks include finance companies, asset-backed commercial paper (ABCP) conduits, limited-purpose finance companies, structured investment vehicles, credit hedge funds, money market mutual funds, securities lenders, and government-sponsored enterprises.

Shadow banks are interconnected along a vertically integrated, long intermediation chain,  which intermediates credit through a wide range of securitization and secured funding techniques such as ABCP, asset-backed securities, collateralized debt obligations, and repo.

This intermediation chain binds shadow banks into a network, which is the shadow banking system. The shadow banking system rivals the traditional banking system in the intermediation of credit to households and businesses. Over the past decade, the shadow banking system provided sources of inexpensive funding for credit by converting opaque, risky, long-term assets into money-like and seemingly riskless short-term liabilities. Maturity and credit transformation in the shadow banking system thus contributed significantly to asset bubbles in residential and commercial real estate markets prior to the financial crisis.

We document that the shadow banking system became severely strained during the financial
crisis because, like traditional banks, shadow banks conduct credit, maturity, and liquidity transformation, but unlike traditional financial intermediaries, they lack access to public
sources of liquidity, such as the Federal Reserve’s discount window, or public sources of insurance, such as federal deposit insurance. The liquidity facilities of the Federal Reserve and other government agencies’ guarantee schemes were a direct response to the liquidity and capital shortfalls of shadow banks and, effectively, provided either a backstop to credit intermediation by the shadow banking system or to traditional banks for the exposure to shadow banks. Our paper documents the institutional features of shadow banks, discusses their economic roles, and analyzes their relation to the traditional banking system.

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