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The Rise and Risks of the Shadow Banking System

Examining the Interconnectedness of the Traditional Banking System and Shadow Banking System

The Federal Reserve's decision to maintain historically low interest rates has made it challenging for banks to maintain profitability through traditional lending methods. As a result, banks have shifted their investment strategy towards securities in recent years. This shift is part of a broader trend of expansion in the shadow banking system, which comprises a complex network of financial institutions and transactions operating outside the traditional banking system. Hedge funds, money market funds, and special purpose vehicles (SPVs) are among the entities that make up the shadow banking system. While the shadow banking system provides credit to businesses and individuals, it also poses significant risks to the stability of the financial system, contributing to systemic risk.

The increased investment in securities by banks highlights the interconnectedness of the traditional banking system and the shadow banking system. This connection raises concerns about the potential transmission of risks and vulnerabilities across the financial system. It is important to examine the implications of this trend for financial stability and consider measures to mitigate the risks associated with the expansion of the shadow banking system.

The increased investment in securities by banks demonstrates the interconnectedness of the traditional banking system and the shadow banking system.

The Shadow Banking System

The Growth and Risks of the Shadow Banking System

The shadow banking system has grown in importance as a component of the financial system in recent decades. The term "shadow bank" was coined by economist Paul McCulley in a 2007 speech at the annual financial symposium hosted by the Kansas City Federal Reserve[1]. The shadow banking system refers to financial intermediaries that fall outside the realm of traditional banking regulations[3]. Its roots can be traced back to the 1970s, when financial innovations like securitization and derivatives first appeared. These advancements enabled banks to offload risks from their balance sheets, resulting in the formation of new entities such as mortgage-backed securities (MBS) and collateralized debt obligations (CDOs) (CDOs).

To control their own risks, banks initially used securitization and derivatives. However, as these financial instruments became more popular, they were used for a broader range of purposes, such as the formation of new investment entities and the funding of various projects. As a result, what is now known as the shadow banking system grew.

The shadow banking system is comprised of several financial institutions and transactions. It includes firms like hedge funds, money market funds, and special purpose vehicles (SPVs), which perform comparable functions to regular banks but are not subject to the same regulations and control. These companies frequently use more leverage than typical banks and may participate in riskier activities such as investing in complicated financial instruments or lending to high-risk clients.

Although the shadow banking system has increased credit availability, it also poses significant risks to the financial system's stability. Companies in the system are intricately linked, which can result in rapid risk spread and widespread financial system collapse. The failure of a single large investment bank, Lehman Brothers, set off a chain reaction of failures and caused credit markets to freeze in 2008.

In response to the concerns raised by the shadow banking industry, regulators have taken a number of steps to strengthen oversight and reduce the potential for systemic risk. Among these measures are the implementation of capital buffers for banks, increased reporting requirements for shadow banking companies, and initiatives to reduce reliance on short-term funding sources.

Bob and Amarii Repo Transaction

US Repo Fact Sheet

Here's an example of how the repo market works:

Bob is a trader at a bank, and he needs to borrow $10 million to finance a Bob agreed to sell the US Treasury securities to Amarii for $90 million in cash. The $10 million haircut represents the difference between the market value of the Treasuries and the amount of cash that Amarii is lending to Bob.

  1. Bob transferred the US Treasury securities to Amarii as collateral for the loan. This means that if Bob defaults on the loan, Amarii can sell the Treasuries to recover his funds.

  2. Amarii held the US Treasury securities as security and lent Bob $90 million for one day.

  3. Bob used the $90 million in cash to finance his trade, with the agreement that he would repurchase the Treasuries from Amarii the next day for $90.9 million.

  4. The next day, Bob bought back the Treasuries from Amarii for $90.9 million, including $900,000 in interest. This meant that Amarii earned $900,000 in interest for lending Bob the cash.

  5. Bob repaid the loan, and Amarii returned the Treasuries to Bob. The repo transaction was complete.

Benefits and Risks of the Repo Market for Short-term Funding

Understanding the repo market is critical to understanding the shadow banking system, which heavily relies on it for short-term funding for high-risk investments. Financial institutions borrow and lend money in the repo market using securities such as US Treasuries as collateral. The average daily aggregate repo and reverse repo outstanding in the United States is $4.3 trillion, with repo averaging $2.5 trillion, according to recent data.

This allows them to obtain funding at a lower cost than other options, such as bank loans or bond issuances. The repo market, on the other hand, can be a source of systemic risk, especially during times of stress when it can quickly dry up, leaving financial institutions with limited access to funding. Furthermore, the use of Treasuries as collateral in the repo market can lead to complex interconnectedness among financial institutions, increasing the risk of financial system contagion.

The shadow banking system has evolved into an important component of the financial system, delivering benefits such as credit availability and financial innovation. But, it also poses substantial hazards to the financial system's stability. The total size of the shadow banking system worldwide is estimated to be around $52 trillion in assets, which is a 75% increase since the financial crisis ended. The 2008 financial crisis brought these vulnerabilities to light, prompting considerable governmental measures aimed at enhancing oversight and decreasing systemic risk.

The crisis highlighted the interdependence of the shadow banking system with the traditional banking system, emphasizing the importance of a coordinated regulatory response to address systemic concerns. Notwithstanding considerable regulatory reforms, constant attention is required to ensure that the risks posed by the shadow banking system are effectively addressed. Future financial crises remain a major threat in the absence of proper oversight and regulation.

The Role of Shadow Banking in Systemic Risk

Systemic risk refers to the possibility of a collapse of the entire financial system, leading to a severe economic slowdown or even depression. This type of risk differs from idiosyncratic risk, which is specific to a particular asset or entity and can be mitigated by prudent portfolio management. Systemic risk cannot be mitigated since it impacts the entire financial system. The shadow banking system plays a significant role in systemic risk. Many shadow banking companies rely heavily on short-term funding, which can be volatile and prone to unexpected withdrawals. This can cause liquidity crises, where several institutions must sell assets simultaneously to meet their obligations, leading to asset price drops and financial instability. The 2008 financial crisis is an example of this kind of crisis.

Secondly, the shadow banking system generates leverage and interconnection, which increase the risk of systemic failure. Many shadow banking companies use leverage to increase their returns, which can exacerbate losses if investments perform poorly. Additionally, the shadow banking system is connected to the standard banking system and the broader financial system. Any difficulties in one part of the system can quickly spread to other areas, causing systemic failure.

To mitigate systemic risk from the shadow banking system, regulators have implemented new laws for money market funds, increased capital and liquidity requirements for banks, and improved transparency and monitoring of the securitization market. Nonetheless, given the continued expansion and evolution of the shadow banking industry, systemic risk remains a significant concern for financial stability. Therefore, it is crucial for regulators and policymakers to remain vigilant and proactive in identifying and addressing potential systemic risks in the financial system.

The information contained in Amarii Holdings website and newsletters is obtained from sources believed to be reliable, but its accuracy cannot be guaranteed. This information is not intended to constitute individual investment advice or to be tailored to your personal financial situation. The views and opinions expressed in these publications are those of the publisher and editors and are subject to change without notice. The information may become outdated and there is no obligation to update it. Any use of this information is at your own risk and Amarii Holdings accepts no liability for any loss or damage resulting from your reliance on it. You should consult with your financial advisers before making any investment decisions to determine if a particular investment is suitable for your needs.

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