Shadow banking funded by repos, securities lending

The shadow banking system in the U.S. is interconnected by a short-term funding chain of repurchase agreements and securities lending that needs more effective supervision, an International Monetary Fund economist says in a report released today.

Shadow banking lenders often are lax in their due diligence because repo loans and securities lending are collateralized. Lenders rely more on the strength of the collateral than the strength of the borrower. This weakens market discipline, which is supposed to regulate the shadow sector.

These are some of the conclusions of Ashok Vir Bhatia, senior economist at the International Monetary Fund, who recommends bringing all financial institutions under the oversight of the Federal Reserve.

He also notes that much of the systemic risk in the U.S. financial system, revealed during the financial crisis, is centered in a few mega-diversified conglomerates that pose an “enormous and critical supervisory challenge.”

“Large BHCs (bank holding companies) with significant short-term uninsured funding, and essentially all of the shadow banking system, proved deeply vulnerable to institutional runs. These runs were a herd response, against a backdrop of chronic data gaps—on counterparties and collateral, especially in the derivative and unregistered ABS (asset-backed securities) realms—and came after a prolonged period of poorly managed risk-taking. Thus not only did regulation and supervision fall short, so too did market discipline— underscoring the need for more effective oversight going forward.”

Bhatia describes the shadow banking system as including mortgage brokers and finance companies, private-label asset backed security (ABS) and asset backed commercial paper (ABCPaper) issuers, structured investment vehicles (SIVs), money market funds, securities broker-dealers and futures commission merchants, derivative product companies, hedge funds, holding companies, and any other types of financial entities engaged in leveraged maturity transformation outside the federal financial safety net.

The cornerstone of the shadow system are the pools of asset-backed securities, which are off-the-books trusts that have no shareholders, no managers, no employees and no bankruptcy court protections. “These are the ultimate ‘robot’ intermediaries, a reality that remains under-appreciated,” writes Bhatia.