The Handbook of Global Shadow Banking, Volume II: The Future of Economic and Regulatory Dynamics [1st ed.] 9783030348168, 9783030348175

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THE HANDBOOK OF GLOBAL SHADOW BANKING Volume II The Future of Economic and Regulatory Dynamics Luc Nijs

The Handbook of Global Shadow Banking, Volume II

Luc Nijs

The Handbook of Global Shadow Banking, Volume II The Future of Economic and Regulatory Dynamics

Luc Nijs

ISBN 978-3-030-34816-8    ISBN 978-3-030-34817-5 (eBook) https://doi.org/10.1007/978-3-030-34817-5 © The Editor(s) (if applicable) and The Author(s) 2020 This work is subject to copyright. All rights are solely and exclusively licensed by the Publisher, whether the whole or part of the material is concerned, specifically the rights of translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction on microfilms or in any other physical way, and transmission or information storage and retrieval, electronic adaptation, computer software, or by similar or dissimilar ­ ­methodology now known or hereafter developed. The use of general descriptive names, registered names, trademarks, service marks, etc. in this publication does not imply, even in the absence of a specific statement, that such names are exempt from the relevant protective laws and regulations and therefore free for general use. The publisher, the authors and the editors are safe to assume that the advice and information in this book are believed to be true and accurate at the date of publication. Neither the publisher nor the authors or the editors give a warranty, expressed or implied, with respect to the material contained herein or for any errors or ­omissions that may have been made. The publisher remains neutral with regard to jurisdictional claims in published maps and institutional affiliations. This Palgrave Macmillan imprint is published by the registered company Springer Nature Switzerland AG. The registered company address is: Gewerbestrasse 11, 6330 Cham, Switzerland

Preface

In this second volume on global shadow banking, three main domains will be further explored. The first domain deals with the macroeconomic fundamentals of the respective shadow banking segments: why do they exist, what problem(s) do they solve, and why are some of these embedded risks so persistent? The second domain captures the global analysis of shadow banking markets. Shadow banking markets, regardless of which segment, are always modeled based on the regulatory environment and economic landscape of a certain jurisdiction. Therefore, despite the many commonalities, shadow banking markets differ in their dynamics, roles they play in the local market and the way exposures are created. A global analysis of those markets comes next. The last domain covered in the book deals with the many open-ends that the sector still characterizes. It gets philosophical every now and then, and related topics like regulatory arbitrage, contract imperfection and governance are brought into the analysis. In the second domain, which encompasses Chaps. 2–6, I then branch out into a geographical survey to experience the shadow banking dynamics around the world, make comparisons, review different policy and regulatory responses, subject them to assessments and shed some light on the first feedback loops we received in recent years from all those changes. The last chapter (Chap. 7), before I draw some conclusions, reads like an anthology of unsolved issues. And with its 22 sections, it requires limited brainpower to understand that there are many issues. Most likely, this is because the regulation enacted so far carries limited cloud, risk in complex global networks is still less understood, tail risk is still largely neglected,1 liquidity2 is treated as a deity, and regulators are, besides being brainwashed by lobbyists on an ongoing basis, still very much confused about what to tackle. In the myriad and madhouse of macroeconomic and econometric modeling, it truly is nearly impossible to divide right from wrong, especially if your target is  Also by market participants; see, for example, S. Chernenko et al., (2015), Who Neglects Risk? Investor Experience and the Credit Boom, Working Paper, mimeo. 2  See for a stylized model of liquidity creation without banks: S.  Kucinskas, (2015), Liquidity Creation Without Banks, VU University/Tinbergen Institute Working Paper, mimeo, August 17. 1

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continuously moving. Complexity and opaqueness are killing any attempts to create effective and consistent regulatory framework in any field. The econometric madhouse, with its so-called analytical logic and its self-proclaimed truths,3 don’t go well with the rational nature of verbal logic needed to create proper and effective regulation. The shadow banking markets is a poster child example of the problematic nature of the relationship between economic principles and the dogmatic disciplines of regulation, a relationship the ‘law and economics’ sphere has been digging into for over half a century now and with very few guiding principles so far. Even more problematic is the fact that the self-constructed superiority of economists have led to a situation where economists, in their capacity of supervisors, lobbyists or otherwise have been driving regulatory content way too much, thereby ignoring the challenging differences between econometric and verbal logic, often using macroeconomic models that are one-sided,4 labeled as reflecting reality or the truth without any sort of critical questions being asked by regulators. The role of the regulator itself was often there to facilitate the legislative process. Very little else was added by them. If your counterparty is a well-structured, organized, cash-rich globally integrated financial system, you have everything to lose. And I realize that public interest might not be the first thing on regulators’ minds these days anymore, although the stability of public financial markets is a public objective that benefits everybody. Closing the trust deficit in order to maintain to stabilize the role of finance in society is not a matter of macroprudential policy and ex ante regulation. If an industry wants to interact with society, it will have to somehow account for the consequences of that interaction, especially in an industry that matters as much as the financial industry. That’s why the distrust stems so much from the fact that society has extensively observed what happens when things go wrong. That financial capital crumbles under distress is something everybody understands and is able to give it its meaningful place in a capitalist society. But the wearing down of social capital following distressed events is something that is not easily repaired nor forgotten (as the losses here are the most enduring). And although banks and the financial industry have recovered some of their luster and poise, there is still a large bill that needs to be settled. Besides the trust element, there is still the element of ‘purpose’ in banking that needs to be redefined and that seems harder than it sounds.5 That problematic field includes the question of the nature of the economic discipline. In recent years, much has been said about the neoclassical monoculture taught at universities and that has a much wider range of implications than just the content of courses,  See, for example, M. Fourcade et al., (2015), The Superiority of Economists, Journal of Economic Perspectives, Vol. 29, Nr. 1, Winter, pp. 89–114. 4  Many welfare models, for example, are built on the dynamic stochastic general equilibrium model (DSGE model). This has created a very one-dimensional view of welfare optimizing policies, despite the fact that many questions can be asked about the intellectual integrity of the model and the recalibrations needed that didn’t happen (yet); see: A.M. Shordone et al., (2010), Policy Analysis Using DSGE Models: An Introduction, FRBNY Economic Policy Review, October, pp. 23–43; M.  Kolosa and M.  Rubaszek, (2015), How Frequently Should We Re-estimate DSGE Models, International Journal of Central Banking, Vol. 11, Nr. 4, December, pp. 279–305. 5  A. G. Haldane, (2016), The Great Divide, Speech by Andrew G Haldane, Executive Director and Chief Economist of the Bank of England, at the New City Agenda annual dinner, London, May 18. 3

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but also the normative nature of peer review and influence.6 One of the questions on which the jury is still out is, to what degree the regulatory framework is appropriate from a risk perspective given the overall risk sensitivity of an interconnected global marketplace?7 The group of 30 concluded before that the overall risk to stability is as great as ever.8 In a day and age when the nexus between banks and capital markets has come to full maturity and has truly gone global, the discussion about financial stability is one about financial markets and equally so about the real economy. The relevance and public interest dimension as such is never far gone.9 Caruana’s approach10 seems balanced and convincing when he claims that regulation is only part of the problem in a context where banking seems to still qualify as a contaminated industry.11 And as regulation is not the only element in the solution mix, three critical elements play and will play a role for a long to come. There is not a single space in the regulatory sphere where the amount, layers and interaction between regulation, policies of all sorts and natures, as well as technical standards- and that on a global basis- are as intense as in the financial sphere. So three words deserve utmost attention: coherence, calibration and complexity12; and that against the backdrop of a well-functioning financial sector is crucial for generating dynamics related to growth and robustness13 while reducing or managing systemic risk. From the perspective of systemic risk, shadow banking can be defined  See in detail: G.  Racko et  al., (2017), Economics Education and Value Change: The Role of Program-­Normative Homogeneity and Peer Influence, Academy of Management Learning & Education, Vol. 16, Nr. 3, July 6, https://doi.org/10.5465/amle.2014.0280; Haldane focuses on the kaleidoscopic nature of the economic discipline and the ‘more questions than answers’—background economics is emerged with as a grandchild of philosophy. See A. Haldane, (2016), The Dappled World, Speech given by Andrew G. Haldane, Chief Economist, Bank of England, GLS Shackle Biennial Memorial Lecture, November 10. 7  A. Dombret, (2016), The New Normal in Banking – Perspectives for Regulators, Speech by Dr. Andreas Dombret, Member of the Executive Board of the Deutsche Bundesbank, at the Bundesbank reception as part of Eurofinance Week 2016, Frankfurt am Main, November 15 (bis.org). 8  G30, (2016), Shadow Banking and Capital Markets. Risks and Opportunities, G30 Working Paper, Washington, DC, November. 9  See regarding the nexus bans/capital markets: H.  S. Shin, (2016), The Bank/Capital Markets Nexus Goes Global, Speech at the London School of Economics and Political Science, November 15, bis.org 10  J. Caruana, (2016) What Are Capital Markets Telling Us About the Banking Sector?, Speech at IESE Business School conference on ‘Challenges for the Future of Banking: Regulation, Governance and Stability’, November 17. 11  C.  Borio, (2016), The Banking Industry: Struggling to Move On, Keynote Speech at the ‘Competition in Banking: Implications for Financial Regulation and Supervision’, Fifth EBA Research, Workshop, November 28–29. 12  Or put differently: (1) how is this all going to work together as one large well-functioning machine, (2) are these policies and regulation tuned-in to each other given the often different objectives the supporting institutions have, and (3) are we sure the lobbying-induced complexity will not make the instruments idle at a point in time that it really matters? See also: S.  Ingves, (2016), Finalising Basel III: Coherence, Calibration and Complexity, Keynote speech at the second Conference on Banking Development, Stability and Sustainability, December 2, bis.org 13  T. Adrian et al., (2016), Vulnerable Growth, Federal Reserve Bank of New York Staff Reports, Nr. 794, September. 6

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as leveraging on collateral to support liquidity promises. Regulation then becomes efficient and welfare enhancing. The jury clearly is still out on the optimal model of regulation to be used and what we anyway can expect from it when it really matters.14 What we do know is that model-based, transaction-based regulation doesn’t work to achieve a macro-­level of financial stability. Holistic, systematic-proof regulation and policies are hard to design. Especially if it needs to be designed on top of the ashes of a regulatory infrastructure that has proven over and over again that it doesn’t have the properties to observe systemic risk and protect macro-level financial stability. There is still quite some thinking that needs to go into how such regulation should be designed, what properties it should have and how it can deal with things that weren’t foreseen, and possibly could not have been foreseen.15 So when I read that the Financial Stability Board (FSB) is moving to the next phase,16 I wonder what that phase is exactly. I truly hope not that we get overly excited by a novel regulatory infrastructure that hasn’t been tested yet. Admittedly, and as the research examined has indicated, the capital requirement regulation has made the system better off.17 Whether that means a whole lot safer remains to be seen. I’m concerned that the jury is still out on that one. And that is a dangerous place to be at a time when memories about the financial crisis are fading and the willingness to go the extra mile in terms of reforms is showing mental fatigue. The numbers in the global economy have become bigger since the last crisis, and so have the numbers in the financial system (USD 260+ trillion in debt) and in particular in the shadow banking system, (USD 52 trillion in shadow banking assets [narrow measurement]).18 I’m not particularly sure if regulations and policies have properties to deal with such financial juggernaut. Combined with the complexity and opacity of some parts of the financial infrastructure, there are still many places to hide. Regulatory arbitrage, contract imperfection, limited liability for corporations and their directors, and the continuous debt bias are still around and constitutive for many shadow banking activities. Nothing about that feels ‘robust’. At least not in the way I would be looking for, after having witnessed the 2007–2009 abyss as a regulator or supervisor. Doing nothing wasn’t an option, doing something an absolute necessity. But doing the right thing is an engagement of a whole different dimension. The illusion of monitoring, supervising, regulating and stress testing  H.  Nabilou and A.M.  Pacces, (2017), The Law and Economics of Shadow Banking, in Iris H. Chiu & Iain MacNeil (eds.), Research Handbook on Shadow Banking: Legal and Regulatory Aspects, Edward Elgar Publishing, Cheltenham, pp. 7–46. 15  See the interesting and recent report on the matter: G.  Prasanna et  al., (2019), Regulatory Complexity and the Quest for Robust Regulation, Advisory Scientific Committee (ASC) ESRB Report Nr. 8, June 4, via esrb.europe.eu 16  R. K. Quarles, (2019), The Financial Stability Board: Moving to the Next Phase, G20 Research Center, University of Toronto, June, pp. 140–141. I guess the true value is in his closing statements: ‘[m]uch progress has been made since the financial crisis. Yet the recent build-up of vulnerabilities in several areas reminds us that we cannot be complacent.’ 17  See for a very good and recent literature review on the issue: BCBS, (2019), The Costs and Benefits of Bank Capital – a Review of the Literature, Working Paper Nr. 37, June 24, via bis.org. But the BCBS also makes the conclusion subject to a number of important considerations. 18  FSB 2019 numbers. 14

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leaves the idea that there is control. I see that slightly differently. Paper is patient, frameworks are bureaucratic in nature, nobody is really accountable and interventions are ex ante or ex post intrinsically insufficient. The central question then is, are we willing to accept everything the free market produces? But in this case, that is a confronting question because many shadow banking activities are triggered by regulation. The regulator therefore is part of the problem. And the central bank has admittedly become the lender of last resort and willing to underwrite private assets without limits. With such friends you don’t need enemies. The manuscript is updated up till and including 30 June 2019. Non-published articles or papers can be accessed through ssrn.com and/or the web page of the relevant university or institution. Between the different editions of this volume, updates will be provided, most likely in an E-book format. Check the website for further information. June 2019

Luc Nijs

Contents

1 The Macroeconomic Dimensions of Shadow Banking  1 1.1 Introduction   1 1.2 Shadow Banking Dynamics and Monetary Policy   5 1.3 Liquidity Transformation in the Shadow Banking Sector   9 1.4 Policy Implications of the Macroeconomic Understanding of Shadow Banking Dynamics and Activities  13 1.5 Liquidity and Economic Growth  15 1.6 Liquidity Risk Transmission in (Shadow) Banking  16 1.7 What Predicts Financial (In)stability?  18 1.8 Traditional Banks and Shadow Banks: Connected at the Hip  19 1.9 The Interaction Between (Capital) Regulation and the Role of the Shadow Banking System  28 1.10 The Emergence of Hybrid Intermediaries: The Organizational Dimension of Shadow Banking  31 1.11 The Macro-View on Shadow Banking: The Search for Levered Beta  38 1.12 Fragility and Shadow Banking: Does It Have to Be That Way?  43 1.13 Regulatory Arbitrage: Many Ways, Few Solutions (So Far)  45 1.14 Shadow Banking Fragility and Implicit Guarantees in the Banking Sector 49 1.15 Should We Get Rid of the Limited Liability Concept in Shadow Banking? 51 1.16 Financial Fragility and Collateral Crises  57 1.17 The Central Bank and the Private Shadow Banking Market  58 1.17.1 Involvement  58 1.17.2 Should There Be a Lender of Last Resort for the Shadow Banking Market?  65 1.17.3 The Limits of Central Banking Liquidity  68

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1.18 (Shadow) Bank Business Models: Fragility and Sustainability  69 1.18.1 Fragility in Shadow Banking  71 1.18.2 Financial Stability Options for Shadow Banking Entities  74 1.19 The Relationship Between the ‘Solvency’ of the Shadow Banking Sector and the ‘Liquidity’ of the Financial Markets: The Systemic Risk Angle  78 1.20 The (Re)use of Collateral in the Repo Market  81 1.20.1 Introduction  81 1.20.2 Rehypothecation of Repos  82 1.20.3 The Use of Collateral and the Nature and Depth of the Interconnectedness in the Shadow Banking Market  85 1.20.4 Central Banks and Their Collateral Frameworks  91 1.20.5 Haircuts and Collateral Reuse  94 1.20.6 Heterogeneous Collateral Damage  95 1.20.7 Collateral Management and Optimization  96 1.21 Collateral Reuse and the Liquidity Trap  97 1.21.1 Introduction  97 1.21.2 Rehypothecation and Collateral Reuse 101 1.21.3 The Collateral Trap 111 2 Shadow Banking Around the Globe117 2.1 Introduction 117 2.2 Assessing Risks in the Shadow Banking Industry 119 2.3 The Role of Debt and Information Insensitivity in Our Contemporary Financial System 120 2.4 Debt Markets and the Shadow Banking Industry 124 2.5 Keeping the Boon and Banning the Bane in Shadow Banking 126 2.6 Explaining the Growth of the Shadow Banking Market 129 2.7 How Does the Growth and Dynamics of the Global Shadow Banking Sector Translate in (New) Risks? 140 2.8 Drivers of the Shadow Banking System 142 2.9 The Role of Regulation Going Forward 144 2.10 Analyzing Different and Comparing Shadow Banking Systems 148 2.10.1 Introduction 148 2.10.2 The (Near) Global Marketplace for Shadow Banking 150 2.10.3 Which Are the Actors in the Nonbank Financial Intermediary Space? 150 2.10.4 Filtering Out Nonbank Financial Activities 151 2.10.5 Interconnectedness Between Banks and Nonbank Financial Entities152 2.10.6 Private Lending and Private Debt Markets 153 2.11 Comparing the Major Shadow Banking Systems 155 2.11.1 Comparison Between the US and the Chinese Shadow Banking Model 155 2.11.2 Comparing the US and European Shadow Banking Sector 158

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2.12 Contemporary Global Developments in the Shadow Banking Market 159 2.12.1 Introduction 159 2.12.2 Overview of Findings 161 2.12.3 Methodology and Detailed Analysis 162 2.12.4 The Continued Issue of the Interconnectedness Between Banks and Nonbank Financial Institutions 166 2.12.5 Macro-View on All Nonbank Financial Intermediation 168 2.13 Global Shadow Banking and Its Relation with (Offshore) Financial Centers169 2.13.1 Introduction 169 2.13.2 The Regulatory Conundrums When Shadow Banking and Tax Havens Meet 172 2.14 Shadow Banking Emergence in Emerging Economies 174 2.15 Global Shadow Banking in Recent Years (2015–2019) 176 2.15.1 The Most Recent Data Tell Us What Exactly 188 2.15.2 Crowdfunding-Based Lending Models Outside the Banking Sector193 2.15.3 Specific Observations in Niche Segments of the Narrow Shadow Banking Market 194 2.15.3.1 UK Real Estate Funds 194 2.15.3.2 Liquidity Issues at Irish Money Market Funds and Government Bond Funds 195 2.15.3.3 The Dynamics of Leveraged Finance 196 2.15.4 The Nature of Nonbank Credit Innovation Is Continuously Changing197 3 The EU Shadow Banking Market203 3.1 Introduction 203 3.2 The Dynamics of the EU Shadow Banking Sector 205 3.3 The Broader Perspective on Shadow Banking 215 3.4 Drivers of Growth of the EU Shadow Banking System 216 3.5 The EU Policy Approach Regarding Shadow Banking 217 3.6 Shadow Banking and the Impact on the Stability of the Financial Sector220 3.7 The EU’s Regulatory Initiatives in the Field of Shadow Banking 222 3.8 Securities Financing Transactions and Re-collateralization 223 3.9 The Interconnectedness Between the Shadow Banking System and the Traditional Banking System 226 3.10 Sizing the European Shadow Banking Market 227 3.10.1 Introduction 227 3.10.2 How Does the European Shadow Banking Market Compare to Those Elsewhere? 228 3.11 Comparison Between the US and European Shadow Banking Segment230

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3.12 The Dynamics of the Shadow Banking Sector and the EU Financial Stability231 3.13 Central Clearing: Also Systemic Risk in the Making in Europe? 236 3.14 The Capital Markets Union and the Securitization Sector 238 3.14.1 Introduction and Context 238 3.14.2 The Structure and Content of the Securitization Regulation 246 3.14.3 Lower Capital Requirements for Securitization Products 250 3.14.4 Will the CMU Project, and in Particular the Securitization Initiative, Make a Real Difference? 252 3.14.5 EU Capital Markets and the CMU Project 257 3.15 Shadow Banking Is Now a Structural Aspect of the European Financial Infrastructure 265 3.15.1 Introduction 265 3.15.2 Country Specifics in the EU Banking Sector 267 3.15.3 Shadow Banking in Switzerland 274 3.15.4 The Shadow Banking Market in the Netherlands 275 3.15.4.1 Introduction 275 3.15.4.2 Special Financial Institutions 277 3.15.5 The Shadow Banking System in Switzerland 279 3.16 European Shadow Banking in Recent Times 281 3.16.1 Introduction 281 3.16.2 The Growth of the EU Shadow Banking Sector and Financial Stability Risk 282 3.17 Safe Asset Creation (in the EU) 285 3.17.1 Introduction: Manufacturing Safe Assets 285 3.17.2 Safe Assets as a Distinct Asset Segment 292 3.17.3 Are Safe Assets a Problem? 300 3.17.4 The Sovereign Bond-Backed Securities Proposal 308 3.17.5 Alternatives to the SBBS Model 314 3.17.6 Are There Downsides to (Private) Safe Asset Creation? 317 4 Shadow Banking in the Americas321 4.1 Introduction 321 4.2 Findings Regarding Shadow Banking in the Americas 322 4.3 The Real Shadow Banking Exposure in the Americas 323 4.4 A Closer Look at the Shadow Banking Industry in the Region 324 4.4.1 Introduction 324 4.4.2 Structure of the Americas Financial Systems 326 4.4.3 Other Financial Intermediaries 327 4.4.4 Interconnectivity Between OFIs and the Banking Sector 327 4.4.5 Remaining Blind Spots 328 4.5 The Role of International Financial Centers in the Region 328 4.6 Existing Risks from Credit Intermediation in the Region 329

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4.7 The Case of Shadow Banking in the Caribbean 4.8 Shadow Banking in Canada: Why Was Canada Not Badly Hit During the Crisis? 4.9 Recent Evolution in the Americas 4.9.1 Introduction 4.9.2 Recent Trends in the Americas (2016–2019)

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330 331 334 334 334

5 Shadow Banking in Asia341 5.1 Introduction 341 5.2 Key Findings of the Asia-Specific Study 342 5.3 Scoping and Role of OFIs in the Asia Region 345 5.4 A Further Examination of the Demarcation Line Between NBFIs and Shadow Banking 347 5.5 The Intensity and Categorization of Shadow Banking Risks in Asia 347 5.6 Some Asian Shadow Banking Illustrations 353 5.7 Drivers of Shadow Banking in South-East Asia (SEA) 353 5.8 The Asian Financial Centers and Their Shadow Banking Markets 358 5.9 Shadow Banking in the Asia Region—Country Specifics 360 5.10 Shadow Banking in China 375 5.10.1 Introduction 375 5.10.2 The Different Components of the Chinese Shadow Banking System377 5.10.3 The Wealth Management Product Group Market and Outlook383 5.10.4 Wealth Management Products and Trust Companies in China387 5.10.5 The Interconnectedness of the Chinese Shadow Banking Segment389 5.10.6 The Chinese Shadow Banking Market and ‘Information Asymmetry’389 5.10.7 Securitization in China 393 5.10.8 Systemic Risk in the Chinese Shadow Banking System 396 5.10.9 The Political Dimension in the Chinese Shadow Banking Segment398 5.11 Chinese Shadow Banking in Recent Years (2016–2019) 409 5.11.1 Stimulus, Regulatory Intervention and a Changing Marketplace409 5.11.2 China’s Corporate Debt Problem 421 6 Shadow Banking in (South) Africa427 6.1 Introduction 427 6.2 The Remaining African Continent 430 6.3 It’s Direct Neighbor: The Middle East 431

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7 Future Directions433 7.1 Introduction 433 7.2 The Effect of Bank Capital Requirement on Growth 433 7.3 The Holistic Financial Industry and Its Function 435 7.4 Is More Market-Based Funding the Solution? 437 7.5 What Role Should Finance Have in Society and What Benefits Should Be Expected? 440 7.6 The Future of Securitization 442 7.7 Asset Management: A Blind Spot in Terms of Shadow Banking 453 7.7.1 Introduction 453 7.7.2 Incentives and Benchmarking 453 7.7.3 Asset Management and Systemic Risk 467 7.7.4 Vulnerabilities Deriving from Asset Management Activities 469 7.7.5 The Involvement of Pension Funds, Sovereign Wealth Funds and ETFs 479 7.7.6 Regional- and Country-Specific Reporting Regarding Asset Management Activities Within the Shadow Banking Sphere 482 7.8 The Globalization of Banking and the Impact of the Financial Crisis 487 7.9 Shadow Banking and Contemporary Unconventional Monetary Policy490 7.9.1 Introduction 490 7.9.2 Macroprudential Instruments and Shadow Banking 491 7.10 Shadow Banking and Basel III: Do the Costs-Benefits of Financial Regulation Still Matter? 508 7.11 Deepening and Growing the Financial Sector: But How Deep and Big Exactly? 518 7.11.1 Introduction 518 7.11.2 Project Finance and the Role of Leveraged Finance 520 7.11.3 As Long as Societies Change, so Do (Shadow) Banking Institutions521 7.11.4 A Decision-Tree for the Regulator and Oversight Bodies 523 7.11.5 Avoiding Ambiguity and Bringing Down the Last Public Puts525 7.11.6 Financialization and Its Long-Term Implications 526 7.12 The Neglected Risk Syndrome 528 7.13 The Limits of Shadow Banking Supervision 532 7.13.1 Introduction 532 7.13.2 The Liquidity Fetishism 532 7.13.3 A Total Reset of the System Is More than Likely Required 534 7.14 A Capital Markets Union for the EU: Meaningless Acronym or Game Changer?536 7.14.1 Introduction 536 7.14.2 Bank-Biased or Market-Biased Financial System? 540

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7.15 A World without Maturity Transformation: Is It Possible? Is It Desirable?542 7.16 The Regulatory Rat Race Can’t Go on Forever: Equity as the Only Real Backstop in a Private Market 547 7.17 Transforming Shadow Banking into Resilient Market-Based Finance: An Illusion? 557 7.18 Policy, Supervision and Regulation: Tackling Structural Developments568 7.19 Private Money Creation and Financial Regulation 572 7.20 (Shadow) Banking, Financial Regulation, Stability and Liquidity: Let the Puzzling Begin… 581 7.20.1 Introduction 581 7.20.2 The Limits of Regulation 587 7.20.3 Do Shadow Banks Undermine Market Discipline of Traditional Banks? 597 7.20.4 Financial Stability and Regulation 605 7.20.5 The Regulation of Private Money 617 7.20.6 What About Leveraged Loans and the NBFIs Involvement? 627 7.21 From Shadow Banking to Market-Based Finance 630 7.21.1 What Does It Take? 630 7.21.2 The Road to Be Traveled: Between Shadow Banking and Free Market-Based Finance 642 7.22 Are Things Really as They Seem They Are? 643 8 Statement of Principal Conclusions657 List of Abbreviations and Glossary673 Index721

List of Tables

Table 1.1 Table 1.2 Table 1.3 Table 1.4 Table 2.1 Table 2.2 Table 2.3 Table 2.4 Table 2.5 Table 3.1 Table 3.2 Table 4.1 Table 5.1 Table 5.2 Table 5.3 Table 5.4 Table 5.5

Shadow banking dimensions under different macroeconomic phases 11 Policies enacted and the ‘liquidity transformation channel’ 14 Different risk channels 20 Dynamics in explaining the boom and bust pattern of the securitization market 27 The macroprudential toolbox with respect to shadow banking 146 Shadow banking assets breakdown for the major jurisdictions 151 Breakdown of global shadow banking assets by market player 151 Common financial instruments in the US/Chinese shadow banking system157 Evolution of the shadow banking market along the lines of the FSB’s five economic functions 182 European securitization statistics (in USD billions, issuance) 206 Regulatory initiatives taken by the EU Regarding the shadow banking market 207 Key findings of the second Americas shadow banking consultation round (2015) 335 Distinction between NBFIs and shadow banking in an Asian context 348 Shadow banking risk identification in Asia 353 Illustration of shadow banking ‘in action’ in Asia 354 The three-layered Chinese shadow banking system 377 Policy objectives for Chinese shadow banking reforms 406

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List of Boxes

Box 1.1 Externalities and the Shadow Banking Sector 54 Box 2.1 Macroprudential Policy Tools and Shadow Banking 130 Box 2.2 2015 FSB New Measure of Shadow Banking Based on Economic Functions160 Box 3.1 Recent Regulatory, Legislative and Policy Initiatives in Europe Regarding Securitization and the Wider Shadow Banking Segment 214 Box 5.1 China Starts (Starting Late 2013) to Crack Down (Somewhat) on Shadow Banking 399 Box 7.1 Accounting Rules and Regulation: Stormy Twins 445 Box 7.2 The Effects of Peer Benchmarking in the Asset Management Industry 455 Box 7.3 Concentration Through Syndication Enhances Systemic Contagion Risk500 Box 7.4 Is Ex Ante Regulation so Much Better than Ex Post Regulation? 510 Box 7.5 The Different Faces of Market Liquidity 575

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1 The Macroeconomic Dimensions of Shadow Banking

1.1 Introduction It is well understood by now that the shadow banking (SB) industry, its players, activities and evolution do not occur in isolation. In fact they are a direct function of all elements including the nexus that shadow banking has with the many policy domains including microeconomic, macroeconomic and monetary and fiscal policies as well as financial regulation and supervision. Also the evolution and innovation in the financial sector impact its outlook, design and content. A look back in recent history provides ‘fuel’ for that line of thinking. Starting in the 1990s and pretty much all the way into the start of the 2008 financial crisis, the financial system (in the US but also elsewhere) did go through a period of rapid change, growth and innovation. Banking as an industry did transform away from the traditional intermediary functions as loan origination and deposit-taking and engaged into a ‘securitized’ banking model through which loans were ultimately distributed to entities in the shadow banking sphere.1 The implication of that happening is that shadow banking entities came to replicate or at least engage in traditional banking activities including credit and maturity transformation. The consequence was that these shadow banking activities took the same risks as banks but with a (very) limited capital base. That combined with overleverage of the financial system overall created the by now well-known consequences which included financial stability and recessionary conditions. What happened in the period 1990–2008 has however been in the making for decades though. Also in the period before 1990 shadow bank credit expanded each time banks went through traditional cyclical contractions. Even more, while consumer credit and mortgages held by traditional banks were positively correlated with gross domestic product (GDP), those holdings, outside the banking sector, were negatively correlated. The two aggregates  G. Gorton and A. Metrick, (2012), Securitized Banking and the Run on Repo, Journal of Financial Economics, Vol. 104, pp. 425–451. 1

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move in different directions following a monetary tightening.2 It was Meeks et al.3 who demonstrated (through a general equilibrium model4) that the ability of traditional banks to securitize can stabilize the overall supply of credit in the system by offloading it in the shadow banking system, but that it (‘the risk taking by those shadow banking entities’) is also at the root cause of increased macroeconomic volatility.5 Their model doesn’t however capture all complexities of shadow banking activities,6 financial innovation (and its flaws7) and regulatory change (prudential regulation and financial system regulation) as well as the imperfect or suboptimal working of some asset markets (e.g. pricing in the collateralized debt obligation, or CDO, markets8). Also the dynamics of special purpose vehicles and their use to reduce the amount of capital required are left out of scope.9 Their model is built on the understanding that there are ‘two types of financial intermediary, each facing endogenous balance sheet constraints which depend on their net worth’.10 The commercial banks

 W.J. den Haan, and V. Sterk, (2010), The Myth of Financial Innovation and the Great Moderation, Economic Journal, Vol. 121, pp. 707–739; Y. Altunbas, et al., (2009), Securitization and the Bank Lending Channel, European Economic Review, Vol. 53, pp. 996–1009; E. Loutskina, and Philip E.  Strahan, (2009), Securitization and the Declining Impact of Bank Finance on Loan Supply: Evidence from Mortgage Originations, Journal of Finance, Vol. 60, pp. 861–889. 3  R. Meeks et al., (2014), Shadow Banks and Macroeconomic Instability, Bank of England Working Paper Nr. 487 (later on published Shadow Banks and Macroeconomic Instability, Journal of Money, Credit and banking, Vol. 49, Issue 7, October 2017, pp. 1483–1516). 4  Their model (p. 8) is built on four key assumptions: (1) Financial intermediation is key to channel supply of credit as deposit holders cannot enforce contracts; (2) ‘financial institutions are unable to completely pledge the assets they hold on their balance sheets as collateral to raise funds from outside investors.’ This causes creditors to limit their funding to banks and consequently to drive a wedge between the ‘returns earned by savers and the costs incurred by borrowers’; (3) the shadow banking system is a valuable system as it allows ‘collateral to be used more efficiently by transforming illiquid loans into tradable assets, thereby enhancing net aggregate liquidity’. See also: B. Holmstrom and J. Tirole, [2011], Inside and Outside Liquidity, MIT Press, Cambridge, MA, and Z. Pozsar et al., [2013], Shadow Banking, FRBNY Economic Policy Review, Issue December, pp. 1–16, who see value in ‘gains from specialization and comparative cost advantages’ but little in activities driven by regulatory arbitrage; and (4) ‘commercial banks transfer aggregate risk to the shadow banking system (such transfers may be complete or partial), but risk is not transferred to unlevered investors outside of the intermediary sector.’ 5  Through a shock that came from within the system; see in detail: M.  Gertler, (2010), Macroeconomics in the Wake of the Financial Crisis, Journal of Money, Credit and Banking, Vol. 42, pp. 217–219. 6  Their focus is on shadow banks engaged in the bank-like activities of credit transformation (issuing fixed obligations against risky assets) and maturity transformation (issuing short maturity obligations against long maturity assets). 7  For securitized assets, these flaws include poor underwriting incentives, flawed modeling assumptions and opaque security design; see in detail: A. S. Blinder, (2013), After the Music Stopped, Penguin Press, NY. 8  J. Coval, et al., (2009), The Economics of Structured Finance, Journal of Economic Perspectives, Vol. 23, pp. 3–25. 9  See for that in detail: M.K. Brunnermeier, (2009), Deciphering the Liquidity and Credit Crunch 2007–2008, Journal of Economic Perspectives, Vol. 23, pp. 77–100, and Z. Pozsar, et al., (2010), Shadow Banking, July, FRB New York Staff Report Nr. 458. 10  Meeks et al., (2014), ibid., p. 4. 2

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originate the loans and decide how much of those to keep on their balance sheet and how much to offload. From there the securitization process starts as described elsewhere in the book. As indicated there, securitization doesn’t mean that commercial banks are no longer exposed to risk. Commercial banks in their turn invest in securitized products as they are better quality ‘collateral’ material than an idiosyncratic loan book on a balance sheet of a commercial bank. They achieve that by ‘exchanging a direct exposure to the real economy for an intra-financial claim’,11 thereby reducing their costs and possible constraints regarding funding and increase their leverage and profitability. The securitization process distributes that risk, often in a rather opaque way over multiple balance sheets of shadow banking entities creating vulnerability, but with the benefit that it expands the supply of credit by broadening the base of quality pledgeable assets. In case of an adverse shock in the system,12 the traditional and shadow banking system moves in tandem as the supply of collateral from the banks dries up, reducing the shadow banking activities. That shortage of collateral also makes commercial banks reduce credit supply to the real economy. Although shadow banks and traditional banks have separate economic functions, they both face financial constraints. The shadow banking market funds itself through the issuance of securitized products (among others). Those products were bought by, among others, commercial banks looking for higher-quality collateral. Nevertheless, shadow banks retain the more risky (equity or first loss tranches) of securitized products. The distribution of the remaining risk between shadow banking entities and investors relies heavily on the type of liabilities issued by the shadow banking entity. That can be: (1) asset-backed securities (ABS) may offer ‘pass-through’ exposure to an underlying collateral pool (risk sharing whereby the risk ‘contingency of cash flows in the underlying loan pool’ is shared between SB and investor)13; or (2) ABS represent fixed (non-contingent) claims,14 that is, brokers issue one-period discount bonds that promise a fixed return. The consequence of that is that the SB incurs all the risk embedded in the transaction. By doing so, the SB starts to incur bank-like risks (through credit and maturity transformation). This distinction is critical as Meeks et al. demonstrate that ‘the composition of the ABS portfolio turns out to be a crucial determinant of both the relative volatility of bank and shadow bank credit, and the co-movement between them’.15 That risk is withheld in the financial system and concentrated on the balance sheets of financial intermediaries and not distributed to ‘external’ unlevered investors.16

 Meeks et al., (2014), ibid., p. 4.  For a literature overview of financial stability issues surrounding shadow banking and securitization, see: Meeks et al., (2014), ibid., pp. 6–8. 13   H.S.  Shin, (2009), Securitisation and Financial Stability, Economic Journal, Vol. 119, pp. 309–332. 14  Those instruments were favored in the market. Many reasons or arguments are available for that to happen: (1) portfolio preferences by institutional investors and foreign creditors, and (2) regulatory arbitrage to get some level of capital relief by commercial banks. 15  Meeks et al., (2014), ibid., p. 11. 16  See also: N. Gennaioli et al., (2013), A Model of Shadow Banking, Journal of Finance, Vol. 13, pp. 1331–1364. 11 12

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The results of the equilibrium model exercise performed by Meeks et al. demonstrate that difference. While in the first scenario (risk sharing) commercial banks are exposed to aggregate risk through both loan and ABS (or in general securitized products) prices, whereby the losses they make on ABS reinforce the losses they make on loans which reduces their balance sheet capacity and forces them to rebalance their portfolios away from loans and toward ABS (they anticipate that the ABS value will appreciate after the shock). The SB party also undergoes a reduction in balance sheet capacity, but ‘the decline in the mark-to-market value of their liabilities as the price of ABS falls offers partial protection to their net worth’.17 Indeed, they can expand their loan holdings by increasing leverage and using the widened loan-ABS spread. In the latter model (where the SB incurs all the risk as commercial banks hold fixed claims). Meeks et al. conclude, ‘the decline in asset prices triggered by the adverse productivity shock is now fully absorbed by shadow bank net worth, which undergoes a substantial contraction.’18 Asset and ABS values decline consequently. In this scenario, whereby commercial banks’ net worth is (partly) protected, they are able to expand their loan holdings even when scaling back on their loan activities. But, as Meeks et al. further conclude, despite that the ‘total effect on aggregate credit is a substantially larger contraction than under risk sharing securitization, resulting in larger declines in investment, and so a deeper recession’.19 That can be explained as follows: in this scenario commercial banks are less exposed to aggregate risk and so their balance sheet is less impacted. But without the ability to securitize their loan book, total credit will fall by more (compared with scenario one). To put it in perspective, under scenario one ‘commercial bank net worth receives an ­additional boost from the revaluation of their ABS portfolios post-shock. They therefore reduce their overall demand for ABS, inducing the loan-ABS spread to fall to eliminate the resulting excess supply.’ In the latter case, ‘the higher leverage of the shadow banking sector tends to create a large ABS supply response which again leads the loan-ABS spread to fall.’20 A further implication is that under scenario two, the macroeconomic volatility observed is larger compared to model one and is caused by ‘the higher effective leverage of the financial system when shadow banks issue debt-like claims’. It was already indicated that commercial and shadow bank credit tend to move in different directions in response to business cycle shocks. But ‘the cyclical behavior of credit components and spreads depend on the source of the shock, as they depend on the differential responses of aggregate investment.’21 Or put differently, heterogeneity within the financial system produces different macroeconomic outcomes22 at least in case of a shock that affects directly the leverage of financial intermediaries (‘the collateral value of assets held or issued by the shadow banking system became impaired’).

 Meeks et al., (2014), ibid., p. 29.  Meeks et al., (2014), ibid., p. 29. 19  Meeks et al., (2014), ibid., p. 31. 20  Meeks et al., (2014), ibid., p. 31. 21  Meeks et al., (2014), ibid., p. 32. 22  Meeks et al., (2014), ibid., pp. 32–33. 17 18

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Securitization shocks lead to a material reduction in real-economy activity even when offset with cuts in official interest rates and enhanced provision of liquidity.23 The reason for that is that the assets held by the shadow banking system become less effective for raising secured funding.24 The immediate implication of that is a reduction in the supply of securitized assets (banks keep loan portfolios in their books, but selling by SB pushes prices downward impacting commercial banks—the SB balance sheets are highly levered and thus balance sheet adjustments are material). The secondary implication is ‘that shadow bank liabilities become less valuable as collateral for commercial banks’.25 The implication is that commercial banks now have to hold more ABS in their portfolio and are less attractive compared to loans. This has material policy implications26 as Meeks et al. conclude that ‘a policy that raises asset values through direct loan purchases is more effective than a policy that supports the price of ABS (by lending to shadow banks by purchasing asset-­backed securities), reducing funding costs for shadow banks’27 and that ‘the ability of banks to securitize loans when their net worth is impaired can have a beneficial effect on the macroeconomy, acting as a stabilizing force for aggregate activity and credit supply. But when securitization is accompanied by high leverage in the shadow banking system, as is the case when ABS have debt-like characteristics, the economy instead becomes excessively vulnerable to aggregate disturbances.’28

1.2 S  hadow Banking Dynamics and Monetary Policy A further domain that deserves attention and that is related to the discussion above is the question that deals with the question to what degree monetary policy is instrumental to the size and dynamics of the shadow banking market, its players and the content of the ­transactions. The drivers behind the SB market were discussed, in particular to what degree monetary policy related to the growth or slowdown of commercial banking assets and inversely, as discussed above, the slowdown or growth of the shadow banking assets and level of securitization activity. Front-running the actual discussion in this matter, it can be reported that Nelson et al. have considered part of this question and conclude that ‘a contractionary monetary policy shock has a persistent negative impact on the asset growth of commercial banks, but increases the asset growth of shadow banks and securitization ­activity’29 and ‘cast doubt on the idea that monetary policy can usefully “get in all the

 M. Del Negro, et al., (2011), The Great Escape? A Quantitative Evaluation of the Fed’s Liquidity Facilities, Staff Report Nr. 520, Federal Reserve Bank of New York. 24  Meeks et al., (2014), ibid., p. 34. 25  Meeks et al., (2014), ibid., p. 35. 26  See in detail: Meeks et al., (2014), ibid., pp. 35–39. 27  Meeks et al., (2014), ibid., p. 39. 28  Meeks et al., (2014), ibid., p. 40. 29  B. Nelson et al., (2015), Do Contractionary Monetary Policy Shocks Expand Shadow Banking?, Bank of England Working Papers, Nr. 521 (later on published Journal of Applied Econometrics, Vol. 33, Issue 2, March 2018, pp. 198–211). 23

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cracks”30 of the financial sector in a uniform way’. Their starting point is what interests us the most; that is, was monetary policy an (important) driver of financial intermediaries’ balance sheet dynamics and evolution in the run-up to the 2008 crisis? Should monetary policy have been more considerate when it comes to the excessive ‘leverage’ buildup and respond in a countercyclical way? These are relevant questions given the fact that US interest rates have been (very) low for a protracted period of time. It also raises questions, to what degree ‘monetary policy’ has effects beyond the reach of the traditional regulatory tools, that is, the effects of monetary policy on the balance sheet growth of financial intermediaries (both commercial banks and shadow banking entities). Their findings demonstrate that the contribution of monetary policy shocks on asset growth in the financial sector as a whole has been small (less than 10% of the variation in asset growth of US commercial and shadow banks during the period 1966–2007). There is a direct link between the balance sheet dynamics of commercial and shadow banking entities and the role of monetary policy in ensuring financial stability.31 The literature on ‘monetary policy shocks’ is not new32 but has traditionally been focused on the impact of the macroeconomy33 and concluded that the impact is relatively modest when measured at the level of GDP (e.g. impact on GDP of a 100 basis point shock). More recently larger effects were identified of monetary policy shocks on asset prices.34 Since the outbreak of the 2008 financial crisis, the scholarly attention has shifted toward the question ‘how monetary policy may affect the balance sheet dynamics of financial intermediaries’. In short, the answer was that monetary policy might be an important factor vis-à-vis intermediaries’ balance sheets.35 But until recently very little efforts had been going into quantifying that relationship.36

 J.C. Stein, (2013), Overheating in Credit Markets: Origins, Measurement, and Policy Responses, Speech, February 7, Federal Reserve Board. 31  T. Adrian and H.S. Shin, (2009), Money, Liquidity and Monetary Policy, American Economic Review, Vol. 99, Issue 2, pp. 600–605. 32  It goes as far back as C.A. Sims, (1980), Macroeconomics and Reality, Econometrica, Vol. 48, Issue 1, pp. 1–48. 33  B.S.  Bernanke, (2005), Measuring the Effects of Monetary Policy: A Factor-Augmented Vector Autoregressive (FAVAR) Approach, The Quarterly Journal of Economics, Vol. 120, Issue 1, pp. 387–422, and H. Uhlig, (2005), What Are the Effects of Monetary Policy on Output? Results from an Agnostic Identification Procedure, Journal of Monetary Economics, Vol. 52, Issue 2, pp. 381–419. 34  Most recently: M. Gertler and P. Karadi, (2014), Monetary Policy Surprises, Credit Costs and Economic Activity, Journal of Monetary Economics, Discussion Paper. See further references: Nelson et al., (2015), ibid., p. 2. 35  In detail: T.  Adrian and H.S.  Shin, (2008), Financial Intermediaries, Financial Stability, and Monetary Policy, Staff Reports Nr. 346, Federal Reserve Bank of New York (published as Jackson Hole Economic Symposium Proceedings, Federal Reserve Bank of Kansas City, pp. 287–334) and T. Adrian and H.S. Shin, (2010), Financial Intermediaries and Monetary Economics, in Handbook of Monetary Economics, Elsevier, Vol. 3, chap. 12, pp. 601–650. 36  With the notable exception of I. Angeloni, et al., (2013), Monetary Policy and Risk Taking, Discussion Paper. They confirm the earlier findings of both (1) Y. Altunbas et al., (2010), Bank Risk and Monetary Policy, Journal of Financial Stability, Vol. 6, Issue 3, pp. 121–129, and (2) G. Jiménez et al., (2014), Hazardous Times for Monetary Policy: What Do Twenty-Three Million Bank Loans Say About the Effects of Monetary Policy on Credit Risk-Taking?, Econometrica, Vol. 82, Issue 2, pp. 463–505. 30

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Woodford indicates: ‘the increase in the riskless short-term rate did reduce demand and checkable deposits of households and firms, but this did not prevent a net increase in the overall liabilities of financial intermediaries, including shadow banks.’ Nelson et al. contribute to our understanding of the nature (and quantification) of the causal relationship between interest rate and balance sheet dynamics.37 The increase (100 basis points) of the central banking rate has a persistently negative effect on commercial bank asset growth (−0.1%), while it had a positive effect on shadow banking asset growth (+0.2%). However, they also conclude that the impact of contradictory monetary policies was larger in the past (1970–1980s) than during the low interest rate environment post-9/11. After 9/11 ‘policy shocks contributed positively to commercial bank asset growth, but shadow banking activity that expanded rapidly due to increasing securitization seemed to have been curbed by expansionary monetary policy shocks’.38 They therefore argued that the ‘overall importance of unexpectedly loose policy in the pre-crisis build up was small relative to other contributing factors’.39 To the extent there is an effect it is the ‘financing and liquidity position’ of banks that seem to be the key determinants of the impact of monetary policy shocks on the balance sheets of commercial banks. They facilitate the policy transmission. This has important policy implications as the financial system may be unable, due to asymmetric information, to channel liquidity to solvent but illiquid intermediaries.40 The countercyclical impact on shadow banking activity might point, according to Nelson et  al., at a ‘waterbed effect’ whereby ‘commercial banks can circumvent tighter funding liquidity constraints following a contractionary policy shock by possibly increasing their securitization activity, leading to a migration of lending activity beyond the regulatory perimeter to the shadow banking sector’. It allows them to transform illiquid loans into more liquid assets and who, once removed from the balance sheet of the commercial banks, are financed by the issuance of tradable securities (rather than with bank assets).41 They strengthen their model by taking into account the role of asset prices and their impact on the ability of shadow banking entities to intermediate funds.42 Falling asset prices erode collateral value which shadow banking entities use to obtain short-term

 Their model is based on that of Christiano et al.: see L.J. Christiano, et al., (1999), Monetary Policy Shocks: What have we Learned and to what End?, in Handbook of Macroeconomics, (ed.) J. B. Taylor, and M. Woodford, Elsevier, Vol. 1, chap. 2, pp. 65–148. 38  Nelson et al., (2015), ibid., pp. 7–8. 39  Their findings are in line with W.J.  Den Haan, and V.  Sterk, (2011), The Myth of Financial Innovation and the Great Moderation, The Economic Journal, Vol. 121, Issue 553, pp. 707–739. They found that following a monetary policy contraction nonbank mortgages increase as opposed to standard bank mortgages that exhibit a significant reduction. Also see: E. Loutskina, (2011), The Role of Securitization in Bank Liquidity and Funding Management, Journal of Financial Economics, Vol. 100, Issue 3, pp. 663–684. 40  See, for example, X. Freixas and J. Jorge, (2008), The Role of Interbank Markets in Monetary Policy: A Model with Rationing, Journal of Money, Credit and Banking, Vol. 40, Issue 6, pp. 1151–1176. 41  Nelson et al., (2015), ibid., p. 9. 42  M.  Gertler and N.  Kiyotaki, (2010), Financial Intermediation and Credit Policy in Business Cycle Analysis, in Handbook of Monetary Economics, Elsevier, Vol. 3, chap. 11, pp. 547–599. 37

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funding.43 The credit crunch caused deleveraging and a further reduction of asset prices. Credit constraints in the financial system substantially amplify the impact of policy shocks on asset prices and on the balance sheet dynamics.44 Reflecting asset prices in their model, Nelson et al. report that the 1% increase in central banking rate ‘continues to be pro-­cyclical for commercial bank asset growth’ and ‘countercyclical for shadow bank asset growth’.45 Over longer periods of time, however, they identify a ‘stable relationship between monetary policy shocks and commercial bank asset growth’ and ‘a countercyclical impact on shadow bank asset growth’.46 One of the drivers behind that countercyclicality could very well be ‘securitization’. The knowledge we already had was that securitization made monetary less efficient (by lowering the interest elasticity of output).47 Since securitization provides commercial banks with additional sources of funding, it makes commercial banks less prone to cost of funding shocks. The implication is that the regulator can less efficiently direct bank lending through monetary policies.48 So, the bottom-line question is whether securitization activities enhance the countercyclical impact of monetary policy shocks on shadow banking or more precisely whether the countercyclical effect of monetary policy works through securitization. To answer that question Nelson et al. estimate ‘the impact of policy shocks on GSE (Government Sponsored Entities) asset growth’.49 The answer to that question is positive50 and supports the understanding provided by Loutskina that securitization has reduced the sensitivity of aggregate lending supply to traditional bank funding conditions and weakened the credit channel of monetary policy. They conclude that indeed monetary policy is a powerful tool tackling financial excesses as it has a reach far beyond that of financial regulation, but also that ‘a monetary contraction aimed at reducing the asset growth of commercial banks would tend to cause a migration of activity beyond the regulatory perimeter to the shadow banking sector. The monetary response needed to lean against shadow bank asset growth is of opposite sign to that needed to lean against commercial bank asset growth’51 which reduces the effectiveness of monetary policy in this respect. That reinforces the need for prudent regulation as advocated by the Financial Stability Board (FSB)52 in order to ‘moderate excessive swings in risk taking by commercial banks’ and maintain monetary policy as a last line of defense

 M.K. Brunnermeier, (2009), Deciphering the Liquidity and Credit Crunch 2007–2008, Journal of Economic Perspectives, Vol. 23, Issue 1, pp. 77–100. 44  M.  Gertler and P.  Karadi, (2011), A Model of Unconventional Monetary Policy, Journal of Monetary Economics, Vol. 58, Issue 1, pp. 17–34. 45  Nelson et al., (2015), ibid., p. 10. 46  Nelson et al., (2015), ibid., p. 11. 47  A. Estrella, (2002): Securitization and the Efficacy of Monetary Policy, Economic Policy Review, (May), pp. 243–255. 48  E. Loutskina, (2011), The Role of Securitization in Bank Liquidity and Funding Management, Journal of Financial Economics, Vol. 100, Issue 3, pp. 663–684. 49  For an extensive definition of GSEs, see Nelson et al., (2015), ibid., p. 31. 50  For an explanation of the differential impact of monetary policy shocks on the balance sheet dynamics of commercial banks and shadow banks, see Nelson et al., (2015), ibid., pp. 13–21. 51  Nelson et al., (2015), ibid., p. 22. 52  FSB, (2013), Strengthening Oversight and Regulation of Shadow Banking, Report, Financial Stability Board. 43

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against financial instability concerns.53 The larger question at stake, given these findings, is ‘whether traditional interest rate policy is at all effective in curbing excessive credit booms fueled by shadow banks’.54 The answer to that is far from certain positive, as was the case with macroprudential policies.55 The aforementioned ‘waterbed effect’ has proven robust across different assumptions and model specifications. Securitization activity rises after monetary contractions and therefore challenges the effect of monetary policy to achieve financial stability in the market. It will force a disproportionately large size of the monetary policy response (needed to curtain rapid commercial bank asset growth) relative to the past, and it would potentially lead to asymmetric impact across the financial sector (nonuniform impact of monetary policy tools). As I advocate elsewhere in the book, regulatory tools are needed that ‘address the buildup of leverage in the regulated sector more directly than monetary policy does’.56 Elsewhere in the book I will review the current regulatory instruments applied in both the traditional and shadow banking market and illustrate the ‘in my understanding’ material benefits of using a Pigovian type of instrument to tackle the issue. Monetary policy ultimately contributed little to the balance sheet expansion of US financial intermediaries post-9/11, leaving room for argumentation toward financial innovation and others as a potential driver.57

1.3 L iquidity Transformation in the Shadow Banking Sector The intermediaries in the shadow banking system aim to produce or maximize liquidity. They do so by issuing securities that behave as ‘cash’ (i.e. very liquid), but under distress when collateral becomes—as discussed—scarce, it turns illiquid. The need of investors, in times of distress, for crash-proof assets forces the shadow banking system to move toward ‘collateral-intensive’ assets. That in itself results in the fact that the SB system shrinks, reducing liquidity and increasing the risk premium, which make prices and investments to fall. Moreira and Savov58 also indicate that it is often followed by a slow recovery and collateral runs. A scarcity of capital within the financial network aggravates the bust in

 L.O.  Svensson, (2013), Some Lessons from Six Years of Practical Inflation Targeting, mimeo, Stockholm School of Economics. 54  Nelson et al., (2015), ibid., p. 22. 55  S.  Aiyar, et  al., (2014), Does Macro-Prudential Regulation Leak? Evidence from a UK Policy Experiment, Journal of Money, Credit and Banking, Vol. 46, pp. 181–214. 56  Nelson et al., (2015), ibid., p. ii. 57  S. Honkapohja, (2014), Financial Innovation and Financial Stability – Comments, Speech, Bank of Finland and B.S. Bernanke, (2009), Financial Innovation and Consumer Protection, Speech, Federal Reserve Board. 58  A. Moreira and A. Savov, (2014), The Macroeconomics of Shadow Banking, Yale/Stern School of Business Working Paper (later on published as in the Journal of Finance Vol. 72, Issue 6, 2017, pp. 2381–2431). 53

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any economic cycle.59 The macroeconomic dimensions of a business cycle and accompanying regulation run through the balance sheets of financial intermediaries as they are the power box of the economy. The nexus between the macroeconomy and the financial sector seems to fall apart in times of distress. In fact, at those times it is demonstrated that liquidity and wealth generation deviate. Moreira and Savov document that ‘securities are liquid only to the extent that they are backed by sufficient collateral to make their payoffs insensitive to private information’.60 ‘A security is liquid if its expected payoff does not depend too much on private information about the state of the economy. This makes it immune to adverse selection and allows it to trade without incurring price impact or other costs.’ Providing liquidity is clearly linked to and constrained by the supply of collateral as that liquidity promise must be backed by assets. The scarcity of that collateral under distress is fueling the growth of the shadow banking sector. The shadow banking sector engages in liquidity transformation as it allows greater liquidity for each dollar/euro of available collateral. Moreira and Savov comment, ‘[w]hereas an always-liquid, money-like security requires enough collateral to remain informationally insensitive at all times, even in a crash, a near-money security that is only liquid absent a crash uses collateral mainly when it is more abundant, making it cheaper to produce.’61 As such, the liquidity frontier is created by the amount of collateral available and the demand determines the distribution of securities at any given point in time. It also explains why shadow banking securities are less in demand as a crash is increasingly likely—that is, those shadow banking securities will become less liquid as the likelihood of a crash increases. As such investors will behave on the trade-off between sensitivity of the liquidity supply and the demand for liquidity, as the likelihood of a crash ‘drives a wedge between the current value of an asset and its collateral value’.62 That creates the following understanding as reflected in Table 1.1. The collateral decelerator implies the slowdown of the economic regression but also makes that a future economic recovery is more protracted. The already highlighted ‘flight to quality (assets)’ following an uncertainty shock and the resulting rise in collateral premia make ‘safe, collateral-rich assets appreciate even as overall prices are falling’63 (collateral mining).64

 M.K. Brunnermeier and Y. Sannikov, (2014), A Macroeconomic Model with a Financial Sector, The American Economic Review, Vol. 104, Issue 2, pp. 379–421. 60  Moreira and Savov, (2014), ibid., p. 2. 61  Moreira and Savov, (2014), ibid., p. 2. 62  Moreira and Savov, (2014), ibid., p. 3. 63  That is something we have been witnessing even years after the 2008 crisis. Moreira and Savov indicate, ‘[t]he negative co-movement between safe and risky assets during crashes reduces the information sensitivity of diversified asset pools, allowing intermediaries to expand the liquidity supply’; Moreira and Savov, (2014), ibid., p. 4. 64  Demand for collateral causes (under uncertainty) investment in the safe but unproductive asset to pick up (‘collateral mining’); see Moreira and Savov, (2014), ibid., p. 21. 59

Agents flee to crash-proof assets and liquidity Spread between SB assets and regular assets widens Supply of liquidity drops sharply (intermediaries try to meet redemptions). The result is less liquidity transformation, less liquidity and higher discount rates Collateral-­intensive shift of asset purchase Discount rates and risk/collateral premia rise Collateral runsd (aka margins spiral), and movement and prices and haircuts reinforce each other (collateral decelerator) Investments, prices and growth fall. Intermediaries turn to storage-­like assets (e.g. T-bonds) Liquidity transformation, and not liquidity supply, leads to growthe (‘a highly liquid economy need not coincide with a fast-growing one’f) as growth remains low even when intermediaries have ‘restocked’ their balance sheet with crash-proof liquidity assets Intermediaries don’t stop investing in productive capital under uncertainty because of a lack of intermediary capital or a lack of investment opportunities but lower levels of liquidity transformation due to a shrunk SB market

Agents are willing to hold SB assets with small margin over cash Liquidity framework expands which promotes savings and allows SB collateral to lever up Enhanced savings create lower funding costs for intermediaries, passed on to agents as a lower discount cost Lower discount costs lead to higher prices (‘the liquidity transformation enabled by shadow banking lowers the funding cost of the productive asset, boosting its price’a), investments and growth.b The effect is higher for assets with low collateral value (riskier mortgages or loans) and shifts the capital mix in the economy toward more risk Liquidity supply more fragile as ‘real assets’ are crowded out Low levels of uncertainty fuel shadow banking activities and assets and more liquidity transformation which leads to economic enhanced level of activity and growth but simultaneously to higher levels of economic vulnerability (‘shadow banking increases the economy’s exposure to uncertainty shocksc)

b

a

(continued)

Moreira and Savov, (2014), ibid., p. 19 ‘By increasing the supply of liquidity for a given amount of collateral, shadow banking lowers discount rates and pushes up prices, investment, and growth’; Moreira and Savov, (2014), ibid., p. 20 c Moreira and Savov, (2014), ibid., p. 3. The link between liquidity transformation and economic fragility is well documented in recent years; see: (1) M. Baron, and W. Xiong, (2014), Credit Expansion and Neglected Crash Risk, Working Paper, (2) J. Bai, Jennie, et al., (2013), Measuring the Liquidity Mismatch in the Banking Sector, Working paper, (3) M. Schularick, and A. M. Taylor, (2012), Credit Booms Gone Bust: Monetary Policy, Leverage Cycles, and Financial Crises, 1870–2008, American Economic Review, Vol. 102, Issue 2, pp. 1029–1061

Uncertainty is high (uncertainty shock)

Uncertainty is low

Table 1.1  Shadow banking dimensions under different macroeconomic phases

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d Moreira and Savov comment: ‘[c]ollateral runs are a side effect of shadow banking and the fragility it generates. At times of high liquidity transformation, an uncertainty shock not only contracts liquidity provision, increasing discount rates and reducing prices, it also increases the volatility of liquidity provision going forward. The heightened exposure to future uncertainty shocks makes discount rates more sensitive to crashes. As a result, collateral values drop faster than prices (haircuts rise), further amplifying the contraction in the supply of liquidity’; see Moreira and Savov, (2014), ibid., p. 4 e J. Bai, et al., (2013), Measuring the Liquidity Mismatch in the Banking Sector, Working Paper f Moreira and Savov, (2014), ibid., p. 20

Table 1.3 (continued)

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The change in the capital mix during an uncertainty shock (liquidity provision contracts) leads to a protracted slow growth scenario even after the uncertainty has receded. The reverse occurs in the buildup phase, where economic growth continues to fuel liquidity transformation (and not economic activity), which is neglected for longer periods of time even when vulnerability is building up. Collateral runs (aka margin spirals) ‘are episodes during which liquidity creation requires progressively greater amounts of collateral, which is equivalent to a rise in haircuts in financial markets’.65 A collateral run occurs when ‘a simultaneous rise in the level and volatility of discount rates’ (caused by an increased level of uncertainty during the peak of the SB market)’…‘The higher level puts downward pressure on prices, while the higher volatility depresses after-crash collateral values, increasing haircuts’.66 The higher haircuts create a contraction in liquidity transformation, shifting the market toward more expensive funding, which leads to falling prices. When the recession bottoms out, the opposite occurs; that is, asset prices become less sensitive to uncertainty reducing haircuts or, as Moreira and Savov indicate, ‘the haircut-price dynamic reverses so that a “collateral decelerator” eventually puts a floor under asset prices’.67 Building on that they conclude that ‘haircuts initially rise as uncertainty begins to subside, which slows down the recovery of asset prices. The same mechanism that amplifies downturns also prolongs their aftermath.’ The ‘flight to safety’ occurs also when uncertainty recedes. The demand for safe assets means collateral dries up and liquidity transformation nosedives. The premium for collateral goes up and so does the discount rate. The yield between shadow banking assets and safe assets widens. The higher the level of liquidity transformation (and therefore collateral is scarce), the more the delta widens. That phenomenon will occur until ‘uncertainty rises sufficiently (or the capital mix becomes safe enough) so that shadow banking shuts down, flight to quality disappears. Thus, flight to quality results from the acute shortage of collateral that occurs when uncertainty rises suddenly after a shadow banking boom’, they conclude.68

1.4 P  olicy Implications of the Macroeconomic Understanding of Shadow Banking Dynamics and Activities After the 2008 financial crisis, governments across the world have turned to ‘unconventional monetary intervention’. Notable in this respect are (1) the Federal Reserve Bank’s (Fed’s) Large Scale Asset Purchase Program (LSAP, 2008–2010) and (2) the Maturity Extension Program (Operation Twist, 2011–2012). The objective was for the former to

 Moreira and Savov, (2014), ibid., p. 21. Collateral runs are different from typical bank runs. In a collateral run, the intermediaries require more collateral in periods of uncertainty. There is no firstcome first-served scenario as is the case in a ‘traditional’ bank run. 66  Moreira and Savov, (2014), ibid., p. 21. 67  Moreira and Savov, (2014), ibid., p. 22. 68  Moreira and Savov, (2014), ibid., p. 24. 65

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support prices of mortgage-­backed securities by buying them in large quantities. Under the latter, the Fed purchased long-dated Treasuries and sold short-dated ones, with the stated goal of reducing long-term interest rates. The regulator enacted the Volcker Rule (separation of commercial banking and proprietary trading) and the Basel Committee put forward the Basel III package. The question on the table is how these initiatives relate to the ‘liquidity transformation discussed.’69 Table 1.2 tries to illustrate, in a condensed format, the nexus between the components and the liquidity transformation channel. Table 1.2  Policies enacted and the ‘liquidity transformation channel’ Asset purchases under the LSAP The program replaces risky capital with safe capital It increases the amount of collateral on the balance sheet of intermediaries Increases subsidiary liquidity, asset prices and investments; decline of discount rate and decline in collateral premium = price of risky capital up, price of risk-free capital down As it impacts ex post prices, and since ex post prices determine ex ante collateral value it also impacts ex ante collateral values Any potential exposures between the securities swapped is backed by the taxpayer Net impact is favorable for risky capital, and negative for safe capital Taper communication can have material impact on asset prices Conclusion: when liquidity transformation is impaired by (moderate to high) uncertainty, an LSAP-like program facilitates the support of asset prices through collateral transformationa Liquidity requirement Liquidity requirements intend to limit the liquidity mismatch between the assets and liabilities of a bank Tool to mitigate fire salesd/collateral run Liquidity requirements are effective mitigating collateral runs and lead to a reduction of shadow banking issuancee Conclusion: ‘By restraining shadow banking in booms, liquidity requirements reduce the economy’s exposure to uncertainty shocks. This means that prices do not fall as fast when uncertainty rises, so collateral values remain relatively high and haircuts low.’f

Maturity Extension Program The program reduces the duration of safe assets on the balance sheet of intermediaries (i.e. central bank buys long-term bonds and sells floating rate bonds in equal $ amountsb) Impacts collateral value of these assets Any potential exposures between the securities swapped is backed by the taxpayer Intervention reduces the price of risky capital due to flight to quality that makes long-term debt appreciate Raises the aggregate supply of capital, but not under any circumstancec

Volcker Rule Separation between market making and prop. Trading is blurred as market making implies holding large inventory of risky assets. Under uncertainty there is a complementarity between risky and safe assets ‘Flight to quality turns safe capital into a hedge for risky capital on intermediary balance sheets, which raises the overall collateral value of intermediary assets’g (continued)

 For an extensive discussion, see Moreira and Savov, (2014), ibid., pp. 24–29.

69

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Table 1.2 (continued) Conclusion of Moreira and Savov, (2014), ibid., p. 26 See R. Greenwood, (2014), A Comparative-Advantage Approach to Government Debt Maturity, Journal of Finance, Vol. 65, pp. 993–1028 c ‘The EMP is based on the idea that risky productive assets are exposed to duration risk just like long-term bonds, so that reducing the supply of long-term bonds might free up balance sheet capacity for risky investment. In our economy the opposite happens because duration becomes a hedge when flight to quality is strong. This makes long-­ term bonds complements rather than substitutes for risky investment.’ See Moreira and Savov, ibid., p. 27 d J. Stein, (2013), The Fire-Sales Problem and Securities Financing Transactions, At the Federal Reserve Bank of New York Workshop on Fire Sales as a Driver of Systemic Risk in Tri-party Repo and other Secured Funding Markets, New York, 4 October 2013 e ‘The reason is that the cap on liquidity provision curtails the principal advantage of shadow money, the ability to create liquidity with less collateral’; Moreira and Savov, (2014), ibid., p. 28 f Moreira and Savov, (2014), ibid., p. 28 g Moreira and Savov, (2014), ibid., p. 29 a

b

1.5 Liquidity and Economic Growth A further question that requires some answers is to what degree liquidity relates to economic growth. That liquidity in macroeconomic terms is supplied by (short-term) real interest rates that move throughout the economic cycle. That cyclicality of the interest level will determine the credit- and liquidity constraints in any given industry. The interesting question can then be framed how the interaction between the fluctuating shortterm interest rate (i.e. the sensitivity of real short-term interest rates to the business cycle) and the credit and liquidity constraint in industries impacts the long-term growth in industries. Aghion et al.70 have been looking into this matter and conclude: ‘(i) the more credit-constrained an industry, the more growth in that industry benefits from countercyclical interest rates; (ii) the more liquidity constrained an industry, the more growth in that industry benefits from more counter-­cyclical interest rates.’71 Their study is remarkable in the sense that typically a clear distinction is drawn between long-term growth of an industry and the macroeconomic (fiscal and monetary) policies put in place to achieve financial stability. In contrast Aghion et al. argue that stabilization can affect growth in the long run. Financial constraints at the industry level were measured by them either ‘by the extent to which the corresponding industry displays low levels of asset tangibility (this measure captures the extent to which the industry is prone to being credit constrained), or by the extent to which the corresponding industry in the United States features high labor costs to sales (i.e. the extent to which the industry is prone to being liquidity-constrained)’.72 Their main finding is

 Ph. Aghion, et al., (2015), Liquidity and Growth: the Role of Countercyclical Interest Rates, BIS Monetary and Economic Department, BIS Working Papers, Nr. 489. 71  Aghion et al., (2015), ibid., p. 32. 72  Aghion et al., (2015), ibid., p. 3. 70

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that ‘the interaction between credit or liquidity constraints in an industry and real short-term interest rate counter-cyclicality in the country, has a positive, significant, and robust impact on the average annual productivity growth rate of such an industry’.73 The lower the asset tangibility of the sector, the more growth inducing the countercyclicality of the short-term interest rate. The more liquidity-dependent the industry, the more growth enhancing that is when the real short-term interest rate is more countercyclical. Their contribution is that they illustrate that there is a significant growth effect from more countercyclical monetary policies on industries. That complemented our existing understanding of an inverse relation between volatility and long-term growth, and the negative impact on growth of both bad institutions and low financial development.74

1.6 L iquidity Risk Transmission in (Shadow) Banking One of the major concerns that exist among regulators and supervisors is the ability of the connected globalized financial industry to ‘facilitate’ contagion. To be more precise the concern is built around the contagion effect, especially in a day and age when the creditto-GDP ratio has been structurally growing in recent decades. In the case of the shadow banking segment, that contagion effect has as an additional complication that the contagion effect occurs throughout (and often simultaneously) a cascade of balance sheets. It is an understatement up till this day, we know very little about this effect, about what are the drivers and how they interact, as well as the question what the effectiveness is of central bank and government interventions aiming to neutralize or mitigate the ‘liquidity risk transmission’. One of the major problems is that, in contrast to many related issues, it doesn’t suffice to analyze data from a macro- or aggregate perspective but that a microlevel analysis is needed to advance our understanding regarding this matter. During the period 2011–2014 a number of projects have been executed that (start to) help us understand this matter in greater detail. More specifically, the question regarding the exposure of (shadow) banks to liquidity shocks and the resulting impact of liquidity shocks on bank lending deserves some further attention. The latter, however, in this context, is only to a minor degree. The prime question is what ‘balance sheet characteristics’ shape the transmission. Buch and Goldberg75 have been looking into the matter survey-

 Aghion et al., (2015), ibid., p. 3.  See in detail: (1) G. Ramey and V. Ramey, (1995), Cross-Country Evidence on the Link between Volatility and Growth, American Economic Review, Vol. 85, Issue 5, pp.  1138–1151, (2) D. Acemoglu, et al., (2003), Institutional Causes, Macroeconomic Symptoms: Volatility, Crises, and Growth, Journal of Monetary Economics, Vol. 50, Issue 1, pp. 49–123, and (3) D. Acemoglu and F. Zilibotti, (1997), Was Prometheus Unbound by Chance? Risk, Diversification, and Growth, Journal of Political Economy, Vol. 105, Issue 4, pp. 709–751. 75  C.M. Buch and L. Goldberg, (2014), International Banking and Liquidity Risk Transmission: Lessons from Across Countries, Deutsche Bundesbank Discussion Paper, Nr. 17. 73 74

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ing dozens of studies conducted in the aforementioned period. What can be noted upfront is that the liquidity risk transmission does not depend, in a consistent way, on balance sheet characteristics, but that across entities and countries there are many interesting variations and distinctions in the way liquidity risk is transmitted into lending (‘there is substantial heterogeneity in the balance sheet characteristics that affect banks’ responses to liquidity risk’). In general it turned out that the balance sheet structure of banks and the liquidity management between the bank holding and the subsidiaries appear to be important for the transmission of shocks. Another important feature for lending was the liquidity window provided by central banks, who often replace the funding channels that were temporarily available in times of market distress. Also important in understanding the wider context is that domestic and international banks behave differently.76 Domestic banks during market distress show more stable lending patterns than their international counterparts. Those international banks use internal capital markets to manage liquidity, and during times of market distress, they reduce funding to subsidiaries, leading to reduced lending. Further, ‘the structure of host country markets and the bank relationship with that market matters as well for the transmission of shocks. Foreign banks remained more committed to countries hosting an affiliated subsidiary, that are geographically close, and that have developed relationships with local banks.’77 The empirical research can be summarized as illustrating the importance of the following features regarding the nature, size and intensity of the shock transmission being built around ‘the nature of the shock (bank-specific versus global), the balance sheet structure, the degree of internationalization of the bank under study, and the role of public sector liquidity support’.78 But can the heterogeneity of banks to liquidity transmission shocks across countries be explained?79 We know already by now that international banks are more prone than domestic banks. We also know that the pattern of balance sheet drivers co-determines liquidity transmission risk, whereby banks with foreign affiliates are more prone to the

 See in detail: (1) N. Cetorelli and L. Goldberg, (2012), Banking Globalization and Monetary Transmission, Journal of Finance, Vol. 67, Issue 5, pp. 1811–1843; (2) N. Cetorelli and L. Goldberg, (2012), Follow the Money: Quantifying Domestic Effects of Foreign Bank Shocks in the Great Recession, American Economic Review, Vol. 102, Issue 3, pp.  213–218; (3) N.  Cetorelli and L. Goldberg, (2012), Liquidity management of U.S. Global Banks: Internal Capital Markets in the Great Recession, Journal of International Economics, Vol. 88, Issue 2, pp. 299–311; (4) S. Claessens and N. van Horen, (2014), Foreign Banks: Trends and Impact, Journal of Money, Credit and banking, Vol. 46, Issue 1, pp. 295–326; and (5) R. De Haas and I. van Lelyveld, (2014), Multinational Banks and the Global Financial Crisis. Weathering the Perfect Storm?, Journal of Money, Credit and banking, Vol. 46, Issue 1, pp. 333–364. 77  C.M. Buch and L. Goldberg, (2014), International Banking and Liquidity Risk Transmission: Lessons from Across Countries, Deutsche Bundesbank Discussion Paper, Nr. 17, p. 7. 78  C.M. Buch and L. Goldberg, (2014), International Banking and Liquidity Risk Transmission: Lessons from Across Countries, Deutsche Bundesbank Discussion Paper, Nr. 17, p. 8. For details and cross-country analysis, see pp. 14–19 and 24. 79  See other research on this topic: (1) V. Acharya, et al., (2013), How do Global Banks Scramble for Liquidity? Evidence from the Asset-Backed Commercial Paper Freeze of 2007, NYU Stern Working Paper; (2) F.  Allen and D.  Gale, (2000), Financial Contagion, Journal of Political Economy, Vol. 108, Issue 1, pp.  1–33; (3) C.  Buch, et  al., (2013), Do Banks Benefit from 76

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liquidity risk than those that don’t. Buch and Golberg add to that understanding that ‘banks with more cross-border lending growth’ are more sensitive to liquidity shocks. Their interpretation is that ‘banks may subordinate cross-border lending relative to domestic lending activity as stress conditions change. This same pattern of results did not in general show up in the changes in bank lending conducted through the foreign branches and subsidiaries of these same banks. In general though, no single balance sheet factor affects banks’ exposure to liquidity risk in a consistent way across time and across countries (or banks).’80

1.7 What Predicts Financial (In)stability? Following the 2008 financial crisis, the search has been on not only to explain contagion and systemic risk and what is driving its size and magnitude, but also what early warning indicators can help explain (or better predict) contagion risk and more specifically financial instability. They should help to develop a set of matrixes in order to identify vulnerabilities in the financial sector. Accordingly, a set of macroprudential tools should be and are developed. In my understanding tax instruments deserve a more prominent role. I consolidated my thinking in the chapter dealing with a Pigovian approach to the financial industry ­elsewhere in the book (Vol. I, chapter 11) where I further hammered down on the issue regarding the relationship of command and control, quantity regulation and tax instrument in this complex and un-ended debate. Most quantification of those early indicators has been performed using what is known as a Bayesian model, that is, where a set of most probable models are averaged and where the search is for those indicators that are most

Internationalization? Revisiting the Market-Power-Risk Nexus, Review of Finance, Vol. 17, Nr. 4, pp. 1401–1435; (4) N. Cetorelli and L. Goldberg, (2011), Global Banks and International Shock Transmission: Evidence from the Crisis, IMF Economic Review, Vol. 59, Issue 1, pp. 41–76; (5) M. Cornett, et al., (2011), Liquidity Risk Management and Credit Supply in the Financial Crisis, Journal of Financial Economics, Vol. 101, Issue 2, pp. 297–312; (6) R. De Haas and N. van Horen, (2013), Running for the Exit: International Banks and Crisis Transmission, The Review of Financial Studies, Vol. 26, Issue 1, pp.  244–286; (7) M.  Drehmann and K.  Nikolaou, (2013), Funding Liquidity Risk: Definition and Measurement, Journal of banking and Finance, Vol. 37, Issue 7, pp. 2173–2182; (8) G. Hale, et al., (2014), Crisis Transmission in the Global Banking Network. Mimeo; (9) F.  Niepmann, (2013), Banking across Borders, Federal Reserve Bank of NY Staff Reports, Nr. 609; and (10) B. Craig, et al., (2014), Interbank Lending and Distress: observables, Unobservables, and Network Structure, Deutsche Bundesbank Working Paper, Nr. 18. 80  C.M. Buch and L. Goldberg, (2014), International Banking and Liquidity Risk Transmission: Lessons from Across Countries, Deutsche Bundesbank Discussion Paper, Nr. 17, p. 20. They make a caveat when interpreting their results when they indicate ‘generally, the explanatory power of the empirical model is weaker the larger the number of banks. In other words, banks are heterogeneous in their lending patterns, and specifications with larger numbers of banks  – regardless of being domestic or global banks – have more unexplained heterogeneity. Heterogeneity which reflects differences in bank business models may contribute to an enhanced resilience of the system. At the same time, a large degree of heterogeneity in which balance sheet characteristics are associated with more volatile responses by banks also complicates finding appropriate regulatory responses.’

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frequently included. Although a number of indicators seem to appear regularly in stress indexes, ‘excessive credit growth81’, ‘unstable funding of banks (loan-to-­deposit ratio)’ and ‘high return of bank stocks’ seem to the best (or the most consistent) early indicators.82 The main purpose of developing a set of early indicators is ‘to quantify the current state of instability in the financial system, i.e. to summarize the level of stress stemming from different sources into one single (usually continuous) statistic’.83 Different systemic and stress events are sought to be made comparable. That exercise is fairly new84 and many different models exist which tend to vary materially in their set-up. The biggest variation in the models is the fact that they differ with respect to correlation between factors being considered or not. For example, some analyses use only levels or growth rates of variables, while some also take the correlation between the different variables into account.85 What they have in common is the fact that they all try to capture risks for the respective financial system in three main segments: (1) the equity market (often measured through an index), (2) the money market (often measured as the spread between uncollateralized and collateralized interbank loans) and (3) the sovereign bond market (often measured as the spread between the bond yields of the countries involved in the study), often with equal weighting. Three main approaches can be identified with respect to early warning indicators: ‘(1) the signal extraction approach’, (2) discrete choice models and (3) the index-based approach.86 The second method is used the most and risk to financial stability is broken in a number of dimensions.87 In Table 1.3 the risk dynamics of the different channels used are reviewed.

1.8 T  raditional Banks and Shadow Banks: Connected at the Hip From various angles we have already concluded that traditional banks and shadow banking entities coexist in the marketplace and that monetary, fiscal and macroprudential policies and financial regulation co-determine the size, nature and magnitude of both. They

 Other measures for excessive growth of assets, such as total asset growth, off-balance sheet growth or the credit-to-GDP gap, are less convincing; see J.  Eidenberger et  al., (2014), What Predicts Financial (In)Stability? A Bayesian Approach, Deutsche Bundesbank Working Paper, Nr. 36, p. 15. Interesting is that customer loan growth is negatively related to financial stress (see table 6, p. 16). 82  See, for example, J. Eidenberger et al., (2014), ibid. 83  See: D. Holló et al., (2012), CISS – A Composite Indicator of Systemic Stress in the financial system. ECB Working Paper Series, Nr. 1426. 84  The first report on this matter is M. Illing and Y. Liu, (2003), An Index of Financial Stress for Canada. Bank of Canada Working Papers, Nr. 14. For an overview of more recent empirical analysis, see Holló et al., (2012), ibid., pp. 3–4. 85  See the above quoted report of D. Holló et al. (2012). 86  For a detailed analysis of the methods, see J. Eidenberger et al., (2014), ibid., pp. 8–9. 87  For example, Eidenberger et al. used six categories (pp. 9–12): ‘(1) risk-bearing capacity of financial institutions, companies and households, (2) mispricing of risk (measured by asset prices), (3) excessive growth of on- and off-balance sheet positions, (4) macroeconomic development, (5) concentration risk, and (6) interconnectedness of banks’. 81

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Table 1.3  Different risk channels Risk-bearing capacity

Mispricing of risk

Excessive growth of on- and off-balance sheet positions Measured through different Measured either by real Determines the ability of asset price variables credit growth or in individual institutions to Collective mispricing of risk relation to GDP as withstand stress and might lead to instability, credit-to-GDP gap (i.e. mitigates the propagation imbalances and bubbles gap between the ratio of shocks in the financial (unraveling causes of credit to GDP and its system distortions) long-term trend). Low bank capitalization Credit-to-GDP gap is and low bank liquidity are House price growth has been often strongly superior in terms of common indicatorsa related to upcoming forecasting The value of the indicator banking crisesc performance ‘profitability’ is less clear. Profitability peaks around Same holds true for average Includes standard loans but also all kinds of ontwo years ahead of a level of equity prices but and off-balance debt. crisisb but it leads over less convincing and low Parameters are total volatility in equity time to better capitalized credit growth, creditmarketsd banks (although major to-GDP gap, customer distributions can prevent Parameters include equity loan growth, total that from happening). bank index, volatility asset growth and Parameters often include: measurements, house growth of off-balance ratings, loan-to-deposit price developments and sheet assets. ratio, ROE, interest margin bonds spread differentials and leverage ratio Macroeconomic Concentration risk Interconnectedness of developmente banks Concentration is a measure Captures the contagion Most robust predictor of of the uneven distribution macroeconomic variables risk arising from actual of exposures and typically is information on external or perceived amplifies the impact of a imbalances, such as the interlinkages in the single (default) event current account balance, financial system Sectoral concentration (e.g. Default cascades in where a high deficit housing) or dominant signals a crisis banking systems are a single creditors (ratio of Other macroeconomic prime example large exposures to total indicators provide a mixed Variable can give mixed assets (average of all bag (e.g. interest rates) signals: interbank banks))f Parameters can be the assets can increase following: GDP, current financial stress but can account-to-GDP ratio, also point at a healthy exchange rate volatility, interbank marketg inflation and banks’ total assets-to-GDP-ratio a D.  Karim, et  al., (2013), Off-Balance Sheet Exposures and Banking Crises in OECD Countries, Journal of Financial Stability, Vol. 9, pp. 673–681 b M.  Behn, (2013), Setting Countercyclical Capital Buffers Based on Early Warning Models: Would It Work? ECB Working Paper, Nr. 1604, and M.  Drehmann, (2011), Anchoring Countercyclical Capital Buffers: The Role of Credit Aggregates, International Journal of Central Banking, Vol. 7, pp. 189–240

(continued)

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Table 1.3 (continued) C. Detken, et al., (2014), Operationalising the Countercyclical Capital Buffer: Indicator Selection, Threshold Identification and Calibration Options, ESRB Occasional Paper Series, Nr. 5 d See: M. Lo Duca and T. Peltonen, (2011), Macro-Financial Vulnerabilities and Future Financial Stress – Assessing Systemic Risks and Predicting Systemic Events. ECB Working Paper Nr. 1311; M. Behn, (2013), Setting Countercyclical Capital Buffers Based on Early Warning Models: Would It Work? ECB Working Paper, Nr. 1604; M.  Brunnermeier et al., (2013), Assessing Contagion Risks from the CDS Market, ESRB Occasional Paper Series, Nr. 4 e Seems less relevant as a predictor Eidenberger et al., (2014), ibid., pp. 17–18 f Seems less relevant as a predictor Eidenberger et al., (2014), ibid., p. 17 g J.  Eidenberger et  al., (2014), conclude in their analysis that there is a negative correlation; that is, a high share of interbank assets indicates positive market sentiment, that is, a well-functioning (short-term) interbank market (p. 17) c

are truly communicating vessels: bank lending versus market-based lending. In that sense traditional commercial banks compete with shadow banks. They both are intermediaries that create safe ‘money-like’ claims, but in different ways. Hanson et  al. indicate: ‘[t]raditional banks create safe claims by holding illiquid fixed-income assets to maturity, and they rely on deposit insurance and costly equity capital to support this strategy.’ Deposit holders are assured as they aren’t hindered by fluctuations in the market value of the banks’ assets. Shadow banks, however, ‘create safe claims by giving their investors an early exit option requiring the rapid liquidation of assets. Thus traditional banks have a stable source of funding, while shadow banks are subject to runs and fire sale losses’.88 Traditional banks therefore have the advantage of holding illiquid fixed-­income products (asset-backed securities, corporate bonds and mortgage-­backed securities) with modest underlying risk. They tend not to hold liquid products such as money-market paper and T-bonds or equities. In contrast the shadow banks hold relatively and in mainstream liquid assets. What is remarkable in the analysis of Hanson et al. is that they demonstrate that commercial banks followed shadow banking–type strategies before the introduction of the federal deposit insurance system.89 They took in deposits and held assets with shorter duration maturities. That caused more runs on banks than is the case today. The turning point in their asset allocation strategy turned out to be the introduction of the deposit insurance system, as Hanson et  al.’s model predicted. They substantiate their models with an analysis of the aggregate asset and liabilities structures of financial institutions that indeed show that contemporary commercial banks hold a larger proportion in their portfolio that are illiquid. The structure of the financial intermediation has changed over time, they conclude, and makes that shadow and commercial banks coexist in the spectrum of providing ‘money-like claims’ to customers that can be used for transaction

 S.G. Hanson et al., (2015), Banks as Patient Fixed-Income Investors, Harvard/Chicago University Working Paper (later on published as Journal of Financial Economics Vol. 117, Issue 3, September 2015, pp. 449–469). 89  Hanson et al., (2015), ibid. Section IV (pp. 21–24). 88

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purposes.90 They coexist but with a different portfolio of assets backing their activities. Traditional banks hold mostly longer-­term financial (FI) products that, although subject to price fluctuations over time, are relatively risk-free at maturity. They rely on the deposit insurance system and their equity position to do so. It allows for deposit holders to ignore the temporal market price fluctuations. But that funding stability comes at a cost in terms of equity and compliance. The shadow banking system relies mainly on a public backstop to ensure money-like claims and a portfolio of mainly liquid assets. They look at ‘fire sales’ (forced sale below the fundamental value of the asset) as a key source of illiquidity. The ‘fire sale’ of a certain type of asset is larger when the asset is held more by shadow banks and less when the asset is held by commercial banks. The (il)liquidity dynamic and the endogenous fire sale discount reflect an equilibrium. Hanson et al. report, ‘when an asset is held by both intermediary types, the relative holdings of banks and shadow banks must be such that the expected loss to a shadow bank from liquidating an asset at a temporary discount to fundamental value is just balanced by the added cost a traditional bank pays for more stable funding’91 ‘transitory non-­fundamental movements in asset prices are central to understanding financial intermediation, and especially the connection between the asset and liability sides of intermediary balance sheets’.92 A stable funding basis is key when your asset portfolio is predominantly made up out of illiquid assets. Although most of the findings of Hanson et al. are properly embedded in existing literature and research, it also includes some interesting normative features, in particular regarding the migration of intermediation activity from the traditional banking sector to the shadow banking sector. That is a point of contention which is permanently on the radar of regulator and supervisors. In particular the question arises to what degree supervisors should be concerned regarding a migration from traditional to shadow banking activities. The regulatory concern is clear: shadow banking creates negative externalities, as the social cost of fire sales exceeds the private costs93—that is, ‘an intermediary that switches from traditional to shadow banking fails to internalize how this switch reduces liquidation prices and, thus, the feasible amount of money creation by other shadow banks’. In a traditional setting when the shadow banking is too large and the commercial banking market is too small, from a social optimum point of view, the regulator can restore that optimum by imposing a set of minimum required haircuts (e.g. capital requirement94) on shadow banks, and in an effort to push money creation back to the

 J.C.  Stein, (2012), Monetary Policy as Financial-Stability Regulation, Quarterly Journal of Economics, Vol. 127, Issue 1, pp. 57–95, and H. DeAngelo and R. M. Stulz, (2014), Liquid-Claim Production, Risk Management, and Bank Capital Structure: Why High Leverage is Optimal for Banks, Fisher College of Business Working Paper Nr. 2013-03-08. 91  Hanson et al., (2015), ibid., p. 1. See also: S. Chernenko and A. Sunderam, (2014), Frictions in Shadow Banking: Evidence from the Lending Behavior of Money Market Funds, Review of Financial Studies, Vol. 27, Nr. 6, pp. 1717–1750. 92  Hanson et al., (2015), ibid., p. 2. 93  Hanson et  al., (2015), ibid., pp.  31–32. Also G.  Gorton and G.  Ordoñez, (2014), Collateral Crises, American Economic Review, Vol. 104, Issue 2, pp. 343–378. 94  They can also function as a Pigovian tax on ‘fire sales externalities’: see in extenso in the dedicated Pigovian chapter. 90

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traditional banking sector. But also traditional banks create social costs that are not fully internalized, as safe bank deposits imply that the taxpayer absorbs tail risk.95 As a result the structure of ‘financial intermediation may be shaped in important ways by the nonfundamental movements in asset prices—due to fire sales, noise trading, slow-moving capital, and other frictions’.96 It is widely acknowledged that the shadow banking sector grew rapidly before the 2008 crisis, to a large degree driven by the demand for the above-­discussed ‘money-like’ claims. That dynamic implies that investors treat short-­term debt generated by the shadow banking market as money-like claims or investments. That makes sense but has until recently not been properly documented. What we did now was that, and as was discussed at large in the chapter on securitization, the securitization market grew rapidly before the 2008 meltdown because it allowed intermediaries to supply more money-like claims.97 These claims (characterized by short-term safety and liquidity) were backed by highly rated long-term securitized bonds as collateral. It was Sunderam98 who demonstrated that investors, using the asset-backed commercial paper (ABCP) as a proxy,99 indeed treated the short-term debt produced by the shadow banking system as a ‘money-like claim’.100 He does so by documenting the ‘high-frequency, micro-evidence of tight interlinkages between the markets for Treasury bills, central bank reserves, and short-term shadow bank debt’. Those interlinkages help us learn about the pricing and quantities of those claims cause ‘if deposits, Treasury bills, and shadow bank debt all deliver monetary services, then the behavior of prices and quantities across the markets for these claims will be interlinked’.101 Two important considerations following the analysis are the following: (1) low yields on T-bills are to be associated with the issuance of shadow bank debt (shadow banking debt and T-bills are substitutes),102 and (2) the shadow banking response is con-

 See in detail: V.  Stavrakeva, (2013), Optimal Bank Regulation and Fiscal Capacity, London Business School Working Paper; R. Greenwood, et al., (2015), A Comparative-Advantage Approach to Government Debt Maturity, Journal of Finance, Vol. 70, Issue 4, pp. 1683–1722. 96  Hanson et al., (2015), ibid., p. 34; G. Pennacchi, (2012), Narrow Banking, Annual Review of Financial Economics Vol. 4, pp. 141–159. 97  See the discussed: G. Gorton, and al., (2012), The Safe Asset Share. American Economic Review, Papers and Proceedings, Vol. 102, pp. 101–106; G. Gorton and G. Pennacchi, (1990), Financial Intermediaries and Liquidity Creation, The Journal of Finance Vol. 45, pp. 49–71. 98  A. Sunderam, (2015), Money Creation and the Shadow Banking System, HBS Working Paper, p. 3, (also published in Review of Financial Studies Vol. 28, Nr. 4, April 2015, pp. 939–977). 99  ABCP was a larger source of short-term financing for the shadow banking system than repo was; see S. Nagel, (2014), The Liquidity Premium on Near-Money Assets. Working Paper, University of Michigan. 100  See for other prior ‘safe asset’ literature: (1) A. Krishnamurthy and A. Vissing-Jorgensen, (2013), What Drives Short-Term Debt Creation? The Impact of Treasury Supply. Unpublished Working Paper, and (2) G.  Gorton and A.  Metrick, (2010), Haircuts, Federal Reserve Bank of St. Louis Review, Vol. 92, pp. 507–519. 101  Sunderam, (2015), ibid., p. 4. 102  See in detail: Sunderam, (2015), ibid., pp. 19–22. 95

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centrated in the issuance of short-term debt.103 Sunderam’s extrapolations indeed indicate that the increase of ABCP in the run-up to the financial 2008 crisis could account for up to 50% by the increased demand for ‘money-like claims’ by investors. The increasing supply of collateral (to the securitization market) in the post-2008 crisis world has made the ABCP supply more elastic, that is, ‘the same demand shock (“for money-like claims” (ed.)) now produces a larger increase in the quantity of short-term debt.’104 So, the growth in shadow banking activities was driven by the demand for claims that provide ‘moneylike claims’ rather than just short-term debt (T-bills and shadow banking claims are treated as substitutes). I discussed the information insensitivity of the debt markets already before.105 The discussed findings can be connected with Sunderam’s analysis regarding securitization markets. Specifically that implies that originators issue too many informationally insensitive securities in good times. That blunts the incentive for investors to become informed. That endogenous scarcity of informed investors fosters markets to collapse when inefficiency takes over from information-ignorance. The need for ‘safe assets’ is often driven by the need of investors to minimize the reliance on costly informed capital and product. That would point at the need for regulation to limit (in a countercyclical way) the issuance of safe securities.106 Securitization and the accompanied tranching have been argued as being instrumental to economizing information costs but have as a downside that is equally instrumental in facilitating market collapses when the scope for adverse selection rises.107 Hanson and Sunderam document that securitization as such blunts ‘investor incentives to build the information production infrastructure needed to analyze securitization cash flows…’ ‘causing inefficient collapses arising from the interaction between issuer security design decisions and investor information acquisition decisions’.108 There are essentially two ways to increase the informational sensitivity of securities issued: (1) ‘limiting the issuance of informationally insensitive debt in good times would raise the demand for informed capital to purchase equity in the primary market, increasing the returns to being informed. This would induce more investors to become informed

 See in detail: Sunderam, (2015), ibid., pp. 22–24. That makes sense as the secondary markets for commercial paper are not very liquid, which implies that the liquidity of ABCP is derived from its short-term maturities. 104  Sunderam, (2015), ibid., p. 5. 105  See also B. Holstrom, (2015), Understanding the Role of Debt in the Financial System, BIS Working Paper, Nr. 479, discussed in detail. 106  See in detail: S.G.  Hanson and A.  Sunderam, (2012), Are There Too Many Safe Securities? Securitization and the Incentives for Information Production, HBS Working Paper (published in Journal of Financial Economics, Vol. 108, Nr. 3, 2013, pp. 565–584). 107  Hanson and Sunderam argue, ‘Securitization helps economize on infrastructure costs by allowing issuers to create informationally insensitive securities that do not require analysis. However, privately optimal securitization can produce an excessive amount of informationally insensitive securities in good times, endogenously resulting in inefficiently low levels of information infrastructure, which exacerbates collapses in bad times’ (p. 1). 108  Hanson and Sunderam, (2013), ibid., p. 1. 103

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ex ante and alleviate underfunding in bad times’, and (2) ‘constraining originators to issue riskier debt in good times would raise the adverse selection profits available to informed investors trading in the secondary market, again increasing the incentives to become informed ex ante’.109 Therefore there is the need for regulatory intervention in this space as the private market is not able to overcome this friction itself. That is caused by (1) a commitment problem (originators cannot commit to limiting their use of informationally insensitive debt in good times as they at that point maximize their profits by issuing large amounts of informationally insensitive debt) and (2) an issuer that issues informationally sensitive ­securities in good times would induce investors to build ex ante information infrastructure capacity. However, that issuer would not necessarily receive funding from informed investors in bad times, implying that infrastructure is a ‘public good’ from the issuers’ perspective (diffuse costs and concentrated benefits). The consequence is that issuers avoid the cost of issuing information-sensitive securities to informed investors as the risk of underfunded loan pools is material in bad times.110 The information infrastructure of investors therefore is limited to the short term. Hanson and Sunderam therefore advocate that the collapse of the primary market for securitization in 2008 was due to a buyers’ strike (due to adverse selection and lack of information infrastructure) among the uninformed investors upon which the primary market tends to rely.111 Their conclusion implies that haircut regulation (in order to limit fire sales) might not suffice to reduce the vulnerabilities of the securitization markets. The fire sale approach112 assumes that the externality is created by the capital structure of the investors; their model suggests that the externality derives from the capital structure of the originators. Regulation that would structure the capital balance sheet of originators (trusts, special purpose vehicles or SPVs, etc.) would then be needed to avoid that ‘near-riskless securities encourage investors to rationally choose to be uninformed’.113 Although there was an understanding about the demand for ‘money-like claims’ as T-bill substitutes as discussed before in this section, there was little known about the underlying forces that drove demand for securitized products. Chernenko et al.114 identified recently ‘beliefs’ (a misunderstanding of the risks of investing in securitizations helped drive investor demand) and ‘incentives’ (agency problems between professional investors and their principals) as major drivers of demand for these products115 and further report as well that the

 Hanson and Sunderam, (2013), ibid., p. 2.  Hanson and Sunderam, (2013), ibid., p. 3. 111  Hanson and Sunderam, (2013), ibid., p. 3. 112  See in detail: Hanson and Sunderam, (2013), ibid., pp. 27–28. Other explanations of the collapse of the securitization market in 2007–2008 were reliance on ‘credit ratings’ and ‘neglected risk’ (pp. 27–29) with literature references. 113  Hanson and Sunderam, (2013), ibid., p. 4. 114  S. Chernenko et al., (2014), The Rise and Fall of Demand for Securitizations, NBER Working Paper Series, Nr. 20777 (December). 115  See in detail: (1) N.  Gennaioli, et  al., (2012), Neglected Risks, Financial Innovation, and Financial Fragility, Journal of Financial Economics, Vol. 104, pp. 452–468, and (2) C.B. Merrill et al., (2014), Final Demand for Structured Finance Securities, Working Paper. 109 110

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heterogeneity in demand initially reported seems more uniform at closer look. To start with the latter first, they identify at a macro-level, that within the institutional investor pool (who are the (only) buyers with deep enough pockets to be active in the securitization market) the insurers and mutual funds increased their share in nontraditional securitizations in the run-up to the crisis (2003–2007) but that the growth rate did not keep pace with the broader credit market (and so they became increasingly underweight to the market). On a micro-level, the variation in holdings in the institutional pool was due to variation across investors and opposed to variation over time. The characteristics that can be attributed to the mutual funds and their managers holding proportionately more of the nontraditional securitized products116 boil mainly down to experience—that is, ‘inexperienced managers invested significantly less in nontraditional securitizations than inexperienced managers’.117 Although tested on many different features that could explain the difference in behavior between (in)experienced managers, the one argument demonstrating convincing (historical) evidence is differences in ‘belief ’. Those that went through earlier and protracted periods of market turmoil seem to have invested less in nontraditional securitized products than those that didn’t. Previous personal experience seems to matter in this case.118 Overall the heterogeneity picture seems to be that for mutual funds ‘belief ’ seemed to have been the largest driver whereas for insurers ‘incentives’ appear to have played an important role. Their findings fit nicely in the growing theoretical framework that helps to explain the boom and bust in the securitization market. That theoretical framework mainly consists of two wings, that is, those that see ‘distorted beliefs’ and those that see ‘distorted incentives’ as an explanation of the boom in securitized products. That is, on top of the demand for money-like claims as discussed above. In parallel the bust following the boom is explained within that theoretical framework by referring to ‘fire sales’ and ‘buyers strikes’.119 Table 1.4 brings the dynamics of the growing body of literature together.

 On the difference between traditional and nontraditional securitizations, see Section I, Chernenko et al., (2014), ibid., pp. 5–6. 117  Chernenko et  al., (2014), ibid., p.  2. See also: (1) U.  Malmendier, and S.  Nagel, (2011), Depression Babies: Do Macroeconomic Experiences affect Risk-taking?, Quarterly Journal of Economics, Vol. 126, pp.  373–416; (2) J.  Campbell, et  al., (2014), Getting Better or Feeling Better? How Equity Investors Respond to Investment Experience, Working Paper. 118  Other explanations cannot be ruled out, in particular those arguments that are incentive-based. They indicate, for example, that in the case of insurance firms ‘holdings of nontraditional securitizations were higher among larger insurers and insurance companies that had fixed-income portfolios managed by external managers’ (p. 3). In particular when the insurers were poorly capitalized (p. 4) pointing at a misalignment of incentives (referring back to the second criteria ‘incentives’). As they indicate, ‘Among small insurers, the key principal-agent relationship was between the insurer, which may have lacked the expertise necessary to directly invest in securitizations, and external portfolio managers. Among larger insurers, the key principal-agent relationship was between creditors and equity holders’ (p. 4). It were those mutual funds with large securitization holdings that also suffered the largest outflows during the crisis, which is in line with our understanding of ‘fire sales’; see E. Dávila, (2014), Dissecting Fire Sales Externalities, New York University Working Paper. 119  See in detail Chernenko et al., (2014), ibid., pp. 7–10. 116

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Table 1.4  Dynamics in explaining the boom and bust pattern of the securitization market Boom pattern Beliefsa Theory is built around the understanding that ‘investors misunderstood the risks of investing in nontraditional securitizations’ Investors neglected the risk of a substantial downward correction of housing prices, and therefore considered a diversified portfolio of residential mortgages (almost) risk-free (and therefore took the AAA rating at face value) Investors ignored the systemic risk in securitization and the deterioration of underwriting standards Beliefs impacted in particular the behavior of ‘unexperienced’ and/or ‘unsophisticated’ investors

Incentivesb Built around ‘agency problems’—that is, they understood the risky nature of nontraditional securitizations, but have been incentivized to buy (more of) these products than if the principal would have done himself Theories differ in where they put the critical agency conflict ‘pain’ Heterogeneity due to (1) performance flow relationship which implies that managers realize that inflows are a function of past performance. They take more risk, to maximize future compensation, even when it doesn’t maximize current performance. The same holds true for insurers who outsource (some of) their portfolios. Insurers cannot properly observe risk in those cases, especially when dealing with AAA-rated securitized that tend to perform well outside the very narrow, low probability case positions; (2) risk shifting between investors and fund managers whereby fund managers bought nontraditional securities to capture the higher yield (thereby increasing their expected payoff) while reducing total firm value at the expense of creditors, for example, in case the investor was a not so wellcapitalized insurer. Investors/fund managers are reluctant to counterinvest and prefer often to ride a bubble rather than lean against them

Bust pattern Fire salesc Buyers striked Strike driven by uncertainty about the ultimate value Forced sales, often due to of securitized products (downward price spiral caused leverage constraints, to by absence of trades) sell at below fundamental value, which Absence or refusal to trade can be caused by (1) investors facing risk shifting, (2) adverse selection further tightened mechanisms (uncertainty about asset valuation leverage constraints widened the gap between informed and uninformed (which forced further fire investors too much and trades subsequently sales—amplification) collapsed) or (3) tightening capital constraints when Buyers were traders with a securities were sold at fire sale discounts more active trading pattern Accounting system played a role: mark-to-market versus cost accounting (continued)

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Table 1.4 (continued) See: (1) N. Gennaioli, et al., (2012), Neglected Risks, Financial Innovation, and Financial Fragility, Journal of Financial Economics, Vol. 104, pp. 452–468, and (2) U. Rajan, et al., (2015), The Failure of Models That Predict Failure: Distance, Incentives and Defaults, Journal of Financial Economics, Vol. 115, Issue 2, pp. 237–260 b See: (1) J. Chevalier, and G. Ellison, (1997), Risk Taking by Mutual Funds as a Response to Incentives, Journal of Political Economy, Vol. 105, pp. 1167–1200; (2) M. Jensen and W. H. Meckling, (1976), Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure, Journal of Financial Economics, Vol. 3, pp. 305–360; (3) V.V. Acharya, M. Pagano and P. Volpin, (2014), Seeking Alpha: Excess Risk Taking and Competition for Managerial Talent, European Corporate Governance Institute (ECGI)  – Finance Working Paper Nr. 398/2014; (4) T.  Adrian and H.  S. Shin, (2014), Procyclical Leverage and Value-at-Risk, Review of Financial Studies Vol. 27, pp. 373–403; (5) A. Landier, et al., (2011), The Risk Shifting Hypothesis, IDEI Working Paper Nr. 699; (6) A. Beltratti and R. M. Stulz, (2012), The Credit Crisis Around the Globe: Why Did Some Banks Perform Better? Journal of Financial Economics, Vol. 105, pp.  1–17; (7) I.  Erel, et  al., (2013), Why did Holdings of Highly-Rated Securitization Tranches Differ so Much Across Banks? Review of Financial Studies, Vol. 27, pp. 404–453; (8) V.V. Acharya, et al., (2013), Securitization Without Risk Transfer, Journal of Financial Economics, Vol. 107, pp.  515–536; (9) B.  Becker and V. Ivashina, (2015), Reaching for Yield in the Bond Market, Journal of Finance, Vol. 70, Issue 5, pp. 1863–1902; and (10) R.  Koijen and M.  Yogo, (2015), The Cost of Financial Frictions for Life Insurers, American Economic Review, Vol. 105, Issue 1, pp. 445–475 c See: (1) C. Merrill, et al., (2014), Were There Fire Sales in the RMBS Market? Ohio State University Working Paper, and (2) A. Ellul, et al., (2014), Mark-to-Market Accounting and Systemic Risk: Evidence from the Insurance Industry, Economic Policy, Vol. 29, pp. 297–341 d See: (1) D.W. Diamond and R. G. Rajan, (2012), Illiquid Banks, Financial Stability, and Interest Rate Policy, Journal of Political Economy, Vol. 120, pp. 552–591; (2) T.V. Dang, et  al., (2013), Ignorance, Debt, and Financial Crises, Working Paper; (3) K.  Milbradt, (2012), Level 3 Assets: Booking Profits, Concealing Losses, Review of Financial Studies, Vol. 25, pp. 55–95; and (4) S.G. Hanson, et al. (2013), Are There Too many Safe Securities? Securitization and the Incentives for Information Production, Journal of Financial Economics, Vol. 108, pp. 565–584 a

1.9 T  he Interaction Between (Capital) Regulation and the Role of the Shadow Banking System It has been already highlighted on a couple of occasions throughout the book that the shadow banking system is a dynamic environment. In that sense, the shadow banking system of 2015 or 2016 is quite different than that of the pre-2008 crisis. It has been illustrated there what factors drive the growth of the shadow banking sector in most parts of the world. Although the answer is subject to many local co-determinants, there is no doubt that (capital) regulation has a strong impact on how the shadow banking system has evolved and will evolve going forward. Duca can be credited for putting things into perspective over multiple decades going back as the early 1960s. His findings, which I will discuss a bit further, indicate that changing information and capital reserve requirements play a material role in shaping the shadow banking market. But equally so did the shift in regulation between banks and nonbank credit institutions. Those elements play a role in

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shaping the shadow banking market longer term. Shoter-term the SB share rose when deposit interest rate ceilings were binding, the economic outlook improved, or risk premia declined, and fell when event risks disrupted financial markets’.120 The funding of the short-term business credit needs of nonfinancial corporations occurred increasingly by nonbanking institutions or by the markets directly (commercial paper) and has doubled since the 1960s. The importance is clear: both commercial paper and nonbank credit markets are vulnerable to market shocks. Or put differently: the share and intensity through which business is financed through securities markets have increased materially displaying the longer-term effect of banking regulation. Bringing to mind what were the identified drivers behind the shadow banking system the following needs to be brought to mind. In the long run the impact of reserve and other regulatory requirements (and securitization) has been identified as instrumental in explaining the shift to using nonbank loans. Also the changes in information costs have been illustrated as having contributed to that phenomenon.121 In the short run the following drivers have been identified: (1) increasing default risk, (2) increasing cost of funds (increased risk premia), (3) liquidity risk and risk aversion, (4) vulnerability of financial firms and (5) the liquidity risk embedded in the financial system.122 It is not a one-way street though; that is, the shift can be both ways (from the traditional banking to the shadow banking sector or vice versa). The most recent crisis illustrated that rising risk premiums in the market can be offset by central banks who purchase assets in the market and that ensure the supply of credit top investment-grade borrowers. That was not the case during the Great Depression of the 1930s, during which commercial paper outstanding fell by about 85% (and only 44% during the 2008 crisis).123

 J.V.  Duca, (2014), How Capital Regulation and Other Factors Drive the Role of Shadow Banking in Funding Short-Term Business Credit, Federal Reserve Bank of Dallas, Research Department Working Paper Nr. 1401 (October). 121  See in detail: (1) A. Berger and G. Udell, (1994), Did Risk-Based Capital Allocate Credit and Cause a ‘Credit Crunch’ in the United States?, Journal of Money, Credit and Banking, Vol. 26, pp.  585–628; (2) G.  Kanatas and S.  I. Greenbaum, (1982), Bank Reserve Requirements and Monetary Aggregates, Journal of Banking and Finance Vol. 6, pp. 507–520; (3) J.V. Duca, (1992), U.S. Business Credit Sources, Demand Deposits, and the Missing Money, Journal of Banking and Finance, Vol. 16, pp. 567–583; (4) L. Ratnovski, (2013), Competition Policy for Modern Banks, IMF Working Paper Nr. WP/13/126; and (5) G.G. Pennacchi, (1988), Loan Sales and the Cost of Bank Capital, Journal of Finance, Vol. 43, Issue 2, pp. 375–396. 122  See: (1) B.S. Bernanke, et al., (1996), The Financial Accelerator and the Flight to Quality, Review of Economics and Statistics Vol. 58, pp. 1–15; (2) T. Adrian and H. S. Shin (2010), Liquidity and Leverage, Journal of Financial Intermediation, Vol. 19, pp. 418–437; (3) J.V. Duca, (2013), The Money Market Meltdown of the Great Depression, Journal of Money, Credit, and Banking Vol. 45, pp.  493–504; (4) N.  Friewald et  al., (2012), Illiquidity or Credit Deterioration: A Study of Liquidity in the Corporate Bond Market During Financial Crises, Journal of Financial Economics, Vol. 105, pp. 18–36; and (5) J.E. Stiglitz, and A. Weiss, (1981), Credit Rationing in Markets with Imperfect Information, American Economic Review, Vol. 71, pp. 393–410. 123  J.V. Duca, (2013), Did the Commercial Paper Funding Facility Prevent a Great Depression Style Money Market Meltdown? Journal of Financial Stability, Vol. 9, pp. 747–758, and B. DuyganBump et  al., (2013), How Effective Were the Federal Reserve Emergency Liquidity Facilities? Evidence from the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility, Journal of Finance, Vol. 68, pp. 715–737. 120

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Duca’s study assesses within that context the short- and long-term relevance of the shadow banking system and in particular how the SB system is impacted by regulatory burdens (on itself and the traditional banking sector) and the information costs. The use of nonbank credit (in particular for commercial paper) is offset against the advantages of bank-based lending which is, due to information and transaction cost advantages, less exposed to risk shifting in the securities markets. Combing the aforementioned shortterm and long-­term drivers four elements were identified that have the potential to influence the relative use of shadow- or market-based funding: (1) reserve and other regulatory requirements, (2) asymmetric information regarding lending and lending compositions, (3) securitization of bank loans and (4) procyclical liquidity premia and leverage.124 Duca’s findings somewhat confirm the existing literature regarding ‘regulatory arbitrage’125 as he concludes that the long-term rise of the shadow banking market is directly and positively related to the reserve requirements of banks and the introduction of financial innovations (e.g. money market funds or MMFs) and that the evolution is negatively correlated to information costs. Regarding the short-term evolution it was observed that (1) the SB share fell when short-term liquidity premia were high, (2) event risks were high and (3) term premia reflected an improving economy. The SB share increased when ‘deposit rate ceilings were more binding or short-run regulatory changes favored nonbank relative to bank finance’. Those findings are ‘consistent with the view that shadow banking is procyclical and vulnerable to liquidity shocks’.126 It is also consistent in a historical context that ‘the provision of credit shifted towards debt whose funding sources were less vulnerable to liquidity shocks’, for example, during the Great Depression. That requires careful attention and continuous reform,127 especially now that it has become clear that capital requirements impact total loans volumes, industrial structure of banking and the relative impact of monetary policy on weak versus stronger capitalized banks.128

 J.V. Duca, (2014), ibid., pp. 6–7.  See: (1) M.J.  Roe, (2011), The Derivatives Market’s Payment Priorities as Financial Crisis Accelerator, Stanford Law Review, Vol. 63, pp. 539–590, and (2) L.A. Stout, (2008), Derivatives and the Legal Origin of the 2008 Credit Crisis, Harvard Business Law Review, Issue 1, pp. 1–38. 126  J.V. Duca, (2014), ibid., p. 31. 127  E.S. Rosengren, (2014), Our Financial Structures—Are They Prepared for Financial Stability? Journal of Money, Credit, and Banking, Vol. 46(s1), pp. 143–156, and P. Jackson, (2013), Shadow Banking and New Lending Channels—Past and Future, in 50 Years of Money and Finance: Lessons and Challenges, The European Money and Finance Forum, Vienna, pp. 377–414. 128  See D.  Corbae and P.  D’Erasmo, (2014), Capital Requirements in a Quantitative Model of Banking Industry Dynamics, Federal Reserve Bank of Philadelphia Working Paper Nr. 14-13. This paper does not include Basel III standards yet and leaves the shadow banking implications unattached. It raises many more questions and some are or are being answered, for example, why do banks offer more floating rate debt than nonbank financial firms do and the wider question of the cross-section/cross-sector effects of the bank debt channel? See: F.  Ippolito et  al., (2014), Bank Loans and the Transmission of Monetary Policy: The Floating Rate Channel, Working Paper. 124 125

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1.10 T  he Emergence of Hybrid Intermediaries: The Organizational Dimension of Shadow Banking Hybrid intermediaries carry in this context the definition of ‘financial conglomerates that control a multiplicity of entity types active in the “assembly line” process of modern financial intermediation, a system that has become known as shadow banking’.129 Cetorelli already argues that for a few years the role and nature of financial intermediation cannot be evaluated, forecasted or properly regulated if the aspect of ‘technology’ is not blended in properly and how it impacts meeting the demand and supply of funds. Without that aspect, the importance of banks as intermediaries, and by extension the rising role of shadow banking, cannot be properly judged. Cetorelli sees in general two major developments: (1) the traditional system of commercial banks as central brokers that performed all functions required for the intermediation of funds has been (gradually) replaced ‘by a much more complex, assembly-line system, with a multiplicity of entity types jointly involved in the completion of the intermediation process’ which has been coined as the ‘shadow banking system’, and (2) a significant organizational transformation in banking firms, which have moved from being traditional commercial banks to become increasingly complex bank holding companies, controlling an enormous amount of subsidiaries and where the traditional commercial banking function is only a small portion.130 It might well be, he argues, that the second evolution is an industry response to the first evolution, a position he took already a few years back.131 The function of commercial banking in a ‘narrow sense’ has been reduced and forced banks almost to ‘move into the shadows’ which in practice translated into expanding the boundaries of their holistic business model to include nonbank business models. It is fair to say that, also under influence of technology, traditional commercial banks received quite some competition in recent years in the core lending space (i.e. deposit-taking and subsequent onward lending with the embedded liquidity and maturity risk). Also securitization as a technique has illustrated the fragmented intermediation chain. Cetorelli comments: ‘the growth of asset securitization and other market innovations, intermediation now takes place through the combined input of a quite diverse group of firms, each contributing some specialized service along much more complex credit intermediation

 N. Cetorelli, (2014), Hybrid Intermediaries, FRB of NY Staff Reports, Nr. 705. ‘A successful hybrid is an offspring of two species that, in a new environment, is better suited for survival than its own parents. Evolution in the financial “ecosystem” seems to have driven the emergence of hybrid intermediaries’; N.  Cetorelli, (2015), Hybrid Intermediaries, Liberty Street Economics, January, 12. 130  Cetorelli, (2014), ibid., p. 1. See also D. Avraham, et al., (2012), A Structural View of U.S. Bank Holding Companies, Federal Reserve Bank of New  York Economic Policy Review, (July), pp. 65–81. The article is part of a special issue: The Evolution of Banks and Financial Intermediation. 131  N. Cetorelli, et al., (2012), The Evolution of Banks and Financial Intermediation: Framing the Analysis, Federal Reserve Bank of New York Economic Policy Review, Vol. 18, Issue 2, 1–12. 129

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chains.’132 It implies more competition from shadow banking entities but also an adaptation from traditional banking conglomerates and an expansion of their organizational design. Through the typical bank holding companies, traditional banking groups are still involved in credit intermediation, but not necessarily through their traditional banking channels. Alternatively, they engage in these activities ‘done through the combined efforts of myriad nonbank firms, including broker-dealers, underwriters, insurance firms, asset management companies, specialty lenders, and others. Financial intermediation goes on in the shadows but with some important qualifications on the specific shade of gray.’133 The financial conglomerate as a whole seems to be better positioned to conduct all the modern-day functions of a financial intermediary compared to the individual subsidiaries including the traditional commercial banking function. From the popular media’s (as well as from the regulators’) view it could be concluded that this evolution only has downsides. I definitely don’t want to downplay the enhanced challenges with respect to the monitoring of risk and the type and nature of the new business models it has brought. The run on shadow banking entities and the systemic risk were center stage in the 2008 financial crisis. Various domains within the ‘shadow banking infrastructure’ were heavily impacted and which included the (1) run on the liabilities of issuers of ABCP, (2) run on ‘repos’, (3) securities lending (recall of cash collateral) and (4) the run on the liabilities of MMFs as extensively described elsewhere in the book. But there are also notable benefits, that is, ‘improved asset and liability management for intermediaries, lower financing costs, gains in liquidity and credit risk allocation, and contributions to the development of capital markets’134; but the vertical integration also provided for ‘better information sharing, centralized risk management, cross-product subsidization, firm-wide guarantees, and internalization of potential frictions that may exist across the separate specialized entities’.135 The value of the ‘organizational angle’ as was approached by Cetorelli provides an extra dimension layer to the discussion about the definition, boundaries and nature of the activities included in the shadow banking system, a discussion that was explored at the beginning of this study. It provides ‘food for thought’ regarding the nature and scoping of oversight and prudential regulation now that in an increasingly rapid fashion the nonbank spectrum (also referred to market-based financing) is becoming center stage in the global ‘financial intermediation’ industry. He seems to imply that credit intermediation that is split over multiple balance sheets, as we have seen in the early shadow banking activities pre-2008 crisis (e.g. securitization), now has become mainstream; that is, the specifics of shadow banking techniques have been mutated and have become a mainstream way of organizational design also for traditional banking groups, undoubtedly driven by the need to adapt, compete and lock-in  N. Cetorelli, (2015), Hybrid Intermediaries, Liberty Street Economics, January, 12 via libertystreeteconomics.newyorkfed.org. Also already to be found in Z.  Pozsar et  al., (2012), Shadow Banking, FRB of NY Staff Reports, Nr. 458, revised. 133  N. Cetorelli, (2015), Hybrid Intermediaries, Liberty Street Economics, January, 12 via libertystreeteconomics.newyorkfed.org. 134  Cetorelli, (2014), ibid., p. 2. 135  Cetorelli, (2014), ibid., p. 6; see also: A. B. Ashcraft, and T. Schuermann, (2008), Understanding the Securitization of Subprime Mortgage Credit, Foundations and Trends in Finance, Vol. 2, Issue 3, pp. 191–309. 132

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market opportunities. I guess that has a basis in reality; that is, the traditional form of intermediation within one organization that ‘simultaneously’ engaged in deposit-taking, maturity, credit and liquidity mismatches is waning.136 That is a process that has been ongoing for decades and is not limited to the SPVs and so on that received all the media attention in recent years. Since the late 1970s insurance firms, leasing companies, MMFs and so on have all changed the intermediation landscape and that provided credit and liquidity solutions distinct from the commercial banks. What makes the recent evolution different than the longer duration evolution is the aforementioned aspect of the ‘technology’ of intermediation. The best-known example of that is the securitization technique. It turned the traditional intermediation model upside down as it changed ‘both the lending model – diminishing the need to hold and manage on-balance sheet portfolios of credit claims – and the funding model as well, since the growing stock of asset-backed securities enhances collateral-­based forms of financing, driving the increasing importance of dealer intermediaries and the markets for both securities lending and repurchase agreements’.137 Intermediation no longer occurs ‘centralized’ but spread out over ‘credit intermediation chains’ and so it is no longer an integrated process but a supply chain looking to effectively match demand and supply of funds. The credit intermediation supply chains that emerged are now owned and managed by nonbanking holdings (often bank holding companies). Cetorelli therefore calls these banking groups hybrid intermediaries, since none of their subsidiaries itself has credit intermediation as a core business model, but the group as a whole is widely represented in that space. In fact, all the different market players138 active in the wider financial sphere have been identifying the cascade of opportunities for which they needed a wider organizational infrastructure, explaining the large number of acquisitions with a diversifying nature (‘significant within-sector consolidation, reflecting nonbanks buying other types of nonbanks’) that occurred during the last decade.139 Although not all banking groups have become hybrid financial intermediaries, Cetorelli comments, ‘I would posit that a firm couldn’t be a successful modern intermediary without having the organizational structure of a financial conglomerate.’140 In fact,

 However, the trend is obvious but that hasn’t avoided that certain institutions (savings bank, community banks, etc.) have stayed truthful to the original model as described. 137  Cetorelli et  al., (2014), ibid., pp.  4–5; see also: A.  Kirk, et  al., (2014), Matching Collateral Supply and Financing Demands in Dealer Banks, Economic Policy Review, Vol. 20, Issue 2, pp. 127–151, and G. Gorton and A. Metrick, (2012), Securitized Banking and the Run on Repo, Journal of Financial Economics, Vol. 104, Issue 3, pp. 425–451. 138  They belong to one or more of the following categories: banks, asset managers, broker-dealers, financial technology companies, insurance brokers, insurance underwriters, investment companies, real estate companies, thrifts and specialty lenders. 139  N. Cetorelli et al., (2014), Evolution in Bank Complexity, FRB of NY Economic Policy Review, December, pp. 85–106, and N. Centorelli and L.S. Goldberg, (2014), Measures of Global Bank Complexity, FRB of NY Economic Policy Review, December, pp. 107–126. On the value creation aspect, see N. Cetorelli, and J. Traina, (2015), Conglomeration and Bank Stock Returns, Working Paper; see a contrario: M.M. Schmidt and I. Walter, (2009), Do Financial Conglomerates Create or Destroy Economic Value?, Journal of Financial Intermediation, Vol. 18, Issue 2, pp. 193–216. 140  N. Cetorelli, (2015), Hybrid Intermediaries, Liberty Street Economics, January, 12. 136

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there is nothing that would prevent nonbanks from engaging in the same vertical expansion momentum as the characteristic of shadow banking entities is that they are not officially recognized as engaging in financial intermediation activities. To prove their point Cetorelli et al. collected regulatory data on the full organizational trees of a large number of bank holding companies (BHCs) and compared them with the most representative BHCs with true banking origins.141 The dataset and comparison when demonstrating ‘similarities in their organizational structure would be an indication of convergence toward the hybrid intermediary business model, and an indication that the path toward hybrid intermediation isn’t exclusive to firms with banking origins’. The data show,142 despite their wide range of industries included or represented, a substantial degree of similarity across all firms, irrespective of their original business model. Well represented (around 80% of total entities analyzed) are credit intermediaries, securities dealers, brokerages, investment banks and other financial investment activities, insurance carriers and investment funds. Remarkable is the level of cross-industry expansion far beyond the typical consolidation strategies. The changing credit supply chains are probably not the only driver, as the same vertical trend is also observed in the nonbank sector. Cetorelli turns the argumentation around when indicating: ‘I argue that developing the organizational structure of a complex financial conglomerate, one that controls those entity types mentioned above—those catering to the process of modern financial intermediation—is a necessary condition to be a successful hybrid intermediary’ ‘efficient integration of the whole process can be achieved through conglomeration’.143 The emergence of credit supply chains leads to hybrid intermediaries, not the other way around. In the second part of his study Cetorelli applies his mainstream analysis to a specific activity being ‘securities lending’. The choice for securities lending has probably everything to do with the complexity of the securities lending intermediation chain. Securities lending is, as discussed, the lending out of securities by often institutional investors owning large portfolios of securities that they hold for longer periods of time. It is a temporary transfer of those securities and the lenders are often, according to the FSB, ‘broker-dealers, engaging in the transaction either for their own market making and for trading activities, or on behalf of their own clients, such as hedge funds’. The complex intermediation chain involved risks which have been well documented in recent times144 and have caused

 The objective is to ‘draw a reasonably clean comparison across financial conglomerates with exante heterogeneous organizational histories and heterogeneous core business activities, with some coming from the core banking side of the industry and some from other directions’; see: N. Cetorelli, (2015), Hybrid Intermediaries, Liberty Street Economics, January, 12. 142  See for a detailed analysis: Cetorelli, (2014), ibid., pp. 7–10. 143  Cetorelli, (2014), ibid., p. 7. 144  See: (1) T. Adrian, et al., (2012), Repo and Securities Lending, Federal Reserve Bank of New York Staff Reports, Nr. 529; (2) P.  Lipson, et  al., (2012), Securities Lending, Federal Reserve Bank of New  York Staff Reports, Nr. 555; (3) F.  Keane, (2013), Securities Loans Collateralized by Cash: Reinvestment Risk, Run Risk, and Incentive Issues, Federal Reserve Bank of New York Current Issues in Economics and Finance, Vol. 19, Issue 3, pp. 1–8; and (4) H. Peirce, (2014), Securities Lending and the Untold Story in the Collapse of AIG, George Mason University Working Paper Nr. 14-12. 141

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regulatory scrutiny in the European Union (EU).145 What changed over time is the fact that historically it was used as a technique to settle client transactions between brokers, but over time it developed into an income-generating activity for all parties involved (the securities are now used in short-selling transactions and in derivative constructions as well as tax/legal arbitrage transactions and constructions). Also the collateral that is provided is often used for reinvestment purposes or for leveraging up the original asset base.146 In such complex intermediation transactions, information asymmetry is a constant problem, that is, quality of borrower and the screening of the collateral especially when the transaction will take place over-the-counter (OTC). The tail risk is often managed by allowing borrowers and lenders to terminate the transaction on-demand and a collateral valuation performed on a daily/weekly basis. That information asymmetry was small when only a small group of brokers were involved but became more problematic when a wider set of market players entered the field that were less familiar with each other. That problem has been somewhat solved through using an intermediation function representing the lenders. Facilitating these transactions over an exchange that acts as a central clearing party (CCP) would further mitigate the risk involved.147 The informational friction indeed has not fully gone away. A sign of that is the fact that the intermediating agent typically offers a ‘credit enhancement’ aka indemnification (contractual obligation against the risk of counterparty default). That implies that when the borrower defaults, the agent is obliged to return the securities to the lender. The exposure is however limited; that is, the difference between the market value of the collateral and the market value of the securities lends out. Offering the indemnification is nothing more than a typical credit guarantee offered by a bank to absorb the loss in a loan portfolio vis-à-vis lenders and deposit holders. In a sense the agent in securities lending also gets involved in credit transformation and therefore financial intermediation. It is very likely given the constraints of the Dodd-Frank Act and the Basel III conditions that indemnification will become materially more expensive for banking institutions and therefore is likely to occur more and more out of the shadow banking system.148 The agent is further often responsible for the cash collateral reinvestment. But since the securities lending transaction can be canceled at any point in time it becomes an effective bank-like liability (maturity and liquidity transformation) for the agent. The intermediation risks149 that come with the position of the agent in securities lending can be summarized as follows150:

 Referring to the 2014 EU Proposal for a regulation of the European Parliament and of the council on reporting and transparency of securities financing transactions. 146  M.  Faulkner, (2007), An Introduction to Securities Lending, Spitalfields Advisors Limited, London. 147  Proposals have been made in that direction: for example, Eurex Clearing, (2014), Eurex Clearing Lending CCP, Overview on the CCP Service for Securities Lending. 148  G. Horner, (2013), The Value and Cost of Borrower Default Indemnification, In View, State Street’s Digest of Topics in Securities Finance, State Street Global Markets, Issue 1. 149  The risks in securities lending are much wider; see International Securities Lending Association (ISLA), (2012), Securities Lending Guide for Policy Makers, London. 150  See in extenso: Cetorelli, (2014), ibid., pp. 14–15. 145

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• Indemnification is a direct claim on the equity providing the indemnity. Calling upon that equity can trigger a cascade of cancellations and liquidity issues. • That distress which shows up on the balance sheet of the agent might compromise other commitments engaged into by the agent. • The cash collateral reinvestment portfolio is prone to run risks when that distress occurs on the balance sheet of the agent, despite segregation of accounts and other protective measures (collateral self-management, avoiding commingled funds, gradual repossession of collateral by borrowers, etc.). • The liquidity stress might be contagious in case the cash/collateral was used in other funding transactions. • Cash collateral reinvestment risk is often not covered by the indemnity provision (as would be the case with banks) which makes it intrinsically fragile unless there is some implicit public or private (i.e. by the agent) backstop guarantee (and accompanying moral hazard).151 It is no surprise that banks, with their large portfolios (and so do a lot of their institutional investor clients which makes access to large pools of portfolios relatively convenient), are among the largest indemnifiers in the field. Cetorelli adds to that ‘they all have trust institutions and other bank-like subsidiaries that for their specific core business are in a natural position to offer and bear the risk of indemnification; they have specialized firms to undertake the administrative functions associated with the role of the agent, such as borrower selection and collateral management, and they also all have broker-­dealer subsidiaries and hence knowledge and expertise from the perspective of the borrower side as well. Finally, they control investment management firms that administer broad sets of investment vehicles, such as money market funds, to handle cash reinvestment needs’,152 thereby hinting at the banks’ ability to integrate the process over the securities lending intermediation chain. Cetorelli identifies that also in insecurities lending the organizational dynamics play out the same way as in his first part of

 There seems to be some evidence that there is an implicit backstop assumption (or at least misalignment between lenders and their agents) among investors given the amount of lawsuits filed post-2008 crisis against agents; see U.S. Government Accountability Office (GAO), 2011, 401(K) Plans: Issues Involving Securities Lending in Plan Investments, Washington, DC: GAO-11359 T. Fed Governor Tarullo indicates: ‘[t]he custodian banks all but universally provided a contractual indemnification to the securities lenders that required them to absorb any losses to the securities lenders if the securities were not returned. But the investment returns, and risk of loss on the reinvestment of cash collateral that would have to be returned to the borrowers of securities, generally were not covered by such indemnifications. Nonetheless, a number of securities lenders seemed to believe otherwise, and in many cases their expectations were fulfilled as custodian banks agreed during the financial crisis to bear at least some of the losses from cash collateral reinvestment programs.’ See D.K. Tarullo, (2012), Shadow Banking After the Financial Crisis, Speech At the Federal Reserve Bank of San Francisco Conference on Challenges in Global Finance: The Role of Asia, San Francisco, California, June 12. op. cit. Cetorelli, (2014), ibid. p. 16. 152  Cetorelli, (2014), ibid., p. 17. 151

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the study; that is, nonbank firms have become significant providers of intermediation services in securities lending of which Blackrock153 is a notable example as not only being the largest asset manager in the world but also one of the largest providers of intermediation services in securities lending. Beyond the benefit of a better understanding of a modern banking group, Cetorelli’s findings regarding the concept of hybrid intermediaries helps in developing effective oversight and regulation of financial intermediaries. It forces an ‘activities (facilitation of credit creation, intermediation of market activities, loan making dependent on shortterm funding) rather than on specific entities’-focused approach toward regulation and oversight and the necessary ‘access to official government backstops’. Indeed, financial intermediation has become decentralized triggering specialization but also triggered an organizational remake causing the fact that traditional banking intermediation is no longer a prerogative of commercial banks. The hybrid intermediaries pose particular regulatory challenges. The fact that these hybrid intermediaries engage in multiple activities, a pure activity-based supervisory model, may lead to suboptimal outcomes or duplication of constraints.154 This is most likely one of the most challenging aspects of the shadow banking sector, especially now that in recent years we have seen operational companies outside the financial sector have started to engage in these intermediation activities. This group includes wholesalers and car producers engaging in financial intermediation activities, often employing a chain of intermediation activities (savings, third-party cash management, credit card management, sale on credit, leading arrangements and even investment activities) outside a typical banking license remit or supervision. It might prove to be so that the financialization of the economy overall has made financial transactions more lucrative than operational activities (in general), and so many firms feel tempted to dip their toes into the treacherous waters of the financial sector, but regulatory scoping and oversight so be fully aware and adapt in a similar way and timely fashion as the market itself. That in itself will be the challenge of the regulatory aspect regarding shadow banking for years and even decades to come. A market-based financing model works perfectly fine and gets back with its feet on the ground regardless of the size and intensity of the shock it has to absorb as long as there is a cushion allowing the firms and the system to, in a proprietary fashion, absorb those shocks (which requires equity or at least loss-absorbing capacity). Fixed-income and credit-related intermediation outside the bank supervisory model was continuously put its stamp on growth, liquidity and credit supply to the market and will magnify the traditional cycle the financial activities undergo.

 See for an interesting, albeit brief, write-up of the dealings of the different subsidiaries of the Blackrock group in the securities lending in the credit intermediation process, which spans from origination of securities lending all the way to the reinvestment management of the cash collateral: Cetorelli, (2014), ibid., pp. 18–19. 154  Cetorelli, (2014), ibid., p. 20. 153

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1.11 T  he Macro-View on Shadow Banking: The Search for Levered Beta It is fair to say that post-2008, most of the attention that has been devoted to shadow banking has been of a micro-view, and it has only been in recent years that the macroview has been given the attention it deserves. That makes sense, in the initial period post-crisis, as the objective was to bring the shadow banking system and its interconnectedness (including those relations with the traditional banking sector) to the attention of policy makers, regulators and supervisors. It became clear from earlier discussions throughout the book that part of the growth of the shadow banking system pre-crisis was due to institutional cash pools looking for safe diversified assets, but with above moneylike returns. Or to be precise equity-like returns but with bond-like volatility. From our discussion regarding the role of debt and the functioning of the debt market, it was clear that shadow bank investors are not looking for alpha, as they are money managers. They are therefore not looking for ‘alpha’ but ‘beta’, but since they are looking for higher returns that must come from ­‘leveraged beta’. The additional question then becomes, who should provide these cash pools with safe liquid assets, the treasury or the shadow banking system? There are important linkages in this respect. The ambition of the SB system to provide levered beta to institutional cash pools influenced the yield of Treasury securities as well as the spreads on mortgages and other fixed-income instruments. It further created balance sheet capacity for the provision of credit to borrowers in the real economy. As discussed in the chapter on Pigovian taxes and securitization, it will be further elaborated that certain SB activities create excess liquidity in the market, which under circumstances can have detrimental side effects. Also monetary policy plays a role as lower Treasury yields drive more liquidity into shadow banking activities and products. Shadow banks are, from that macro-‘angle’, in essence tools that create safe T-bill like products in the structural absence of T-bills. One can wonder if modern financial theory since Markowitz et al. hasn’t created an illusion where above-zero returns can be gained with minimal or disproportional risk taking. In case the answer to that question would be yes, the zero-rate policies have put an end to that line of thinking. Smart beta,155 especially in the Western world, essentially comes, in recent years, down to ‘leverage’ and very little more. Wholesale funded levered bond

 A material portion of the investor base in this space will likely disagree with this statement. Nevertheless, much of the smart beta themes is about better portfolio diversification, arbitraging on risk premia through better structuring and so on. But most of that would and does not yield the fixed-income returns generated by institutional investors. The rest will have to be explained otherwise. See for an intro regarding smart beta: Towers Watson, (2013), Understanding Smart Beta, Sydney; EDHEC, (2014), Robustness of Smart Beta Strategies, Scientific Beta, Paris; W. Cazalet, (2014), Beyond Active and Passive: Using Smart Beta Strategies to Build More Efficient Portfolios, Dreyfus, EDHEC, (2013), Smart Beta 2.0, Paris; B.I. Jacobs and K.N. Levy, (2014), Smart Beta Versus Smart Alpha, The Journal of Portfolio Management, Invited Editorial Comment, pp. 1–3; J. Hsu, (2014), Value Investing: Smart beta versus Style Indexes, The Journal of Index Investing, Vol. 5, Issue 1. 155

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portfolios, according to Pozsar, serve essentially two purposes: ‘first, the provision of quasi Treasury bills through the issuance of shadow money claims to fill the structural shortage of genuine Treasury bills available for institutional cash pools to park their funds in, and second, the provision of excess returns with low volatility – equity-like returns with bondlike volatility  – to those who provide the equity “tranche” of levered bond portfolios: shareholders in financial holding companies (in the case of global banks’ and dealers’ bond portfolios) and the ultimate investors that invest in levered bond funds.’156 The SB-created ‘money claims’ raise the short-term funding available in the market which provides for the leverage that allows to boost expected returns. It has many applications in the SB market, also in the repo market. Wholesale funding and levered fixed-income investing are a financial reflection or implication of economic imbalances related to ‘secular stagnation’, in a globalized context.157 Shadow banking money claims are different from their public counterparts. Public shadow money is backed by public assets although the promise to return the money claim on par or near par on demand is private. But the assets are public and therefore considered (near) risk-free as they benefit from the liquidity window of the Treasury. Private shadow money claims are not more than private money backed by private assets and with a private promise to return the claim (near) on par on demand. They don’t have access to that public liquidity backstop. The broker-dealers and the MMFs are the critical players in the private liquidity provision through SB entities. So much of the money market claims are built on uninsured deposits and shadow banking money claims. Capital market lending through money market funding essentially occurs in that space.158 That also nullifies to a large degree the view that household funding accounts for a big chunk (together with the interbank market funding) for the financial intermediaries funding. A big chunk comes from institutional investors.159 Unlike retail investors, most cash held by institutional parties goes into the financial, not real, economy. But given their size, they would assume bank counterparty risk (effectively an uninsured position) when putting that money on a bank deposit, so they look elsewhere to put those cash amounts to work.160 A first safe alternative are T-bills, but that is a narrow market161 with fairly inelastic supply. So there is limited supply of true safe assets and a limited willingness by cash pools to absorb counterparty risk (through uninsured deposit holdings in excess of the deposit insurance thresholds).

 Z. Pozsar, (2015), A Macro-View of Shadow banking: Levered Betas and Wholesale Funding in the Context of Secular Stagnation, Working Paper, January, p. 2. 157  Pozsar, (2015), ibid., p. 3; L. Summers, (2013), Why Stagflation might Prove to be the New Normal, Summer blog. 158  P. Mehrling et al., (2013), Bagehot Was a Shadow Banker: Shadow Banking, Central Banking, and the Future of Global Finance, Bank of England, Working Paper. 159  See also Z. Pozsar, (2014), Shadow Banking: The Money View, OFR Working Paper 14-4, July. 160  S. Claessens et al., (2012), Shadow Banking: Economics and Policy, IMF Staff Discussion Note, SDN/12/12. 161  At least judged based on monetary premia and a demand/supply analysis for the products, see: (1) R.  Greenwood et  al., (2010), A Comparative-Advantage Approach to Government Debt Maturity, HBS Working Paper Nr. 11–035, and (2) Z. Pozsar, (2011), Institutional Cash Pools and the Triffin Dilemma of the U.S. Banking System, IMF Working Paper, Nr. WP/11/190. 156

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Therefore, they turn to those middle shadow banking money claims, realizing they are not as safe as T-bills but safer than an unsecured deposit status.162 That implies that retail investors often hold more unsecured deposits than institutional investors and that banks’ core liabilities are noncore assets for those institutional cash pools and the other way around; that is, banks’ noncore liabilities are core assets for institutional cash pools.163 Now the drivers behind the rise in wholesale funding markets have become clear, its uses can be analyzed. Pozsar aims to illustrate that wholesale funding and leveraged fixedincome investing are two sides of the same coin. That implies that leverage is likely to occur in many portfolios even those that traditionally are considered unlevered. So it is about the presence of leverage in the different spheres of the investment market through SB money claims. That leverage can also occur through securities lending engaged in by institutional cash pools and derivative constructions.164 But not all of that wholesale funding will eventually make it to the real economy, at least not through traditional banks. Another part of the chain is dominated by the ‘broker-dealers’. The parties who this class of intermediary funds is a whole lot less clear compared to local and global banking institutions. Pozsar indicates: ‘[w]hat we do know is that only a relatively small portion of the short-term repo funding raised by broker-dealers is used to fund dealers’ inventories of long-term securities (an analogue of global banks’ wholesale-funded bond portfolios), and that their bulk ends up being passed on to institutional clients through reverse repo loans (through matched, or close to matched books). This suggests that broker-dealers, similar to global banks and money funds, also function as money dealers but mostly onshore and near-exclusively in the secured money market.’165 Their use of repos to fund their own portfolios is material but incomparable as a technique with loans funded by deposits as is done by banks through the credit intermediation process. What Pozsar here aims at is less comforting, that is, that the rise in institutional cash pools and their behaviors as discussed and the rise in the volume of securities financing are directly related (being ‘the flipside of ’). Broker-dealers are well connected to the other players of the financial spectrum, not in the least the asset managers. What the evidence tells us is that broker-dealers are massive borrowers and lenders of money in the secured money market, but that only a small portion of the short-term funding raised by them via repos is to fund their own inventory of securities (for market-making transactions). The biggest chunk (80% according to Pozsar) is used for so-called ‘matchedbook money dealing activities’, that is, ‘the intermediation of cash versus securities between clients long securities and in need of funding, and cash pools long cash and in need of collateral’166 of which half occurs based on the overnight repo market. The amount of transac-

 Pozsar, (2015), ibid., p.  6, and Z.  Pozsar, (2014), Shadow Banking: The Money View, OFR Working Paper. He argues, ‘secured repos issued by dealers and the diversified exposure to unsecured claims that prime money fund shares represent are safer claims than an unsecured credit exposure to any single bank through uninsured deposits.’ 163  Pozsar, (2015), ibid., p. 7. 164  IMF, (2014), Chapter 1: Improving the Balance between Financial and Economic Risk Taking, GFSR report, October. 165  Pozsar, (2015), ibid., p. 8. 166  Pozsar, (2015), ibid., pp. 9–10: 60% of that category is used for ‘overnight borrowing to fund overnight lending and term borrowing to fund term lending’. 162

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tion that broker-dealers facilitate for which bonds are used as collateral is larger than for those transactions where equity collateral is used (in their prime brokerages). Although the traditional view is that most of this brokerage lending is to hedge funds, Pozsar demonstrates that most goes to either repos or derivatives.167 That implies that not long/short hedge funds but asset managers and levered bond funds/separate account managers (which can also qualify as hedge funds) are the prime volume takers using broker-­dealers as their intermediaries. Levered bond funds occurred only after the tech bubble burst, and is explained by ‘over-concentration in equities and inadequate returns on safe long-term assets’.168 The lowering of interest rates after the burst (and 9/11) by the Fed created a need among institutional investors for products that created the abovementioned equity-like returns with bond-like volatility.169 All the products developed were essentially driven by the notion of targeted risk/return through leverage often transacted through securities financing (securities lending, repos, etc.) or derivatives (swaps, futures). Derivatives are often used to create an artificial reality when the supply of safe T-bills is not available or they provide a better risk-return profile. The idea was to create (levered) bond funds with equity-like returns (or better) but lower levels of risk or volatility for that matter. Lending at short-term rates was implicit in all those levered bond fund strategies, thereby creating ‘levered beta’ rather than ‘alpha’. The borrowing at short-term rates is used for (1) funding—funding of levered bond positions—(2) shorting/securities lending—funding is needed as collateral—and (3) margining in case of derivatives. In such a context the broker-­dealer intermediates between ‘cash pools searching for safety and levered bond portfolios searching for yield’.170 Repos collateralized by bonds have now become shadow money claims replacing T-bills that are lacking in supply for risk-averse institutional cash pools. Levered bonds funds and their need to beat the benchmark matches with the safety-seeking cash pools. Cash pools get the safety of the levered bond funds position and levered bond funds get their returns through leverage-enhanced betas (they use the cash provided by cash pools as collateral). The broker-dealer intermediates but also absorbs imbalances in demand/supply,171 but against an often very tiny capital base. Repos have become the working capital of the financial industry. Institutional cash pools have, through their behavior, created a shift from financing economic transactions to providing working capital to the financial sector which is constantly in need for returns given the material asset-liability mismatches that exist and that are enlarged through ultralow market interest rates. Securities financing does have its place amid financing businesses, purchasing existing assets and consumer credit as a fourth type of credit.172

 Pozsar, (2015), ibid., p. 10.  R. Dalio, (2004), Engineering Targeted Returns & Risks, Bridgewater Associates. 169  So high volatility allocations to equities were replaced by levered low volatility bonds to equal out returns without notable sacrifices. It created new fixed-income strategies, that is, total return, absolute return and risk parity funds often based on credit arbitrage or are solutions-driven. 170  P. Mehrling et al., (2013), Bagehot was a Shadow Banker: Shadow Banking, Central Banking, and the Future of Global Finance, Bank of England, Working Paper. 171  Pozsar, (2015), ibid., p. 12, ‘sometimes short (term funding of overnight exposures) and sometimes long (overnight funding of term exposures)’. 172  Pozsar, (2015), ibid., p. 13. For a detailed review of all actors and investment vehicles involved, see Pozsar, (2015), ibid., pp. 13–17. 167 168

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As indicated, the reduction of market interest rates has fueled the rise of safety-seeking cash pools and levered bond funds. That makes sense. Most of our welfare systems are built upon the understanding of the availability longer-­term normal market interest rates. If not asset-liabilities go out of whack and institutions cannot live upon their promises, leading to higher insurance premia, cutting back on pension payments and so on. Those lower interest rates should have fueled economic growth which we need. An excess supply economy is not fixed with low interest rates either. That has not delivered upon its promise up till today which has led to the conclusion of a secular stagnation and macro-imbalances.173 Summers indicates three ways in which low interest rates cause financial stability: (1) increase risk taking as investors look for yield, (2) leads to irresponsible lending, (3) fuels Ponzi-type systems as low interest rates are low relative to expected returns. To that effect shadow banking has been the financial economy reflection of the same real economy imbalances that are behind the recently revived concept of secular stagnation.174 These imbalances have to do with the skewed distribution of income (capital vs. labor175) and the already mentioned imbalances in future promises. Bringing Pozsar back in: also portfolio preferences of cash pools (for safe short-term assets which are prone to runs when not met with a public backstop as is the case in shadow banking claims) and demographic factors (magnifying asset-liability mismatches) have played a role in increasing financial stability risk.176 A search for yield is a problem, not when interest rates are low in absolute terms, but low relative to expected returns as it promotes arbitrage given the fixed liabilities of many investors. Underfunded pension funds and insurance firms are well represented in the club of levered bond investors and securitized products. A lot of the products which are known as long-only products are materially levered which makes the exposure to leverage larger than could be derived from the normal asset class categories. The bottom line is that there is a degree of correlation between underfunding of pension funds and so on and the degree of allocation to risky (levered) assets.177 It has led to a creeping up of leverage in the system and since ever more capital is managed by a smaller and smaller set of global asset managers, it implies systemic risk (especially when they are forced to sell). Pozsar concludes that institutional investors, in order to meet liabilities, in an environment of underfunding, allocate more to levered and thus risky products. Those products are managed by managers

 VoxEU, (2014), Secular Stagnation: Facts, Causes and Cures, (eds. C. Eurlings and R. Baldwin), London. 174  L. Summers, (2014) in VoxEU, (2014), Secular Stagnation, ibid. 175  Pozsar laments, ‘We can interpret the growth in corporate cash pools as a reflection of imbalances in the distribution of present incomes between capital and labor accumulated over time’ …other causes include ‘globalization, demographics, technological progress, increased sophistication at arbitraging of global tax regimes, and what has been referred to as the rise of the weightless economy’ (pp. 18–19 in detail). 176  Pozsar, (2015), ibid., p. 20. 177  R.C. Caballero, (2013), The Shortage of Safe Assets, Bank of England Presentation, May. 173

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who have to beat the benchmark by offering equity-like returns with bond-like volatility.178 Financial globalization operates as an undercurrent and has contributed to the many imbalances this world knows, not only the economic ones.179

1.12 F ragility and Shadow Banking: Does It Have to Be That Way?180 It was already discussed how the shadow banking sector is inherently fragile and this for many reasons. Some refer to the nature of the products and transactions they are involved in.181 Others refer to the lack of a public liquidity backstop for the shadow banking sector provided by central banks.182 Others point to the nature of banking and derive the inherent and embedded fragility out of there. We have concluded and will conclude that regulatory arbitrage plays a pivotal role in the emergence, design and functioning of any shadow banking system. Regulatory arbitrage induces the coexistence of regulated commercial banks and unregulated shadow banks. But treating the shadow banking and traditional banking sector identical from a regulatory point of view also has its distinct implications. It can stifle growth and it leads to suboptimal results given current levels of capital requirements. Luck and Schempp have been looking a little closer at the dimensions of fragility and it has been discussed before. Let’s remind us of the conclusions first: ‘[f ]irst, the relative size of the shadow banking sector determines the stability of the financial system. If the shadow banking sector is small relative to the capacity of secondary markets for shadow banks’ assets, shadow banking is stable. In turn, if the sector grows too large, it becomes fragile. Second, if regulated commercial banks themselves operate shadow banks, a larger shadow banking sector is sustainable. However, once the threat of a crisis reappears, a crisis in the shadow banking sector spreads to the commercial banking sector. Third, in the presence of regulatory arbitrage, a safety net for banks may fail to prevent a banking crisis.’183 Maturity transformation has been identified as a key cause of instability and fragility in both the banking and shadow banking segment. The difference is that maturity transformation is limited in the banking sector as the interbanking market will close at some point and the capital requirement will eat out of the expected returns. That is not the case in the

 ‘Through a combination of long-only, levered and synthetic exposures to credit, maturity and liquidity risks’; Pozsar, (2015), ibid., p. 22. 179  Pozsar suggests some policy initiatives that could contribute to reducing or neutralizing some of these imbalances; see Pozsar, (2015), ibid., pp. 23–28. 180  S. Kapoor, (2012), Banks: How They Work and Why They Are Fragile, Re-Define Working Paper. 181  J.C. Stein, (2010), Securitization, Shadow Banking and Fragility, Harvard Working Paper. 182  S.  Claessens and L.  Ratnovski, (2014), What Is Shadow Banking, IMF Working Paper Nr. WP/14/25. 183  S. Luck and P. Schempp, (2014), Banks, Shadow Banking and Fragility, ECB Working Paper Nr. 1726, August, Frankfurt am Main. 178

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shadow banking sphere where these elements will have no, or at least no, critical role. However, there are other issues. As was illustrated in the MMF sphere as a major provider of liquidity, sharp contractions in short-term funding become possible in the shadow banking sector, and how such crises may ultimately spread to the commercial banking sector. Fragility then refers to the fact certain entities and/or activities embed the possibility to create or trigger panic-based runs. Luck and Schempp described the process as follows: ‘If the short-term financing of shadow banks breaks down, they are forced to sell their securitized assets on a secondary market. If the size of the shadow banking sector is small relative to the capacity of this secondary market, shadow banks can sell their assets at face value in case of a run. Because they can raise a sufficient amount of liquidity, a run does not constitute an equilibrium. However, if the shadow banking sector is too large, the arbitrageurs’ budget does not suffice to buy all assets at face value. Instead, cash-in-the-market pricing leads to depressed fire sale prices in case of a run. Because shadow banks cannot raise a sufficient amount of liquidity, self-fulfilling runs constitute an equilibrium.’184 Their second finding is that when commercial banks engage in shadow banking themselves, an enlarged shadow banking market is sustainable. By intertwining, the shadow banking market benefits from the safety net of the commercial banks. But that comes with a number of caveats. First, there is an outer limit after which the entangled system becomes unsustainable and fragile. And when it does, it impacts the entire sector (including the commercial banking sector) right away. That bridges to their third finding which was that a safety net in the commercial banking sector will not protect against the instability coming from the shadow banking sector with which it is now intertwined. Regulatory arbitrage and hybrid intermediaries that are active in the entire credit intermediation supply chain undermine the efficacy of the safety net. The size of the shadow banking sector is therefore key to the stability of the financial sector as a whole. But Luck and Schempp comment, ‘[o]ne needs to keep in mind that – under the presumption that regulation is in place for a good reason – it is not regulation in itself that poses a problem, but the circumvention of regulation.’185 That is indeed a very large and uncertain presumption. I have been commenting on financial regulation in general and the regulatory avalanche in particular facing the banking shadow banking sector in recent years. From the overview it became clear that the regulator has not only been overshooting but also that he has not fully exploited the different options he had available to the full extent; has not been looking into the different ex ante and ex post options; has not properly distinguished between command and control, quantity regulation and tax instruments available; and has overall been focusing on symptom treatment rather than root-cause analysis. So indeed it is a big presumption Luck and Schempp are making. Regulatory arbitrage is a problem. But should it be avoided or prevented? The nature of the financial regulation in place determines the nature, size, scope and intensity of regulatory arbitrage and helps to understand the variety of financial dislocations that occur between countries, continents and different parts of the financial infrastructure.186

 S. Luck and P. Schempp, (2014), ibid., p. 2.  S. Luck and P. Schempp, (2014), ibid., p. 3. 186  See, for example, J.F. Houston, (2012), Regulatory Arbitrage and International Bank Flows, The Journal of Finance, Vol. 67, Issue 5, pp. 1845–1895. 184 185

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1.13 R  egulatory Arbitrage: Many Ways, Few Solutions (So Far) It is all the more surprising that since regulatory arbitrage is such an important part in explaining the fragility of shadow banking, the literature on regulatory arbitrage is so thin, even from a general perspective. Most analyses don’t go beyond identifying, blaming and criticizing regulatory arbitrage. But there is no substantive (or comprehensive) analysis of what is regulatory arbitrage, what exactly is wrong with it and what is the range of options for addressing it.187 Harmonization of laws has always been proposed as the solution to the phenomenon but since harmonizing regulation is such a contentious process, finance, which has always been the creative twin compared to regulation, has been moving swifter and more determined. Refreshing was the reading of Riles who indicates that another angle could bring solace. That angle is the ‘conflict of law approach’. She explains: ‘[u]nlike the harmonization paradigm, which pursues legal uniformity, the Conflicts approach accepts that regulatory nationalism is a fact of life, and sets for itself the more modest goal of achieving coordination among different national regimes. Under the Conflicts approach, the point is not to define one set of rules that apply for all, as is the case in public international.’ ‘Rather, the point is to define under what circumstance a particular dispute or problem shall be subject to one state’s law or another.’ ‘The advantage of this approach is that it provides a far more nuanced, sophisticated, and nevertheless manageable approach to answering practical questions such as, “when should so-called host regulators of a global systemically important financial institution defer to so-called home regulators, and vice versa?” A further advantage is that it requires no new legislation, no new agreements to be hammered out at global conferences of regulators, nothing but the more forceful and creative application of laws that are already part of the legal systems of all of the nations in which major financial centers are found.’188 That approach works well for me and deserves further analysis.189 Regulatory approach intends to allow the arbitrageur to perform the same economic functions but under conditions that are less burdensome in terms of tax rates, compliance or capital requirements. It consumes less input costs for the same if not more output. However, the complications with banks is that they are deeply entangled in the domestic infrastructure and legislation and are dependent on the national (or in the case of the EU regional) central bank and deposit guarantee systems. Regulatory arbitrage works in favor of banks as long as things go well, but the downside is offloaded on the counterparty, that is, the government and by extension the taxpayer. Asymmetry in relations has never worked well for protracted periods of time. But in this case there is more: the same economic functions yield a certain level of risk. Regulatory arbitrage doesn’t take that risk away. It shifts it elsewhere, in a different entity, other country or offshore, and/or spreads

 A.  Riles, (2014), Managing Regulatory Arbitrage: A Conflict of Laws Approach, Cornell International Law Journal, Vol. 7, pp. 63–119. 188  A. Riles, (2014), ibid., pp. 66–67. 189  See for a kick-start: A. Riles, (2014), ibid., pp. 68–76. 187

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the economic function and therefore risk over multiple parties and therefore it becomes opaque and less controllable. That sounds as if regulatory arbitrage in fact adds risk as it now has become uncertainty and therefore no longer manageable and measurable. Yorulmazer190 has been looking into this aspect and concluded that regulatory arbitrage in most cases provides limited insurance (besides the direct tax benefits and lower capital requirements which are or can be sizeable in themselves) but that often the economic functions shifted away from the original regulatory framework now by the market are often priced (materially) higher than their intrinsic value (‘fair value’). That in itself is another benefit from regulatory arbitrage; that is, ‘the economic function is priced higher, and often excessively high’ given the lower input costs due to lower taxes, lower compliance costs and lower reserve requirements. But on aggregate it implies that regulatory arbitrage increases the overall level of risk that emerges from the financial system. Based on that another line of thought, complementing the conflict of law theories discussed by Riles, is that it could well be a good idea to use domestic ‘anti-abuse legislation’ or ‘economic theory’ or ‘fraus legis’ to capture regulatory arbitrage, in case the downside sits with the domestic government. To make it ideal it would require coordination or even a treaty to engage joint action-taking by government given the natural cross-border dynamics of banking. It’s an avenue worth exploring, and which goes well beyond the boundaries of this book, but with good fundamentals. That model could well be used in a variety of situations. As it turned out, regulatory arbitrage is not only used by banks in terms of their activities, but also in terms of their organizational design. Karolyi and Taboada evidenced that ‘a form of “regulatory arbitrage” in which cross-border bank acquisition flows involve primarily acquirers from countries with stronger supervision, stricter capital requirements, more restrictions on bank activities, and stronger private monitoring than those of their targets. Target and aggregate abnormal returns around the deal announcements are positive and larger when acquirers come from countries with more restrictive bank regulatory environments.’191 There is no evidence that acquirer or target peer banks’ contributions to systemic risk increase around these acquisitions. This could be considered a benign sort of ‘regulatory arbitrage’. However, that picture is not complete when excluding the tax benefits of those cross-border transactions. It matters very little if the US has a fair supervisory model if the real arbitrage of the deal sits in the tax benefits that come from doing cross-border acquisitions192 overseas which often leads to the fact that overseas losses can be used to offset

 T.  Yorulmazer, (2012), Has Financial Innovation Made the World Riskier? CDS, Regulatory Arbitrage and Systemic Risk, FED NY Working Paper, September. He looked specifically at the case of credit default swaps (CDSs) and to what degree they provide effective insurance to banks that use them (which turned out to be limited) and further identified that those CDSs can be traded at a price higher than their fair value, which reflects the value of regulatory arbitrage banks exploit. CDSs help banks expand their balance sheet, which, in turn, can fuel asset price bubbles. 191  G. Karolyi and A. Toboade, (2015), Regulatory Arbitrage and Cross-Border Acquisitions, The Journal of Finance, Vol. 70, Issue 6, pp. 2395–2450. 192  D.J. Marples and J.D. Gravelle, (2014), Corporate Expatriation, Inversions and Mergers: Tax Issue, Congressional Research Service, R43568, September 25; S. Webber, (2011), Escaping the U.S. Tax System: From Corporate Inversions to Re-domiciling, Tax Notes International, July 25, pp. 273–295. 190

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US profits or that the effective seat of business shifts overseas, most of the times under better tax conditions than before.193 But regulatory arbitrage has a cause. In basic terms that cause lies in the fact that a bank cannot have an unconstrained balance sheet structure and activities that include a public service. Regulatory arbitrage and its nature and depth will to a large degree be defined by the nature and magnitude and it will be constrained. Or, put differently, an unconstrained bank is a bank that has an optimal capital structure that depends on its business model. Capital requirements can impose constraints on bank decisions. If a bank’s optimal capital structure also meets regulatory capital requirements with a sufficient buffer, the bank is unconstrained by these requirements. Unfortunately that is hardly the case. Boyson et al.194 demonstrate that certain techniques, securities and related transactions show a direct correlation with the level and nature of constrainedness of a bank. They show that unconstrained banks do not engage in certain transactions that exploit regulatory arbitrage of some sort and that others do in function of their level and nature of being constrained as a bank.195 They also demonstrate that banks using those techniques and instruments are riskier than other banks with the same amount of regulatory capital.196 Those banks in turn were more adversely affected by the credit crisis. There is a clear feedback loop between the size and nature of financial regulation and the way it constrains financial institutions as well as the nature and size of regulatory arbitrage exercised in the market by some agents.197 It does not only explain to a large degree the behavior of banks. Temesvary comments: ‘U.S. banks are significantly more likely to enter foreign markets with relatively laxer bank capital and disclosure requirements, and exit foreign markets with relatively stricter deposit insurance schemes and more restrictions on activities. Banks substitute away from foreign affiliate lending (via

 S. Raice, (2014), How Tax Inversions Became the Hottest Trend in M&A (mergers and acquisitions), Wall Street Journal, August 5. These structures are now under review and new legislation is upcoming to tackle M&S that is solely driven by tax benefits. J.D. MCKinnon and D. Paletta, (2014), Obama Administration Issues New Rules to Combat Tax Inversions, Wall Street Journal, September 22. 194  N.M. Boyson et al., (2014), Why Do Banks Practice Regulatory Arbitrage? Evidence from Usage of Trust Preferred Securities, Wharton Working Paper. 195  See also: B.  Balasubramanian and K.  B. Cyree, (2010), Why Do Banks Issue Trust Preferred Securities?, University of Mississippi, Working Paper; A. Beltratti and R. M. Stulz, (2012), The Credit Crisis Around the Globe: Why Did Some Banks Perform Better?, Journal of Financial Economics Vol. 105, pp.  1–17; G.  Benston, et  al., (2003), Bank Capital Structure, Regulatory Capital and Securities Innovations, Journal of Money, Credit and Banking Vol. 35, pp. 301–322. 196  See also: L.  Laeven and R.  Levine, (2009), Bank Governance, Regulation, and Risk-Taking, Journal of Financial Economics Vol. 93, pp.  259–275; A.  Thakor, (2013), Bank Capital and Financial Stability, EGCI Working Paper. 197  See further: A.N.  Berger and C.H.S.  Bouwman, (2013), How Does Capital Affect Bank Performance During Financial Crises?, Journal of Financial Economics Vol. 109, pp.  146–176; A.N. Berger, et al., (2008), How Do Large Banking Organizations Manage Their Capital Ratios?, Journal of Financial Services Research Vol. 34, pp. 123–149; M. Berlin, (2011), Can We Explain Banks’ Capital Structures?, Philadelphia Fed Business Review Q2 2011, pp. 1–12; H. DeAngelo and R.  M. Stulz, (2014), Liquid-Claim Production, Risk Management, and Capital Structure: Why High Leverage Is Optimal for Banks, Working Paper, Ohio State University; Asli DemirgüçKunt, et al., (2013), Bank Capital: Lessons From the Financial Crisis, Journal of Money, Credit and Banking Vol. 45, pp. 1147–1164. 193

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subsidiaries in the foreign country) towards cross-border lending (originating from the U.S.) in foreign countries with more powerful and independent bank regulators and limits on activities.’198 But the understanding and implications go further. Managing regulatory arbitrage will require a more thorough rethink of bank capital regulation as such, in particular when ‘shadow banking’ can be seen as a direct collateral product of regulatory arbitrage which it to a large degree is. The review can include abandoning risk weighting, embedding resolution mechanisms in financial regulation, a simpler form of capital structure (yes, simpler than suggested in Basel III), and capital requirements should be set on an institutional basis and not derived from an aggregate generic formula that can be tampered with.199 It will require finding a new optimum between simpler and more transparent financial regulation on the one hand and reducing discretion in bank regulation on the other.200 The upshot should result in regulation that doesn’t combat regulatory arbitrage to mitigate and neutralize the incentives to engage in regulatory arbitrage.201 Although some believe that simpler rules are easier to arbitrage, the evidence suggests the exact opposite. In tax arbitrage, which is much better researched than financial arbitrage, the findings are consistent. Hindriks et al. indicate that simple linear tax schedules are typically found to be more robust to problems of tax arbitrage than complex rules. That is because complexity increases the number of loopholes through which the tax-avoider can slip.202 Indeed, evidence suggests that complexity of the tax system may be the single largest determinant of tax avoidance across countries.203 There is no tax or financial system that will avoid entirely that risk will shift to where it is the cheapest. But is very clear that regulatory complexity creates wormholes204 and that regulatory complexity, in particular the use of internal models,205 appears to have had an important bearing on bank failure and that in more general terms the regulatory frame-

 J.  Temesvary, (2014), The Role of Regulatory Arbitrage in US Banks’ International Lending Flows: Bank-Level Evidence, Working Paper, November. 199  See for some suggestions: C. Fullenkamp and C. Rochon, (2014), Reconsidering Bank Capital Regulation: A New Combination of Rules, Regulators, and Market Discipline, IMF Working Paper Nr. WP/14/69. 200  See for the latter aspect: A.G. Haldane, (2013), Constraining Discretion in Bank Regulation, Speech given at the Federal Reserve Bank of Atlanta Conference on ‘Maintaining Financial Stability: Holding a Tiger by the Tail(s)’, Federal Reserve Bank of Atlanta, April 9. 201  See also A.G. Haldane, (2013), ibid., p. 3. 202  A.G. Haldane, (2013), ibid., pp. 8–9; J. Hindriks, et al., (1999), Corruption, Extortion and Evasion, Journal of Public, Vol. 74, pp. 395–430. 203  G. Richardson, (2006), ‘Determinants of Tax Evasion: A Cross-Country Investigation’, Journal of International Accounting, Auditing and Taxation, Vol. 15, pp. 150–169. 204  See for a practical application: C.W. Calomiris and J.R. Mason, (2004), Credit Card Securitization and Regulatory Arbitrage, Journal of Financial Services Research, Vol. 26, pp. 5–27. They demonstrate that regulatory capita arbitrage is an important consequence of securitization. The avoidance of capital requirements through securitization is motivated through efficient contracting and safety net abuse (i.e. the liquidity window of the central bank). 205  See also J.-E. Colliard, (2014), Rational Blinders. Strategic Selection of Risk Models and Bank Capital Regulation, ECB Working Paper Series Nr. 1641, February. He indicates that ‘The regulatory use of banks’ internal models aims at making capital requirements more accurate and reducing regulatory arbitrage, but may also give banks incentives to choose their risk models strategically. Current policy answers to this problem include the use of risk weight floors and leverage ratios. I show that 198

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works which have been most prone to arbitrage are those where complexity and opacity have been greatest.206 Haldane concludes, ‘[t]he current mix of complexity and self-regulation may provide too few constraints. Complexity has meant that avoidance and a­ rbitrage can flourish behind a curtain of opacity. And self-regulation has meant that even as one wormhole is closed, others can be created in their place.’207 Maybe there will be room in the future for what Henderson and Tung208 call ‘reverse regulatory arbitrage’ whereby the regulators are to choose the banks they are willing to regulate. It will provide market signals about intrinsic riskiness of banks. That could be combined, as they suggest, by a financial incentive for the regulators to avoid bank failure. It creates an auctioning system that will better allocate requirements and skills on the side of the regulator and will enhance market discipline through branding, transparency and communication. All in all that will improve the ‘regulatory efficiency’ in the financial sector. Until that can become a reality, my preference goes to another instrument that uses market disciplining and price signal in the market and an incentive. In the chapter on Pigovian instruments in the financial sector I elaborated on the key aspects of how such an instrument could be modeled according to exposures and externalities. Pigovian instruments improve materially the regulatory efficiency in the banking sector,209 which can only be applauded. The whole idea is to contribute to a sound and long-term optimal allocation of (limited) resources while protecting the public interest from all sorts of market shenanigans and financial innovations. It was for a reason that Miller already in 1986 highlighted that ‘[t]he major impulses to successful innovations over the past twenty years have come, I am saddened to have to say, from regulation and taxes’.210

1.14 S  hadow Banking Fragility and Implicit Guarantees in the Banking Sector So it seems that we are stuck with a fair level of fragility in the shadow banking sector. We know that is caused by a lack of public backstop, too little equity for the risk absorbed, concentration and asymmetric risk caused by products and methodologies that were either used inappropriately or understood suboptimally. Beyond that it was demonstrated that shadow banking as a phenomenon is to a large degree the product of regulatory arbitrage.

banks for which those are binding reduce their credit supply, which drives interest rates up, invites other banks to adopt optimistic models and possibly increases aggregate risk in the banking sector.’ 206  M. Cihak, et al., (2012), Bank Regulation and Supervision Around the World: A Crisis Update, World Bank Policy Research Working Paper Series, Nr. 6286. 207  A.G. Haldane, (2013), ibid., p. 9; also V. Fleischer, (2010), Regulatory Arbitrage, University of Colorado Working Paper. 208  M.T. Henderson and F. Tung, (2013), Reverse Regulatory Arbitrage: An Auction Approach to Regulatory Assignments, Iowa Law Review, Vol. 98, pp. 1895–1934. 209  See recently: J. Masur and E.A. Posner, (2015), Towards a Pigovian State, University of Chicago, Public Law & Legal Theory Working Paper Nr. 503, January, pp. 21–29. 210  M.H.  Miller, (1986), Financial Innovation: The Last Twenty Years and the Next, Journal of Financial and Quantitative Analysis Vol. 21, Issue 4, pp. 459–471.

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And we learned that the interconnectivity of the global financial system will do all the rest in terms of contagion and the creation of systemic risk. But if we are stuck with fragility and given the expectation that Basel III and the likes will push more of our financial infrastructure into the ‘shadows’, we might delve a little deeper into the dynamics of that fragility. The nexus between banks and shadow banks includes many dynamics and channels. One of those channels is the ‘implicit guarantee(s)’ that cover the traditional banking sector. The implicit guarantees are there to deposit holders that are protected from shocks that might occur so that the effective banking risk sits with the equity and junior debt holders of the financial institutions in case of a bank run, insolvency or outright failure of a financial institution. By coupling the shadow banking activities to the bank holding company (BHC) or parent company of the financial institution, they implicitly have expanded the coverage artificially to include these shadow banking entities. Failures in that segment will contaminate the whole banking institution and will trigger ultimately the implicit guarantees provided by the government. Górnicka indicates that ‘[w]hen the demand for financial assets is high, BHCs expand their own bank investments to increase the value of guarantees and to boost the off-balance intermediation.’ She advocates ‘[t]he traditional banking and the shadow banking sectors both expand, bank defaults are more frequent, and costs of deposit insurance are higher than in the absence of guarantees to the shadow banking sector.’211 Implicit guarantees212 can arise also in the absence of information asymmetries between sponsors and investors, but purely as a result of regulatory arbitrage. The existing demand for higher-yielding, information-insensitive financial assets will increase the size of the off-balance sheet transactional volume which will implicitly push the bank’s investments beyond the optimal level relative to a situation where that implicit guarantee is absent. That has policy implications that once again relate to regulatory arbitrage as ‘regulatory arbitrage in the form of implicit guarantee contracts can never be ruled out, lowering the capital requirement relative to the level optimal in the absence of guarantees is welfare improving when the costs of regulatory interventions are high. This happens as the capital requirement effectively restricts the optimal bank investment in comparison to the size of the shadow banking sector.’213 The guarantee claim coming from the shadow banking sector is very sizeable relative to the traditional lending segment of the banking sector. It also hints at the fact that bank parents with large banking components can offer higher implicit guarantees than parent

 L.A. Górnicka, (2014), Shadow Banking and Traditional Bank Lending: The Role of Implicit Guarantees, Tinbergen Working Paper (later on published in Journal of Financial Intermediation, 2016, Vol. 27, Issue C, pp. 118–131). 212  For a review regarding the literature on implicit guarantees in shadow banking, see L.A. Górnicka, (2014), ibid., pp. 4–6. 213  L.A. Górnicka, (2014), ibid., p. 3. 211

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companies with small(er) banking214 segments.215 The presence of implicit guarantees will put the focus of the banking institution on the possible profitability and a lot less on the risk in the projects they engaged in or ‘guarantees distort risk taking incentives and might increase the riskiness of the traditional banking sector’. That is consistent with Acharya et al.216 who concluded that ‘regulatory arbitrage was the main motive behind setting up conduits: the guarantees were structured so as to reduce regulatory capital requirements, more so by banks with less capital, and while still providing recourse to bank balance sheets for outside investors. Consistent with such recourse, we find that conduits provided little risk transfer during the “run”217: losses from conduits remained with banks rather than outside investors and banks with more exposure to conduits had lower stock return.’

1.15 S  hould We Get Rid of the Limited Liability Concept in Shadow Banking? That is an interesting question. Limited liability of corporations has not been with us and is not a natural phenomenon. When the limited liability concept was introduced, so did change the natural behavior of market participants and the organizational dynamics of these organizations.218 Corporate governance is clearly impacted by the limited liability concept. It has even been demonstrated in recent times that the impact of the concept goes as far as being accountable for ‘asset price bubbles and their creation. Limited liability induces a moral hazard problem which shifts demand for risk and drives prices of risky assets above their fundamental value. It changes behavior of corporate officers and increases the willingness to take on risk.’219

 J.  Matej̆ ů, (2015), Limited Liability, Asset Price Bubbles and the Credit Cycle: The Role of Monetary Policy, CERGE-EI Working Paper Nr. 535, April. Loose monetary policies do the rest of the work. He comments: ‘loose monetary policy induces loose credit conditions and leads to a rise in both fundamental and non-fundamental components of stock prices. Positive shock to nonfundamental component triggers a financial cycle: collateral values rise, lending and default rates decrease. These effects reverse after several quarters, inducing a credit crunch. The credit boom lasts only while stock market growth maintains sufficient momentum.’ 215  L.A. Górnicka, (2014), ibid., p. 4. 216  V.V.  Acharya, et  al., (2013), Securitization Without Risk Transfer, Journal of Financial Economics, Vol. 107, Issue 3, pp. 515–536. 217  See also: Y. Altunbas, et al., (2009), Securitisation and the Bank Lending Channel, European Economic Review, Vol. 53, Issue 8, pp. 996–1009; M.K. Brunnermeier and M. Oehmnke, (2013), The Maturity Rat Race, The Journal of Finance, Vol. 68, Issue 2, pp. 483–521; M. Harris, et al., (2014), Higher Capital Requirements, Safer Banks? Macroprudential Regulation in a Competitive Financial System, Working Paper; A. Segura, (2013), Why Did Sponsor Banks Rescue Their SIVs? A Reputational Model of Rescues, CEMFI Working Paper. 218  See in detail: D. Millon, (2006), Piercing the Corporate Veil, Financial Responsibility, and the Limits of Financial Liability, Washington and Lee Legal Study Paper Nr. 2006–08. 219  See L.  Shi and D.H.  Downs, (2015), The Impact of Reverse Regulatory Arbitrage: Evidence from Bank Holding Companies, Journal of Estate Finance and Economics, Vol. 50, Nr. 3, pp. 307–338. Their empirical analysis tests for the impact of a new policy in the period 2007–2009, 214

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Limited liability and regulatory arbitrage220 are connected at the hip. Wang is stepping in even suggesting to use the nature and intensity of regulatory arbitrage as a measurement of risk for financial regulation in general. She categorizes risk measures into three classes: free of regulatory arbitrage, of limited regulatory arbitrage and of infinite regulatory arbitrage. Coherent risk measures by definition are free of regulatory arbitrage and dividing risks will not reduce the total capital requirement under a coherent risk measure.221 The regulatory arbitrage is also linked to the emergence of financial innovation and in particular the use of hybrid instruments which has materially burdened most balance sheet of limited liability companies with materially enhanced levels of ‘financial leverage’.222 In terms of shadow banking, Schwarcz has indicated already that the time is right to review the limited liability concept in the shadow banking sector, which has and will structurally change the financial landscape. He rethinks the corporate governance assumption that owners of firms should always have their liability limited to the capital they have invested. He comments, ‘[i]n the relatively small and decentralized firms that dominate shadow banking, equity investors tend to be active managers. Limited liability gives these investor-­managers strong incentives to take risks that could generate outsized personal profits, even if that greatly increases systemic risk. For shadow banking firms subject to this conflict, limited liability should be redesigned to better align investor and societal interests.’223 The limited liability concept and its optimality should be revised to ‘make certain investors financially responsible, by reason of their ownership interests, for their firm’s liabilities beyond the capital they have invested’.

which in short enhanced the supervisory oversight by the Federal Reserve Board, on the quantity and quality of loan originations by mortgage banking subsidiaries of BHCs. We show that loan production moved from mortgage banking subsidiaries to their affiliated depository institutions after the policy change. The quality of loans originated by mortgage banking subsidiaries of BHCs increased after the policy change: The denial rates for mortgage applications increased, loan-toincome ratios decreased and the proportion of owner-occupied houses increased in mortgage banking subsidiaries more than they did in other types of lenders. 220  For the historical emergence, see M.S. Knoll, (2008), The Ancient Roots of Modern Financial Innovation: The Early History of Regulatory Arbitrage, Oregon Law Review, Vol. 87, pp. 93–116; also see S.L.  Schwarcz, (2014), The Governance Structure of Shadow Banking: Rethinking Assumptions About Limited Liability, Notre Dame Law Review, Vol. 90, pp. 4–14. 221  R.  Wang, (2015), Regulatory Arbitrage of Risk Measures, University of Waterloo Working Paper, November. 222  T.M.  Carlin et  al., (2006), Hybrid Financial Instruments, Cost of Capital and Regulatory Arbitrage: An Empirical Investigation, Journal of Applied Research in Accounting and Finance (JARAF), Vol. 1, Nr. 1, pp. 43–55. 223  See S.  L. Schwarcz, (2013), Regulating Shadows: Financial Regulation and Responsibility Failure, Washington and Lee Law Review Vol. 70, Issue 3, pp.  1781–1828, and later on S.L. Schwarcz, (2014), The Governance Structure of Shadow Banking: Rethinking Assumptions About Limited Liability, Notre Dame Law Review, Vol. 90, pp. 1–30.

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Financial regulation acts as a cocoon. Within the boundaries of the legislation, the sovereign can commit to certain implicit and explicit guarantees. But how do you regulate, finance and secure a shadow banking system that is embedded in the free and deregulated financial and capital global market. Such commitments don’t exist and cannot be enforced. Market agents that operated under a limited liability model can be subject to ‘market failure that externalizes the systemic costs of taking a risky action’. Those shadow banking firms should be required to bear the equity risk and put more skin in the game in order to better align incentives between their firms and society.224 The limited liability concept is always prone to ‘externalities’, but that the shadow banking model is extremely prone to them and that ‘that current law does not—nor are adaptations to traditional legal remedies likely to—adequately internalize those externalities’. Market failures know five categories and three of them relate directly to corporate governance of which the ‘limited liability concept’ is part. Those are information failure, agency failure and externalities (externalizing harm onto third parties). The externalities aspect is the most relevant for shadow banks and their ‘market-embedded’ business models are very sensitive to causing systemic risk to the entire financial system due to failure of their business models. Market failures then equate business model and responsibility failure on the side of shadow banking institutions.225 The ‘disintermediation’ in the shadow banking system has added a new source of instability on top of those already embedded in the traditional banking sector. In the traditional sector existing market failures include the ‘information’ (asymmetry) and ‘agent’ (principal-agent issues) failure. The shadow banking system adds to that the ‘externalities’. Externalities cause third parties, who are not engaged in financial transactions, to incur the cost of that coming with certain transactions or the collateral impact of them. Whether externalities are ‘market failures’ or the consequences of ‘market failures’ is slightly irrelevant in this context as all types of market failures can end in ‘externalities’. However, in a globalized and highly interconnected world, externalities greatly contribute to ‘systemic risk’. Therefore the ‘externality’ aspect should be reframed to be type-casted as ‘responsibility failures’, that is, a firm’s ability to externalize a significant portion of the costs of taking a risky action.226 Schwarcz indicates that requalification also points at the fact that the regulator itself and not only individual firms cause externalities227 and should bear responsibility. That would imply internalizing the costs of these externalities which would require for it to be meaningful materially higher levels of equity (see also Box 1.1).

 S.L. Schwarcz, (2014), ibid., p. 3.  S.L. Schwarcz, (2014), ibid., pp. 15–16. 226  See in detail: S. L. Schwarcz, (2013), Regulating Shadows: Financial Regulation and Responsibility Failure, Washington and Lee Law Review Vol. 70, Issue 3, pp. 1781–1828. 227  The fact that regulation can cause externalities when destabilizing the market I discussed at length in L.  Nijs, (2015), Neoliberalism 2.0: Regulating and Financing Globalizing Markets. A Pigovian Approach to 21st Century Markets, Palgrave Macmillan, London, chapter four. 224 225

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Box 1.1  Externalities and the Shadow Banking Sector Externalities and the Shadow Banking Sector Externalities refer to the fact that third parties are faced with the negative consequences (therefore ‘negative externalities’) of a transaction to which they were not part and that transaction did not take into account the financial implication (of that negative externality). Externalities can be seen as the consequences of market failures and not market failures themselves. The term ‘externalities’ conflates cause and effect, referring only to a failure’s consequences, Schwarcz indicates.228 Therefore responsibility failure refers to ‘causation’ and the latter term to ‘consequences’. All market failures can end in externalities. That has implications for the ‘limited liability concept as discussed’.229 The responsibility failure points at causation and not at the consequences (symptom treatment versus root cause treatment). Responsibility failure helps to frame the concept of ‘disintermediation’ and helps understand the fragility of the system. Also here we go back to the phenomena of ‘liquidity’ and ‘maturity’ transformation. They occur as well in the traditional banking sector where they are embedded in (tight) regulation. Engaging in liquidity and maturity transformation without a public backstop will undeniably lead to systemic risks.230 Combining that with the limited liability concept as discussed (which implies that shareholders aren’t responsible for the liabilities of the firm) leads to the conclusion that the interest of investors may conflict with the interest of their firm(s). Even if the firm would become liable for the externalities it caused, the firm’s shareholders will never be held liable. Disintermediation makes responsibility failure more likely. A lot of the shadow banking entities out there are managed directly by the shareholders (or they constitute a significant portion of the shareholder base). The managers of these firms (who are also shareholders) can take decisions from which they benefit as a shareholder but at the cost of the firm who bears the liability. Since their pecuniary element as a shareholder is much larger than as a manager, the asymmetry is clear. That asymmetry doesn’t occur in the traditional banking sector where managers are typically invested in keeping their job, their performance is indirectly compensated via stock price increases and where the bulk of profits are paid to shareholders. (continued)

 S.L. Schwarcz, (2013), ibid., p. 1800; I came to similar conclusions in Nijs, (2015), ibid., chapter four. The externality merely signals that a market failure has occurred. 229  See also M.  Sunshine, (2009), How Did Economists Blow It-They Missed the Negative Externalities of America’s Limited Liability Society, Sunshine Report, September 8. 230  G. Gorton and A. Metrick, (2010), Regulating the Shadow Banking System, Brookings Working Paper, p. 1. 228

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Box 1.2  (continued) The solutions suggested go all way from lifting the limited liability (the question then by how much), the mandatory contribution to a financial stability funds ex ante by shadow banking managers and a broader liability coverage to other directors who take inappropriate risks.231 Also suggestions have been made for self-monitoring, but there is no evidence backing such suggestions and their effectiveness.232 Others suggest a full-blown application of traditional banking regulation. It was advocated elsewhere that they might prove inconsistent with the parameters used for the optimal outcome of banking regulation. A full coverage would require an ex ante total rethink of the financial infrastructure regulation.233 Current regulation however very thinly addresses the problem of the shadow banking–specific issues related to responsibility failures.

The enhanced sensitivity (and thus ‘responsibility’) in this respect lies in the following aspect234: • The limited liability of investors in shadow banking entities is less concerned about potential information asymmetries. Since the downside of the market failure sits with the sovereign this is a particular concern for shadow banking entities. • The moral hazard known to banking in general has systemic consequences (‘externalities’) as it is market-embedded and therefore goes beyond the shadow banking entities and their direct counterparties. • The investor-managers of shadow banking entities benefit directly from the gain of risk taking without any downside. In the shadow banking market investor-managers benefit directly, not indirectly, from gains as is the case in the traditional banking segment. Those gains are often related to short-­term investments which enhance the moral hazard component.

 R.  T. Miller, (2010), Oversight Liability for Risk-Management Failures at Financial Firms, Southern California Law Review, Vol. 84, pp. 47ff. See also: E. Avgouleas and J. Cullen, (2014), Market Discipline and EU Corporate Governance Reform in the Banking Sector: Merits, Fallacies, and Cognitive Boundaries, Journal of Law and Society, Vol. 41, Issue 1, March, pp.  28–50; A.  Argandoña, (2012), Three Ethical Dimensions of the Financial Crisis, IESE Working Paper, WP944, January; regarding the complications in terms of enforcement of the duties by corporate officers under the limited liability concept and some solutions, see: M.W. Shaner, (2014), The (Un) Enforcement of Corporate Officers’ Duties, UC Davis Law Review Vol. 48, Issue 1, pp. 271–336. 232  Quite the opposite in fact; see: G. Kolesnik, (2015), Modelling ‘Race to the Bottom’ Effect on the Self-Regulated Markets, MPRA Paper Nr. 64138, May. 233  See Schwarcz, (2013), ibid., pp. 1810–1824. 234  See, for an extensive write-up, S.L. Schwarcz, (2014), ibid., pp. 14–22. See also in detail: S. L. Schwarcz, (2013), Regulating Shadows: Financial Regulation and Responsibility Failure, Washington and Lee Law Review Vol. 70, Issue 3, pp. 1799–1824. 231

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• Counterparties of shadow banking entities have very few options and chances of recovering the damages of externalities they internalized rather than the shadow banking entities themselves. Recovering damages would force them to demonstrate ‘causality’ between action and damages which is highly problematic in a market-based business model as is the case for shadow banking entities. The solution according to Schwarcz might lie in the lifting the cap on limited liability. However, it cannot be totally lifted as that would stifle investments by investors as they would turn fully ‘risk averse’ if their liabilities might well exceed potential gains. Schwarcz indicates that the redesign of the limited liability model in shadow banking should aim to realize that ‘(i) it should increase such liability in a way that increases investor incentives to monitor (and guard against) the firm’s potential to trigger systemic risk; (ii) it should minimize investor risk aversion and encourage investment by setting a cap on liability sufficient to make investors comfortable that the expected value of their potential gains should exceed, by a sufficient margin, the expected value of their potential losses; (iii) it should discourage cross-investor monitoring by ensuring that any given investor’s liability is independent of the liability of other investors; and (iv) to ensure fairness and maintain efficiency, it should increase liability only for investor-managers (because it is that dual nature that creates the real risk)’.235 As some of these objectives conflict, any solution would fail at least one of the objectives and perfectness can only be aimed for in this context. Some suggestions have been made in terms of the criteria that would lift the limited liability threshold. Those include compensation levels of investors, pro-rata lifting of the limited liability in function of each investor’s investment or limiting the lifting of the limited liability to those investors that have the ‘capacity to control’ in shadow banking institutions. Although they all have pros and cons, Schwarcz correctly indicates that none of them addresses the element of systemic risk.236 That will always be the problem. With our current models of risk measurement and the risk aversion they triggered at the level of investors worldwide, there will never be sufficient equity capital (or better ‘risk absorbing capital’) available to absorb systemic risk in a deregulated global marketplace. How would that be possible: only the amount of outstanding derivatives makes a multiple of the global GDP, not to even mention the relationship between financial assets and GDP. GDP might not be the right denominator, but changing it will not change the end conclusion. A solution to the shadow banking systemic risk aspect should not be looked for in the shadow banking sector but

 S.L. Schwarcz, (2014), ibid., pp. 24–25.  S.L. Schwarcz, (2014), ibid., pp. 27–28. See also: L. Guntay and P. Kupiec, (2014), Taking the Risk out of Systemic Risk Measurement, Federal Reserve Bank of Atlanta Working Paper, August, mimeo. It is the reaction to initial losses rather than the losses themselves that determines the extent of a crisis; see R. Bookstaber et al., (2014), An Agent-Based Model for Financial Vulnerability, OFR Working paper Nr. 14–05, September. 235 236

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in the wider financial infrastructure and might require quantity regulation to effectively limit ‘risk creation’ by private market agents and only allows to do so vis-à-vis real economy risks.237

1.16 Financial Fragility and Collateral Crises It has been argued, and was dealt with extensively elsewhere, that risk traditionally is related to counterparty information and in general is asset pricing information-sensitive. Dang et  al.238 have been leading the way regarding the understanding, however, that debt markets have become information-insensitive and rely on ex ante third-party information but only on the margin. Once distress impacts the system, debt becomes information-sensitive leading to the contagion and panic effect well known. What has made the situation worse, and the system more vulnerable, is the fact that debt securities are being used to secure other debt instruments. It explains why small shocks can lead to large crises. Gorton and Ordoñez have been looking into this and comment: ‘[f ]inancial fragility builds up over time because it is not optimal to always produce costly information about counterparties. Short-term, collateralized, debt (e.g., demand deposits, money market instruments)—private money—is efficient if agents are willing to lend without producing costly information about the value of the collateral backing the debt. But, when the economy relies on this informationally-insensitive debt, information is not renewed over time, generating a credit boom during which firms with low quality collateral start borrowing.’239 A small shock, as a consequence, can trigger a large swing from information insensitivity to information sensitivity. Agents p ­ roduce information about lower-quality debt securities (as collateral) and that leads to a decline in output and consumption.

 A rudimentary analysis would highlight that in case global GDP is about USD 100 trillion, and assuming one can butterfly protect against risk, that would lead to a maximum of 200 trillion in derivatives and other products and not the USD 800 billion and growing anno 2015. 238  T.V. Dang et al., (2010), Ignorance, Debt and Financial Crises, Columbia/Yale/NBER and MIT Working Paper, (latest updated version April 2015). They indicate, ‘[d]ebt as collateral transfers the most value intertemporally. When that debt is used as collateral for another debt contract, the “debt-on-debt” preserves symmetric ignorance because it minimizes the incentive to produce private information about the payoffs, so debt is least information-sensitive, i.e., liquid. But, bad public news (a shock) about the value of the collateral that backs the debt can cause information insensitive debt to become information-sensitive.’ 239  G. Gorton and G. Ordoñez, (2014), Collateral Crises, American Economic Review, Vol. 104, Issue 2, pp. 343–378. 237

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1.17 T  he Central Bank and the Private Shadow Banking Market 1.17.1 Involvement The central bank played a material role during the aftermath of the financial crisis. Some go as far as claiming that central banks brought the economy and the financial system back from the brink. Regardless of the true magnitude of the support central banks provided, what was recalled was the fact that the public system came to the help of what essentially is a private (shadow banking) market. And the central bank in that context played the role of ultimate lender of last resort (LOLR). By doing so, they expanded their toolkit and broadened the liquidity bandwidth to include nonbanks. In fact central banks, by expanding their role in an organic way, became ‘market makers’ vis-­à-­vis the shadow banking market. That in itself already created discussion about the nature and size of that intervention. Some see the role of central banks evolve toward a ‘market maker of last resort’.240 Others see that as only realistic and desirable if the regulatory safety net would be equally applicable to the shadow banking sector.241 Questions can be asked regarding the risks central banks incurred and incur/absorb on their balance sheets, which ultimately shine off on the taxpayer. The 2008 financial crisis was not the first one where the smoking gun looked a lot like ‘money-like claims’.242 Many support the view that structural reform of the shadow banking market is needed to justify any future support to be received by the private sector shadow banking market by central banks. It is not that because central banks can provide official liquidity support (almost in an unlimited fashion) that they should do so to support the private sector shadow banking market. Being too accommodative would only increase fragility is the train of thought. My attempt of defining the central problem is that private sector ‘money creation’ doesn’t occur on existing liquidity but can happen ‘out of nothing’.243 ‘Created money’ can disappear, or as Adtian and Shin indicated in 2009, ‘when liquidity dries up, it disappears altogether rather than being re-­allocated elsewhere.’244 The permanent interaction between the official banking system and the shadow banking system has created many

 See most recently M. Carney, (2013), The UK at the Heart of Renewed Globalization, Speech 24 October 2013. 241  D.K. Tarullo, (2013), Shadow Banking and Systemic Risk Regulation. Remarks at the American for Financial Reform and Economic Policy Institute conference, November 22; M. Wolf, (2012), Seven ways to fix the system’s flaws, Financial Times, January 22. 242  For a historical overview, see T.G. Moe, (2013), Shadow Banking: Policy Challenges for Central Banks, Levy Economics Institute, Working Paper Nr. 802, May, pp. 6–8. 243  C.  Borio, (2012), The Financial Cycle and Macroeconomics: What Have We Learnt? BIS Working Papers Nr. 395, December. 244  T.  Adrian and H.  S. Shin, (2009), The Shadow Banking System: Implications for Financial Regulation, Staff Report Nr. 382, Federal Reserve Bank of New York. 240

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new liquidity channels with often severe ebbs and flows. This has created risk dynamics that ‘have not yet been sufficiently appreciated’245 and this despite the fact that those private liquidity markets are highly endogenous with the overall health and liquidity of the overall financial system. It was already discussed how the shadow banking market and its most famous products have been inductive and known for quite the opposite they were designed to do: risk concentration rather than risk dispersion. The reality behind that was unlimited private credit formation which for the banks translated into higher leverage and higher short-term profits. The implication is that the ability to create credit became literally ‘infinite’. But none of this has translated in more credit flowing to the real economy. In fact, the recent quantitative easing (QE) has learned that the relation between bank credit and central banking liquidity is very weak. That makes the shadow banking channels and risk transition extra worrisome. Since they can create credit and deposits ‘in one go’, the effective ability to create volatile swings and magnify procyclical behavior in markets is enormous.246 It was Henry Minsky who in his legendary book Stabilizing and Unstable Economy already indicated that the periods of stability in the market have always been used to enhance wealth by using leverage on those (temporary stable) returns. That excessive leverage always translates into future instability. With all the regulators we have witnessed that the self-­correcting and self-stabilizing nature of the globalized free market is fairly limited. While working through the regulation that emerged post-crisis, it might be so that a flair of discontent will take over from rational analysis. It is very likely that you are not alone. The lesson that we learned long time ago is that ‘equity’ or, more broadly, ‘funding sources with loss absorbing capability’ are a much better fix than massive ‘command-and-control legislation’. We also learned that tax instruments. That all doesn’t seem to resonate well with regulators around the world. We have discussed before the reason why that might be the case. Nevertheless, macroprudential instruments are increasingly becoming part of a regulatory toolkit that should help to mitigate the excessive credit cycle. Although general rules to do so can be recognized in the post-crisis regulatory jungle, many instruments still dodge the bullet or receive preferential treatment, that is, repo and derivatives, rehypothecation247 and so on benefit on a going concern basis, but also under bankruptcy laws.248 The relentless need for financial institutions to secure cheap funding amid a Basel III environment (in particular the liquidity coverage ratio and the net stable funding ratio, or NSFR, increase the demand for liquid high-quality assets) implies a wide cascade of

 B. Coeuré, (2012), Global Liquidity and Its International Implications, Speech at the BIS-ECB Workshop on Global Liquidity and Its International Implications, February 6. 246  T.G.  Moe, (2014), Shadow Banking: Policy Challenges for Central Banks, Levy Economics Institute, Working Paper Nr. 802, May, pp. 10–11, who goes on to stress the need for a reorientation of our financial models given the fact that private credit and deposit creation has never been an assumption or precondition to any of our financial models. 247  M. Singh, (2012), Puts in the Shadow. IMF Working Paper, Nr. WP/122/229, and M. Singh, (2013), The Changing Collateral Space. IMF Working Paper, Nr. WP/13/25. 248  E. Perotti, (2013), The Roots of Shadow Banking. CEPR Policy Insight No. 69, December. 245

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collateral chains.249 That chain has been c­ omplemented with a wide assortment of instruments that include repos, covered bonds and derivative trades. In particular the repo market is extremely vulnerable. Bilateral trades in the bond market lead to an endogenous bond liquidation cost for investors. That bond liquidation cost induces dealers and cash investors to arrange repos and further provides incentive for cash investors to stop entering into repos when the repo market collapses.250 In general it can be concluded that the new legislation will have a material effect on pricing, the structure of the market, and that the effect on risk for banks and the markets in general is by and large still poorly understood.251 All types of ‘collateral transformation services’ will occur from collateral mobilization (from institutional investors), increased reuse (higher collateral velocity), collateral pooling and the reemergence of asset creation and collateral upgrading (which will mainly occur through bundling collateral of different qualities).252 Some of these mechanisms are even actively supported by scholars and the regulator.253 As Singh already indicated in 2013, many of these mechanisms (in particular collateral transformation) will strengthen the nexus between the bank and the shadow banking market.254 This interconnectedness will, under stress, not contribute to the resilience of the financial infrastructure as such. His analysis goes back to what we concluded in the chapter on Pigovian taxes, that is, the fact that the regulator has expanded his toolbox in recent years to have a decent set of macroprudential tools was not so much based on diligent analytics but merely an ‘ad hoc’ implementation of a potpourri of tools based on regulatory desires and without proper theoretical foundations or models supporting the implementation. The implications longer term can therefore not be overseen, especially since these macroprudential tools directly impact the functioning of monetary tools, fiscal tools and macroeconomic instruments. The liquidity window offered by central banks in recent years does reduce the need for safe assets in the market, but violates somewhat the philosophy of Basel III.255 The collateral need and position will continue to be a concern for central banks as it stretches the nexus between the banking and shadow banking system. This includes the risk that comes with the securitization of the large unsecured repo

 T.G.  Moe, (2013), Shadow Banking: Policy Challenges for Central Banks, Levy Economics Institute, Working Paper Nr. 802, May, pp. 12–19. 250  See in detail: H.  Tomura, (2012), On the Existence and Fragility of Repo Markets, Bank of Canada Working Paper Nr. 2012–17. 251  P.  Gai et  al., (2013), Bank Funding and Financial Stability, (A.  Heath, L.  Matthew and M. Manning (eds.), Liquidity and Funding Markets, Reserve Bank of Australia); A. Heath et al., (2013), OTC Derivatives Reform: Netting and Networks, (A. Heath, L. Matthew and M. Manning (eds.), Liquidity and Funding Markets, Reserve Bank of Australia). 252  T.G. Moe, (2014), Shadow Banking: Policy Challenges for Central Banks, Levy Economics Institute, Working Paper Nr. 802, May, p. 13; A. Hauser, (2013), The Future of Repo: ‘Too Much’ or ‘Too Little’, Speech given at the IMCA Conference on the future of the repo market, London, June 11. 253  See, for an overview, T.G. Moe, (2043), Shadow Banking: Policy Challenges for Central Banks, Levy Economics Institute, Working Paper Nr. 802, May, p. 14. 254  M. Singh, (2013), The Economics of Shadow Banking, A. Heath, L. Matthew and M. Manning (eds.), Liquidity and Funding Markets, Reserve Bank of Australia. 255  S.W. Schmitz, (2013), The Liquidity Coverage Ratio Under Siege, www.voxeu.org 249

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and OTC positions CCPs are exposed to and has a high risk of concentrating risk in the system.256 It is clear that the massive scale of collateral needed257 to meet all types of new regulations will put pressure on the securitization techniques and therefore also on central banks to provide liquidity and end fire sales on a continuous basis. It seems to be so that the provision of liquidity by central banks for private money in the SB system is without ending and a more realistic alternative would be to focus liquidity on supporting real structural reforms that when implemented successfully will reduce the need for that central banking liquidity. Although central banks in principle cannot issue money without some sort of collateral backing (a claim issued against itself does not qualify as collateral), they can issue new money against government securities they purchased in the secondary market within the framework of monetary intervention or policy.258 In a liquidity squeeze the same pattern unfolds repeatedly: commercial banks need more liquidity while their counterparties withdraw collateral which heats up the fire sales, in particular in the interbanking market. Central banks typically responded to that with a softening of the collateral requirements on their liquidity window or reducing the quality thresholds of that collateral, for example, by accepting ABS and others rather than government bonds. By doing so they facilitated ‘collateral manufacturing’ and fueled the leverage in the SB system. That system seems to prolong and extend itself in recent times by extending maturities, accepting wider ranges of assets and offering forex liquidity lines based on international swap lines. Being so accommodative, central banks did not only become the lender of last resort but also encouraged banks to enhance maturity transformation. The tension is clear between the new banking rules and the collateral implications259 and the rules and practice over time will prove to be inconsistent. Seeking the balance implies a judgment to what degree endogenous growth of shadow banking liabilities contributes to or fuels systemic risk. Indeed Borio and Disyatat already in 2011 indicated that ‘[t]he fundamental weaknesses in the international monetary and financial system stem from the problem of “excess elasticity”: the system lacks sufficiently strong anchors to prevent the buildup of unsustainable booms in credit and asset prices (financial imbalances) which can eventually lead to serious financial strains and derail the world economy.’260 A better proposition would then be constraining the liquidity creation by the shadow banking system rather than impose limitations on central banking liquidity. Nobody in his right mind would

 T.G.  Moe, (2013), Shadow Banking: Policy Challenges for Central Banks, Levy Economics Institute, Working Paper Nr. 802, May, p. 15. 257  For an overview of the collateral dilemmas ahead and the accompanying policy challenges, see T.G.  Moe, (2013), Shadow Banking: Policy Challenges for Central Banks, Levy Economics Institute, Working Paper Nr. 802, May, pp. 16–24. 258  L.I. Jácome, et al., (2012), ‘Central Bank Credit to the Government: What Can We Learn from International Practices?’ IMF Working Paper Nr. WP/12/16, International Monetary Fund Washington, DC. 259  See in detail: A. Chailloux, et al., (2008), Central Bank Collateral Frameworks: Principles and Policies, IMF Working Paper WP/08/222, International Monetary Fund, Washington, DC. 260  C. Borio, and P. Disyatat, (2011), Global Imbalances and the Financial Crisis: Link or No Link? Working Paper Nr. 346, Bank for International Settlements, Basel, Switzerland. 256

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justify public liquidity backstops to be used for speculative credit creation, especially since we, as discussed elsewhere, have come to understand that continuous deepening of financial liquidity doesn’t contribute to the real economy.261 The question can be asked out loud whether the recent adoptions in terms of rehypothecation, financing transactions and transparency will be sufficient to counterbalance the still strong incentives for nonbank credit growth, through the acceptance of and lowrisk weighting of collateral-based credit transactions, to further materially develop. All efforts might end in vain,262 and central banks will stay and become the global fire brigade of the financial market without ending. More needs to be done, Fischer said recently and detailed: ‘[w]hile there have been some improvements in the plumbing of money markets, many nonbank financial firms, including hedge funds and broker-dealers, continue to rely on secured short-term funding to finance their activities, many of which involve longer-term and illiquid assets. This maturity transformation remains a key vulnerability. Further, many of the firms that rely on this maturity transformation are highly levered and thus more vulnerable to threats to their solvency’ … ‘Second, and more generally, we need to be alert to changes and trends in the financial system that may pose risks to financial stability, particularly those stemming from areas of the nonbank sector that are not subject to prudential supervision. For example, the asset management industry has both grown and evolved in recent years. Mutual funds and exchange-­traded funds that track the returns of indexes of relatively illiquid assets have mushroomed in size. Examples include funds tracking the return on leveraged loans, credit default swaps, and other less liquid assets’… ‘Third, there are also areas of the nonbank financial system into which we have only a limited view. While the data we have on hedge funds has improved, we still need to get a complete picture of the scope and size of hedge fund activities. Data coverage of the vast derivatives market could also be improved.’263 The argument used against intensifying further rules will undeniably refer to the fact that liquidity in the market will reduce when repo market will shrink after new regulation comes in. Taking that stance implies that central banks will also become the lender of last resort for the SB system,264 which then becomes a natural extension of the traditional banking sector.

 See the discussed works of Cecchetti and Kharroubi; see also T.G.  Moe, (2014), Shadow Banking: Policy Challenges for Central Banks, Levy Economics Institute, Working Paper Nr. 802, May, p. 20. 262  Many seem to appreciate the situation as such given the stance they took on the matter. They include E. Warren, S. Bair, E. Perotti and S. Fischer; see, among others: E. Perotti, (2013), The Roots of Shadow banking, CEPR Policy Insight, Nr. 69, December and S. Fischer, (2015), The Importance of the Nonbank Financial Sector, Speech at the ‘Debt and Financial Stability– Regulatory Challenges’ conference, the Bundesbank and the German Ministry of Finance, Frankfurt, Germany, March 27. 263  S. Fischer, (2015), The Importance of the Nonbank Financial Sector, Speech at the ‘Debt and Financial Stability–Regulatory Challenges’ conference, the Bundesbank and the German Ministry of Finance, Frankfurt, Germany, March 27. 264  U. Bindseil and L. Laeven, (2017), Confusion About the Lender of Last Resort, via voxeu.org. January 13. 261

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Pros and cons are available in the literature.265 But can a position be taken at this stage to advocate that central banks become the backstop of all players in the financial market who engage in maturity and credit transformation and creation? Can that be done realizing that our macroprudential views and regulation are novel and often untested and without a solid theory behind it? Without knowing what the long-term implications will be of these policies? Can that be done without an upfront framework about the role of central banks, the occurrence and behavior of systemic and contagion risk under a variety of situations and the resilience of liquidity parameters? How can we say yes to all that without really knowing what we say yes to, under the umbrella of ‘we need to secure stable and liquid global markets at all times’? If you secure a market you secure all parties, not only the solvent and creditworthy ones. That can’t be right and can’t be justified even if a central bank would become a ‘market maker’. It would absorb effective credit risk and the taxpayer will undeniably be left holding the bag once again. Even if we can agree on such a theoretical framework, one can never say yes with full confidence as the i­mplications of the next duress cannot be properly anticipated. There needs to be a window of conditions counterparties need to adhere to before being able to access the central bank liquidity window. Securing a market ‘as such’ would become a Ponzi scheme of which the taxpayer will be last in line. And would central banks secure any market, large or small, instrumental to the real economy or not? The debate on this is muddling through somewhat. While scholars try to get a better grip on systemic risk, contagion, stability, fire sale dynamics and so on, the huge range of models and outcomes shows the long road ahead. At the same time the political and regulatory debate has stemmed somewhat after the regulatory interventions of 2009–2014 as if the last word has been said. In fact, what used to be a market that needed severe regulation now has become an extended platform for some, extending the range of credit services over and beyond the traditional banking sector, and on which we should rely less. There is a circularity in all that. The banking sector has always been ‘heavily’ regulated because it served a function of public interest. Now that the credit intermediation channels is broken, partly due to ineffective regulation, partly due to the fact that the credit intermediation ‘channel’ now has stopped being a channel and became a market in itself that is at risk of overtaking the real economy, questions need to be asked and answered regarding the role of the central bank and the taxpayer it ultimately represents. If the endogenous growth of shadow banking credit is not managed, the market-based financing system will outgrow not only the amount of quality collateral but also the ability of the monetary system to ensure its robustness. Tying the shadow banking creation to the needs of the real economy sounds theoretically good but ignores the problem that our welfare systems require a fixed-income return of about 7–8% to be stable over time. That explains the constant demand for SB products. Our welfare systems ultimately were built in the period 1950–1960s and reflect those conditions, which are no longer valid in the current global marketplace. So the job ahead seems to be twofold. Tie credit creation to real economic demand and ensure that welfare systems produce predictable outcomes that are realistic. There is not a single regulator or politician who wants to break that news

 T.G.  Moe, (2014), Shadow Banking: Policy Challenges for Central Banks, Levy Economics Institute, Working Paper Nr. 802, May, p. 22. 265

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to their constituents. So in a certain way our welfare systems have partly caused the rise of the SB system and so the radical changes needed might not be limited to the financial sector but also our broader socio-economic fabric. Serving a public function, the central banks will have to reflect on the benefits of the system to society. The incremental growth can be justified only if it meets a societal need. If not, the financial markets become rent-seeking and the financial industry and its relentless growth reflect that vulture-like ­behavior. It becomes a hypertrophic sector. The rentseeking dynamics will have to be removed; that is, those activities that while profitable from an individual point of view are not so from a societal point of view.266 That includes (in)direct duping of unsophisticated investors. Direct bundling involved the selling of products to investors who in case they would understand all the intricacies of the product would not buy them and the indirect format includes selling those products that while attractive to large and sophisticated investors turn out to be costly for those not part of that category. It further involved reducing the agency problems that might exist between the financial sector and the real economy or, worse, different typologies of fraud who have become ‘features of the industry’. But also within the framework it needs to be realized that also government interventions are often fostering these observed inefficiencies. A full-blown unqualified public backstop to the shadow banking sector through the central banking liquidity window might be next on that list. Regulation and in particular ‘demand-and-control’ are often used as a first line of defense, in particular in the financial sector. However, every regulatory intervention implies welfare costs, hence my suggestion for more Pigovian approaches in the financial sector and elsewhere (see the Pigovian chapter). Pigovian approaches have two benefits267: (1) they use the price signal effect of the market to steer behavior and (2) they take into account welfare effect. That is important as the economic discipline is in general very silent regarding the welfare effects of wealth distribution. A last point refers to the implication of easy barriers to entry regarding profitable opportunities in the financial sector. A realtor with a fixed sales commission will benefit when the price of the house and/or land will go up. That attracts new entrants in the realtor sector and creates lower productivity in the sector with real wages that stay flat.268 The same occurs in the financial sector, but then skewed down due to a limited number of global and regional banking giants, A-branded hedge funds and private equity firms. Talent has to compete and because of that compensation equalization occurs slower. The extreme shareholder centrism and the shift from stakeholder to shareholder finance is upon us. That shift in the banking sector meant shifting credit management from Originate-to-Hold (OTH) to Originate-to-Distribute (OTD). That shift increased systemic risk damaging the common good of financial stability. Stakeholder-oriented

 See L. Zingales, (2015), Does Finance Benefit Society, HBR and NBER/CEPR Paper, January, in particular chapter 3, pp. 13–23. 267  They have more benefits but I only refer here to those that matter in the context described. 268  C.-T. Hsieh, and E. Moretti, (2003), Can Free Entry Be Inefficient? Fixed Commissions and Social Waste in the Real Estate Industry, Journal of Political Economy, Vol. 111, Issue 5, pp. 1076–1122. 266

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banks seemed to weather the financial crisis relatively better with more heterogeneous systems proving more resilient. Heterogeneity in banking governance-orientations and ownership-structures seems to add value reducing the probability of financial crises.269

1.17.2 S  hould There Be a Lender of Last Resort for the Shadow Banking Market? That is a very critical policy question that has been and is widely discussed. Many opinions float, some driven by analysis, some based on interests. Wasn’t the new avalanche of (liquidity) regulation be supposed to just end in the fact that the central bank would no longer be needed as the public backstop for the shadow banking system going forward? And that after central banks injected extraordinary amounts of liquidity into the market during or after the financial crisis. In the aftermath, lawmakers and regulators have taken steps to reduce the likelihood that such lending would be required in the future, including the introduction of liquidity regulations. These changes were motivated in part by the argument that central bank lending entails extremely high costs and should be made unnecessary by liquidity regulations. By contrast, some have argued that the loss of liquidity was the result of market failures, and that central banks can solve such failures by lending, making liquidity regulations unnecessary. Carlson et al. argue that LOLR lending and liquidity regulations are complementary tools. They comment, ‘[l]iquidity shortfalls can arise for two very different reasons: First, sound institutions can face runs or a deterioration in the liquidity of markets they depend on for funding. Second, solvency concerns can cause creditors to pull away from troubled institutions.’ Using examples from the recent crisis, they argue that ‘central bank lending is the best response in the former situation, while orderly resolution (by the institution as it gets through the problem on its own or via a controlled failure) is the best response in the second situation’. They also contend that ‘liquidity regulations are a necessary tool in both situations: They help ensure that the authorities will have time to assess the nature of the shortfall and arrange the appropriate response, and they provide an incentive for banks to internalize the externalities associated with any liquidity risks.’270 Others feel very different about the role of central banks. Sissoko, based on macroeconomic analysis and history, advocates against the role of LOLR of central banks for the shadow banking market. She advocates, ‘I conclude that because of its heavy reliance on collateralization, the shadow banking is a poor substitute for the traditional banking system and does not merit the support of a “dealer” of last resort.’ Building on an earlier framework she developed she explains ‘that in an environment with liquidity constraints banks are special because their history of default is public, so unsecured bank borrowing

 See in detail and for a literature review: G. Ferri and A. Leongrande, (2015), Was the Crisis Due to a Shift from Stakeholder to Shareholder Finance? Surveying the Debate, Euricse Working Papers, Nr. 76|15. 270  M. Carlson et al., (2015), Why Do We Need both Liquidity Regulations and a Lender of Last Resort? A Perspective from Federal Reserve Lending during the 2007–2009 US financial crisis, BIS Working Paper Nr. 493, March. 269

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is incentive compatible when bankers profit from their special characteristic by underwriting the debt of the nonbanks in the economy. This debt circulates as bank liabilities and can resolve the liquidity constraints faced by the economy entirely, facilitating economic growth (and generating fees for bankers). Because being liquidity constrained is a significant penalty, a simple trigger strategy played by banks against defaulting nonbanks can support an environment where borrowers limit their own debt, credit is generally available, and the economy grows to its maximum potential.’271 She thereby steps away from the earlier discussed model of Gorton and Ordoñez272 also dealing with banks as issuers of ‘information-insensitive’ assets. She historically explains the central banking role as twofold: (1) the lender of last resort made the provision of banking services incentive compatible for bankers who effectively faced unlimited liability by providing highpowered money in liquidity crises and thereby averting the threat of a transition to a no-credit equilibrium. (2) The lender of last resort played a second, very important role: in order to maintain the ‘safe’ quality of the money supply the central bank withdrew support from any bank that it believed to be overissuing debt. The shadow banking market developed against a background where the second role of the central bank is forgotten and ‘solvency for large banks was effectively redefined to incorporate public sector support’. Qualifying shadow banking as market-based finance is compromising the fact that it ‘refers to a bank-guaranteed system of finance based on commercial paper and repurchase agreements, that provides little funding for private sector assets and significant funding for investment banks’. To that effect ‘shadow banking has disintermediated commercial banks, it has done so by reintermediating investment banks  – using repurchase agreements, which are a form of funding that is even more unstable than deposits, due to their reliance on collateral that is remargined daily’. She also comments on the collateral market that shadow banking is and its destabilizing effect ‘growth of the collateralized money market that shadow banking represents is probably destabilizing the incentive structure that is the product of centuries of institutional evolution and that undergirds the traditional unsecured money markets upon which the past 250 years of economic growth have been founded’. So the lender of the central bank as liquidity provider in times of distress turns out to be a ‘policy designed to give the largest dealer banks access to central bank credit and to support them through a crisis’. That has adverse implications as ‘this policy only protects asset markets from fire sales of assets belonging to the select group that has access to central bank lending, not from fire sales in general, because dealer banks do not extend credit in the same way that commercial banks do’. She concludes that shadow banks therefore should not be given unconditional access to the liquidity window provided by the central banks. In particular she adds because ‘commercial banks traditionally bear risk for the

 C. Sissoko, (2014), Shadow Banking: Why Modern Money Markets are Less Stable Than 19th c. Money Markets But Shouldn’t Be Stabilized by a ‘Dealer of Last Resort’, Center for Law and Social Science Research Papers Series No. CLASS14–20, Legal Studies Research Papers Series No. 14–21, September 11. 272  G. Gorton and G. Ordoñez, (2014), Collateral Crises, American Economic Review, Vol. 104(2), pp. 343–378. 271

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economy, whereas dealer banks traditionally avoid bearing risk over time themselves but instead facilitate the allocation of that risk to others. As a result, dealer banks should not receive support similar to that of commercial banks, because they do not play the same role in the economy that commercial banks do.’ Also Sissoko brings up the collateral aspect273 and it relationship with central banking policies. It will, going forward, be a key point to continuously analyze whether and how the design of central banks’ operational frameworks influences private collateral markets, including collateral availability, pricing, related market practices and market performance under stress. A working group has been examining these issues by reviewing available information from a range of sources, including central bank case studies as well as surveys and interviews with private sector participants in collateral markets.274 They comment on their findings: ‘[c]entral banks influence markets for collateral through either the supply of assets available for use as collateral (a scarcity channel), the pledgeability of assets in private transactions (a structural channel), or both. They therefore have a variety of design choices at their disposal to influence collateral markets as well as to fine-tune the effects of their operations on these markets. While central bank operating frameworks are not usually the most important factor influencing collateral markets, the evidence presented in this report indicates that the influence of central banks may at times be significant, in particular during crisis times.’275 They elaborate: ‘[c]risis times, are associated with greater scarcity of collateral in the financial system, as declining market confidence prompts a shift from unsecured to secured financing. Under such conditions, central banks may operate on a much larger scale, in some instances also inducing unintended side effects on collateral markets that have to be managed. Moreover, they are more likely to attempt to directly influence the functioning of collateral markets, for example by introducing facilities that allow banks to post illiquid collateral assets in place of liquid securities that, in turn, can be used to obtain funding in the private market.’276 This highlights the importance of carefully monitoring the effects of central bank operations on collateral markets, as well as the need for central banks to examine their operational frameworks to ensure preparedness for any future crisis response. The report also assesses the menu of available policy instruments that can influence collateral markets. Among other things, it suggests

 ‘Central bank operations are, in essence, asset swaps which alter the mix of assets available for use by private market participants. For example, a central bank that is providing liquidity to the financial system will typically either take collateral or purchase assets outright – so that, in either case, the central bank liquidity provided may be partly offset by a reduction in the stock of assets available for use as collateral in private transactions, such as repurchase agreements’; Study Group report (infra). 274  Study Group established by the BIS Committee on the Global Financial System and the Markets Committee, (2015), Central Bank Operating Frameworks and Collateral Markets, Committee on the Global Financial System Markets Committee, CGFS Papers Nr. 53, March. 275  In normal times, when central banks tend to operate at the margin and on a limited scale, they typically set the features of their operating framework to be market-neutral. Beyond the intended effect on interest rates or asset prices, the impact of operations on collateral markets as such will thus tend to be small (pp. 1–2). 276  Study Group established by the BIS Committee on the Global Financial System and the Markets Committee, (2015), Central Bank Operating Frameworks and Collateral Markets, Committee on the Global Financial System Markets Committee, CGFS Papers Nr. 53, p. 2. 273

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that, to prepare for any crisis response, some aspects of operational frameworks may need to be examined. This includes the adequacy of available inventories of collateral assets and of central banks’ risk management capabilities in stressed financial conditions. But central banking policies also define the amount of credit available in the market (or has the potential to), through its liquidity window. That occurs in a context where we, as discussed, are still learning when, how and why macroprudential policies are effective and are still in the process of ‘theory building’.277 What we do know, however, is that credit booms have implications for both the public and the private sectors. The liquidity does not only yield low returns in some asset classes but predominantly ‘accumulation of risks on and off the balance sheets of many financial intermediaries, particularly banks, as well as by a substantial increase in public and private sector debt in some countries. Understanding the relation between liquidity and the excessive accumulation of risks remains a central policy question.’ It also affects incentives, Santos examined. He indicates: ‘[i]n the case of the government sector, credit booms may affect the incentives of different interest groups to agree on policies for reform or fiscal stabilization. In the case of the private sector, it may change the incentives of originators to produce good assets (through changes in the joint distribution of knowledge and capital). Credit booms complicate the evaluation of policies and agents and in addition may facilitate the entrenchment of interest groups and the deterioration of governance institutions (the political economy multiplier).’278 It may further lead in the financial sector to ‘leverage and fragility in a particular segment of the financial services sector’.279 The implications can be disastrous as ‘credit booms can have long-lasting effects beyond the asset price correction and misallocation of capital that accompanies them. They transform institutions and the longrun growth rates of the affected economies, potentially for the worse.’280

1.17.3 The Limits of Central Banking Liquidity Recent years have illustrated the abundant willingness of central banks to provide liquidity, also directly or indirectly to the private money creation business embedded in the shadow banking segment of the market. They adjusted their collateral requirements to facilitate and cater to an even higher level of liquidity provisioning. But we also learned that liquidity is highly procyclical and has the potential to dry up overnight. The opinion of Bagehot ‘lend at high interest rates against good collateral’ has been taken to extremes. It raises questions about the elasticity of the liquidity supply by central banks. Within a regulated banking sector that answer was more or less clear and could be calculated. Now that the liquidity window has been expanded to include the shadow banking segment,

 See recently: C. McDonald, (2015), When is Macroprudential Policy Effective?, BIS Working Paper Nr. 496, March. 278  T. Santos, (2015), Credit Booms: Implications for the Public and the Private Sector, BIS Working Paper Nr. 479, January. Politicians and manager can worsen the effect of credit booms by their actions (p. 25). 279  P. Bolton, T. Santos and J. Scheinkman, (2014), Uninformed Capital, Leverage and Origination Incentives, manuscript, Columbia University. 280  Santos, (2015), ibid., p. 24. 277

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that answer has become unclear. Besides the fact that central banks now have lower-rated collateral that might impact their creditworthiness and ultimately stability of the system, there is no real framework available to address that question.281 Keeping in mind the discussed information insensitivity of debt, it can be recalled that riskier debt has a higher likelihood of turning into an information-sensitive security under market duress. The ‘liquidity illusion’ to a large degree bypasses those boundaries and assumes under all conditions that central banks are willing and will step in to provide liquidity when needed. Although there are benefits in terms of the ability to finance long-term projects at lower rates, the liquidity illusion might trigger material collateral damage. Although the central bank can easily work under assumptions of ‘negative equity’, it will have economic implications. Those most likely will include deflationary pressures. Providing large amounts of liquidity also in a way threatens the independence of the central bank as it now effectively interferes in the market activity of resource allocation.282

1.18 ( Shadow) Bank Business Models: Fragility and Sustainability A question that has often arisen post-2008 crisis was not only the question regarding what transaction and asymmetries in relations engaged in between financial institutions have led and were leading to interconnectivity, systemic risk and/or enhanced contagion risk. A lot of research has been going into what transactions and relations have been leading to increased systemic and contagion risk. A whole lot less efforts have been going into the question regarding what organizational dimensions contribute to systemic risk and financial vulnerability. Traditionally studies focused on certain business model characteristics and their relation to bank risk, that is, capital, operating efficiency, funding sources, securitization283 and in general the link with financial markets, corporate governance and diversification.284 Altunbas et al. have been extensively looking to the matter. They have been looking into the question how is risk related to business models. It turned out that institutions with higher-risk exposure had less capital, higher levels of credit expansion, less reliance on consumer deposits, larger size, greater reliance on short-term market funding and aggressive credit growth. Those institutions that posed lower levels of risk were those characterized by a strong deposit base and greater income diversification. They measured (in different ways) realized bank risk ‘namely the likelihood of a bank rescue, systematic risk and the intensity of recourse to central bank liquidity’.

 See T.G. Moe, (2012), Shadow Banking and the Limits of Central Bank Liquidity Support: How to Achieve a Better Balance Between Global and Official Liquidity, Levy Economics Institute Working Paper 712, April. 282  T.G. Moe, (2012), ibid., pp. 31–32; see also W. Buiter, (2008), Can Central Banks Go Broke, Center for Economic Policy Research, Policy Insight Nr. 24, May. 283  J.C. Stein, (2010), Securitization, Shadow banking and Financial Fragility, Daedalus, Vol. 139, pp. 41–51. 284  Altunbas et al., (2011), Bank Risk During the Financial Crisis. Do Business Models Matter?, ECB Working Paper Series, Nr. 1394, pp. 12–18. See in detail for each item: (1) D.C. Wheelock and P.W. Wilson, (2000), Why do Banks Disappear? The Determinants of U.S. Bank Failures and 281

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They also concluded that the effect of business models is non-linear—that is, business models had a different impact on riskier banks compared to non-­riskier banks. In the same research they were inconclusive regarding the question whether greater stock market capitalization involves real value creation or reflects an accumulation of latent risk.285 Or to be precise: ‘[t]he level of distress of the riskier banks is more sensitive to loan growth, customer deposits and market funding. More precisely, a stronger customer deposit base is relatively more effective in reducing distress for the riskier compared to the less risky banks. Similarly, a higher proportion of market funding increases the likelihood of distress of the riskiest banks although it has no effect on the less risky institutions.’286 A wider organizational matter regards the question to what degree the organization structure of financial institutions (headquarters with branches, headquarters with subsidiaries, foreign versus domestic financial institutions, etc.) leads to different responses and behaviors to macroprudential regulation. Danisewicz et al. more specifically looked into the question whether cross-­border spillovers of macroprudential regulation depend on the organizational structure of banks’ foreign affiliates by analyzing changes in macroprudential regulations in foreign banks’ home countries. That makes sense as by focusing on branches and subsidiaries of the same banking group, they are able to control for all the factors affecting parent banks’ decisions regarding the lending of their foreign affiliates. They conclude that there are important differences between the type of regulation and the type of lending displayed by financial institutions—that is, following a tightening of capital regulation, branches of multinational banks reduced interbank lending growth by 6% more relative to subsidiaries of the same banking group, while lending to nonbanks did not exhibit such differences.287

Acquisitions, Review of Economics and Statistics, Vol. 82, pp. 127–138; (2) K.J. Stiroh, (2010), Diversification in Banking, in A. Berger, P. Molyneux and J. Wilson (eds.), The Oxford Handbook of Banking, Oxford University Press, Oxford, pp. 146–171; (3) L. Laeven and R. Levine, (2009), Bank Governance, Regulation and Risk-Taking, Journal of Financial Economics, Vol. 93, Nr. 2, pp. 259–275; (4) S. Kwan and R.A. Eisenbeis, (1997), Bank Risk, Capitalization, and Operating Efficiency, Journal of Financial Services Research 12, Nr. 2–3, pp. 117–131; (5) Asli DemirgüçKunt and H.P. Huizinga, (2010), Bank Activity and Funding Strategies: The Impact on Risk and Return, Journal of Financial Economics, Vol. 98, pp.  626–650; (6) A.  Boot and A.V.  Thakor, (2010), The Accelerating Integration of Banks and Markets and Its Implications for Regulation, in A. Berger, P. Molyneux and J. Wilson (eds.), The Oxford Handbook of Banking, Oxford University Press, Oxford, pp. 58–90; and (7) A. Beltratti and R.M. Stultz, (2011), Why Did Some Banks Perform Better During the Credit Crisis? A Cross-Country Study of the Impact of Governance and Regulation, Journal of Financial Economics, Vol. 86, pp. 1–39. 285  Y. Altunbas et al., (2011), Bank Risk During the Financial Crisis. Do Business Models Matter?, ECB Working Paper Series, Nr. 1394. 286  Altunbas et al., (2011), ibid., pp. 5–6. 287  P. Danisewicz et al., (2015), On a Tight Leash: Does Bank Organisational Structure Matter for Macro-Prudential Spillovers?, Bank of England Working Paper, Nr. 524 (published later in Journal of International Economics, 2017, Vol. 109, Issue C, pp. 174–194).

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Their research is well embedded in various strands of existing literature,288 particularly in those areas of research that relate to how multinational banks transmit financial shocks to their balance sheets across country borders and how differences between banks—such as being geographically distant, poorly capitalized or a branch versus a subsidiary—affect how these spillovers occur as well as the cross-border spillovers of regulatory changes via multinational banks’ operations.289 They explain the difference in foreign bank behavior under reference to ‘the difference of the legal distinction between branches and subsidiaries. Under the branch structure foreign affiliates constitute an inseparable part of the parent organization.290 This structure allows for cheaper and more flexible t­ransfer of funds between the parent and its foreign entity. Subsidiaries on the contrary are considered as standalone institutions, with their own board of directors that are separately capitalized and are subject to the host country regulations.’ The organizational form of the foreign branch also impacts the degree of control the parent company has over its foreign branch or affiliate. Branches are ultimately an integral part of the parent company while on the contrary subsidiaries and their decisions are to a large degree taken and approved by the subsidiaries’ board of directors. The parent company therefore in reality can impact much more and faster the decisions of a branch than that of a subsidiary. That control very likely includes decision-making regarding reducing lending through the branch in the foreign market in case of a capital requirement tightening in their home country. The illustration of those relations is of a challenging nature as some of the variables including the size and depth of the ‘home bias’ are difficult to observe and quantify.291 Interestingly enough, the scholars didn’t observe a differential in case of a tightening in lending standards and reserve requirements does between branches and subsidiaries.

1.18.1 Fragility in Shadow Banking It has become clear that a lot of the fragility in the shadow banking market relates to the fact that these entities engage in bank-like activities (credit-, maturity and liquidity transformation) but outside the historically and permanently updated web of regulation soft law and without having access to the liquidity window of the central bank or the lender of last resort—that is, there is no public backstop. It is Luck and Schempp292 that have illustrated how sharp in a business model characterized by maturity transformation contractions in short-term funding can be and how ferociously the contamination can be toward the commercial banking sector.

 Danisewicz et al., (2015), ibid., pp. 1–5.  Danisewicz et al., (2015), ibid., p. ii. 290  Danisewicz et al., (2015), ibid., pp. ii and 11–16. 291  They reduce the challenges ‘by using an identification strategy that focuses on lending provided by branches and subsidiaries which belong to the same banking group’. They limit their sample to ‘foreign affiliates of multinational banks that operate at least one branch and one subsidiary’. 292  S. Luck and P. Schempp, (2014), Banks, Shadow Banking and Fragility, ECB Working Paper Series, Nr. 1426. 288 289

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In their excellent work, which essentially works around the theoretical concept that shadow banking emerges to circumvent financial regulation, Luck and Schempp draw three main conclusions: (1) Size and (in)stability go hand in hand in the shadow banking market. Fragility rises materially in case the shadow banking market grows fast and disproportionately large compared to the arbitrage capital. Fragility in their context is defined as the possibility that panic-based runs may occur. That definition works out as follows: ‘[i]f the short-term financing of shadow banks breaks down, they are forced to sell their securitized assets on a secondary market. If the size of the shadow banking sector is small relative to the capacity of this secondary market, shadow banks can sell their assets at face value in case of a run. Because they can raise a sufficient amount of liquidity, a run does not constitute an equilibrium. However, if the shadow banking sector is too large, the arbitrageurs’ budget does not suffice to buy all assets at face value. Instead, cash-in-the-market pricing leads to depressed fire sale prices in case of a run. Because shadow banks cannot raise a sufficient amount of liquidity, self-fulfilling runs constitute an equilibrium.’293 If the shadow banking segment is too large relative to the available regulatory capital re-sale prices are depressed due to cash-in-the-­market pricing, and self-filling runs become possible.294 (2) In case commercial banks engage themselves in shadow banking activities, a larger shadow banking sector is sustainable. That is because in that scenario shadow banking indirectly benefits from the public safety net to which the commercial banks have access.295 (3) A safety net for banks may not only be unable to prevent a banking crisis in the presence of regulatory arbitrage, but it may also be costly for the regulator (or taxpayer). That makes sense: when commercial and shadow banking is distinct a run in the shadow banking segment doesn’t affect the commercial banking sector. When those markets however are intertwined, a systemic crisis will impact both segments. Regulatory arbitrage does effectively undermine the public safety net available for commercial banks. Although a quantification of where the size of the shadow banking sector effectively contributes to fragility remains difficult, it is clear that size, magnitude of the maturity mismatch and interconnectedness with the regulated banking sector should all be treated as main variables in that equation.296 As regulatory arbitrage (and its magnitude) is the crucial aspect in the analysis, it could be expected that reducing regulation would be recommended. However, and in contrast to other scholars,297 that is not the case with Luck and Schempp

 Luck and Schempp, (2014), ibid., pp. 2 and 4–8.  Luck and Schempp, (2014), ibid., p. 4. 295  See also J.C.  Stein, (2010), Securitization, Shadow Banking and Financial Fragility, Harvard University Working Paper, May. 296  Luck and Schempp, (2014), ibid., pp. 3, 24–28. 297  G. Ordoñez, (2013), Sustainable Shadow Banking, NBER Working Paper Nr. 19022. See also: A. Segura, (2014), Why Did Sponsor Banks Rescue Their SIV? A Signaling Model of Rescues, Bank of Italy Working Paper, and A. Schleifer and R.W. Vishny, (1997), The Limits of Arbitrage, Journal of Finance, Vol. 52, Issue 1, pp.  35–55. See also: C.A.E.  Goodhart, et  al., (2012), Financial Regulation in General Equilibrium, NBER Working Paper Nr. 17909, and C.A.E.  Goodhart, et al., (2013), An Integrated Framework for Analyzing Multiple Financial Regulations, International Journal of Central Banking, January, pp. 109–143. 293 294

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who advocate regulation imposed on banks that would reduce moral hazard. Plantin however, who studied the optimal regulation of banks, advocates, for example, that tight capital requirements may spur shadow banking activity. He advances: ‘[i]f it is not possible to regulate the shadow banking system at all, then relaxing capital requirements for traditional banks so as to shrink shadow activity may be more desirable than tightening them.’ If it is not possible to regulate the shadow banking system at all, then ‘relaxing capital requirements for traditional banks so as to shrink shadow activity may be more desirable than tightening them’. He alternatively suggests imposing minimal haircuts on repos rather than tightening capital requirements for traditional banks.298 As shadow banks are financial intermediaries that conduct maturity, credit and liquidity transformation without access to central bank liquidity or public sector credit guarantees, they pose specific risks and create vulnerabilities of a specific nature. Examples of shadow banks include finance companies, asset-backed commercial paper 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. The shadow banking system provides 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. Pozsar et al. have documented the specific vulnerabilities per type of shadow banking entity and activity, using the 2008 financial crisis and the experiences back then as a testing platform.299 A complicating factor will be the shadow banking role of regulated banks as discussed. It was Cetorelli and Peristiani300 that indicated that if origination per se has been moved to SPVs in the asset-backed securitization business, banks retained their role as underwriter, trustee and servicer. They also argue that if banks have faced some competition

 G.  Plantin, (2014), Shadow Banking and Bank Capital Regulation, Toulouse School of Economics Working Paper, also published in Review of Financial Studies, Vol. 28, Issue 1, January 2015, pp. 146–175. 299  Z. Pozsar et al., (2012), Shadow Banking, Federal Reserve Bank of NY, Staff Report Nr. 458, February (initial version July 2010). See for a broader evaluation of the shadow banking literature by T.  Adrian and A.B.  Ashcraft, (2012), Shadow Banking: A Review of the Literature, Federal Reserve Bank of NY, Nr. 580, October. A year later they developed, taking into account their earlier analysis, a framework for monitoring the shadow banking market taking into account the web of regulation spreading throughout the banking sector and based on a function-level analysis (and not an entity-based analysis); see: T.  Adrian, A.B.  Ashcraft and N.  Cetorelli, (2013), Shadow Bank Monitoring, Federal Reserve bank of NY, Staff Reports Nr. 638, September. 300  N. Cetorelli and S. Peristiani, (2012), The Role of Banks in Asset Securitization, Federal Reserve Bank of New York Economic Policy Review, Vol. 18, Issue 2, pp. 47–64. 298

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from finance companies in the originating and servicing segments, they retain a significant and growing share of these activities. Overall, Cetorelli and Peristiani show empirically that large bank holding companies and investment banks have been major contributors to all phases of the development of shadow banking.301 It points at the misconception of opposing bank and nonbank lending, as they in effect are complements because financing provided by nonbank entities typically requires the direct involvement of banks in one capacity or another. Blanc-­Grude comments: ‘[t]hus, if banks must remain heavily involved in driving the different functions allowing the origination of new credit, it should be acknowledged that allowing the creation of private debt funds in order to address a funding gap for SMEs or infrastructure is essentially a way to allow the origination of long-term loans off banks’ balance sheets.’302 Banks will continue to play a role in intermediation and origination despite the fact that banks’ balance sheet room is expensive and other investors may well want to take risk associated with these new loans.303

1.18.2 F inancial Stability Options for Shadow Banking Entities Any sort of stability mechanism to stabilize shadow banking entities should start with the question of what economic mechanism drives or motivates any particular shadow banking activity. Those motivations can range from (1) specialization, (2) mispricing of (public) guarantees, (3) regulatory arbitrage, (4) negligence of risk, (5) agency issues, (6) need for short-term funding and (7) the desire for private money creation.304 Adrian concludes carefully with: ‘[p]olicies will need to react dynamically to the changing financial landscape to contain threats effectively. Importantly, shadow bank policies need to take a system wide, macro-prudential view, due to the tight interconnections and potentially powerful spillovers among shadow banking entities, and between shadow banks and core regulated financial institutions.’305 Also the securitization process, where increased leverage fuels global imbalances, directly leads to sensitivities. Or as Adrian and Shin reiterate, ‘[w]hen the claims and obligations between leveraged entities have been netted out, the lending to ultimate borrowers must be funded either from the equity of the intermediary sector or by borrowing from creditors outside the intermediary sector.’306 Potential regulation will require a combined systemic risk coverage and macroprudential oversight kind of regulatory dynamics.307 That has every-

 F. Blanc-Brude, (2013), Discussion of the Central Bank of Ireland Discussion Paper on Loan Origination by Investment Funds, EDHEC Working Paper, September 12, p. 8ff. 302  F. Blanc-Brude, (2013), ibid., p. 10. 303  See also T.  Lane, (2013), Shedding Light on Shadow Banking, CFA Society, 26 June 2013, Toronto. 304  See extensively T.  Adrian, (2014), Financial Stability Policies for Shadow Banking, Federal Reserve Bank of NY, Staff Papers, Nr. 664, pp. 2–12. 305  T. Adrian, (2014), ibid., p. 20. 306  T.  Adrian and H.S.  Shin, (2009), The Shadow Banking System: Implications for Financial Regulation, Federal Reserve Bank of NY, Staff Report Nr. 382, July, p. 11. 307  Adrian and Shin, (2009), ibid., pp. 14–17. 301

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thing to do with the intrinsically changing landscape of financial intermediation in recent times.308 Although maturity transformation renders shadow banks intrinsically fragile, a combination of less leverage, asset risk and maturity transformation will be the preferred regulatory outcome to ensure survival during future periods of stress. Even more, the reliance on and incentives for traditional banks to rely on shadow banking entities for intermediation and return enhancement persist. Any regulatory effort undertaken in this respect will lead to a balancing point between capital and liquidity requirements and returns. A properly priced and public backstop cannot be the only solution in the mix. Additionally, any given monitoring system (that feeds into regulation) will have to distinguish between shocks, which are difficult to prevent, and vulnerabilities that amplify shocks, but can be reduced by preemptive actions. That regulation will have to be in sync not only to cover the shadow banking sphere but asset markets overall, the wider nonfinancial sector, nonbank intermediation and will pay attention to those entities posing a systemically important sort of some sort. In any such framework there will be a policy trade-off between reducing systemic risk and the cost of financial ­intermediation.309 That is the logical consequence of the fact that maturity transformation is full of liquidity, collateral and asset liquidation constraints. Those constraints ultimately create runs of a variety of types. Since these constraints are endogenous and by far and large depend on the balance sheet and fundamentals of the financial intermediaries involved,310 the fragility is deeply rooted and directly linked to systemic risks, therefore mitigating this phenomenon will come at a cost either ex ante or ex post (and then all bets are of who will carry the burden and what the size of the exposure will be).311 Realizing that shadow banks tend to hold more opaque assets than their regulated counterparts, the dynamics of any ex post exposure don’t require a lot of additional qualification.312 The question ex post is whether regulation or macroprudential policy should be preferred, or a (blended) combination. Regarding macroprudential policies, it was highlighted before that the introduction of those policies occurred ad hoc rather than following a tough academic disciplined model and body of analysis. The circumstances justified that, so it seems. It is only years later that we now start to understand the impact of some of the decisions made five to six years ago.313 For example, the fact that too low for too

 See extensively: T.  Adrian and H.S.  Shin, (2010), The Changing Nature of Financial Intermediation and the Financial Crisis of 2007–2009, Federal Reserve Bank of NY, Staff Report, Nr. 439, April (revised edition). 309  See in detail: T. Adrian, D. Covitz and N. Lang, (2013), Financial Stability Monitoring, Federal Reserve Bank of NY, Staff Reports, Nr. 601, (revised edition) August. 310  And the collateral they accept and provide in the chain, as shocks to the valuation of those assets converts information insensitivity of the instruments to contagion risk. 311  See in detail: A. Martin et al., (2013), The Fragility of Short-Term Secured Funding Markets, Federal Reserve Bank of NY, Staff Report, Nr. 630, September. 312  Bringing to mind the seven aforementioned dynamics of shadow banking as defined by Adrian. See also T. Adrian et al., (2013), Shadow Banking Monitoring, Federal Reserve Bank of NY, Nr. 638, September, in particular pp.  15–22. This report includes a monitoring framework aligned with these seven drivers as discussed earlier. 313  See, for example, regarding protracted periods of long interest rates and the failure of agents to anticipate the extent of abnormally favorable (market) conditions; F. Verona et al., (2013), (Un) anticipated Monetary Policy in a DSGE Model with a Shadow Banking System, Bank of Finland Discussion Paper Nr. 4, Helsinki. 308

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long interest rates policy induces an increase in the leverage and bonds issued by the entrepreneurs that resort to the shadow banking system. Overall, bubble creation or boom and bust scenarios are the consequence. However, as Verona et  al. conclude: ‘[h]owever, the price of capital does not feature the gradual build that is typically associated with booms nor the below-average levels typically associated with busts. In turn, when the policy path is unanticipated, the model generates a boom-bust dynamics: (i) output, investment and total credit increase and respond in a hump-shaped pattern; (ii) the price of capital rises steadily while the policy interest rate is too low, and then falls abruptly to below its steady-state level.’314 Also the intertwining between banks and nonbanks, the long cascading chains of financial intermediation as discussed also impact the ability to create prudential regulation. The bottom-line reality is that in a market-based financial system, it is becoming more and more difficult to isolate banking risks from financial market risks. That is something the FSB seemed to have forgotten when making the move from regulating shadow banks to transforming shadow banks into market-based financial intermediaries. Or worse, they have not forgotten but decided to ignore that crucial aspect, because without it, there is no regulator who would be close to the argument that market-­based finance is a direct alternative to regulated financial intermediation as we know it. Boot and Thakor indicate in this respect: ‘[t]his integration (between banks and shadow banks (ed.)) generates two effects that work in opposite directions. On the one hand, individual banks become better equipped to manage their own risks because it becomes easier and less costly to hedge these risks using the market. This could reduce the risk of an individual bank failing due to an idiosyncratic shock. On the other hand, there is an increase in the probability that a shock to a small subset of banks could generate systemic effects that ripple through the financial market, so that this banks-markets integration may be causing an elevation of systemic risk.’315 Within that paradigm a material number of questions stay, for now, unanswered.316 Gabor, from her side, focuses on the key nodes that the interconnectedness between banks and shadow banks create as well as the, often, common exposure they create. Her take on it is that the collateral-intensive nature of shadow banking generates two mechanisms of interconnectedness: the risk management framework and the reuse/rehypothecation channel.317 Both have systemic implications, together generating an important political conflict for the management of shadow banking because private leverage is born in, and can destabilize, government debt markets. She advanced with the fact that collateral-­intensive finance thus confronts central banks and governments with a deeply political question: what governance arrangement is best suited to manage the sys-

 F. Verona et al., (2013), ibid., p. 26.  A.W.A.  Boot and A.V.  Thakor, (2013), Commercial Banking and Shadow Banking: The Accelerating Integration of Banks and Markets and the Implications for Regulation, Washington University in St. Louis Business School, Working Paper Nr. 13/005, pp. 33–34. 316  Boot and Thakor list a number of the questions that remain on the table; ibid., pp. 34–35. 317  D. Gabor, (2014), Shadow Interconnectedness: The Political Economy of (European) Shadow Banking, UWE Bristol, Working Paper, pp. 6–10. 314 315

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temic risks generated through shadow activities that blur the lines between financial stability policy and fiscal policy?318 Every meaningful answer would include a coordination between private money creation and innovation in the shadow banking sector and central bank in order to manage the implied interconnectedness. But how difficult is that if those same governments want to remain attractive to financial activities that are highly mobile in nature.319 But she indicates, ‘in the absence of central bank support, a crisis in shadow banking worsens both sovereign funding conditions and financial fragility.320 Central banks may find interventions unpalatable because so far crisis policies have relied on the implicit assumption that the pre-crisis institutional architecture—an inflation-oriented independent central bank and a fiscally-prudent government—should remain in place and be strengthened by a revamped macro-prudential framework. This perspective is now obsolete. The political economy of shadow banking renders central bank independence irrelevant and the current macro-institutional architecture outright damaging to macroeconomic stability.’321 These connections are both systemic and fragile. The repo connection, for example, is both systemic and fragile, that is, fragile because they are the cheapest source of funding for leveraged financial activity, but also because practices of risk management and reuse can amplify concerns about collateral quality and ignite liquidity spirals. They are systemic because repo markets are now the most significant source of market funding for banks and nonbanks with large trading portfolios. But what counts as acceptable in a crisis of shadow banking fundamentally depends on the institutional structures in which the repo market is embedded.322 However, it can be concluded with Pozsar et  al. that the reform effort has done little to address the tendency of large institutional cash pools to form outside the banking system. Thus, we expect shadow banking to be a significant part of the financial system, although almost certainly in a different form, for the foreseeable future.323

 D. Gabor, (2014), Shadow Interconnectedness: The Political Economy of (European) Shadow Banking, UWE Bristol, Working Paper, pp. 12–16. 319  T.  Rixen, (2013), Why Reregulation after the Crisis is Feeble: Shadow Banking, Offshore Financial Centers, and Jurisdictional Competition. Regulation & Governance, DOI: https://doi. org/10.1111/rego.12024 320  See also S. Flandreau, (2013), Do Good Sovereigns Default? Lessons from History, BIS Working paper Nr. 72, pp. 19–26. 321  D. Gabor, (2014), ibid., p. 3. 322  D. Gabor, (2014), ibid., pp. 16–17. 323  Z. Pozsar, et al., (2013), Shadow Banking, Federal Reserve Bank of New York: Economic Policy Review, Vol. 19, Nr. 2. See also: D. Fiaschi et al., (2013), The Interrupted Power Law and the Size of Shadow Banking, Working Paper. Fiaschi et al. engage in an interesting experiment. They, based on the Forbes 2000, show that the distribution of asset sizes for the largest global firms follows a Pareto distribution in an intermediate range that is ‘interrupted’ by a sharp cutoff in its upper tail, which is totally dominated by financial firms. This contrasts with a large body of empirical literature which finds a Pareto distribution for firm sizes both across countries and over time. They claim that the missing mass from the upper tail of the asset size distribution is a consequence of shadow banking activity and that it provides an estimate of the size of the shadow banking system. See for a reflection of the volumes provided by the shadow banking sector to the nonfinancial part of the 318

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One of the remaining questions is ‘sustainability’ of capital flows flowing into the SB segment following Basel III.324 Indeed Basel III is co-shaping the future dynamics of the shadow banking sector.325

1.19 T  he Relationship Between the ‘Solvency’ of the Shadow Banking Sector and the ‘Liquidity’ of the Financial Markets: The Systemic Risk Angle The financial crisis as such demonstrated the strong nexus between the solvency of institutions and the liquidity issues of the financial system as such. It was observed and discussed before that the run on shadow banking entities and products was linked to the credit distress of the underlying assets and in particular the collateral provided in these transactions.326 Even those institutions that had access to a public liquidity window of some sort experienced run-like dynamics.327 Many have discussed the importance of liquidity and solvency for determining the nature and size of bank runs3278; few have actually looked into the nexus between solvency of institutions and the liquidity of the financial system ‘as such’. Only in recent year that angle has been studied, but only in modest volumes.329 In particular Pierret has been dedicating quite some focused attention to this question. She concluded: ‘I find that banks lose their access to short-­term funding when markets expect they will be insolvent in a crisis. Conversely, the expected amount of capital a bank should raise to remain solvent in a crisis (its capital shortfall) increases when the bank holds more short-term debt

economy: J. Gallin, (2013), Shadow Banking and the Funding of the Nonfinancial Sector, Finance and Economics Discussion Series Divisions of Research & Statistics and Monetary Affairs Federal Reserve Board, Washington, DC, Working Paper Nr. 2013/50. 324  P. Jackson, (2012), Basel III and Shadow Banking, in Future Risks and Fragilities for Financial Stability, (D.T. Llewellyn and R. Reid eds.), Larcier/Suerf, June, pp. 29–40. 325  See in detail: B. Bauer and Ph. Wackerbeck, (2013), Into the Shadows: How Regulation Fuels the Growth of Shadow Banking Sector and Banks Need to React, The European Financial Review, June–July, pp. 28–30. 326  D.  Covitz, et  al., (2013), ‘The Evolution of a Financial Crisis: Collapse of the Asset-Backed Commercial Paper Market’, Journal of Finance, Vol. 68, Issue 3, pp. 815–848. 327  R.  Iyer, et  al., (2012), Do Depositors Monitor Banks?, MIT Working Paper; R.  Huang and L.  Ratnovski, (2011), The Dark Side of Bank Wholesale Funding, Journal of Financial Intermediation Vol. 20, Issue 2, pp. 248–263. 328  D. Diamond and R. Rajan, (2005), Liquidity Shortages and Banking Crises, Journal of Finance Vol. 60, Issue 2, pp. 615–647; S. Morris and H. S. Shin, (2008), Financial Regulation in a System Context, Brookings Papers on Economic Activity 2008, pp. 229–261. 329  M. Cornett, et al. (2011), Liquidity Risk Management and Credit Supply in the Financial Crisis, Journal of Financial Economics Vol. 101, Issue 2, pp. 297–312; D. Pierret, (2015), Systemic Risk and the Solvency-Liquidity Nexus of Banks, International Journal of Central Banking, Vol. 11, Issue 3, pp. 193–227.

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(has a larger exposure to funding liquidity risk). This solvency-liquidity nexus is found to be strong under many robustness checks and to contain useful information for forecasting the short-term balance sheet of banks. The results suggest that the solvency-liquidity interaction should be accounted for when designing liquidity and capital requirements, in contrast to Basel III regulation where solvency and liquidity risks are treated separately.’ Pierret’s analysis has contributed many aspects to our thinking and understanding about the topic. Besides demonstrating the causality between the ‘solvency’330 and ‘liquidity’331 aspect, Pierret demonstrates that when solvency risk increases, the amount of short-term debt is reduced in the market. Markets limit the amount of short-term funding that a firm can receive when it becomes riskier. Highs levels of short-term debt on the books of financial institutions (FIs) increase the level of solvency risk. That understanding makes sense and is even intuitively well accepted: the liquidity management of firms and the market assessment of solvency are intertwined. But there is also an asymmetry in the response of solvency to liquidity versus liquidity to solvency as Adrian indicates: ‘short-term debt makes firms fragile, while more fragility causes depositors to withdraw funding.’332 Pierret further indicates that those FIs with a capital shortfall tend to respond stronger to a reduction in short-term debt and that those firms with a capital shortfall experience a larger decline in short-term debt when the solvency risk increases (unexpectedly). Pierret further highlights that of all the components that measure solvency risk (SRISK developed by Acharya et al.) the improvement of the ratio of market capitalization to total assets is most relevant to predicting the level of short-term debt experienced. Adrian, a little while later, has added to that knowledge by trying to improve the identification of shocks as was developed under Pierret’s model.333 The nexus ‘solvency-liquidity’ is an important one and in late 2014334 Adrian suggested the Federal Reserve to take that nexus into account as it would ‘include a capital charge proportional to the amount of short-term wholesale funding in the macro-prudential GSIB surcharge’, the charge enacted in 2014 on global systemically important financial institutions. This rule would incentivize global banks to hold more capital to risk-weighted assets and rely less on short-term debt to fund their activities. Pierret’s model (or an advanced version of it) would then be instrumental in deciding ‘what the appropriate level of a capital surcharge for short-term wholesale funding’ would be. Additional considerations, according to Adrian, that could be taken into account are the following:

 The common accepted solvency measurement is that of Acharya et al.: see V. Acharya, et al., (2012), Capital Shortfall: A New Approach to Ranking and Regulating Systemic Risks, American Economic Review Vol. 102, Issue 3, pp. 59–64. The SRISK developed is at least to a certain degree a ‘forward-looking market-based measure’. 331  Liquidity is measured by the difference between short-term debt and total assets. 332  T.  Adrian, (2015), Discussion of Systemic Risk and the Solvency-Liquidity Nexus of Banks, Federal Reserve Bank of New York Staff Reports, Nr. 722, p. 2 (also published in International Journal for Central Banking, 2015, June, pp. 229–240). 333  Adrian, (2015), ibid., pp. 2–4. 334   Federal Register, (2014), Risk-Based Capital Guidelines: Implementation of Capital Requirements for Global Systemically Important Bank Holding Companies, Vol. 79, Nr. 243, pp. 75473–75496. 330

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• The interrelation between solvency and liquidity fragility would be expected to vary as a function of the level of capital and liquidity regulation.335 Although the theory has given us models, most of them are too abstract or prone to too many variables to be meaningfully convertible into legislation. Adrian indicates, ‘[h]ence a precise estimate of the substitutability of capital and liquidity would be very welcome.’ • The underlying economic frictions that give rise to the interrelatedness of solvency and liquidity problems are still somewhat of a mystery although literature has given us ‘a number of possible channels, including coordination problems, fire-sale externalities, and network effects, among others’. Also in this context Pierret’s model can be instrumental as it provides some interesting parameters that can help link solvency and liquidity issues to specific mechanisms, for example, the fraction of wholesale funding over total deposits, the degree of intra-financial exposure or the potential for fire sale vulnerability. • Possible legislation needs to take into account the notion of aggregate vulnerability and the reality of aggregate lending with different funding profiles. To that extent the regulator faces a trade-off between systemic risk and returns. Adrian indicates, ‘[t]ighter regulation tends to reduce aggregate vulnerability, but credit intermediation becomes more expensive. Regulators have to weigh the overall level of risk in the financial system against the cost of reduced credit intermediation.’336 • In case ‘capital and liquidity requirements might be substitutable’, the right calibration of capital and liquidity requirements will improve welfare. That will require, however, that the link between liquidity and solvency can be analyzed at ‘aggregate’ level. That didn’t happen in Pierret’s model and also not in previous models designed.337 • Liquidity rules are important to stabilize the system. Capital rules are needed to prevent a crisis from happening (or at least mitigate it). The framework of analysis should therefore be extended to include not only the ‘solvency-liquidity’ nexus but also the ‘liquidity-capital’ nexus. It would help to calibrate ex ante ‘central bank lending of last resort type of policies’ and ‘recapitalization frameworks’. There is also a wider ‘change’ in analysis emerging. While traditionally financial regulation was developed from the perspective of a partial equilibrium taking into account ‘coordination issues’, in more recent years the ‘micro’ view has been paralleled by a ‘macro’ view and analysis. That trend provides useful insights into the nature and relationship

 Adrian, (2015), ibid., pp. 4–5. He asks the question out loud: to what extent would a marginal increase in the capital requirement allow the relaxation of a liquidity requirement (or a liquidity backstop), keeping the overall level of fragility constant? Or, in reverse, to what extent would a government guarantee for runnable deposits allow a relaxation of capital requirements, keeping overall fragility constant? 336  Adrian, (2015), ibid., p.  5; See also: T.  Adrian, and N.  Boyarchenko, (2012), Intermediary Leverage Cycles and Financial Stability, Federal Reserve Bank of New York Staff Reports Nr. 567. 337  T.  Adrian, and M.  Brunnermeier, (2010), CoVaR, Federal Reserve Bank of New  York Staff Report Nr. 348; they ask the question to what extent the distress of an individual institution might impact the overall level of systemic risk. 335

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between credit intermediation and systemic infrastructure risk.338 Both liquidity and capital regulation attempt to reduce risk taking in the financial sector. But their impact on systemic risk and aggregate growth is different. Adrian and Boyarchenko illustrate: ‘both types of prudential regulation can help reduce systemic risk, capital requirements typically have a stronger adverse impact on growth, via increased credit intermediation costs.’339 Therefore there is a risk-return trade-­off in every choice the regulator and supervisor will make in this respect.

1.20 The (Re)use of Collateral in the Repo Market 1.20.1 Introduction It is fair to say, and the FSB acknowledges, that data on the use and reuse of collateral are somewhat general and ‘skimmy’ or at least very general. That makes sense as before the crisis there was hardly any attention for ‘the use and reuse of collateral’. The only attention the topic received was from the legal sphere and was contractual (and therefore micro-viewed) in nature. But since the world started to understand that use and reuse of collateral have to potential to lead to and/or magnify systemic risk and possible contagion effects, the quest was on to get a better understanding of the size of the ‘reuse’ market. Fuher et al.340 recently made an effort to develop a methodology to estimate the reuse of collateral based on actual transaction data. They focused on the Swiss franc repo market but the model has general validity. The availability of securities is critical, as reusing collateral allows banks to conduct transactions regardless of a potential collateral constraint. The reuse will limit that constraint and is therefore widely championed.341 The discussion regarding the availability of quality collateral is not going to go away somewhere very soon. But the literature has mainly focused on the (structure of the) repo market and the macroeconomics of the industry, but very little on the reuse of collateral and the size of collateral rehypothecation. Reuse and rehypothecation can be defined as: ‘[re\]ehypothc is the right by financial intermediaries to sell, pledge, invest or perform transactions with client assets they

 See, for example, T. Adrian, and N. Boyarchenko, (2013), Liquidity Policies and Systemic Risk, Federal Reserve Bank of New  York Staff Reports Nr. 661; M.  Brunnermeier, and Y.  Sannikov, (2014), A Macroeconomic Model with a Financial Sector, American Economic Review Vol. 104, Issue 2, pp. 379–421; Z. He and A. Krishnamurthy, (2013), Intermediary Asset Pricing, American Economic Review Vol. 103, Issue 2, pp. 732–770. 339  Adrian, (2015), ibid., p. 6, and originally T. Adrian, and N. Boyarchenko, (2013), Liquidity Policies and Systemic Risk, Federal Reserve Bank of New York Staff Reports Nr. 661. 340  L.M. Fuhrer et al., (2015), Reuse of Collateral in the Repo Market, Swiss National Bank Working Paper, Nr. 2015/2 (also published in Journal of Money, Credit and Banking, Vol. 48, Issue 6, September 2016, pp. 1169–1193). 341  See, for example, A. Levels, and J. Capel, (2012), Is Collateral Becoming Scarce? Evidence for the Euro Area. The Journal of Financial Market Infrastructures, Vol. 1, pp. 29–53. 338

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hold’ and the reuse of collateral as ‘securities delivered in one transaction [that] are used to collateralize another transaction’.342 Thus, the right to reuse securities ‘arises in a repo transaction automatically and does not need to be explicitly granted by the collateral provider’. Their overall conclusion is that the reuse of collateral was popular pre-­2008 crisis when roughly 10% of the outstanding interbank volume was based on reused collateral. Furthermore, they show that reuse increases with the scarcity of collateral—that is, it decreases when the collateral availability increases.343 The reuse in the interbank market is positively related with the general securities borrowing activity of banks. Fuhrer et  al. indicate that ‘banks simultaneously reuse collateral in the interbank market and borrow securities from clients. Further, we find evidence for a significant impact of the maturity of the transaction on the reuse probability. Banks reuse collateral if they lend cash longterm and borrow cash short-term. This allows them to keep a relatively small pool of securities’.344 That is critical from a policy point of view cause ‘if collateral scarcity increases, banks will have an incentive to reuse collateral, which in turn increases leverage and interconnectedness in financial markets’.345

1.20.2 Rehypothecation of Repos As all assets can be used within the context of collateral reuse or re­hypothecation, so can repos. Dealers of all sorts in the market intermediate funds and collateral between cash lenders (e.g. money market funds) and their (prime brokerage) clients (e.g. credit hedge funds). In contrast to an ideal situation where the dealer would engage in repos with cli-

 See also: J. Aitken, and M. Singh, (2009), Deleveraging After Lehman – Evidence from Reduced Rehypothecation, IMF Working Paper, Nr. WP/ 09/42. 343  L.M. Fuhrer et al., (2015), ibid., p. 3. 344  L.M. Fuhrer et al., (2015), ibid., p. 3. 345  See in more detail on the matter: (1) J.M. Bottazzi, et al., (2012), Securities Market Theory: Possession, Repo and Rehypothecation, Journal of Economic Theory, Vol. 147, pp. 477–500; (2) Committee on the Global Financial System (CGFS), (2013), Asset Encumbrance, Financial Reform and the Demand for Collateral Assets, CGFS Papers Nr. 49; (3) D.  Duffie, (2013), Replumbing our Financial System: Uneven Progress, International Journal of Central Banking, Vol. 9, pp.  251–279; (4) E.  Eren, (2014), Intermediary Funding Liquidity and Rehypothecation as Determinants of Repo Haircuts and Interest Rates, Stanford University Working Paper; (5) S.  Infante, (2014), Money for Nothing: The Consequences of Repo Rehypothecation, Federal Reserve Board Working Paper; (6) G. Gorton and A. Metrick, (2012), Securitized Banking and the Run on Repo, Journal of Financial Economics Vol. 104, pp. 425–451; (7) A. Levels and J. Capel, (2012), Is Collateral Becoming Scarce? Evidence for the Euro Area, The Journal of Financial Market Infrastructures, Vol. 1, pp. 29–53; (8) L. Mancini, et al., (2013), The Euro Interbank Repo Market University of St. Gallen Working Paper Nr. 2013/16; (9) C. Monnet, (2011), Rehypothecation, Business Review, Federal Reserve Bank of Philadelphia, pp. 18–25; and (10), M. Singh, (2011), Velocity of Pledged Collateral: Analysis and Implications. IMF Working Paper Nr. 256. 342

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ents under similar or at least symmetric terms, reality is different in the sense that they do so under different repo terms with each counterparty. That is in his own interest (of the dealer) as the asymmetric terms, and in particular the differences in haircuts346 (which is the amount or percentage by which the dealer calculates the value of the assets [and its reduction] for the purposes of capital requirements, margin requirements or collateral levels) can under circumstances generate a positive cash balance347 for the dealer and can be a material source of liquidity for the dealer. Margin requirements and haircuts are critical tools as they are directly linked to procyclicality of the financial sector.348 Infante349 demonstrated that there is a pattern in the behavior regarding repo rehypothecation and dealer default. Dealers receive funds from money market funds through the tri-party market and distribute them to their prime brokerage clients in the bilateral market.350 More particularly the dealers with higher default risk tend to be more exposed to runs by collateral providers than to runs by cash lenders, who obviously are completely insulated from a dealers’ potential default. Collateral providers’ repo terms are further sensitive to changes in a dealer’s default probability and its correlation with the collateral’s outcome, whereas cash lenders’ repo terms are unaffected by these changes. Infante models these differences in haircuts observed in both the bilateral and tri-party repo market, with a view toward understanding the collapse during the recent financial crisis but also to further understand the empirical evidence regarding the predictive power and the sensitivities surrounding haircuts in the repo market. The model predicts that as the correlation between the dealer’s default and collateral values increase, the bilateral market haircut will decrease because the probability of losing a valuable asset is greater.

 ‘The haircut or initial margin represents the potential loss of value due to (1) price volatility between regular margining dates (in case there is a default between a calculation of a margin call and the payment or transfer of margin in response to that margin call) and (2) the probable cost of liquidating collateral following an event of default, as well as (3) inconsistencies between the valuation methodologies used in margining and for a default. There are three broad issues: delays in liquidation, price volatility and the potential price impact of a default by the issuer of the collateral asset. Time delays include: how long it takes to respond to a margin call (operational risk); the likelihood of a delay in liquidation due to a legal challenge to the non-defaulting party’s title to the collateral asset or his right to net (legal risk); and how quickly the entire holding of a collateral asset could be liquidated without a significant market impact or how far might the price fall or be forced down by faster selling (liquidity risk). If the cash and collateral are denominated in different currencies, price volatility must include the effect of exchange rate fluctuations’; via icmagroup.org—What is a haircut? 347  ‘The difference in margins between these repo contracts implies a cash surplus for intermediaries, effectively giving them a liquidity windfall through repo rehypothecation’ (p.  1). CGFS Papers (2010), footnote 347. 348  See in extenso: CGFS Papers, (2010), The Role of Margin Requirements and Haircuts in Procyclicality, Report submitted by a Study Group established by the Committee on the Global Financial System, March. This Study Group was chaired by David Longworth of the Bank of Canada. 349  S. Infante, (2015), Liquidity Windfalls: The Consequences of Repo Rehypothecation, Finance and Economics Discussion Series 2015–022. Washington: Board of Governors of the Federal Reserve System; see also: S.  Infante, (2014), Money for Nothing: The Consequences of Repo Hypothecation, Federal Reserve Board Working Paper, November 14. 350  Infante, (2015), ibid., p. 23. 346

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The open question remains why cash lenders do not directly interact with cash borrowers which could well lie in the opaqueness of the cash borrowers and the positions they take with that borrowed cash (e.g. credit hedge funds) which creates a natural concern regarding the counterparty risk on the side of the lenders. That risk seems to be appreciated better by dealers as they often execute the trades engaged in by the borrowers. His model builds on existing ones including that of Eren who created the model regarding intermediary funding liquidity and rehypothecation and demonstrates their relationship with the level of repo haircuts and interest rate levels applied.351 In fact, the models assume a chain of repos. In that cascade the haircuts will become more sizeable and the chain magnifies earlier haircuts. Therefore repo transactions often involve overcollateralization (aka haircuts). Dang et al.352 demonstrated before that the existence of haircuts is due to ‘sequential trade in which parties may default and intermediate lenders face liquidity needs’. When there is a likelihood that the borrower will default, then the lender’s liquidity needs and own default risk in a subsequent transaction to sell the collateral become paramount. The haircut size depends on ‘(i) the default probabilities of the borrower, (ii) the liquidity needs of the lender, (iii) the default probability of the lender in a subsequent repo transaction and (iv) the nature of the collateral’. Ultimately, the discussion tends to drift back to the inherent instability of the (shadow) banking sector. In the discussion about the most appropriate regulation, most of the focus has been going toward the ex ante avoiding of runs and contagion. Very little attention has been going to the ex post design of appropriate regulation that functions optimally in case the next shock arrives. The real risk from a regulatory point of view is to end with complacency about the robust nature of the ex ante regulation in place. That would ignore that despite all the incoming regulation, shocks and crises do and will occur in the future. More focus on the effective functioning of the ex post model to limit contamination, ring-fence risk and assets in a timely fashion and appropriate cross-border resolution mechanisms should be warranted. Looking at the European solution generated to tackle a next systemic banking crisis I get little convinced. There are many different reasons for that, of which a thorough discussion is clearly out of scope in this context. And yes, even if we would be able to design adequate and properly functioning ex post regulation including bailouts, this would not imply that optimal intervention completely isolates shadow banking intermediaries from a crisis. In fact, optimal public sector intervention imposes costs on, for example, money market funds by requiring them to liquidate some collateral. What we know for sure is that a commitment to no bailouts contributes to financial instability as, for example, the repo market collapses in the wake of a run without a public safety net. Otto and Reed are willing to go the extra mile and comment that bailouts can help minimize the costs of ‘runs on repos’ in which there would be large-scale

 E. Eren, (2014), Intermediary Funding Liquidity and Rehypothecation as Determinants of Repo Haircuts and Interest Rates, Stanford Working Paper. 352  T.V. Dang et al., (2013), Haircuts and Repo Chains, Colombia Working Paper, October, mimeo; C. Julliard et al., (2019), What Drives Repo Haircuts? Evidence from the UK Market, Working Paper, January 30; W.  Lou, (2016), Repo Haircuts and Economic Capital, Working Paper; A.  Muley, (2016), Collateral Reuse in Shadow Banking and Monetary Policy, Working Paper, January 7, mimeo. 351

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liquidation of collateral as a result of the liquidity crisis.353 That would increase the overall social welfare and optimum.354 Otto and Reed document that public sector intervention in their model can play an important role in ‘stabilizing the repo market by preventing massive liquidation of collateral which causes repo markets to collapse’. Policy makers aiming to increase stability of the repo market in times of crisis should carefully consider the use of public funds to stabilize shadow banking institutions. Nevertheless, as some liquidation of collateral is optimal, Otto and Reed also show that optimal policy does impose some losses among participants in the shadow banking system.355

1.20.3 T  he Use of Collateral and the Nature and Depth of the Interconnectedness in the Shadow Banking Market The use of collateral in the shadow banking system has a number of implications that relate directly to the level of interconnectedness: (1) at the level of risk management and risk management protocols and (2) the use and reuse of collateral in the system. Both have systemic implications, as the buildup of leverage (which goes further with the reuse of collateral than normal market circumstances would justify) and the private money creation has the potential to destabilize the state budget. It raises questions from a wider perspective in terms of the relation between monetary and financial stability questions but also fiscal policies. That is particularly true in political economies as is the case in the eurozone where ‘the management of money is political’.356 Gabor357 indicates that the political economy of shadow banking is, in her opinion, too narrowly focused on the ‘regulatory arbitrage’ aspect of the SB segment. Partly that can be blamed on the fact that the literature of collateralization is particularly thin. Gabor further points at the fact that the use and reuse of collateral in the shadow banking system

 D.L.  Otto and R.R.  Reed, (2015), Bailouts and Instability in the Shadow Banking System, University of Alabama Working Paper. 354  See a contrario: T. Keister, (2014), Bailouts and Financial Fragility, Mimeo, Rutgers University. 355  Otto and Reed, (2015), ibid., p. 28. See further regarding this matter: F. Allen and Douglas Gale, (2000), Financial Contagion, Journal of Political Economy, Vol. 108, pp. 1–33; B. Begalle, et al., (2013), The Risk of Fire Sales in the Tri-Party Repo Market, Federal Reserve Bank of New York Staff Report. K.  Boulware, et  al., (2014), How Does Monetary Policy Affect Shadow Banking Activity? Evidence from Security Repurchase Agreements, Mimeo, University of Alabama; M. Cipriani, et al., (2014), Gates, Fees, and Preemptive Runs, Finance and Economics Division Series; D. Diamond and P. Dybvig, (1963), Bank Runs, Deposit Insurance, and Liquidity, Journal of Political Economy, Vol. 91, pp.  401–419; G.  Gorton and A.  Metrick, (2012), Securitized Banking and the Run on Repo, Journal of Financial Economics Vol. 104, pp.  425–451; E.S.  Rosengren, (2014), Our Financial Structures. Are They Prepared for Financial Instability? Journal of Money, Credit and Banking Vol. 46, pp. 143–156. 356  J. Kirshner, (2003), Money is Politics, Review of International Political Economy, Vol. 10, Issue 4, pp. 645–660. 357  D. Gabor, (2013), Shadow Interconnectedness: The Political Economy of (European) Shadow Banking, UWE Bristol University Working Paper. 353

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occurs through a variety of channels: the repo market, securitization and the collateral intermediation. That makes it a systemic component of the shadow banking sector.358 The reason why it is political lies in the fact that governments provide the preferred form of collateral for private finance—that is, ‘private leverage is born in sovereign debt markets’.359 She comments: ‘[t]herein lies the politics of interconnectedness weaved through shadow banking activities. Collateral-­intensive finance connects government bond markets to financial stability, and in doing so, it entangles macroeconomic relationships between central banks, governments and private financial institutions.’360 Collateralized finance works both ways for the sovereign bond markets. It improves liquidity in boom times and destabilizes the sovereign bond market under duress. At the extreme, one might consider forcing collateral managers to leave the sovereign markets or apply a (financial activities) tax.361 But in order to make that call it needs to be understood how collateral use and reuse create systemic interconnectedness. Although the question remains whether one should focus on activities or entities (or both) when considering systemic issues, it has been clear from the literature that collateral intermediation has always been seen as a subset of securitization or the repo market.362 Securitization was seen as the imperfect risk-spreading mechanism, while the collateral intermediation deserved a position of its own in that hall of shame. Indeed, the collateral management practices and the systemic interconnectedness flows through two channels. Repo transactions cover a wide arsenal of transactions in the shadow banking world. As such, every asset can be used as collateral in a repo transaction. That has risk management implications. Since these are private transactions, counterparty risk now becomes collateral risk as literally every asset can be collateralized. Repos are just another name for securities lending: the bonds can be used by the counterparty as collateral (reuse) to finance activities in the repo market, while maintaining the exposure to that risk (the economic stays with the underlying provider, while the legal ownership for the period of the collateral transfer goes to the lender). Gabor indicates that bifurcation is crucial to understand the implied risk in the collateral markets: ‘[t]he distinction between the economic and legal interpretations is crucial for interconnectedness. It makes repo different from other forms of secured lending…A repo cash borrower is a seller of collateral because the transfer of ownership is crucial to protect the cash lender (the buyer of collateral) in case of default. In other words, the legal status of a repo transaction morphs the counterparty risk.’ The counterparty risk—that the borrower defaults—is

 S.  Bair, (2013), Everything the IMF Wanted to Know About Financial Regulation and Was Afraid to Ask, IMF Seminar, Washington, and R. Comotto, (2012), Shadow Banking and Repo, European Repo Council Paper. 359  D. Gabor, (2014), ibid., p. 2. 360  D. Gabor, (2014), ibid., p. 2. 361  D. Gabor, (2013), The Financial Transactions Tax and Shadow Banking. Mimeo, UWE Bristol University Working Paper. 362  S.  Claessens, (2012), Shadow Banking: Economics and Policy, IMF Staff Discussion Note, SD/12/12; T. Moe, (2012), Shadow Banking and the Limits of Central Bank Liquidity Support: How to Achieve a Better Balance between Global and Official Liquidity, Levy Economics Institute Working Paper Nr. 712. 358

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converted into ‘collateral risk’—that the collateral provided by the borrower falls in price below the value of the loan. Both parties should now be concerned about the value of the collateral. If the use and reuse of collateral create cascades of collateral intermediation the intrinsic risk is impossible to determine, in particular when pieces of collateral are rebundled with other newer assets. The rehypothecation is indeed the second channel for the creation and transmission of systemic risk. The link between the buildup of private leverage and the repo market is clear ‘[a]s long as the cost of the repo (the repo rate and the haircut) remains below the expected return on the repo-ed assets, the borrower can increase its leverage as long as it can repo the new assets it buys’.363 The lower the haircut (the discount to fair value of the collateral asset for determining the level of the loan provided), the higher the borrower can leverage. Since haircuts have an inclination of being procyclical, they tend to be low when markets are confident and the other way around and are the lowest-cost source of leverage out there in the market. The rehypothecation can occur between the same counterparties or between different parties (tri-­party repos), thereby creating collateral chains or networks.364 Those networks of chains have the potential of creating systemic risk in the financial system.365 Since the central banks became involved in the collateral markets monetary policy has become a relevant aspect within the judgment of the systemic dimension.366 In fact it is not only monetary policy but all regulatory interventions after the financial crisis that had and have a profound impact on the repo markets and its dynamics.367 It has led some to conclude that collateralization has now become part of the financial plumbing tools on which financial markets thrive.368 A key aspect will be the more intense need of collateral in a variety of transactions. Safe collateral is known for its liquidity, fixed payments and solid tenure and credit rating (if available). Many transaction regulations, including the Basel III norms, require high-quality liquid assets (HQLA). Different opinions exist about the impact of those interventions on the collateral market. Lopez et al. at least are confident that ‘the prevailing view is that widespread shortages are unlikely to occur, for at least four reasons. First, price adjustments will correct any imbal-

 D. Gabor, (2014), ibid., p. 8.  See in detail: M. Singh, (2011), Velocity of Pledged Collateral: Analysis and Implications, IMF Working Paper Nr. WP/11/256; M.  Singh, and P.  Stella, (2012), Money and Collateral, IMF Working Paper Nr. WP/12/95; M. Singh, (2012), The (other) Deleveraging, IMF Working Paper Nr. WP/12/179; M.  Singh, (2013), The Changing Collateral Space, IMF Working Paper Nr. WP/13/25. 365  European Commission, 2013. Shadow Banking  – Addressing New Sources of Risk in the Financial Sector, Communication, September 4; FSB, (2012), Global Shadow Banking Monitoring Report 2012, Basel. 366  M.  Singh, (2013), Collateral and Monetary Policy, IMF Working Paper Nr. WP/13/186; S. Carpenter, et al., (2013), ‘Analyzing Federal Reserve Asset Purchases: From Whom Does the Fed Buy?’ April, Staff Paper Nr. 2013–32; P.-O. Gourinchas, and O. Jeanne, (2012), Global Safe Assets, BIS Working Paper Nr. 399, December. 367  T.  Rixen, (2013), Why Reregulation after the Crisis is Feeble: Shadow Banking, Offshore Financial Centers, and Jurisdictional Competition, Regulation and Governance, Vol. 7, Issue 4, pp. 435–459. 368  M. Singh, (2014), Collateral and Financial Plumbing, Risk Books, London. 363 364

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ances in demand and supply and provide incentives to efficiently redistribute collateral from those with a surplus to those with a deficit. Second, recent and future expected increases in the amount of HQLA should satisfy most, if not all, of the expected additional demand. Third, the multi-year time frame over which new regulations will be implemented should mitigate any abrupt changes in collateral prices or business practices. Fourth, regulators and market participants can expand their collateral eligibility criteria on a risk-adjusted basis, or provide prudent collateral transformation services to increase the pool of assets regarded as safe or to help efficiently allocate collateral across market participants.’369 The need for collateral has been growing in recent years, even before the 2008 financial crisis. Despite the limitations on reuse of collateral in some jurisdictions, shadow banks developed a number of techniques to overcome the shortage for safe collateral: (1) shadow banks mine collateral with a variety of entities—they identify pools of assets that can serve as collateral, and borrow them through repo transactions; (2) shadow banking entities have been using the collateral framework of the central banks to engage in collateral transformation and even engage in securitization to create private debt that could be used for posting as collateral370; (3) innovations to manufacture new pools of collateral, in particular for those assets that are highly wanted (i.e. T-bonds, because of their low-risk profiles and therefore low haircuts that allow to economize financial transaction costs), thereby enhancing their profitability. Most shadow banking products371 allowed to create safe assets that could be collateralized, especially since at a certain point in time the supply of US T-bonds and T-bills was no longer sufficient to meet demand.372 A shadow banking crisis takes the form of a liquidity spiral, which essentially reflects the interconnectedness of the shadow banking market. Private money claims as produced by the shadow banking sector rest on collateral cascades. Therefore those runs occur differently to traditional banking systems where the run is caused by depositors losing confidence. Liquidity spirals can be defined as ‘a combination of funding problems for individual financial institutions and falling asset prices’. The collateral network implies a joint and similar exposure to the same limited pool of collateral and therefore exposure to the same collateral price volatility.373 The best collateral to weather market volatility and that turmoil and that

 J.C.  Lopez et  al., (2013), The Market for Collateral: The Potential Impact Of Financial Regulation, Bank of Canada Financial System Review June 2013, pp.  45–53; D.  Brigo et  al., (2013), Counterparty Credit Risk, Collateral and Funding, Wiley & Sons, Hoboken. 370  T. Moe, (2012), Shadow Banking and the Limits of Central Bank Liquidity Support: How to Achieve a Better Balance Between Global and Official Liquidity, Levy Economics Institute Working Paper Nr. 712. 371  ‘Securitization is a subset of collateral intermediation activities, and functions to connect distinct financial institutions through new collateral chains’; Gabor, (2013), ibid., p. 10. 372  Z. Pozsar and M. Singh, (2011), The Nonbank-Bank Nexus and the Shadow Banking System, IMF Working Paper WP/11/289, Washington, DC, December; A. Giovannini, (2013), Risk-Free Assets in Financial Markets, BIS Working Paper Nr. 72, pp.  73–79; P.  Hördahl and M.  King, (2008), Developments in Repo Markets During the Financial Turmoil, BIS Quarterly, December, pp. 37–54. 373  M. Brunnermeier and L. Pederson, (2009), Market Liquidity and Funding Liquidity, Review of Financial Studies Vol. 22, Issue 6, pp. 2201–2238. 369

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will be least sensitive to price fluctuations will be those assets that are least informationinsensitive.374 This implies stable collateral values and stable funding conditions. Indeed, uncertainty about pricing translates into uncertainty about the quality of the asset. Therefore AAA-rated markets can also lose liquidity overnight. To safeguard that information insensitivity, banks tend to operate and behave as secret parties in the market.375 Although the crisis learned that market agents sheltered in the government securities markets, the question remains whether that is because of the robustness of that market or because of the expectation of an implicit or explicit policy intervention on the side of the issuer, that is, the central bank. The repo market has an inclination to create and fuel procyclicality, even in the safest markets. Nevertheless, and although the questions have been asked, there is no clear account about the reason why certain markets stay safer and stable than others. The European debt crisis is in fact a repo crisis and the questionable understanding of what the safeness is of the different European T-bonds.376 Gabor concludes, ‘[r]epo connections are fragile because they are the cheapest source of funding for leveraged financial activity, but also because practices of risk management and reuse can amplify concerns about collateral quality and ignite liquidity spirals. They are systemic because repo markets are now the most significant source of market funding for banks and nonbanks with large trading portfolios. A run on shadow banking occurs as a downsizing of collateral networks, with a smaller number of connections supported by the same collateral simultaneous with a narrower range of acceptable collateral.’377 The institutional structure (the puts that Singh refers to) is what makes the differences in terms of the swiftness and robustness of stabilizing the repo market in times of distress. According to some, the infrastructure needs to involve the requirements and demands of civil society for which under the current technical regulation there is no room.378 One of these areas is the impact of new regulation covering the repo and collateral markets that have come in in recent years. Although the finance scholarship seems to have a hard time getting their head around the true demand and supply dynamics of the collateral market, it is expected that no sharp shortages will occur. That doesn’t take away, however, that there will be material bottlenecks that can lead to significant turbulence in the financial markets. Collateral transformation can then be used to mobilize the market. But then, again, collateral management techniques379 differ between banks and deriva-

 G.  Gorton and A.  Metrick, (2012), Securitized Banking and the Run on Repo, Journal of Financial Economics, Elsevier, Vol. 104, Issue 3, pp.  425–451; P.  Gourinchas and O.  Jeanne, (2012), Global Safe Assets, BIS Working Papers Nr. 399, Basel; T.V.  Dang et  al., (2013), The Information Sensitivity of a Security, Columbia Working Paper, November; T.V.  Dang, (2012), Ignorance, Debt and Financial Crisis, Working Paper. 375  T.V. Dang et al., (2014), Banks as Sacred Keepers, NBER Working Paper Nr. 20255 (also published in American Economic Review Vol. 107 (2017), pp. 1005–1029). 376  Gabor, (2014), ibid., pp. 13–16. 377  Gabor, (2014), ibid., p. 16. 378  M.  Thiemann and M.  Birk, (2015), The Regulation of Repo Markets: Incorporating Public Interest Through a Stronger Role for Civil Society, SAFE Working Paper Nr. 25, February. 379  See in detail: R. W. Anderson and K. Jõeveer, (2014), The Economics of Collateral, LSE Working Paper, April, pp. 14–24. 374

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tives markets infrastructures including, in particular, CCPs.380 The consequence is that ‘weaknesses in infrastructure make it likely that collateral will be immobilized, at least temporarily, in one part of the system and unable to meet the demand in another part of the system’.381 The reforms as they have been coming not only sacrifice the benefits of multilateral netting but also increases demand for (interim) liquidity to service those incoming margin calls (which mitigate counterparty risk). The bottom line is that more collateral will not take credit risk away as ‘[c]hanging patterns in the use of collateral may not eliminate risk, but it will have implications for who will bear risks and on the costs of shifting risks. Changing structures can eliminate risks at the cost of not creating the underlying credit and of not seeing the associated investment undertaken.’382 That knowledge becomes increasingly daunting when realizing that the different segments of the collateral and repo market have their own dynamics and techniques leading to specific risks and contagion effects.383 Singh documented the economics of shadow banking from this perspective and in particular the demand/supply issues (for safe assets) and the liquidity and funding challenges that stem from that position in the market. Systemic risk dynamics can occur when ignoring those dynamics. He points out that current regulatory approaches are actively pushing banks away from short-­term, secured, wholesale funding markets and incentivizing them to issue more deposits and term funding. The likely result would be that riskier activities move outside the banking system.384

 R. W. Anderson and K. Jõeveer, (2014), The Economics of Collateral, Working Paper, April.  R. W. Anderson and K. Jõeveer, (2014), ibid., p. 35. 382  R. W. Anderson and K. Jõeveer, (2014), ibid., p. 36. See also: T. Adrian et al., (2013), Repo and Securities Lending, Federal Reserve Bank of New York Staff Report Nr. 529; S. Anderson, et al., (2013), To Link or Not to Link? Netting and Exposures Between Central Counterparties, Bank of Canada, Working Paper Nr. 2013–6; D. Bauer, et al., (2013), Optimal Collateralization with Bilateral Default Risk, Working Paper, Georgia State University; D. Duffie et al., (2014), Central Clearing and Collateral Demand, European Central Bank, Working Paper Nr. 1638; M. Tambucci, (2014), Margins and Financial Collateral for Derivatives Contracts: How to Deal with Procyclical Implications in a Financial Crisis, Journal of Securities Operations and Custody, Vol. 6, Issue 3, pp.  240–263; P.  Tucker, (2014), Regulatory Reform, Stability and Central Banking, Brookings Institution Working Paper, January 16. 383  See, for example, Zhang, who illustrates a key friction, the ‘maturity mismatch between short-term repo and long-term investments that banks need to finance. The resulting rollover risk in repo financing leads to a new contagion mechanism specific to the bilateral repo market. The default of a borrower reduces the liquidity of his lenders’ asset portfolio, without reducing their equity value. But, with a less liquid portfolio, lending banks are more likely to default in the future when they start financing their own investment. So, illiquidity becomes contagious through default. Moreover, the contagious illiquidity interacts with banks’ valuation over the repo contract, forming a failing mechanism’; see S.  Zhang, (2014), Collateral risk, Repo Rollover and Shadow Banking, NY University Working Paper. 384  See M.  Singh, (2013), The Economics of Shadow Banking, Reserve Bank of Australia’s Conference of ‘Liquidity and Funding Markets’, August 19 and 20, 2013, via rbs.gov.au 380 381

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1.20.4 Central Banks and Their Collateral Frameworks385 It has been made clear before that one of the areas that has been largely overlooked after the crisis was that of the collateral markets, the use and reuse of collateral between market agents, the interaction between market agents and central banks and collateral frameworks in which these transactions take place and how very different transactions are managed within that framework. Also very little attention has been devoted to the impact on collateral markets of new and incoming legislation that impacts (in)directly the collateral markets and its demand-supply relationship. It can be analyzed from the perspective of being part of monetary policy, regulation or the liquidity window between central banks and FIs. The latter view is important though: central banking money is injected in the markets based on the terms agreed, not in the market itself, but in the collateral frameworks and interest rate policies of central banks. The consequence is that collateral frameworks can impact markets or better they can distort markets. Liquidity and the consequence allocation of resources in the economic can become asymmetric when these collateral frameworks are not properly managed. Choices made in the collateral framework will have a distinct impact on market forces, market discipline and interest rate impacts.386 It is only in recent years that the topic has been given more attention.387 The Eurosystem adapted its collateral framework during the crisis to accept lower-rated assets as collateral. Higher haircuts were applied to insure against liquidity risk as well as the greater volatility of prices of lower-rated assets. The adaptation of the collateral framework was necessary to provide sufficient liquidity to banks in the euro area periphery in particular. It was concluded that the changes in the collateral framework were necessary for the European Central Bank (ECB) to fulfill its treaty-based mandate of providing liquidity to solvent banks and safeguarding financial stability.388

 See extensively on the topic: J. Capel, (2015), Central Bank Collateral, DNB Occasional Studies Vol. 13–3, Amsterdam. Also: C.  Weber, (2016), The  Collateral Policy of  Central Banks—An Analysis Focusing on  the  Eurosystem, ifo Beiträge zur Wirtschaftsforschung Nr. 72, via ifo.de. K.G. Nyborg, (2017), Collateral Frameworks: The Open Secret of Central Banks, January 24, via voxeu.org. K.G.  Nyborg, (2016), Collateral Frameworks: The  Open Secret of  Central Banks, Cambridge University Press, Cambridge, UK. 386  See in detail on this topic: K.J. Nyborg, (2015), Central bank Collateral Frameworks, SFI (Nr. 51) and CEPR Working Paper Nr. 10663, February. 387  A notable exception is A.  Chailloux, et  al., (2008), Central Bank Collateral Frameworks: Principles and Policies, IMF Working Paper Nr. WP/08/222. They already indicated post-crisis, for example, (i) the collateral framework needs to include market incentives (for adverse selection); (ii) central banks face trade-offs between risk and counterparty access. 388  G.B.  Wolff, (2014), Eurosystem Collateral Policy and Framework: Was It Unduly Changed, Bruegel Policy Contribution, Issue 2014/14, November. The US and other central banks also relaxed collateral rules to meet liquidity objectives. For prior coverage, see S. Cheun et al., (2009), The Collateral Frameworks of the Eurosystem, the Federal Reserve System and the Bank of England and the Financial Market Turmoil, ECB Occasional paper Series Nr. 107, December. See for a recent update M. Corsi, (2018), The Eurosystem Collateral Framework and the Functioning of Collateral markets, ECB Central Banking Seminar, July 13, via ecb.europe.eu 385

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It must be indicated that the different frameworks applied by central banks are not symmetric or identical. The same holds true for the collateral frameworks applied by central counterparties. Central bank collateral frameworks generally have the broadest eligibility criteria, which is attributed to their statutory requirements and factors that relate to the depth of the local capital markets and bond markets in particular. CCP frameworks tend to use a narrower framework in terms of what is considered as regards acceptable margin collateral. Given the role of CCPs in centralizing counterparty risk management, this narrower approach for margin collateral is both understandable and desirable.389 The following conclusions were drawn when comparing collateral frameworks in the ECB study390: • Almost all frameworks accept debt securities issued by central governments/central banks and cash including covered bonds. • Other marketable assets—such as debt securities issued by credit institutions, as well as corporate bonds and asset-backed securities—are accepted mainly in central bank frameworks, while equities, bank guarantees and gold are generally only eligible within some regulatory frameworks and only to a certain extent, as well as for the margin collateral of some CCPs and for non-centrally cleared over-the-counter derivatives. • Non-marketable assets are only accepted by few central banks. • Collateral accepted in foreign currency is possible by its terms and conditions vary materially (limitations and temporality). • Haircuts tend to apply (wide variety of haircuts and conditions) and most collateral assets need to meet additional requirements (minimum credit rating and/or guarantees from issuing government). • Most central banks and market parties accept collateral made available through collateral transformation mechanisms. • Since most models look similar, although not in detail, a further harmonization of practices was not recommended. • Overall, central bank collateral frameworks today tend to be somewhat broader than in mid-2007, accepting more asset types, including in some cases cross-border collateral. Although the basic principle has always been that collateral provided to central banks should be risk- and credit-free, that principle has been (implicitly) let go. By doing so, central banks are increasingly exposed to economic and political risks.391 The use of repos

 See for a comparative study of ‘collateral frameworks’ around the world and different parties involved: ECB, (2013), Collateral Eligibility Requirements. A Comparative Study across Specific Frameworks, ECB Working Paper, July. 390  BIS Market Committee, (2013), Central Bank Collateral Frameworks and Practices, A report by a Study Group established by the Markets Committee (chair G. Debelle), BIS Markets Committee Reports, Basel. They indicate that despite the commonalities in principles, major differences exist. The observed diversity in protocols in these frameworks reflects differences in local factors such as central bank legislation, financial market structure and state of development and whether there is a structural liquidity surplus or deficit in the relevant financial system. 391  U.  Bindseil, (2015), Central Bank, Collateral, Asset Fire Sale, Regulation and Liquidity, Presentation, Madrid, May 29. 389

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is common within the framework. The use of repos within the central banking frameworks has been material in recent years and has raised the question regarding ‘arbitrage’ in that relationship. Fecht et al. document the existence of systemic arbitrage whereby banks funnel credit risk and low-quality collateral on to the balance sheet of the central bank. Relatively weaker banks use lower-quality collateral to demand disproportionately larger amounts of central bank money (liquidity). They document, however, that this occurred also before the onset of the 2008 financial crisis. In most frameworks solvent banks are obliged to provide additional collateral in case the collateral value of their pledged assets falls short of their outstanding credit with the central bank. The exposure thereby is confined to the risk that a bank fails while at the same time the pledged collateral does not cover the outstanding credit. However, systemic arbitrage392 may increase the fragility of the interbank market and the unconventional monetary policies introduced by the ECB in response to the crisis increases the scope for systemic arbitrage.393 As Fecht et al. indicate, ‘systemic arbitrage benefits weak banks, it undermines market discipline, distorts competition in the banking sector, and might even aggravate tensions in money markets. Systemic arbitrage could be prevented if the correlation risk – the risk that a bank defaults while its pledged collateral fails to cover the outstanding credits – is correctly reflected in the rates at which a bank obtains credit.’394 That seems difficult given the number of eligible counterparties. Therefore they recommend, ‘[i]n practice, mitigating systemic arbitrage requires limiting this combination of large set of eligible banks and collateral. This can be done by implementing a primary dealer system, where only prime banks can borrow directly from Eurosystem, or confining the list of eligible collateral to assets of the highest quality.’395 Monetary and financial systems are fundamentally built on top of the collateral that central banks choose to accept in exchange for central bank money. To understand money and the broader financial system, it is therefore necessary to understand central bank col-

 F. Fecht, et al., (2015), Collateral, Central Bank Repos, and Systemic Arbitrage, Working Paper, March 6, pp.  7ff. See also: U.  Bindseil, (2014), Monetary Policy Operations and the Financial System, Oxford University Press, Oxford; P.  Abbassi, et  al., (2014), Cross-Border Liquidity, Relationships and Monetary Policy: Evidence from the Euro Area Interbank Crisis, Bundesbank Discussion Paper Nr. 45/2014; V.V.  Acharya, and S.  Steffen, (2015), The Greatest Carry Trade Ever? Understanding Eurozone Bank Risks, Journal of Financial Economics Vol. 115, Issue 2, pp. 215–236. 393  Fecht et  al., (2015), ibid., pp.  3–4. See also: J.H.  Cochrane, (2014), Monetary Policy with Interest on Reserves, Journal of Economic Dynamics and Control Vol. 49, pp. 74–108; I. Drechsler, (2013), Who Borrows from the Lender of Last Resort?, Working Paper. 394  Fecht et al., (2015), ibid., p. 27. See also: J. Eberl and C. Weber, (2014), ECB Collateral Criteria: A Narrative Database 2001–2013, Ifo Working Paper; A. Van Rixtel and G. Gasperini, (2013), Financial Crises and Bank Funding: Recent Experience in the Euro Area, BIS Working Paper Nr. 406. 395  Fecht et al., (2015), ibid., p. 27. See also: S. Gabrieli and Co-Pierre Georg, (2014), A Network View on Interbank Market Freezes, Deutsche Bundesbank Discussion Paper Nr. 44; K.G. Nyborg, (2015), Collateral Frameworks: The Open Secret of Central Banks, book manuscript, University of Zurich and Swiss Finance Institute; K.G. Nyborg and P. Őstberg, (2014), Money and Liquidity in Financial Markets, Journal of Financial Economics Vol. 112, Issue 1, April, pp. 30–52. 392

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lateral frameworks, Nyborg concludes after he illustrated how collateral frameworks work and interact with markets, banks and, ultimately, the real economy.396 He demonstrates and argues that collateral frameworks can bias the private provision of ‘real’ liquidity and thereby the allocation of resources in the economy. They in turn can affect market prices of financial assets and undermine the efficient working of money markets. More generally, they can impair market forces and discipline and promote politics in the monetary and financial system. Most obviously, collateral frameworks affect the balance sheets of central banks. That can lead to loss of creditworthiness, with its collateral impact on financial stability and the real economy. But most importantly, the collateral framework and conditions can impact market discipline. Nyborg indicates that current ‘haircuts do not reflect market conditions and the prices to which they are applied to calculate collateral values are in the majority of cases based on theoretical models rather than direct market prices’.397 It points at the fact that the collateral framework is not a system but a monetary (policy) tool398 for most central banks and therefore, given its possible impact on the real economy, requires and deserves more attention than it has received so far in recent years.

1.20.5 Haircuts and Collateral Reuse The implementation of haircuts and some of the Basel III rules will lead to an enhanced need for collateral availability, mostly of the highest quality. Questions have been asked about the availability of those in the market and were discussed elsewhere. Collateral reuse and rehypothecation is primarily driven by two dynamics: (1) it allows to generate more leverage than in the situation where the reuse is not applied, and (2) asset shortage in the market (of a certain quality). That has a number of implications: (1) the practice makes markets more vulnerable to fire sales, and contagion risk in particular when price volatility spreads to questions about the quality of assets, and (2) the reuse of assets can impact the welfare optimum. Adolfatto et al.399 assessed that in high inflation–high inter-

 K.J. Nyborg, (2015), ibid., p. 34; A. Al-Eyd, and S. Pelin Berkmen, (2013), Fragmentation and Monetary Policy in the euro area, IMF Working Paper Nr. 208; F. Allen, et al., (2014), Money, Financial Stability and Efficiency, Journal of Economic Theory, Vol. 149, pp. 100–127; J. Caruana, (2011), Why Central Bank Balance Sheets Matter, Keynote address at the Bank of Thailand, BIS conference. 397  Nyborg, (2015), ibid., p.  35; A.  Krishnamurthy, et  al., (2014), Sizing up repo, Journal of Finance, Vol. 69, pp. 2381–2417; L. Mancini, (2014), The Euro Interbank Repo Market, Working Paper Nr. 1316, University of St. Gallen, School of Finance; D. Miles and J. Schanz, (2014), The Relevance or Otherwise of the Central Bank’s Balance Sheet, Journal of International Economics, Vol. 92, pp. 103–116. 398  An add-on feature are the government guarantees that are used to gain eligibility and improve collateral values; see Nyborg, (2015), ibid., p.  36; C.  Rősler, (2015), Frictions in the Interbank Market: Evidence from Volumes, Working Paper, University of Zurich and Swiss Finance Institute. 399  D. Adolfatto et al., (2017), Rehypothecation and Liquidity, European Economic Review, Vol. 100, pp. 488–505. See also: V. Maurin, (2015), Re-Using Collateral: A General Equilibrium Model 396

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est rate economies, rehypothecation improves economic welfare but that markets in general tend to use the practice in excessive volumes and therefore lead to a suboptimal result. Regulation could constrain that practice. However, most incoming regulations implicitly encourage the use of rehypothecation and reuse of assets given the additional requirements for collateral and haircuts applied.

1.20.6 Heterogeneous Collateral Damage The use and reuse of collateral is one thing; the management of these collateral supply chains is another. Collateralization and its reuse often serve to relax liquidity constraints.400 Many things can occur that affect asset prices in the process, and that have nothing to do with the intrinsic value of the collateral. Questions regarding the intrinsic quality of the collateral lead generally to contagion risk spreading leading to fire sales. But there are other elements that can play a role and those elements are ‘exogenous’. One of the most dominant elements that we are aware of and that affect asset prices is ‘transaction cost shocks’. Transaction costs in financial markets are composed of bid-ask spreads,401 commission, fees, taxes, delay cost, price appreciation, market impact, timing risk and opportunity cost. A transaction cost shock hence alters the wedge between the price of the seller and the buyer and influences trading behavior.402Transaction cost shocks affect assets heterogeneously. The market value or price of an asset is determined by the sum of its discounted future cash flows. Hence, the price of an asset declines by the present value of the transaction cost shock payable on all future transactions of this specific security. A transaction cost shock affects all investors that value their assets at market prices, not only those that engage in trading activity. That is also the case for collateral provided or reused. They conclude that banks tend to be more impacted than other financial institutions when the collateral is (re)used in monetary policy transactions—that is, banks suffer a smaller collateral loss when faced with transaction cost shocks.

of Rehypothecation, European University Institute Working Paper, February 12; he indicates, ‘[w]hen some fundamental securities are missing, rehypothecation delivers strict welfare gains by relaxing collateral constraints. These gains appear significant in segmented markets where collateral scarcity issues are more acute’; also see P. Gottardi and F. Kubler, (2014), Dynamic Competitive Economies with Complete Markets and Collateral Constraints, Technical report; A. Kirk, et al., (2014), Matching Collateral Supply and Financing Demands in Dealer Banks. Economic Policy Review, Federal Reserve Bank of New York; M. Singh, (2014), Financial Plumbing and Monetary Policy, IMF Working Paper Nr. WP/14/111, International Monetary Fund. 400  V.V. Acharya and L.H. Pedersen, (2005), Asset Pricing with Liquidity Risk, Journal of Financial Economics, Vol. 77, Issue 2, pp. 375–410. 401  T.W.  Epps, (1975), Security Price Changes and Transaction Volumes: Theory and Evidence, American Economic Review, Vol. 65, Issue 4, pp. 586–597. 402  R. A. Lennkh and F. Walch, (2015), Collateral Damage? Micro-Simulation of Transaction Cost Shocks on the Value of Central bank Collateral, ECB Working Paper Series Nr. 1793, Frankfurt, May, pp. 6–7.

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In a European context that has its implications according to Koulischer.403 He explains that a currency Union404 naturally limits the ability of the central banks to use interest rate policy to accommodate asymmetric shocks. Collateral policies405 can serve to ‘dampen asymmetric shocks in a currency area when these shocks also affect the collateral held by banks and when collateral portfolios of banks differ systematically across countries’. In a situation where banks in two countries use collateral to borrow from the money market or a central bank that targets a level of interest rate (or investment) in each economy, ‘a potentially distressed bank may experience a “collateral crunch” regime where it is constrained in its access to funding due to a moral hazard problem’.406 When banks are symmetric, the central bank responds to a collateral crunch by lowering its policy rate. This relaxes the incentive problem by lowering the funding cost of the bank. Under the same assumption that banks are asymmetric, the central bank faces a heterogeneous transmission of its interest rate—that is, a unit change in rate has a smaller effect on the economy rate of the distressed country. The central bank typically sets a high interest rate which is well transmitted in the booming economy and relaxes the haircut on the collateral owned by the distressed bank.

1.20.7 Collateral Management and Optimization High-quality collateral is in greater demand now than it was before the financial crisis, due to more prudent counterparty risk management as well as new regulations governing OTC derivatives and liquidity. Against this background financial institutions are currently reassessing their collateral management. In practice, firms have been dealing with the increased need for collateral through (1) optimization,407 (2) reuse and rehypothecation408 and (3) transformation.409 That leads to new risks as liquidity risks, greater interdependence and procyclicality.410 The higher demand for collateral will undoubtedly lead to upward pressure on prices, particularly of high-quality collateral assets. Individual scarcity at the level of individual institutions is possible. These developments will incentivize financial institutions to use their available collateral as efficiently as possible (collateral optimization) or to make better use of received collateral (collateral reuse or rehypotheca-

 F.  Koulischer, (2015), Asymmetric Shocks in a Currency Union: The Role of Central Bank Collateral Policy, Banque de France Working Paper Nr. 554, Paris, March 13. 404  P.  Benigno, (2004), Optimal Monetary Policy in a Currency Area, Journal of International Economics, Vol. 63, pp. 293–320. 405  N.E. Cassola, and F. Koulischer, (2016), The Collateral Channel of Open Market Operations, ECB Working Paper Nr. 1906, May. 406  F. Koulischer, and D. Struyven, (2014), Central Bank Liquidity Provision and Collateral Quality, Journal of Banking & Finance, Vol. 49, pp. 113–130. 407  J.  Capel and A.  Levels, (2014), Collateral Optimisation, Re-Use and Transformation, DNB Occasional Studies Vol. 12 Nr. 5, Amsterdam, pp. 15–24. 408  J. Capel and A. Levels, (2014), ibid., pp. 25–28. 409  J. Capel and A. Levels, (2014), ibid., pp. 29–34. 410  J. Capel and A. Levels, (2014), ibid., pp. 35–40. 403

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tion). Institutions may also engage in more repo or securities lending transactions to obtain assets of the desired type (collateral transformation), using their other (lowerquality) assets as collateral.411

1.21 Collateral Reuse and the Liquidity Trap 1.21.1 Introduction Collateral plays an important role in supporting a vast range of transactions that help ensure the efficient functioning of the financial system. But collateral markets also have the potential to exacerbate risks to financial stability,412 not least given that during periods of market stress demand for high-quality collateral may increase, while collateral availability may fall. Baranova et al.413 examined how the potential imbalance between collateral supply and demand changes as a function of market stress. It offers an estimate of the increase in market volatility sufficient to cause a dislocation in the market for collateral and a subsequent deterioration in market functioning. They conclude that from the perspective of financial stability, the implications of an imbalance between the supply and demand of collateral414 are likely to be comparatively benign, but that the implications of

 J. Capel and A. Levels, (2014), ibid., p. 47. See also on the issue: Committee on the Global Financial System (CGFS, 2013)., Asset Encumbrance, Financial Reform and the Demand for Collateral Assets, CGFS Papers Nr. 49; D. Duffie, et al., (2014), Central Clearing and Collateral Demand, ECB Working Paper Series Nr. 1638; European Securities and Markets Authority (ESMA), (2013), Trends Risks Vulnerabilities, London; A. Houben and J.W. Slingenberg, (2013), Collateral Scarcity and Asset Encumbrance: Implications for the European Financial System, Banque de France – Financial Stability Review, Nr. 17 (April). T.V. Koeppl, (2013), The Limits of Central Counterparty Clearing: Collusive Moral Hazard and Market Liquidity, Queen’s Economics Department Working Paper Nr. 1312; C. Sidanius and F. Zikes, (2012), OTC Derivatives Reform and Collateral Demand Impact, Bank of England Financial Stability Paper Nr. 18; A.L. Levels and J.J. Capel, (2012), ‘Is Collateral Becoming Scarce? – Evidence for the Euro Area’; DNB Occasional studies Vol. 10, Issue 1 and Journal of Financial Market Infrastructures Vol. 1, Issue 1, pp. 29–53. 412  Corradin et al. conclude that the use of collateral is neither a sufficient nor a necessary condition for financial stability. To ensure the stability of collateralized markets a mix of micro- and macroprudential regulation, as well as a sufficient supply of safe public assets that can be used as collateral, is needed. They first studied the role of collateral in the financial system, with special emphasis on the implications for financial stability and the conduct of monetary policy. In detail: S. Corradin et  al., (2017), On Collateral: Implications for Financial Stability and Monetary Policy, ECB Working Paper Nr. 2107, November 7. 413  Y. Baranova et al., (2016), The Role of Collateral in Supporting Liquidity, Bank of England Staff Working Paper Nr. 609, August (also published in Journal of Financial Market Infrastructures, Vol. 5, Nr. 1, September, pp. 1–26). What makes the work special is the fact that it offers a framework for ‘considering how changes to the structure of the financial system – and, in particular, the network of market intermediaries who stand between the largely unleveraged institutions that act as end suppliers and users of collateral – might change the level of market stress at which these risks are likely to crystallize’ (p. 4, 12ff). 414  See on the demand and supply of collateral (and financial stability): S. Corradin et al., (2017), On Collateral: Implications for Financial Stability and Monetary Policy, ECB Working Paper Nr. 411

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a reduction in the willingness and/or ability of market participants to act as intermediaries in collateral markets are likely to have more serious consequences for market functioning. The impact of this behavior is potentially pernicious. As market stress increases the intermediation capacity of dealers required to move collateral from end-suppliers to enddemanders starts to exceed that which dealers are willing and/or able to provide.415 Following the 2007–2009 financial crisis the regulator did not only include mandatory clearing of OTC derivatives for CCPs, the liquidity coverage ratio (LCR) as well as introducing haircuts for uncleared derivatives.416 One notable prudential measure was the introduction of the collateral (initial margin)417 existing of high-quality liquid assets for banks and other market agents to act as a backstop against anticipated cash outflows.418 The justification of such measures lies ultimately in the effectiveness of the measure in case of a default of a CCP and the impact on the marketplace. Post-introduction of the rule, we didn’t experience any major default419 and thus a hypothetical analysis is justified. No surprise that after a default of a CCP, the demand for HQLA would spike. The question then is, is the depth of the market sufficient to absorb such demand? That is a question separate from the question about the optimal structure of the CCP’s waterfall. The question whether the market has sufficient capacity for the additional demand is a function of margin demands, loss of gains and in general the way that regulation affects the clearing members’ liquidity coverage requirements. What should also be observed is that markets change and evolve as well as a consequence of ­incoming regulation, for example, collateral requirements. It was concluded that, with respect to collateral in particular, ‘the demand for collateral arising from relatively new prudential rules is manageable, and that variation margin gains haircutting (as a strategy for a CCP to restore itself ) is not unduly disruptive’.420 The question about the need for collateral in times of material market distress goes

2107, November. They argue that ‘using collateral is neither a sufficient nor a necessary condition for the efficiency and stability of financial markets. Using collateral may create new sources of financial market instabilities. Secured markets can “freeze”, much like unsecured markets, and there can be amplification and contagion effects, especially when collateral assets are scarce’ (p. 3). 415  Y. Baranova et al., (2016), ibid., p. 15. 416  M. Bardoscia et al., (2018), Multiplex Network Analysis of the UK OTC Derivatives Market, Bank of England Staff Working Paper Nr. 726, London; S. Ghamami and P. Glasserman, (2017), Does OTC Derivatives Reform Incentivize Central Clearing?, Journal of Financial Intermediation, Vol. 32, pp. 76–87. 417  ‘Initial margin’ is provided to cover against potential future losses after early termination (closeout) of a contract, incurred between the point of default and the eventual settlement of the contract (the margin period of risk). See Turing and M. Singh, (2018), The Morning After—The Impact on Collateral Supply After a Major Market Default, IMF Working Paper Nr. WP/18/228, October, p. 4. The initial margin can then be changed later on as market conditions change. In case margins are adjusted frequently (weekly, daily, hourly) as a function of the value and changes in the value of the contract, they are called ‘variation’ margin. 418  High collateral reduces potential default losses, but leads to foregone profitable trades. See W. Huang, (2019), Central Counterparty Capitalization and Misaligned Incentives, BIS Working Paper Nr. 767, via bis.org 419  Also see V.  Bignon and V.  Guillaume, (2017), The Failure of a Clearinghouse: Empirical Evidence, Banque de France Working Paper Nr. 638, August. 420  D. Turing and M. Singh, (2018), ibid., p. 4.

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beyond the question of waterfalls and the need for CCPs to manage defaults. The collateral supply needed is affected by the obligation to clear OTC derivatives, through HQLA requirements, where there is no possibility to net or use rehypothecation.421 The prudential standards have tended to favor the use of cash as margin by clearing members. Those members with securities collateral will normally repo out securities in order to provide cash, which then is deposited by the CCP at the central bank. That in itself reduced money supply since cash deposited as margin is not available to the CCP or other market agents. Turing and Singh conclude that the fear that the market might not be able to cope with the demand for HQLA might be overstated, in particular for US collateral, where collateral velocity is still relatively low. In Europe, however, HQLA is in short supply.422 As discussed, collateral reuse plays an important role in the operations and functioning of global financial markets. It increases the availability of collateral, and therefore reduces costs (funding, transactional, etc.) for market participants as a given pool of collateral assets can be reused to support more than one transaction. Lowering transactional costs increases market liquidity, and consequently facilitates price discovery and market efficiency. But there is a downside: it may also present risks to the financial system, for instance, by potentially increasing interconnectedness between market participants and contributing to a buildup of excessive leverage of individual entities and in the financial system as a whole.423 Other arguments424 could be: • increase the interconnectedness of market participants, especially financial intermediaries, due to chains of transactions involving the reuse of collateral; • contribute to the buildup of excessive leverage of individual entities and in the financial system as a whole; • increase the sensitivity of market participants to counterparty credit risk, especially in stressed conditions, and, hence, reduce their willingness to roll over secured transactions (or decide not to permit the reuse of their collateral), potentially raising cost or decreasing quantities of available short-­term credit; • induce fire sales in stressed market conditions if entities liquidate assets to raise cash in order to repurchase recalled collateral; and • amplify stress in the market, resulting from a distressed entity recalling its collateral. Non-cash collateral reuse refers to a situation where a market participant receives ‘securities of whatever sort or nature’ as collateral in a transaction he engages into and then subsequently sells, pledges or transfers this collateral in a second transaction. The discussed rehypothecation model is subpart of this technique. Receiving collateral can be the

 R. Cont, (2018), Margin Requirements for Non-Cleared Derivatives, ISDA White Paper.  M. Hoerova et al., (2018), Benefits and Costs of Liquidity Regulation, ECB Working Paper Nr. 2169, July. 423  FSB, (2016), Transforming Shadow Banking into Resilient Market-Based Finance, Possible Measures of Non-Cash Collateral Re-Use, February 23, London. The document was set up as a consultation document. Market feedback was published in FSB, (2016), Public responses to the February 2016 report ‘Possible Measures of Non-Cash Collateral Re-Use’, May 4, London. 424  FSB, (2016), ibid., p. 1. 421 422

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consequence of many different types of transactions (reverse repos, securities or margin lending or OTC derivatives). Collateral can, besides being reused, also be sold. That creates intrinsically a short position at the level of the seller as the collateral at some point needs to be returned. The FSB has been pondering what measures, beyond a collateral velocity index that measures the number of times a piece of collateral is re-pledged in unrelated transactions, would be instrumental monitoring this market.425 These data could then help in mitigating issues as interconnectedness and concentration risk in financial markets. In breaking down the understanding of collateral reuse, the following granularity can be used: (1) total collateral reuse at jurisdictional or global level; (2) the collateral reuse reliance rate, that is, the proportion of posted collateral made up of received collateral that was reused. The reliance rate indicates to what degree market actors use collateral to finance their own operations or that of their clients; (3) the concentration of reuse of collateral; (4) the collateral circulation length: it measures the average length of collateral chains; (5) the collateral multiplier: it measures collateral velocity and provides a proxy for the magnitude of the contribution of collateral reuse to the buildup of leverage in the financial system.426 These matrixes were then later on in 2017 adopted as the final standard for measuring collateral reuse in the financial markets.427 In parallel with the efforts undertaken within the context of these matrixes for the use and reuse of collateral, the notion of rehypothecation has been examined. Rehypothecation can be seen as a further specification of collateral reuse in financial transactions. Although the technique can be used in a variety of transactions and situations, rehypothecation is used a lot in broker-­dealer relations which triggers a variety of market-related questions. The FSB’s work in this context can be seen as a further advancement of the work they started already in 2013 when they released their ‘Policy Framework for Addressing Shadow Banking Risks in Securities Lending and Repos’.428 Already in

 FSB, (2016), ibid., p. 3. Essentially three models can be used: asking entities to report collateral reuse, an exact measure can be calculated by requiring entities to report collateral posted or by reporting the amount of own assets involved in collateral transactions. Aguiar et al. created a collateral map to show how this function of the financial system works, especially with secured funding and derivatives activity. It provides insights into the increased demand for collateral, the reduced capacity for banks to act as collateral intermediaries, and examples of risks and vulnerabilities in collateral flows. See in detail: A. Aguiar et al., (2016), A Map of Collateral Uses and Flows, OFR Working Paper Nr. 16–06, May 26. A network depicting secured funding flows thus implicitly reveals a network of collateral flows. They comment, ‘[c]ollateral can also be presented as its own network to show collateral arrangements with bilateral counterparties, triparty banks, and central counterparties; the purpose and incentives of collateral exchanges; and participants involved.’ 426  See FSB, (2016), ibid., pp. 6–8, for a full review of calculations and constraints. 427  FSB, (2017), Transforming Shadow Banking into Resilient Market-Based Finance, Non-Cash Collateral Re-Use: Measure and Metrics, January 27, London. Bijkerk and de Vries analyze the effect of competition on asset-based loan markets on interest rate distributions and the mobility of small firms. See: S. Bijkerk and C.G. de Vries, (2019), Asset-Based Lending, Tinbergen Institute Discussion Paper Nr. 2019-032/VII, May 1. 428  FSB, (2013), Policy Framework for Addressing Shadow Banking Risks in Securities Lending and Repos, 29 August, London. 425

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2013 they FSB urges further analysis of rehypothecation and that ‘an appropriate expert group should be established to examine possible h ­ armonization of client asset rules with respect to rehypothecation, taking account of the systemic risk implications of the legal, operational, and economic character of rehypothecation’.429,430

1.21.2 Rehypothecation and Collateral Reuse Rehypothecation can be described as the use by a financial intermediary of assets provided by a client, to engage in further transactions by said financial intermediary (dealer or bank) making the loan for which the hypothecation was provided. Initially, assets were provided as collateral for a secured borrowing (e.g. loan to buy home or margin loan provided to a hedge fund). The financial intermediary uses the assets provided and pledges them to one or multiple third parties to source the financing needed to provide to the initial client, or simply to facilitate other transactions for clients (e.g. short selling). When the regulatory framework doesn’t prohibit, the assets pledged by the client can also be used to finance other non-client-related transactions (e.g. inventory or proprietary trading). Reuse of collateral is typically broader in scope and is not limited to the use of client assets. It can involve any use of assets provided as collateral by a financial intermediary. The most common example is that of a repo.431 When a market party is in need for short-term cash to finance its operations, it may provide the cash lender with any collateral and a commitment to repurchase that or similar collateral in the future at a fixed price. The cash lender can, during the interim, reuse such securities, and pledge them as collateral in other transactions the cash lender engages into.432 The changing regulatory landscape since 2008 has increased the need for collateral (to cover all sorts of margin requirements). That has increased the amount of collateral available and reduced the cost of using collateral. During and after the Basel 3, 3.5

 FSB, (2013), ibid. Recommendation 8.  Does redeployability of assets create crash risk? wonder Chen et al. The balance is this: ‘[o]n one hand, greater asset redeployability engenders liquidity benefits that should enhance financial stability, thereby mitigating future stock price crash risk. On the other hand, asset redeployability enables managers to opportunistically exploit asset sales to engage in upward real earnings management in order to hide bad news, which, in turn, increases future stock crash risk.’ They identify a positive correlation in particular for those firms experiencing both internal and external pressure regarding earnings management. See in detail: Y. Chen et al., (2017), The Dark Side of Asset Redeployability: Future Stock Price Crashes, Working paper, mimeo, June. 431  See also: G. Issa and E. Jarnecic, (2016), Collateral Re-Use as a Direct Funding Mechanism in Repo Markets, University of Sydney Working Paper, mimeo. 432  That works this way for private lenders but also for central banks (aka lenders of last resort). Choi et al. show that (contrary to what is generally accepted) it may be optimal for the lender of last resort to lend against low-quality collateral. That is because lending against low-quality collateral exposes the central bank to counterparty risk but improves the pool of collateral in funding markets and can unlock frozen markets. See in detail: D.B. Choi et al., (2017), A Theory of Collateral for the Lender of Last Resort, Working Paper, mimeo, March 12. 429 430

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and 4 implementation, the need for collateral in the market and is expected to go up. The full set of benefits of rehypothecation and collateral reuse can be summarized433 as follows: • It increases the lending capacity for both financial intermediaries and their clients while lowering funding costs.434 The consequence is that the financial intermediary has to use less of its own securities and thereby reducing balance sheet costs. • It reduces the cost associated with long and short positions in equities and other securities. It therefore facilitates price discovery and efficiency in markets. • It reduces pressure on collateral supply that may be associated with increased posting of initial margin following OTC derivatives or securities financing transactions. The multiple reuse of the same assets as collateral provides for an effective supply of collateral assets. • It enhances market functioning under normal and stressed conditions, by facilitating securities settlements and potentially reducing fails. A settlement failure occurs when either the seller does not deliver the securities or the buyer doesn’t pay on the preset date. It can lead to credit and liquidity risks, and discourage overall lending behavior in the market given the perceived default risk. • It supports the implementation of monetary policy as many central banks rely on secured transactions to implement monetary policy. The potential downside or exposures that come with rehypothecation can be described as435: • Risks arising from obstacles to client wishing to access their securities. Operational constraints might occur when clients try to access their collateral but are hindered in doing so due to, for example, insolvency issues when securities end up being frozen for some time. Not properly segregating collateral and assets might trigger this to happen or when a conflict of rights occurs with respect to the securities. The implication of such inability to access might be that clients cannot adjust their positions, loss in port-

 See in extenso: FSB, (2017), Rehypothecation and Collateral Re-use: Potential Financial Stability Issues, Market Evolution and Regulatory Approaches, January 25, pp. 3–5. 434  Assuming that the haircut paid by the client is higher than the haircut by the financial intermediary for the repo. 435  See in extenso: FSB, (2017), Rehypothecation and Collateral Re-use: Potential Financial Stability Issues, Market Evolution and Regulatory Approaches, January 25, pp.  6–9. Also: C.  Monnet, (2011), Rehypothecation, Business Review, Federal Reserve Bank of Philadelphia, Q4; S. Infante, (2014), Money for Nothing: The Consequences of Repo Rehypothecation, Federal Reserve Board Working Paper, September 19; S. Infante, (2015), Liquidity Windfalls: The Consequences of Repo Rehypothecation, Finance and Economics Discussion Series 2015–022; E.  Erem, (2014), Intermediary Funding Liquidity and Rehypothecation as a Determinant of Repo Haircuts and Interest Rates, Stanford University Working Paper, July 26; J.  Brumm, et  al. (2017), Re-use of Collateral: Leverage, Volatility and Welfare, Working Paper, mimeo; L. Fuhrer, et al. (2016), Re-use of Collateral in the Repo Market, Journal of Money, Credit and Banking, Vol. 48, Issue 6, pp. 1169–1193. 433

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folio value, but where it might trigger secondary effects in the market causing contagion and under circumstances systemic risk. Regulatory arbitrage in case rehypothecation rules are not harmonized. In many countries limitations on the use of rehypothecation and/or reuse of securities exist. They take different shapes and forms ranging from different transparency rules, which assets are available, different level of asset protection. Those differences may lead to cross-border regulatory arbitrage which in turn might cause interconnectedness and complicates unwinding transactions when subject to different regulatory regimes. A visible example of this was the Lehman Brothers’ global prime brokerage business that was operated out of London as it could provide lower-cost funding than when being operated out of the US.436 In essence, it facilitates and constitutes a form of systemic arbitrage.437 Rehypothecation and collateral reuse might assist in the buildup of leverage. Using the collateral provided by clients, financial intermediaries can finance other market transactions or proprietary transactions.438 Rehypothecation and reuse of collateral might contribute to procyclical effects through liquidity and funding risk illusions during dormant times in the market and increased activity during periods of market stress. Leaving rehypothecation programs during periods of enhanced stress, market participants might magnify credit and operation risks and consequently amplify funding strains. Those activities might enhance interconnectedness. It was described already how the fact that in the chain of reuse or rehypothecation a party that might find itself unable to deliver reused collateral might be triggering further falls down the channel, leading eventually to a substantial shock. The moment that the amount of collateral available in the market is fallen short of the amount required to unwind transactions expiring at a given point in time, frictions might occur. The reuse of collateral might contribute to the procyclicality in the financial sector. During economic boom times, credit is readily available and therefore market parties are willing to engage in collateral reuse and by doing so increase market liquidity and reduce volatility. It might lead to the amplification of risk related to the sudden price changes of collateral. The FSB indicates: ‘[a] sudden drop in the value of securities widely held as collateral can result in wide-spread and substantial margin calls and higher haircuts, or even the exclusion of these securities from the pool of eligible collateral.’439 That

 See M. Mitchell and T. Pulvino, (2012), Arbitrage Crashes and the Speed of Capital, Journal of Financial Economics, Vol. 104, pp. 469–490. 437  F. Fecht et al., (2016), Collateral, Central Bank Repos, and Systemic Arbitrage, Swiss Finance Institute Research Paper Series Nr. 16-66, November. 438  See FSB, (2017), Rehypothecation and Collateral Re-use: Potential Financial Stability Issues, Market Evolution and Regulatory Approaches, January 25, p. 7, for data starting 2006. 439  See FSB, (2017), ibid., p. 9. Lou developed a haircut model by expanding haircut definitions beyond the traditional Value-at-Risk measure and employing a double-exponential jump-diffusion model for collateral price. See W. Lou, (2016), Haircutting Non-Cash Collateral, Working Paper, mimeo, October 29. See regarding the impact of haircut policies on the use of collateral by bank 436

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can then put further downward pressure on collateral prices. The reuse of collateral increases under those circumstances the risk of contagion through fire sales in case multiple transactions use the same collateral or highly correlated securities as collateral. • An unexplored source of liquidity risk faced by large broker-dealers are collateral runs. By setting different contracting terms on repurchase agreements with cash borrowers and lenders, dealers can source funds for their own activities. Cash borrowers internalize the risk of losing their collateral in case their dealer defaults, prompting them to withdraw it. This incentive creates strategic complementarities for counterparties to withdraw their collateral, reducing a dealer’s liquidity position and compromising her solvency. Collateral runs are markedly different from traditional wholesale funding runs because they are triggered by a contraction in dealers’ assets, rather than their liabilities.440 When studying existing practices, it was demonstrated by various market participants that the inclusion of cross-lien provisions in prime brokerage agreements contributes to complexities both in case of insolvency and when identifying counterparty risk. With such provisions, the financial ­intermediary can use all client assets to further their business. Also the position of a client in bankruptcy cases is unclear and they are often left behind as a general creditor in such proceedings. Also there seems to be an awareness of ‘enhanced reinvestment risk’ with respect to cash collateral posted pursuant to securities lending. Although this cash collateral was often invested in short-term but deeply liquid assets, the crisis learned that under sufficient stress these reinvestment vehicles experienced liquidity and losses. Finally, weaknesses in tri-party arrangement is another concern observed in the marketplace. It was common, and in some countries it still is common, that tri-party service providers unwind all positions in the morning and recollateralize them in the evening. This unwinding and rewinding of positions and the implied providing or refraining from intraday credit might result in some financial intermediaries losing access to finance. Absence of intraday credit provided by clearing banks left intermediaries with no choice other than to default on maturing trades. Worse, the access to uncommitted intraday credit during the day (between unwinding and rewinding) or absence of it created channels of contagion across tri-party service providers, cash lenders and security dealers.441

and the impact on funding costs: N. Casola and F. Koulicher, (2016), The Collateral Channel of Open Market Operations, Banque de France Working Paper Nr. 593, May. 440  S.  Infante and A.P.  Vardoulakis, (2018), Collateral Runs, Collateral Runs, Finance and Economics Discussion Series 2018–022. Washington: Board of Governors of the Federal Reserve System, https://doi.org/10.17016/FEDS.2018.022 441  See in extenso: FSB, (2017), ibid., pp. 9–12.

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Following the 2007–2009 crisis a number of regulatory changes were implemented to avoid or mitigate the abovementioned exposures. On that a list of regulatory changes are included:442 • The US tri-party repo market was reformed443 in order to reduce the financial stability risks related to collateral reuse and reduce the systemic risk of the tri-party repo system altogether. For example, the amount of transactions that are financed with intraday credit provided by a clearing bank has been materially reduced. Although a run on the repo market was a central driver in the financial crisis, direct reform of the repo market has not been prioritized.444 • Enhancement of disclosure requirements for funds’ securities financing transactions (the US). Starting 2016, the disclosure requirements for these transactions have been enhanced in order to improve access and quality of information available. This data includes position-level information on securities on loan, collateral reinvestments, repos and so on. • In Europe MiFID II forces investments firms to disclose their intent to reuse assets provided by clients and require their upfront consent. Investment firms are further forced to make adequate arrangements to properly be able to segregate assets in case of insolvency.445 • Regulatory reforms for banks. Under Basel III and in particular its risk-­based capital framework focuses on updated risk weightings, higher capital ratios and so on. • Other international regulatory reforms: these include enhancing client asset protection regimes and haircut standards for non-centrally cleared securities financing transactions. Regarding the latter the FSB’s work during the period 2013–2015 has been discussed extensively and has resulted in dedicated EU legislation.446 The Basel Committee provided guidance on the rehypothecation of margin exchanged for noncentrally cleared derivatives. The Basel Committee on Banking Supervision and the International Organization of Securities Commissions (BCBS-IOSCO) requirements allow the rehypothecation, re-­pledge or reuse of cash and non-cash collateral collected as variation margin (VM), while setting conditions under which firms are allowed to re-hypothecate collateral provided as initial margin (IM).447 Also IOSCO provided

 In extenso: FSB, (2017), ibid. pp. 12–15.  A private-sector tri-party repo task force sponsored by the Federal Reserve Bank of New York was tasked with reforming that part of the financial spectrum along the lines of three identified exposures and vulnerabilities. See footnote 29, p. 12, of FSB, (2017), ibid. 444  Indirect measures taken, for example, reforms aimed at curbing financial institutions’ reliance on short-term funding sources and capping bank balance sheets, will limit the threat repo markets pose to systemic stability. See in detail: J. Cullen, (2016), The Repo Market: Collateral and Systemic Risk, Working Paper, mimeo. 445  Directive 2014/65/EU of the European Parliament and of the Council of 15 May 2014 on markets in financial instruments and amending Directive 2002/92/EC and Directive 2011/61/EU. 446  Regulation (EU) 2015/2365 on transparency of securities financing transactions and of reuse entered into force in December 2015. 447  FSB, (2017), Rehypothecation and Collateral Re-use: Potential Financial Stability Issues, Market Evolution and Regulatory Approaches, January 25, p. 15. Also: S. Infante et al., (2018), The Ins and Outs of Collateral Re-Use, FEDS Notes, December 21, https://doi.org/ 10.17016/2380-7172.2298 442 443

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guidance regarding the protection of client assets. Finally, the FSB provided guidelines regarding the Key Attributes of Effective Resolution Regimes for Financial Institutions.448 The reuse of collateral arrangements and their optimality have been studied in the context of the shadow banking system. Muley describes: ‘rehypothecation as the direct repledging of the collateral received in a debt contract by the lender, while securitisation (pyramiding) is the use of the debt contract itself as collateral. With securitisation, the value of the repledgeable collateral, and hence the amount that can be borrowed, is limited by the face value of the original debt contract. Rehypothecation of the collateral449 enables borrowing of an amount that is typically greater than the face value of the debt backed by that collateral. The rehypothecating lender effectively borrows from the borrower the excess value of the collateral over the face value of the debt.’ She demonstrates that when the lender’s cash flows are sufficiently pledgeable to the borrower, rehypothecation is a Pareto improvement on securitization.450 Park studies the misallocation of collateral under two scenarios: (i) different temporary shocks (that increase the risk of failure of the intermediary in the collateral chain); and (ii) different persistent shocks (random aggregate shocks). He concludes that when negative temporary shocks reduce the borrower’s willingness to allow rehypothecation, the economy drops further, but it recovers faster. In addition, in a more protracted period, good shocks can lead to a greater fall in output in the future.451 The downside effect of collateral reallocation ‘arises from the assumption that collateral is not perfectly liquid in the sense that: (a) the shadow value of collateral is higher for borrowers than for lenders; and (b) the market for collateral is not frictionless, so that buying or selling collateral is costly’.452 In case the intermediary fails, the collateral cannot be returned to borrowers who value them the highest. Based on the experiences during the financial crisis as well as the period after the financial crisis during which a variety of regulatory changes have been implemented, a number of behavioral changes regarding reuse of collateral and rehypothecation have been observed in the market. They can be summarized453 as including:

 See FSB, (2017), ibid., pp. 15–16. All initiatives referred to here are discussed at the appropriate places throughout both volumes of the book. 449  See for a flow of collateral analysis to and from dealers and the level of encumbrance and or rehypothecation: S. Infante et al., (2018), The Ins and Outs of Collateral Re-use, FEDS Notes. Washington: Board of Governors of the Federal Reserve System, December 21, https://doi. org/10.17016/2380-7172.2298 450  A. Muley, (2016), Collateral Re-Use in Shadow Banking and Monetary Policy, MIT Working Paper, mimeo; A. Muley, (2016), Re-Use of Collateral: Rehypothecation and Pyramiding, Working Paper, May 14, mimeo; A. Muley, (2016), Rehypothecation and Monetary Policy, Working Paper, mimeo. Also: G. Issa and E. Jarnecic, (2016), Collateral Re-Use as a Direct Funding Mechanism in Repo Markets, Working Paper, mimeo. 451  H. Park, (2017), Collateral Reuse, Collateral Mismatch and Financial Crisis, Working Paper, January 31, mimeo. See also: C.M. Kahn, and H. Park, (2017), Collateral, Rehypothecation, and Efficiency, UIUC Working Paper, mimeo; H. Park, (2016), Collateral Reuse and Business Cycle, MIT Working Paper, November 16, mimeo. 452  H. Park, (2017), ibid., p. 3. Also see D. Duffie, et al., (2015), Central Clearing and Collateral Demand, Journal of Financial Economics, Vol. 116, Issue 2, pp. 237–256. 453  FSB, (2017), ibid., pp. 16–19. 448

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• Clients have engaged in a thorough review of contractual terms in the negotiation of their prime brokerage agreements. In particular the abovementioned cross-lien provision has been reviewed. Even more, a comprehensive and full review of all documentation regarding all sorts of transactions has been observed. • Enhanced due diligence and operational changes: in particular counterparty risk. Also spreading of risk occurs by way of using multiple prime brokerages or the other way around by using less brokerages in order to be able to more closely monitor counterparty credit risk. • Enhanced risk and collateral management454: including improved liquidity management. In the repo market there is the understanding that financial stability risk is driven by liquidity constraints and not reuse of collateral. Tighter collateral management includes ‘paying closer attention to the types and quality of collateral accepted (the types that can be liquidated in times of stress), reviewing counterparty credit risk and ensuring that the haircuts are appropriate’.455 Also more attention has been provided to default scenarios: sufficient haircuts to manage liquidation risk,456 intra-­firm transaction, related collateral demands. • Other changes in market practices: in particular in the repo market, transactions are more commonly settled as a sale (i.e. ‘if a client purchases a bond with a subsequent agreement for a counterparty to repurchase that bond, there is nothing different in that transaction than if the client were simply just buying a bond’).457 The question has been asked to what degree and what elements could be part of harmonization efforts in this field. Historically, the idea has always been that protecting clients and their assets against distress at the level of the financial intermediary was central in any regulatory effort. Broad-based financial stability risk was not part of that evaluation. The latter has changed after the financial crisis. In that context the following regulatory approaches have been assessed and followed458:

 Central securities depositories are essential for the timely posting or delivery of collateral for payments, development of the capital market and other purposes (infra Wendt et al. pp. 7–8 and 23). Central bank’s intraday credit, either for monetary policy or for payment systems purposes, relies heavily on timely availability of collateral. The securities depositories are also important in this respect, beyond their other contributions in terms of effective implementation of monetary policy, the credibility of a government’s debt management program and safe and efficient securities markets. See F.  Wendt et  al., (2018), Organizing Central Securities Depositories in Developing Markets—7 Considerations, IMF Working Paper Nr. WP/18/66, March. Choosing the correct model might prove to be a challenge, hence the considerations provided by Wendt et al. 455  FSB, (2017), Rehypothecation and Collateral Re-use: Potential Financial Stability Issues, Market Evolution and Regulatory Approaches, January 25, p. 18. 456  See also F.  Glaser and S.  Panz, (2016), (Pro?)-Cyclicality of Collateral haircuts and Systemic Illiquidity, ESRB Working Paper Series Nr. 27, October. They use the noise in bond yields with and without haircuts to measure systemic illiquidity. 457  FSB, (2017), ibid., p. 19. 458  FSB, (2017), Rehypothecation and Collateral Re-use: Potential Financial Stability Issues, Market Evolution and Regulatory Approaches, January 25, pp. 19–22. 454

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• Disclosure to and consent from clients. The client decides whether the better terms (e.g. lower financing costs) in exchange for the rehypothecation are adequate or not. Making informed decisions is driven by the information protocol. • Reporting requirements: regarding the location(s) of client assets, volumes of collateral used, transferability of client assets and so on. • Prohibition or limitation on rehypothecation of client assets (partly or in full) to fund own-account activities. In such scenarios, the regulator prohibits the financial intermediary from using client assets for purposes other than providing financing to clients. These assets might therefore not be used to fund proprietary trading or providing working capital to the firm. • Alternatives to traditional creditor treatment in bankruptcy. Newly introduced ‘client asset protection programs’ shield investors from the trouble of traditional creditor treatment in bankruptcy, often by providing relief from the traditional stays common in insolvency regimes. Assets can then easier be repatriated. In many countries459; the insolvency regimes applicable to broker-dealers give preference to customers vis-à-vis other creditors. A customer’s cash and securities are protected (including the reused collateral) up to the customer’s net equity (cash and securities held minus any amount owed by the customer to the broker-dealer). • Capital and liquidity regulation for financial intermediaries permitted to re-hypothecate client assets.460 Involves the imposition of capital standards. The basic idea is that the broker-dealers can meet their obligations toward customers, as well as other creditors and counterparties. Liquidity standards may complement capital standards. It is in line with the 2013 FSB461 recommendations that ‘only entities subject to adequate regulation of liquidity risk should be allowed to engage in rehypothecation of client assets’. The existing approaches regarding the rehypothecation of client assets take place through prime brokerages activities, in both the US and Europe.462 Their regulatory approach, however, is vastly different. The US approach is characterized by the fact that broker-dealers registered with the US Securities and Exchange Commission (SEC) can re-hypothecate client assets with their consent (obtained through their margin agreements). The focus is on maintaining liquid assets and the segregation of client funds.

 Including the US based on the Securities Investor Protection Act of 1970 (SIPA).  See for an evaluation: D.  Andolfatto, et  al., (2017), Rehypothecation and Liquidity, Federal Reserve Bank of St. Louis, Working Paper Series, Nr. 2015-003D, updated re-issue, July. Also see A. Geromichalos, and L. Herrenbrueck, (2016), Monetary Policy, Asset Prices, and Liquidity in Over-the-Counter Markets, Journal of Money, Credit and Banking, Vol. 48, Issue 1, pp. 35–79; A.  Geromichalos, and L.  Herrenbrueck (2017), A Tractable Model of Indirect Asset Liquidity, Journal of Economic Theory, Vol. 168, March, pp. 252–260. A.A. Zevelev, 92016), Does Collateral Value Affect Asset Prices? Evidence from a Natural Experiment in Texas, Working Paper, mimeo. 461  FSB, (2013), Policy Framework for Addressing Shadow Banking Risks in Securities Lending and Repos, 29 August, London. 462  The regime in other countries tends to follow that of either the US or Europe. For a full overview, see FSB, (2017), Rehypothecation and Collateral Re-use: Potential Financial Stability Issues, Market Evolution and Regulatory Approaches, January 25, pp. 22–26. 459 460

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The process the broker-­dealer has to go through is known as the two-step process.463 They are designed to protect customers by segregating their securities and cash from the brokerdealers’ proprietary business activities. In case the broker fails, the securities and cash will be available to be returned to customers. In case of insolvency, these client assets are labeled as ‘customer property’. On the other hand the European approach is laid down in Markets in Financial Instruments Directive II (MiFID II) and describes the process under which investment firms are permitted to reuse client assets with their consent. What they are, however, not allowed to do under the European arrangement is to conclude title transfer financial collateral arrangements (TTCAs) with retail clients (it is allowed in relation to professional clients and other qualifying counterparties). Separate ledgers need to be maintained under order to guarantee the proper segregation of assets for each of the appropriate categories of clients. There are exceptional situations thinkable where TTCA with wholesale clients is not allowed when there is only a very weak link/connection between the client’s liabilities and the use of client instruments by means of TTCA. Investment firms also need to take appropriate measures to prevent the unauthorized use of client assets. Situations envisaged are as follows: (1) arrangements in case the client does not have enough provision on the settlement date; (2) ensuring that the firm can deliver assets to clients on the settlement date; (3) prompt requesting of assets on settlement date and (4) when client assets are reused, the borrower must ensure the appropriate amount and quality nature of collateral is provided and the value of that collateral needs to be in balance with the client assets at any given point in time during the transaction. There is no harmonization yet of insolvency and bankruptcy regulation in the EU (there are partly arrangements to ensure a swifter management of cases with cross-border arrangements however) which might explain different approaches used by the individual Member States. Further the Securities Financing Transaction Regulation (SFTR)464 imposes minimum market-wide conditions to be met regarding rehypothecation of clients’ assets. Those conditions include: prior consent, disclosure of risks and implications of rehypothecation. The overall objective is that the client is provided with sufficient information at all times in order to make appropriate investment decisions. Also other financial entities such as funds, CCPs and central depositories are all subject to additional disclosure requirements regarding the rehypothecation of client’s assets.465 In short, the differences

 SEC Exchange Act Rules 8c-1 & 15c3–3 (called the hypothecation rules). No commingling of client and proprietary assets is allowed. Extensively described in FSB, (2017), Rehypothecation and Collateral Re-use: Potential Financial Stability Issues, Market Evolution and Regulatory Approaches, January 25, p. 23. 464  Regulation (EU) 2015/2365, of the European Parliament and of the Council of 25 November 2015 on transparency of securities financing transactions and of reuse and amending Regulation (EU) No 648/2012; OJ L 337, 23.12.2015, pp. 1–34. 465  Besides aforementioned Regulation (EU) 2015/2365, also Directive 2014/91/EU of the European Parliament and of the Council of 23 July 2014 amending Directive 2009/65/EC on the coordination of laws, regulations and administrative provisions relating to undertakings for collective investment in transferable securities (UCITS) as regards depositary functions, remuneration policies and sanctions, OJ L 257, 28.8.2014, pp. 186–213; Regulation (EU) No 648/2012 of the European Parliament and of the Council of 4 July 2012 on OTC derivatives, central counterparties 463

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in regulatory approach between the US and Europe come down to: (1) differences in bankruptcy treatment of re-hypothecated client assets in various jurisdictions, (2) existing customer protection regimes and (3) the existence of different property interest laws.466 Harmonizing the different regulatory approaches that exist might assist in (1) avoiding regulatory arbitrage, by avoiding that financial intermediaries are incentivized to transfer activities and client assets across jurisdictions. However, clients do not factor in regulation at lot when deciding where to open brokerage accounts, but prioritize other arguments like funding costs, location of assets and bankruptcy protection rules. The different regulatory systems don’t seem to trigger a lot of regulatory arbitrage in this matter; (2) the promotion of a global level-playing field which may promote consistency among client asset rules; (3) enhanced transparency of client asset protection standards which might lead to a better understanding of the treatment of client’s assets in various jurisdictions and reduce client uncertainty particularly during times of stress. Enhanced transparency might also facilitate easier financial intermediary resolution in case client assets are treatment similar or identical across assets. However, practice learns that post-crisis many customers spread their assets across multiple brokerages and their main focus being the credit quality of their prime brokers. Contrasting practice with the three recommendations the FSB made in 2013467 to address potential stability risk, it can be concluded that the current practice covers the individual objectives (client consent, reporting mechanisms, no outright prohibition of rehypothecation, restrictions to fund inventory and/or proprietary transactions, etc.). The FSB sees no further need to harmonize regulatory approaches468 but relies on some existing policy measures to address the residual financial stability risk associated with collateral reuse.469

and trade repositories, OJ L 201, 27.7.2012, pp.  1–59, Regulation (EU) No 909/2014 of the European Parliament and of the Council of 23 July 2014 on improving securities settlement in the European Union and on central securities depositories and amending Directives 98/26/EC and 2014/65/EU and Regulation (EU) No 236/2012, OJ L 257, 28.8.2014, pp. 1–72 and Directive 2002/47/EC Directive 2002/47/EC of the European Parliament and of the Council of 6 June 2002 on financial collateral arrangements, OJ L 168, 27.6.2002, pp. 43–50. Also Basel III implemented (Regulation (EU) No 575/2013) applies global standards on bank capital to credit institution and investment banks. 466  FSB, (2017), Rehypothecation and Collateral Re-use: Potential Financial Stability Issues, Market Evolution and Regulatory Approaches, January 25, p. 26. 467  Those three recommendations were: (1) financial intermediaries should provide sufficient disclosure to clients in relation to rehypothecation of assets so that clients can understand their exposures in the event of a failure of the intermediary; (2) client assets may be re-hypothecated by an intermediary for the purpose of financing client long positions and covering short positions, but they should not be re-hypothecated for the purpose of financing the intermediary’s own-account activities; and (3) only entities subject to adequate regulation of liquidity risk should be allowed to engage in the rehypothecation of client assets. See FSB, (2013), Policy Framework for Addressing Shadow Banking Risks in Securities Lending and Repos, 29 August. 468  Also because further harmonization comes with some additional complications and challenges; see FSB, (2017), Rehypothecation and Collateral Re-use: Potential Financial Stability Issues, Market Evolution and Regulatory Approaches, January 25, p. 29. 469  See FSB, (2017), ibid., pp. 29–32.

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Those existing mechanisms include: (1) the Basel regulatory framework and in particular the leverage ratio which incentivize banks to keep reuse activity below excessive levels, and (2) the BCBS’ supervisory framework for measuring and controlling large exposures will reduce concentration risk to single counterparties470; (3) the Basel framework reduces procyclicality through the liquidity coverage ratio471 and the net stable funding ratio. The former forces to hold high-quality liquid assets; the latter is designed to ensure that banks have liabilities that are sufficiently stable given the liquidity characteristics of their assets. Also the in 2015 completed ‘Regulatory Framework for Haircuts on Non-centrally Cleared Securities Financing Transactions’ which provided quality standards to calculate haircuts and a framework of numerical haircut floors that will apply to non-centrally cleared securities financing transactions (and in which financing against collateral other than government securities is provided to nonbanks) has led post-implementation to an increased usage of CCPs when clearing transactions thereby reducing adverse liquidity shocks.

1.21.3 The Collateral Trap Financial markets and wholesale financial markets in particular allocate assets (and thus deposits) across the economy and the financial spectrum. These flows are not unconstrained, as incentive issues might arise. The constraining element is often ‘collateral’.472 How market agents behave depends largely on the volume, value and composition of the

 BCBS, (2014), Supervisory Framework for Measuring and Controlling Large Exposures, April.  The liquidity ratio as part of the overall reform package has turned the pre-crisis financial architecture based on a system of mobile collateral into a model with immobile collateral. The LCR requires that (net) short-term bank debt be backed by (essentially) Treasuries (‘high-quality liquid assets’). See in detail G. Gorton and T. Muir, (2016), Mobile Collateral Versus Immobile Collateral, BIS Working Paper Nr. 561, May. 472  Collateral constraints ultimately also play a role in defining the limits of monetary policy and its independence in an open economy. In the interaction between capital flows and (domestic) collateral constraints monetary policy faces a critical floor knows as the ‘Expansionary Lower Bound’ (ELB) which is defined as an interest rate threshold below which monetary easing becomes contractionary. That ELB can be positive and thus can be a more stringent constraint as the ‘Zero Lower Bound’. Given the fact that the ELB is affected by international monetary and financial conditions international spillover can occur. See in detail P. Cavallino and D. Sandri, (2018), The Expansionary Lower Bound: Contractionary Monetary Easing and the Trilemma, IMF Working Paper Nr. WP/18/236, November. There is growing argumentation that international capital flow movements effectively have the potential to undermine the ability of monetary policy to ensure macroeconomic stability (particularly in emerging economies). See, for example, recently: N.  Arregui et  al., (2018), Can Countries manage their Financial Conditions Amid Globalization, IMF Working Paper Nr. WP/18/15. Cavallino and Sandri rationalize these concerns, providing a theory how capital mobility can hinder monetary policy. The bottom line is that the interaction between capital flows and domestic collateral constraints can undermine monetary transmission. The aforementioned ELB ‘constraints the ability of monetary policy to stimulate aggregate demand, placing an upper bound on the level of output achievable through monetary stimulus’ (pp. 3, 15–16). Also: Y.S. Baskaya et al., (2017), International Spillovers and Local Credit Cycles, NBER Working Paper Nr. 23149; G.B.  Eggertson et  al., (2017), Are Negative Nominal Interest Rates Expansionary?, NBER Working Paper Nr. 24039. 470 471

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collateral provided by market agents. Boissay and Cooper,473 who study the fragility of the interbank markets, create a distinction between ‘outside’ and ‘inside’ collateral. Inside collateral, such as loans, create what they call a ‘collateral pyramid’. That refers to the fact that the cash flow from one particular loan can be used as a pledge to secure another loan. Those collateral pyramids create what we have discussed as being ‘safe assets’. But privately created safe assets come at the cost of the near certainty of creating at some point systemic panics in the market. Quality of collateral, haircuts and transparency474 or even a limitation on the type of collateral to be used will prevent that from happening.475 Interesting enough, a comparison was developed between the use of collateral versus guarantees. Although the question related to information sharing and the impact on adverse selection, it has been shedding some interesting light on the market mechanism of both instruments and their usefulness within a capital markets context.476 Outside collateral, such as government paper, serves better as a foundation and stabilizes the aforementioned pyramid. The less outside collateral, the more prone the pyramid is to implosion. As there not enough real safe assets to support the wholesale market (or any other financial market for that matter), the market ends up with a ‘collateral trap’.

 F.  Boissay and R.  Cooper, (2016), The Collateral Trap, BIS Working Paper Nr. 565, May. Cavallino and Sandri rationalize these concerns. 474  The understanding of how quality of collateral, contagion and increase of risk interact is still ‘ambiguous’. The same holds true for the question how increased risk translates into changes in asset prices and asset allocations. See, for example, G.  Phelan, (2017), Collateralized Borrowing and Increasing Risk, Economic Theory Vol. 63, Issue 2, pp. 471–502. 475  I don’t want to artificially disparage the effects that haircuts and other similar impact on the collateral channel have. The stylized models demonstrate a reduction in contagion effect, but then again our understanding of contagion and the transmission channels is still embryonic. There are those studies that demonstrate that a ‘loss in collateral value reduces both the amount and the maturity of firm debt and leads firms to contract investment, employment, and assets’…‘and that the legal reform may distort investment and asset allocation decisions, as firms that reduce their holdings of assets with low collaterizable value and firms that hold more liquid assets consequently become less productive and innovative’. See in detail: G.  Cerqueiro et  al., (2016), Collateral Damage? On Collateral, Corporate Financing and Performance, ECB Working Paper Nr. 1918, June. Their results indicate that the reform may have had negative consequences for the real economy. They also conclude that the reduction in operating scale (less investments, employment and assets) makes these firms less efficient and less innovative. Also see M. Gruskin, (2015), Declining Collateral and Increasing Low Leverage Firms, Journal of Applied Finance, Nr. 2, pp. 1–19. The resilience of the financial system largely depends on the quality of collateral. Runs are often triggered by the underlying question about the nature of the of the collateral backing underlying (often short-term) debt. Gorton and Laarits don’t sugar-wrap it and conclude that ‘there is a shortage of high-quality collateral’. They use as a central parameter the ‘convenience yield on short-term debt’ as it is a good indicator for the demand-supply of short-term safe debt taking into account the availability of high-quality collateral. As a response the private sector has issued more (unsecured) commercial paper at shorter maturities. Their results suggest that there is a ‘shortage of safe debt now compared to the pre-crisis period, implying that the seeds for a new shadow banking system to grow exist’. See in detail G. Gorton and T. Laarits, (2018), Collateral Damage, Financial Stability Review, Banque de France, April, pp. 73–82. 476  R. de Haas and M. Millone, (2020), The Impact of Information Sharing on the Use of Collateral Versus Guarantees, Working Paper, World Bank Economic Review, Vol. 34, S1, S14–S19. 473

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Markets secured by inside collateral are thus inherently less stable. Since the universe of safe assets is limited, the ability to borrow depends on the collateral availability of the borrower. If lenders believe that borrowers are high quality, lending conditions will generally be relaxed. Only an abundant availability of government paper will stabilize the pyramid and act as a foundation. It was discussed before as to what degree it is the role of the government to produce sufficient Treasuries to satisfy the private market demand for safe assets. And what would ultimately be the difference between providing that abundant level of securities (ex ante) compared to acting as a final and ultimate backstop or LOLR (ex post). One could argue that the inclination to intervene (bail in) post-crisis for central bank and government is constrained due to the contagion effect it might deliver versus the markets as such. Questions can be asked about the macroprudential use and effects of haircut and margins. Collateral is playing an increasingly important role in the post-crisis financial system. The use of collateral is governed by specific risk management practices, including margin and haircut requirements. Margin and haircut practices can exacerbate systemic risks, by contributing to the buildup of excessive leverage in the financial system during upswings and deleveraging during downswings. Macroprudential policy may have a role in addressing systemic risks arising from margin and haircut requirements linked to market failures. While regulatory requirements477 consider procyclicality risks, there is no explicit mandate for the use of margins and haircuts to meet macroprudential objectives. A number of potential macroprudential tools target margin and haircut requirements. Those include: (1) fixed numerical floors for initial margins and haircuts would introduce absolute minimum requirements; (2) time-varying floors on initial margins and haircuts would allow macroprudential authorities to steer haircut and margin levels in a countercyclical manner; (3) macroprudential margin add-ons could be an alternative approach to fixed numerical or time-varying margin floors; (4) macroprudential collateral pool buffers are another alternative approach to fixed numerical or time-varying margin floors; (5) margin and haircut ceilings are an ex ante cap on the maximum acceptable margin and haircut levels, inclusive of any add-ons; and (6) speed limits on margin and haircut increases would result in a ceiling being imposed on increases in margins or haircuts over a given time period. The use of margins and haircuts to meet macroprudential objectives requires consideration of these objectives, their scope and consistency with existing regulation and governance.478

 Regulatory requirements play a major role in the choice of banks, both directly and indirectly through clientele effects. Bank loans are used by euro area banks both as central bank collateral for short-term liquidity insurance purposes and for longer-term funding purposes for issuing covered bonds or asset-backed securities. See in detail F. Koulischer and P. Van Roy, (2017), Using Bank Loans as Collateral in Europe: The Role of Liquidity and Funding Purposes, NBB Working Paper Nr. 318, April. 478  See in detail on all these matters: ESRB, (2017), The Macroprudential Use of Margins and Haircuts, February, Frankfurt am Main, February. The implementation of macroprudential tools for margins and haircuts also raises practical challenges and further empirical and conceptual analysis is needed with a view to improving existing legislation and filling the knowledge gap to better assess choices between different regulatory and policy instruments. 477

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Perfect collateral is scarce. Cash seems the only perfect collateral in the sense that it provides simultaneous counterparty credit risk protection and derivatives funding. Securities are imperfect collateral due to collateral segregation or differences in CSA and repo haircuts. Additionally, the collateral rate term structure is not observable in the repo market.479 Ultimately, there is a wide variety of quantitative implications on the reuse of collateral including financial market leverage, volatility and overall welfare dynamics. The ability to reuse yields the benefit of covering more transactions with the same pool of assets. That implies that reuse directly magnifies leverage and volatility in markets. When limiting reuse, the opposite effect can be observed—that is, limiting reuse decreases volatility.480 However, the impact of such a decrease on welfare is non-linear. Welfare increase occurs only in case the reuse leads to a situation where market participants are able to share risks more effectively. Limiting, but not banning, seems to be the better option, which is what essentially indirectly occurs when applying haircuts.481 That is a necessity as the heterogeneity of market participants’ beliefs (and risk aversion) triggers the build of leverage beyond what is optimally needed to share risks.482 There are more reasons why that is a good idea. Collateral needs balance sheet space to move within the financial sector. The recent legislation in this field constrains private sector bank balance sheets and therefore impedes collateral flows. That then has an impact on monetary policy transmission, the f­unctioning of money markets and market liquidity. When analyzing this, most literature has focused on the repo market and the tension of central banks to provide balance sheet space. Singh, however, analyzed in this context the role of securities lending, derivatives and prime brokerage markets as suppliers of collateral. He further highlights the incentives created by new regulations for different suppliers of collateral.483

 L. Wujiang, (2017), Discounting with Imperfect Collateral, Working Paper, June 11, mimeo.  Or the other way around: the ability of agents to reuse frees up collateral that can be used to back more transactions. Reuse thus contributes to the buildup of leverage and significantly increases volatility in financial markets. When introducing limits on reuse, Brumm et al. find that volatility is strictly decreasing as these limits become tighter, yet the impact on welfare is non-monotone. Allowing for some reuse can improve welfare as it enables agents to share risk more effectively. Allowing reuse beyond intermediate levels, however, can lead to excessive leverage and lower welfare. So they provide a rationale for limiting, yet not banning, reuse in financial markets. See in detail: J.  Brumm et  al., (2019), Re-Use of Collateral: Leverage. Volatility and Welfare, ECB Working Paper Nr. 2218, December 19. 481  See for the current state of affairs: Autorité des marchés financiers (AFM), (2016), The Re-Use of Assets. Regulatory and Economic Issues, Working Paper, November 9; P. Gottardi et al., (2017), A Theory of Repurchase Agreements, Collateral Re-Use, and Repo Intermediation, European University Department of Economic Working Papers Nr. 2017–03, March; EC, (2017), REPORT FROM THE COMMISSION TO THE EUROPEAN PARLIAMENT AND THE COUNCIL under Article 29(3) of Regulation (EU) 2015/2365 of 25 November 2015 on transparency of securities financing transactions and of reuse and amending Regulation (EU) No 648/2012, COM (2017) 604 final, October 19. The latter is part of a permanent monitoring effort by the European authorities. 482  J. Brumm et al., (2017), Re-Use of Collateral: Leverage, Volatility and Welfare, Swiss Finance Institute Research Paper Series Nr. 17–04, February 6, pp. 22–25. 483  M.  Singh, (2017), Collateral Reuse and Balance Sheet Space, IMF Working paper Nr. WP/17/113, pp. 16–20. See also in extenso: M. Singh, (2016), Collateral and Financial Plumbing, 2nd edition, Risk books, London, UK. 479 480

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The consequence is that in the new regulatory framework banks will (try to): ‘(1) maximize profits per unit of balance sheet space and thus act as “net” risk transfer (e.g., derivative margins, and certain prime brokerage positions) will be preferred by banks relative to “gross” flows (e.g., repos, and in some cases securities-lending); and (2) seek to limit the central bank footprint in the plumbing by not providing balance sheet space in an ad hoc manner. Improved functioning of the collateral market will likely bring benefits in monetary policy transmission, money market signals, and market liquidity.’484 Cross-border financial flows arise when countries differ in their abilities to use assets as collateral. Financial integration between countries and economies is a way of sharing scarce collateral. Leveraging on and tranching assets might be an interesting proposition for foreign investors. Ultimately, foreign demand for collateral and collateral-based financial promises increase the collateral value of domestic assets. Cheap foreign assets could generate attractive returns to investors who do not command collateral to issue promises. But, global capital flows respond to these fundamentals in a dynamic way and by doing so export and amplify financial volatility.485 These flows arise as a way for countries to share scarce collateral and to trade contingent claims, including safe and negative beta assets.486 Securitization has become the preferred platform to generate those assets and

 Ibid., p. 24.  See A. Fostel et al., (2017), Global Collateral: How Financial Innovation Drives Capital Flows and Increases Financial Instability, University of Virginia Working Paper, February, mimeo. The other way around works as well. Collateral has a role in managing innovation. See Y. Mao, (2017), Managing Innovation: the Role of Collateral, Working Paper, mimeo. Mao derives three conclusions from the analysis conducted: ‘(1) an increase in collateral value leads to more patent filings, especially in industries different from the parent firm, with each patent receiving higher citations on average, (2) in response to collateral shocks, firms restructure their innovation strategies through multiple channels, including internal research and development (R&D), the acquisition of innovative targets, and corporation venture capital (CVC) investment—equity investment in start-ups by incumbent firms, and (3) the effect of collateral shocks on innovation is more pronounced for firms that are ex ante credit constrained but is mitigated if firms are located in metropolitan statistical area (MSA) areas with high local real estate price volatility.’ 486  It can be referred to the specific section about ‘safe assets’. Negative beta assets are safe assets that ‘tend to increase in value in bad states of the world. For example, long-maturity bonds increase in price in bad states because long-term interest rates decline, even as the face value of the promised payoffs remain the same’ (p. 4). Overall, their policy recommendation is in line with mine (see the Pigovian chapter) of the relevance of capital controls (as a Pigovian model) but add to the understanding that ‘while there are benefits to accessing foreign financial markets, even for developed economies these benefits may come at the cost of importing financial volatility. Thus, while others have pointed out the trade-offs for emerging economies, we show that there may also be relevant trade-offs for mature economies’ (p. 40). Also see A. Fostel and J. Geanakoplos, (2016), Financial Innovation, Collateral, and Investment, American Economic Journal: Macroeconomics, Vol. 8, pp.  242–284; F.  Gong and G.  Phelan, (2016), Debt Collateralization, Capital Structure, and Maximal Leverage, Working Paper, Williams College, mimeo; G.  Phelan, (2016), Financial Intermediation, Leverage, and Macroeconomic Instability, American Economic Journal: Macroeconomics, Vol. 8, pp.  199–224. Also Singh and Goel report that the use of long-dated securities as collateral for short tenors—for example, in securities lending and repo markets, and prime brokerage funding—impacts the risk premia (or moneyness) along the yield curve, also implies that short-term market rates are effectively determined in the pledged collateral market, 484 485

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trade them internationally.487 Within the context of new regulation collateral has also found a new role for itself: as a medium for lender (mis)coordination. That is ‘when the liquidation of collateral (or declining to roll over a loan) before the completion of an investment project is inefficient, greater collateral exacerbates the coordination failure and helps trigger the run, i.e., excessively strict collateral requirements raise the risk of a coordination failure among lenders and a premature termination of the loan’.488 Or in other words: the amount of collateral (in a certain transaction or market [segment]) has a destabilizing feedback effect by increasing the likelihood of a run. Because of that, ‘lenders tend to be patient when deciding on the amount of collateral: when choosing a high level collateral, lenders must balance the potential for better recovery489 should the borrower default with their increased likelihood of prematurely abandoning the project’.490 Although Auh and Yun particularly looked at the repo market, their findings are generally applicable. The risk that insuring against a future ­downside can create time-inconsistency problems (e.g. a premature run) once misfortune (e.g. borrower default) occurs is applicable to a wide variety of financial contracting circumstances.491

where banks and other financial institutions exchange collateral (such as bonds and equities) for money. See M. Singh and R. Goel, (2019), Pledged Collateral Market’s Role in Transmission to Short-Term Market Rates, IMF Working Paper Nr. WP/19/106, May. 487  G. Phelan and A.A. Toda, (2016), Securitized Markets, International Capital Flows, and Global Welfare, Working Paper, mimeo. 488  J.K. Auh and H. Yun, (2017), The Full Story of Runs, Working Paper, April, mimeo, p. 4. 489  H. Degryse et al., (2019), How Do Laws and Institutions Affect Recovery Rates on Collateral? Working Paper, April 22, mimeo. 490  J.K.  Auh and H.  Yun, (2017), ibid., p.  29. See further on the topic: C.W.  Calomiris, et  al., (2017), How Collateral Laws Shape Lending and Sectoral Activity, Journal of Financial Economics, Vol. 123, pp. 163–188; M. Campello and M. Larrain, (2016), Enlarging the Contracting Space: Collateral Menus, Access to Credit, and Economic Activity, Review of Financial Studies, Vol. 29, pp. 349–383; G. Gorton and G. Ordoñez, (2014), Collateral Crises, American Economic Review Vol. 104, pp. 343–378; Z. He and A. Manela, (2016), Information Acquisition in Rumor-Based Bank Runs, Journal of Finance, Vol. 71, pp. 1113–1158. 491  Ibid., p. 29.

2 Shadow Banking Around the Globe

2.1 Introduction It has become clear by now that regulating, in case that would be the preferred option, the shadow banking sector is more a challenging task. Indeed, regulating a moving target has its profound challenges. The shadow banking sector of 2019 is a totally different one than the one in 2007/2008 when we entered the financial crisis. Also, the spectrum of opinion on the matter indicates it is a multifocal issue that can be approached as a way to ‘marketbased financing’ that can help us get credit intermediation going again in many countries to those that focus more on the macroprudential risks that are naturally embedded in using unregulated vehicles and categories of entities that engage in large-scale credit intermediation. The issue the latter sees is that those shadow banking entities have no proprietary backstop or, put differently, they have no other backstop than the central bank or the taxpayer. The focus taken will also define the approach toward what regulation is needed for the traditional banking sector.1 Both segments relate to each other as communicating vessels. It is fair to say that the regulator, pundits and so on have been focusing too much on what we know about the stock markets and its functioning and apply it to the debt markets2 when creating regulation. I will flesh out that position a bit further in the next section.

 S.  Samuels, (2015), Withering Regulation Will Make for Shrivelled Banks, Financial Times, January 13. 2  B.  Holstrom, (2015), Understanding the Role of Debt in the Financial System, BIS Working Paper Nr. 479. 1

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The time that shadow banking will go away as a point of contention is not anywhere soon. Especially not now that the shadow banking industry globally is nearing its precrisis3 peak4 and the road to simplification of financial products and the global financial infrastructure5 is a slippery slope full of chicanes with little progress so far. The risks embedded in this is that, despite the fact that shadow banking means many different things in different jurisdictions globally, some of the key drivers are common across the shadow banking market in both advanced and emerging market economies. It is very likely that the shadow banking market in both developed and developing economies will continue to grow both as a result of stricter regulation on banks and their balance sheet repair efforts and the protracted low interest rate environment. That in itself doesn’t mean that the systemic risk and parameters are going to be the type of activities of the shadow banking market that will consistently be the same (or similar) over time. Operating in a changing paradigm will require going forward by monitoring using various indicators, preferably simultaneously, to assess different types of risks and developments including the migration of risk types as the composition of activities in the various shadow banking jurisdictions and subsegments changes over time. Part of that analysis needs to be involved in an analysis of the driver of growth of the shadow banking market. Or, to be specific, ‘shadow banking tends to take off when strict banking regulations are in place, when real interest rates and yield spreads are low and investors search for higher returns, and when there is a large institutional demand for assets, for example from insurance companies and pension funds.’6 While judging those parameters against the current environment, there is enough reason to believe that the growth patterns experienced in recent years will continue in the years to come. In particular, given the avalanche of additional legislation, this is to be expected, as well as given the fact that the effect of the implementation of Basel III which will continue until 2019 and which will have incremental lasting effects in the run-up to 2019 and most likely thereafter as well. Policy implementation globally will be a challenging task, in particular to reflect the different dynamics and shadow banking markets in the different jurisdictions while maintaining some consistency in macroprudential terms on a global scale. It must be well understood that in developing economies, with often-shallow financial markets, the shadow banking market can contribute to access to credit in situations where the traditional banking sector due to regulatory and capacity constraints7 cannot provide that service. But also in developed markets (the US, euro area, etc.), part of the shadow banking sector can be credited with providing long-term credit to the private sector in an environment where the traditional banking sector has been withdrawing from certain fields of the credit market. Shadow banking also has the potential to improve the efficiency of the financial system by deepening liquidity and risk sharing in the market.

 Referring here to the 2007/2008 crisis for those confused about how many crises we have had in the last half a decade. 4  S. Fleming, (2014), Shadow Banking Nears Pre-crisis Peak, Financial Times, October 30. 5  S. Das, (2015), Risks Lure in Failure to Simplify Finance, Financial Times, January 8. 6  FSB, (2014), Global Shadow Banking Monitoring Report, p. 38. 7  For example, ‘restriction on lending or deposit rates’. 3

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2.2 A  ssessing Risks in the Shadow Banking Industry Although risk in itself is a subjective measure, from a macroprudential perspective there is a need to ‘objectivize’ the measurement of risk. That requires balance sheet metrics and data sets with a sufficient level of granularity. Although continuously prone to refinement and improvement, the set of metrics seems to carry consensus. These involve maturity and liquidity transformation risk, leverage, credit risk, and interconnectedness. Also new forms of shadow banking activities like peer-to-peer lending display large quantitative gaps. In particular, systemic risks pose their problems regarding quantification. These risks can be partly derived from the asset price data available. The contribution of shadow banking assets to systemic risk has been growing since the financial crisis and accounts in the US for one-third of total systemic risk in the market.8 In the UK and the eurozone, this risk contribution to the financial sector is materially lower, since these financial markets are more bank-­based financial systems. In order to facilitate that, the Financial Stability Board (FSB) has introduced the already discussed five economic functions and activity criteria. Key to going forward now will be to integrate the entity and activity dimensions of shadow banking and its implications for appropriate regulation, also taking into account the risk for cross-border regulatory arbitrage. It will further embed regulatory action reflecting the drivers of the growth of the shadow banking market which includes (1) term- and interest rate spreads, (2) real gross domestic product (GDP) growth, (3) capital constraints in the traditional banking sector, (4) bank institutional growth and (5) institutional investor growth. The International Monetary Fund (IMF)9 more recently developed a shadow banking risk matrix. It should be observed that the definition of shadow banking is directly linked to the risk dimensions it captures/should capture.10 One could argue that the following risk dimensions will occur regardless of the definition used: • The risk of ‘runs’: Through credit intermediation the shadow banking (SB) entities induce bank-like sources of risk including runs; credit exposures on the asset side combined with high leverage on the liability side; and liquidity and maturity mismatches between assets and liabilities. The fact that these risks tend to occur faster and in a more magnified way in the shadow banking markets is due to the already i­ ndicated ‘absence’ of an official liquidity backstop and are not subject to prudential supervision.11

 FSB, (2014), Global Shadow Banking Monitoring Report, p. 39.  See in detail: IMF, (2014), Global Financial Stability Report (October). Risk Taking, Liquidity and Shadow Banking. Curbing Excess While Promoting Growth, World Economic and Financial Surveys; chapter 2, Shadow Banking Around the Globe: How Large and How Risky?, pp. 65–105 but in particular pp. 81–86. 10  For an illustration of the operations of the traditional versus shadow banking market, see IMF, Global Financial Stability Report, Figure 2.3, p. 69. 11  See extensively o.a. T. Adrian, (2014), Financial Stability Policies for Shadow Banking, FRBNY Staff Reports Nr. 664, Federal Reserve Bank of New York. 8 9

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• Agency issue: The disaggregation of financial intermediation activities across multiple institutions (and therefore across multiple balance sheets) tends to be a hotbed for a wide variety of agency-related issues.12 • Opacity and complexity: These characteristics lead to, in situations of distress, herding behavior and a joint flight to quality and transparency.13 • Leverage and procyclicality: A combination of high asset prices and low margins on secured financing, the shadow banking market facilitates high levels of leverage for other market agents. Distress will cause the value of, for example, collateral to dislocate and consequently margins will increase, leading to the contagion effect of deleveraging and spiraling margins.14 • Spillovers: The contagion effect works through existing (ownership) linkages and facilitates spillover effects in case of a flight to quality, fire sales or event-driven runs.15 • Asset bubble creation: ‘[i]n good times, shadow banks also may contribute substantially to asset price bubbles because, as less regulated entities, they are more able to engage in highly leveraged or otherwise risky financial activities.’16

2.3 T  he Role of Debt and Information Insensitivity in Our Contemporary Financial System Much has been said about the increasing indebtedness of the private and public sectors in many countries of the world and what the causes are. It is all the more surprising then that in our policy responses regulators seem to ignore the specifics of debt in our contemporary financial system. What often happens is that the experiences with the stock market are transposed to the debt market. However, stock markets are fundamentally different than debt or money markets. We have known, over time, from the stock market that they are about price discovery with a view toward allocating risk efficiently. That makes sense, as the stock market is about allocating capital to well-performing companies and less to non- or underperforming companies. Whether that is optimally achieved in our current markets with passive products accounting for more than half of the volume is questionable but not relevant here. Money or debt markets on the other hand are about

 See in detail: T. Adrian, et al., (2013), Shadow Bank Monitoring, FRBNY Staff Report Nr. 638, Federal Reserve Bank of New York. 13  R. Caballero and A. Simsek, (2009), Complexity and Financial Panics, NBER Working Paper Nr. 14,997, National Bureau of Economic Research, Cambridge, Massachusetts. 14  M. Brunnermeier and L. H. Pedersen, (2009), Market Liquidity and Funding Liquidity, Review of Financial Studies, Vol. 2, issue 6, pp. 2201–2238. See also the discussion regarding the risks involved in securities lending and repos elsewhere in the book. See extensively: FSB, (2013), Policy Framework for Addressing Shadow Banking Risks in Securities Lending and Repos. 15  See in detail and for illustrations: IMF, (2014), Global Financial Stability Report, pp. 60–61. 16  Z. Pozsar et al., (2013), Shadow Banking, Economic Policy Review, Vol. 19, Issue 2, pp. 1–16. 12

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c­ reditworthiness and managing the cost of lending. Or, to be precise, it is about ‘­obviating the need for price discovery using over-collateralised debt to reduce the cost of lending’.17 Since the logic is different, the policy response should be as well. Holmström provides a view toward the information insensitivity of debt caused by the structure of debt contracts. It is this essential feature that helps Holmström explain why ‘opacity often enhances liquidity in credit markets and therefore why all financial panics involve debt’. It also explains, or could help explain, why so much of the trading in opaque securities in recent decades occurred on very little or no information. The understanding of this will have material impact when constructing regulation regarding transparency, capital buffers and related regulation.18 In contrast to stock markets, the role of debt markets is to provide liquidity for economic agents. The cheapest way to do so is to use ‘over-collateralised debt that obviates the need for price discovery’.19 That functional difference has created two entirely different systems in which the differences go beyond the features of price discovery, but also has implications at the level volumes, transparency, risk sharing and information (in)sensitivity.20 The central thesis that Holmström brings forward is that liquidity in the debt markets doesn’t require (incremental) transparency. On the contrary, he claims that ‘what is required for liquidity is symmetric information about the payoff of the security that is being traded so that adverse selection does not impair the market. Without symmetric information adverse selection may prevent trade from taking place or in other ways impair the market. Trading in debt that is sufficiently over-collateralised is a cheap way to avoid adverse selection. When both parties know that there is enough collateral, more precise private information about the collateral becomes irrelevant and will not impair liquidity.’21 Thus, when none of the parties involved in a debt transaction has an informational advantage, the market will be free of fears of adverse selection and therefore liquid.22 Incremental public information can make private information relevant as some traders

 See in detail: B. Holmström, (2015), Understanding the Role of Debt in the Financial System, BIS Working Paper Nr. 479. 18  See a contrario: R. Gilson and R. Kraakman, (2014), Market Efficiency After the Financial Crisis: It’s Still a Matter of Information Costs, Virginia Law Review, Vol. 100, Issue 2, pp. 313–375. They advocate that transparency requires market discipline and provide a warning indicator about impending buildup of systemic risk. 19  B. Holmström, (2015), ibid., p. 3. He advocates his case by going back to the origins of the debt markets, that is, the Chinese pawnshops during the Tang Dynasty (pp. 3–4). 20  See in detail B. Holmström, (2015), ibid., pp. 4–7. To be precise: ‘risk-sharing versus liquidity/ funding provision, price discovery versus no price discovery, information-sensitive versus insensitive, transparent versus opaque, large versus small investments in information, anonymous versus bilateral, small unit trades versus large unit trades and collateralized versus unsecured’ (pp. 7 and 35). Each of these elements makes the debt/stock market two coherent but separate systems that are carefully designed. 21  B. Holmström, (2015), ibid., p. 5. 22  Holmström makes a comparison with the initial Chinese pawnshop situation: ‘[i]t did not matter that the pawnbroker’s valuation of the watch was different from the borrower’s. It sufficed that the pawn broker felt confident that he could recover the loan by selling the watch, while the borrower was protected by the right to redeem the watch’ (p. 5). 17

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will interpret publicly released information better or differently than others.23 (Precise) price discovery should therefore not be the central objective (and is also not possible) of regulation as it is a costly bilateral setting that takes time and will reduce liquidity in the debt market. The absence of a formal process of price discovery is also one of the prime reasons why debt is cheap or, put differently, ‘debt is an optimal contract for funding an investment, precisely because debt minimizes the cost of price discovery’.24 That situation can be offset with the more costly situation once that holistic system is broken (e.g. in case of a debt default or failure of a repo). The additional questions that then come up delay the increasingly costly process. How does the value of the debt fare when new information comes to the market and what is the role (if any) of private information ­coming to the market. The moment debt is nearing the default moment, the debt becomes information sensitive.25 The precise measure that captures the information sensitivity of debt to information acquisition equals the expected savings to the buyer from avoiding a lossmaking purchase if she acquires information known as the ‘Information Acquisition Sensitivity (IAS)’.26 The implication of the study of Dang et al. is that debt is the best collateral as it is the least sensitive to public information as its value varies less than any other contract with the same initial expected value. It is therefore optimal to use debt (or debt-on-debt) as collateral to insure against future liquidity shocks.27 Debt then also becomes the best possible collateral in the discussed shadow banking system, at least assuming that assets in the transaction are equally sensitive to public information. That also helps explaining why banks hold ‘assets that have the lowest sensitivity to public information, which includes debt without traded equity such as mortgages, and they should issue debt on the liability side, because such liabilities will be least likely to trigger information acquisition’.28 Purposeful and intentional opacity and information-­sparse by design could be a good

 See for an application in the case of securitization: M. Pagano and P. Volpin, (2012), Securitization, Transparency and Liquidity, Review of Financial Studies, Vol. 25, Issue 8, pp. 2417–2453. 24  The much-acclaimed Costly State Verification (CSV) model developed decades ago supports this finding. They argue that default can usefully be thought of as contingent price discovery. See in detail: D. Gale and M. Hellwig, (1985), Incentive Compatible Debt Contracts: The One-Period Problem, Review of Economic Studies, Vol. 52, Issue 4, pp.  647–663; R.  Townsend, (1979), Optimal Contracts and Competitive Markets with Costly State Verification, Journal of Economic Theory, Vol. 21, pp. 265–293. 25  The model built around that understanding can be found with: T.V.  Dang et  al., (2012), Ignorance, Debt and the Financial Crisis, mimeo, Yale University. Their main finding is that lessrisky collateral makes debt less information-sensitive. 26  ‘If IAS is larger than the cost of information acquisition, the buyer will acquire information; if IAS is smaller the cost of information acquisition, she will refrain from acquiring information’ (Holmström, [2015], ibid., p.  10). For a discussion on how the IAS changes as the underlying parameters change, see Holmström, (2015), ibid., pp. 10–12. 27  See also: P. DeMarzo P, et al., (2005), Bidding with Securities: Auctions and Security Design, American Economic Review, Vol. 95, Issue 4, pp. 936–958. 28  Holmström, (2015), ibid., p. 12. Banks should therefore hold (or would benefit most from) lowrisk assets and secrecy tends to be beneficial in banking relations. See in detail: T.V. Dang et al., (2014), Banks as Secret Keepers, mimeo, Yale University and R. Breton, (2007), Monitoring and the Acceptability of Money, mimeo, Centre national de la recherche scientifique. 23

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description of the contemporary debt markets29 and has the potential to be socially v­ aluable.30 That position can be derived from the fact that the liquidity provision (also to deposit holders) is a form of insurance and that public information destroys insurance opportunities.31 But all the listed items that make sense in good times and support liquid markets push risk into the tail, in particular when collateral gets impaired and the prevailing trust is broken. Regardless of the tragic consequences of the panic events, runs and spillover effects support the informational position taken, that is, information-insensitive debt becomes information-sensitive debt. The consequence is that investors will start looking for additional information, which cannot be done swiftly enough (as there is no price discovery system in the debt markets), to overcome herding behavior, around the same information, with the well-known consequences. The intensity of those panics illustrates how much the debt markets and its presumed liquidity rely on overcollateralization and trust rather than a precise evaluation of values.32 At that point in time, private information becomes relevant, breaking the symmetric ignorance. Panics and distress can therefore qualify as information events.33 During such distress, many aspects interact34 (contagion, fire sales, domino effects, interconnectedness, etc.) and it seems impossible to disentangle what drives what in such scenarios.35 The question then arises to what effect more transparency (i.e. informational efficiency) would have helped to contain contagion. That could be done through trading of credit default swaps (CDSs) on and/or the ABX index. In such a market, traders could have betted both ways and where the market would have found the price of systemic risk. The evidence as presented36 shows that the CDS market didn’t really contribute to forecasting systemic risk.

 See for why transparency could have negative effects in the (shadow) banking sector: Holmström, (2015), ibid., pp.  13–15. Those could include ‘preventing adverse selection’ and ‘alleviating the winner’s curse’ and why purposeful opacity can enhance liquidity: (1) opacity provides the time to adjust to fluctuations in daily net asset value (NAV); (2) coarseness of bond ratings makes approximately equal collateral look equal (‘commonality reduces adverse selection’) in the eyes of investors; and (3) money markets are symmetrically ignorant providing stability. 30  See for a wide variety of research on this matter as listed by Holmström, (2015), ibid., p. 13. 31  See for the initial position: J. Hirshleifer, (1971), The Private and Social Cost of Information and the Reward to Inventive Activity, American Economic Review, Vol. 61, Issue 4, pp. 561–574. 32  G. Gorton and G. Ordonez, (2014), Collateral Crises, American Economic Review, Vol. 104, issue 2, pp. 343–378. 33  See for evidence of that position: W. Perraudin and S. Wu, (2008), Determinants of Asset-Backed Security Prices in Crisis Periods, Research Paper, Nr. 8/3, RiskControl, London. They demonstrate that during panics significant new public information caused beliefs to diverge rather than converge to a common, lower price level. 34  See: D.  Covitz, (2013), The Evolution of a Financial Crisis: Collapse of the Asset-Backed Commercial Paper Market, Journal of Finance, Vol. 68, Issue 3, pp. 815–848, and M. Brunnermeier, (2009), Deciphering the Liquidity and Credit Crunch 2007–08, Journal of Economic Perspectives, Vol. 23, Issue 1, pp. 77–100. 35  See in case of the repo market: A. Martin et al., (2014), Repo runs, Journal of Finance, Vol. 69, Issue 6, pp. 2343–2380. 36  Holmström, (2015), ibid., pp. 17–19. 29

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2.4 D  ebt Markets and the Shadow Banking Industry As elaborated on before, the shadow banking sector has witnessed remarkable growth in recent decades to now account for about 60% of the financial intermediation sector. It has been accused of causing the financial sector. I refrain from such statements and am more interested in the questions that would help us understand why the market was interested in difficult to understand, highly complex opaque products that as such added very ‘little real economy benefits’. Part of this had to do with the fact that in the period 1980–2010 savings from emerging economies had been flowing into the West and in particular the US, and considered safe. Given the highly sophisticated ‘securitization’ framework in the US, it provided a scalable environment that could make better use of collateral.37 At least compared to the traditional banking sector that kept mortgages on the banks’ books until maturity and where the funding base was deposits. Or, as Holmström indicates, ‘[i]t (“securitization”) was designed to manufacture, aggregate and move large amounts of high-quality collateral long distances to reach distant, sizable pools of funds, including funds from abroad.’38 The shadow system, from that perspective, was a kind of temporary parking lot for foreign money coming into the US. The US also held at that point a lot of raw material to produce large amounts of AAA-rated securities, that is, real estate, preferably of the kind that was debt-free or underleveraged. That raw material worked its way, as discussed earlier in this book, through the (lengthy) transportation and intermediation chain39 sliced and diced in debt tranches whereby collateral was used in a contingent way. That contingent use of capital is and was seen as being more efficient than just keeping those mortgages on the balance sheet of the originating banks. It needs to be observed and acknowledged that there is only now an emerging body of research that models the role of collateral and the behavior of collateral under various market conditions.40 Collateral earns a liquidity premium in case there is a shortage of safe private assets. In an equilibrium model, the aggregate volume of collateral repositions when uncertainty unfolds. Holmström indicates: ‘moreover, when there is a serious enough shortage of collateral, the government will find it optimal to alleviate the situation by supplying collateral that is backed up by taxpayer money. This is more efficient

 See in detail: R. Caballero, (2009), The other Imbalance and the Financial Crisis, Pablo Baffi Lecture, and R. Caballero et al., (2008), An Equilibrium Model of Global Imbalances and Low Interest Rates, American Economic Review, Vol. 98, Issue 1, pp. 358–393. 38  Holmström, (2015), ibid., p. 20. 39  See in detail: A. Krishnamurthy, et al., (2014), Sizing up repo, Journal of Finance, Vol. 69, issue 6, pp. 2381–2417, and A. Copeland et al., (2014), Repo Runs: Evidence from the Tri-Party Repo Market, Staff Report, Nr. 506, Federal Reserve Bank of New York. 40  See in detail: J.  Geanakoplos, (2010), The Leverage Cycle, in D.  Acemoglu, K.  Rogoff and M.  Woodford (eds.), NBER Macroeconomics Annual 2009, National Bureau of Economic Research; A.  Rampini and S.  Viswanathan (2010), Collateral, Risk Management and the Distribution of Debt Capacity, Journal of Finance, Vol. 65, pp. 2293–2322; and B. Holmström and J. Tirole, (2011), Inside and Outside Liquidity, MIT Press, Cambridge, MA. 37

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than having the private sector invest in safe assets to cover exceptional severe shortages. The advantage of the government is that it can act ex post, when it is clear that such a shortage is at hand. No funds are tied up in advance.’41 The rise of the shadow banking market can from that (theoretical) perspective perfectly be explained. In essence, it was a market response to a rising demand for safe assets. Compared to the traditional banking sector, it had advanced the situation by making collateral contingent and make it circle faster, and by doing so it attracted globally more capital and securitization produced seemingly just that, that is, safe assets. Holmström comments: ‘when the crisis hit, bailouts by the government, which many decry, were inevitable…. [T]he theory supports the view that bailouts were efficient even as an ex ante policy (if one ignores potential moral hazard problems). Exchanging impaired collateral for high-quality government collateral, as has happened in the current crisis, can be rationalised on these grounds.’42 Although ‘theoretically’ correct from a policy point of view, it can be questioned as to whether it is the equilibrium mode; even when catering to effective demand, it was argued elsewhere that the securitization mechanism is imperfect and leaves tail risk behind in the system which cannot be absorbed by the shadow banking system itself, as often the entities involved are not sufficiently capitalized. This besides the fact that the multi-balance sheet transactions have been leading to opacity that directly fueled contagion risk and spillovers of various natures, as discussed before and further in the book. In an information-insensitive debt that falls into the hands of a crisis and becomes information-sensitive, a return to normal (end of the crisis) implies a return of confidence. That equals a return to ‘a no-questions asked environment’ or return of the ‘information-insensitivity of the debt market’. A sufficient recapitalization does seem to be the most appropriate answer, at least if accompanied with transparency that allows investors to be assured that certain defaults can be straightened out. The US seemed to have fared better in doing so. Draghi’s comment ‘I will do whatever it takes’ can be seen as opaque (no precise information was given for a long time) and has managed to keep the markets calm in the symmetrically ignorant debt market, at least until early 2015 when persistent deflation threats combined with continued dismal economic growth forced him to engage in quantitative easing (QE) activities of an unparalleled size. Although we can adequately assess (or at least somewhat) the responses ex post of the start of the crisis, it remains somewhat troublesome how to regulate the shadow banking market in a way that stabilizes the system ex ante. The CDS market offers no help or hope, at least when looking for ex ante indicators. Transparency also doesn’t seem to directly contribute to solving the real problem and so is relying on market discipline and price discovery. Transparency can lead to market discipline but also has material downsides.43

 Holmström, (2015), ibid., p. 22.  Holmström, (2015), ibid., p. 22. 43  I. Goldstein and H. Sapra, (2013), Should Banks’ Stress Tests Be Disclosed? An Analysis of the Costs and Benefits, mimeo, The Wharton School, University of Pennsylvania; T.  Schuermann, (2014), Stress Testing Banks, International Journal of Forecasting, Vol. 30, Issue 3, pp. 717–728. 41 42

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2.5 K  eeping the Boon and Banning the Bane in Shadow Banking The financialization of our economies and societies has led to a situation that can be described as a new sort of global imbalance where there is not enough risk taking (in support of growth), but material or elevated levels or excesses of financial risk taking44 that in itself could pose material challenges to the stability of the global infrastructure. Admittedly, new financial regulation has pushed risk levels into the shadow banking sector and unconventional monetary policy has pushed asset prices across a range of assets to elevated levels and whereby credit spreads have effectively become too narrow to compensate for default risk (in some segments of the credit market). Obviously, promoting economic risk taking by improving the transmission of monetary policy to the real economy is a meaningful objective. And also addressing financial excesses through better micro- and macroprudential policies (see infra). But starting with the traditional banking sector, it was concluded that many banks (40% globally, 70% in eurozone) are not equipped to optimally provide credit to the market in a way that fosters growth. To do so, a more fundamental overhaul of these banking models is needed which invariably would include ‘a combination of repricing existing business lines, reallocating capital across activities, consolidation, or retrenchment’.45 Indeed, doing okay as a bank doesn’t put you in a position to actively promote growth; athletic fitness is required to do that. This suboptimal fitness has pushed a lot of the credit asset flow in the direction of shadow banking entities, often under the illusion of constant liquidity. It is only when bank credit reaches the market that the economic risk-taking process can start. But as indicated, the credit intermediation process is broken, as the focus has shifted to financial risk taking rather than managing economic risk. The boon is that shadow banking can and does complement the traditional banking sector by expanding access to credit or by supporting market liquidity, maturity transformation and risk sharing. For example, in developing economies, finance companies and microcredit lenders often provide credit and investments to underbanked communities, subprime customers and low-­rated firms,46 while in developed economies the SB system enhances the ­efficiency of the financial sector by enabling better risk sharing and maturity transformation and by deepening market liquidity.47 On the other hand, and given the above-discussed risk profiles, it needs to be observed that, given the illustrated wide set of entities involved, ‘systemic risk’ and ‘regulatory arbitrage’ require a wide net to include a vast amount and heterogeneously constructed

 See J. Viñals, (2014), The New Global Imbalance: Too Much Financial Risk-Taking, Not Enough Economic Risk-Taking, IMFdirect, October 8. 45  J. Viñals, (2014), ibid. 46  S. Ghosh et al., (2012), Chasing the Shadows: How Significant Is Shadow Banking in Emerging Markets? Economic Premise, World Bank Note Series, Vol. 88, pp. 1–7. 47  S. Claessens et al., (2012), Shadow Banking: Economics and Policy, IMF Staff Discussion Note SDN/12/12, International Monetary Fund, Washington. 44

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pool of shadow banking assets. The implication is that risk profiles and characteristics can differ even across similar activities as they will behave based differently on the countryand regulatory context. As already indicated in the introductory chapter, different measures exist regarding the shadow banking market and each adds a shade of gray to the measurement pallet. Structurally, there are three types of measurement protocols: (1) based on the flow of funds which capture the financial assets of other financial intermediaries (OFIs); (2) based on the flow of funds captured and sectoral accounts, which is the methodology used by the FSB (both broad and narrow measures); and (3) through measuring the size of ‘non-core liabilities’. It includes noncore liabilities both from banks and from ‘other financial corporations’.48 The prime aspect that distinguishes methods 1 and 3 from method 2 is the exclusion of non-money market funds (non-MMFs). This difference is due to the fact that in non-MMFs the actual capital risk is with the underlying investors.49 Nevertheless, the FSB includes them in their measurement. More recently, the concern has been ventilated that these funds can be exposed to bank-like risks issuing money-like liabilities and can be vulnerable to runs especially when holding illiquid assets and facing easy redemptions. These can lead to fire sales elsewhere in the system and can be magnified through leverage or concentration of assets in portfolios and will lead to enhanced levels of market volatility.50 In the current climate, market and liquidity risk51 has increased significantly. What is particularly concerning is that financial markets have rallied, due to a large degree being supported by unconventional monetary measures, and have as such disconnected their performance from that of the real economy. The consequence is that asset prices for most categories are elevated beyond their historical bandwidths,52 which is historically rare especially when combining with abnormally low risk premiums.

 The two most dominant reports regarding this measure are (and which are discussed elsewhere, although in different parts of the book): (1) H. S. Shin, (2010), Macro-Prudential Policies Beyond Basel III, Policy Memo, Princeton University, Princeton, New Jersey, and (2) A. Harutyunyan et al., (2015), Shedding Light on Shadow Banking, IMF Working Paper, Nr. WP/15/1, International Monetary Fund, Washington. See also: IMF, (2014), Global Liquidity  – Key Aspects for Surveillance, IMF Policy Paper, Washington, March. ‘A narrow measure of noncore liabilities excludes those confined to the financial sector; it is thus a proxy for the intermediation between ultimate lenders and ultimate borrowers—that is, between the financial sector and the real economy. The difference between the broad and narrow measures represents an estimate of the amount of credit intermediation conducted within the shadow banking sector’ (IMF, [2014], Global Financial Stability Report, ibid., October, pp. 72–73). The different measurements yield different results as can be compared through table 2.1 (p. 73). 49  The other methods therefore exclude them as well as some other studies: for example, K. BakkSimon et al., (2012), Shadow Banking in the Euro Area: An Overview, ECB Occasional Paper, Nr. 133, European Central Bank, Frankfurt and T. Adrian, (2012), Shadow Banking: A Review of the Literature, FRBNY Staff Report Nr. 580, Federal Reserve Bank of New York. 50  Office of Financial Research (OFR), 2013, Asset Management and Financial Stability, OFR Report, U.S.  Department of the Treasury, Washington, and M.  Feroli et  al. (2014), Market Tantrums and Monetary Policy, Chicago Booth Research Paper 14–09, Initiative on Global Markets, University of Chicago Booth School of Business, Chicago. 51  See in detail: IMF, (2014), Risk Taking, Liquidity and Shadow Banking, ibid., pp. 31–41. 52  IMF, (2014), ibid., pp. 2 and 7 (Figure 1.6). 48

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The low rates resulted by these unconventional monetary measures have caused c­ orporations to take on more leverage but without any material effect on investments and productivity capacity. That waning level of economic risk combined with a rising level of ‘pure’ financial risk is not limited to the developed world but also, somewhat uneven, observable in the developing world.53 The risk of default in the nonbanking sector is therefore materially enhanced; and in countries, this phenomenon is directly linked by the credit providing function of the shadow banking sector as is the case, for example, in China. Although the interbank liquidity market has been constrained by regulation since 2013–2014, the liquidity for continued funding through the shadow banking sector has often been generated through wealth management products and ‘firm-to-firm entrusted loans’. The sensitivity in the Chinese shadow banking remains as the shadow banking sector is exposed (in contrast to the traditional banking sector) to high-risk credit and suffers from tiny capital cushions. Combining this with the fact that capital flows are increasingly cross-border also in and between emerging economies, the risk for cross-­ border spillovers is on the rise. About a third of that alien credit is related to exposures in the nonbank sector in China. A wider perspective on the issue helps us to understand that the misbalance between financial and economic risk taking also related back to the fact that the banking sector, and in particular the global banking infrastructure, is still coming to terms with the changing regulatory environment and the impact on their business models and profitability forecasting. A well-functioning credit intermediation system is obviously key to channel financial into economic risk. That transition undeniably includes repricing of certain activities and reallocation of capital across the various divisions and activities and potentially spin-off of certain existing activities.54 While monetary accommodation continues to stay critical with varying degrees across the world, to kick-start the recovery, banks encourage economic risk taking; it is the same financial accommodation that creates the liquidity risk that leads to changes in the structure of the credit markets. The most obvious one is the shift of credit intermediation to the shadow banking sector and the asset management industry in particular. While capital buffers have increased and leverage has reduced in the banking sector,55 the availability of credit has shifted to the shadow banking sector, which historically has always demonstrated a higher level of risk appetite. Market-based financing has taken the role and filled the plugs that the banking sector vacated. It needs to be reminded here that indirectly much of the ‘market-based financing’ still is backed by traditional banking balance sheets. From a policy point of view, two items are high on the agenda: ‘(1) strengthening the credit transmission channels by improving the monetary policy trade-off between financial and economic risk; and (2) using macroprudential policies to contain new and evolving financial stability risks, including growing market and liquidity risks emerging from

 See in detail: IMF, (2014), ibid., pp. 16–19.  See in detail: IMF, (2014), ibid., pp. 21–31. 55  See for the impact of recent financial regulation of banks and their activities; IMF, (2014), ibid., p. 59 (Table 1.7). 53 54

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the shadow banking system’.56 In order to improve the resilience of market structures, a better understanding is needed regarding the impact between the effect of financial regulation and macroprudential policies and the provision of debt through the shadow banking sector. More ­specifically, the central concern regarding liquidity risk comes down to the ‘the liquidity risk arising from the mismatch between the liquidity promised to fund owners in good times and the cost of illiquidity when meeting redemptions in times of stress’.57 Although the mix of regulatory and policy actions is going to be different per region and even country, often it implies rebalancing credit allocation to more productive area of the economy. This requires efficient risk (re)pricing, rolling back of guarantees and undeniably the default of nonviable corporations.

2.6 E  xplaining the Growth of the Shadow Banking Market Although the growth of the shadow banking market is uneven and asymmetric across regions and countries (and so is its definition by comparison), there are certain trends that those submarkets have in common. As a kind of first line of argumentation series, the following can be highlighted: (1) the search for yield58 (given the higher-risk appetite of the shadow banking market vs. the traditional banking market and a low-rate sovereign bond market) and the role of (international) capital flow intermediator59; (2) the regulatory arbitrage (given the many different macroprudential responses to very different shadow banking markets) as well as the tighter bank regulation which has fueled the search by investors for nonbank intermediation, a phenomenon that has been ongoing

 IMF, (2014), ibid., p. 43. For an in-depth analysis of the trade-off between the benefits of monetary accommodation in support of economic activity and balance sheet repair, and the downside risks associated with financial excesses that could, if they become systemic, pose risks to the real economy, see IMF, (2014), ibid., pp. 41–48. 57  IMF, (2014), ibid., pp. 45–48. 58  See in detail: (1) P. Jackson, (2013), Shadow Banking and New Lending Channels—Past and Future, in 50 Years of Money and Finance: Lessons and Challenges, Vienna: The European Money and Finance Forum; (2) T. Goda, et al., (2013), The Contribution of U.S. Bond Demand to the U.S. Bond Yield Conundrum of 2004 to 2007: An Empirical Investigation, Journal of International Financial Markets, Institutions and Money, Vol. 27, pp. 113–136; (3) T. Goda and Ph. Lysandrou, (2014), The Contribution of Wealth Concentration to the Subprime Crisis: A Quantitative Estimation, Cambridge Journal of Economics, Vol. 38, Issue 2, pp. 301–327; (4) Ph. Lysandrou, (2012), The Primacy of Hedge Funds in the Subprime Crisis, Journal of Post Keynesian Economics, Vol. 34, Issue 2, pp. 225–253. 59  P. Mehrling, et al., (2013), Bagehot Was a Shadow Banker: Shadow Banking, Central Banking, and the Future of Global Finance, Shadow Banking Colloquium, a project of the Financial Stability Research Program of the Institute for New Economic Thinking as well as the aforementioned H.S. Shin, (2010), Macro-prudential Policies Beyond Basel III, Policy Memo, Princeton University, Princeton, New Jersey. 56

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long before the financial crisis and its run-up60; and (3) the complementaries with the rest of the financial system. This has been mentioned already on a number of occasions throughout the book. In particular in emerging markets, the shadow banking market has been thriving on the growth of pension funds and insurance companies that often require investment funds and other nonbank intermediaries to facilitate transactions. Because of the often low levels of liquidity and market infrastructure, the shadow banking market often plays a complementary role to the existing banking infrastructure. But also, in the developed world, the shadow banking market plays a role. In that part of the world, institutional cash pools of a variety of sizes and backgrounds have continuously been looking for (direct) alternatives for deposits and safe assets.61 Institutional cash pools include ‘the liquidity tranche of foreign exchange reserves, corporate cash pools, institutional investors, and securities lenders’ cash collateral reinvestment accounts’.62 In its 2014 Global Financial Stability reports, the IMF also highlights the fact that the drivers of the shadow banking market(s) have not been empirically assessed. The question can be raised as to how meaningful macroprudential (tax) regulation needs to be construed in absence of a meaningful understanding of what drives the industry. This has led to situations that macroprudential regulation was often driven more by gut feeling than by modeled and empirical understanding. See Box 2.1 for a contextual understanding of this matter.

Box 2.1  Macroprudential Policy Tools and Shadow Banking Macroprudential Policy Tools and Shadow Banking Macroprudential tools have been around for a long time. Nevertheless, they have been enjoying renewed attention since the 2008 financial crisis. Indeed, the financial crisis has pointed at a real pain, that is, the fact that finance (and wider financialization of our economy and society) can and from time to time does have a materially adverse effect on the functioning of our economy and our financial system. It was also learned the hard way that the existing, and yes extensive, set of microprudential, monetary, fiscal and other policies, even when (continued)

 See in extenso: (1) D.  Vittas, (ed.), (1992) Financial Regulation—Changing the Rules of the Game, Washington, World Bank Publications; (2) G. Kanatas and S. I. Greenbaum, (1982), Bank Reserve Requirements and Monetary Aggregates, Journal of Banking and Finance, Vol. 6, Issue 4, pp.  507–520; (3) G.F.  Udell and A.  N. Berger, (1994), Did Risk-Based Capital Allocate Bank Credit and Cause a Credit Crunch in the U.S.?, Journal of Money, Credit and Banking, Vol. 26, Issue 3, pp. 585–628; (4) J.V. Duca, (1992), U.S. Business Credit Sources, Demand Deposits, and the Missing Money, Journal of Banking and Finance, Vol. 16, Issue 3, pp. 567–583; (5) J.V. Duca, (2014), What Drives the Shadow Banking System in the Short and Long Run? FRB Dallas Working Paper, Nr. 1401, Federal Reserve Bank of Dallas, Dallas; and (6) B.S. Bernanke, and C.S. Lown, (1991), The Credit Crunch, Brookings Papers on Economic Activity, Vol. 2, pp. 204–239. 61  See in detail (also discussed extensively elsewhere in the book): Z. Pozsar, (2011), Institutional Cash Pools and the Triffin Dilemma of the U.S.  Banking System, IMF Working Paper, Nr. WP/11/190, International Monetary Fund, Washington. 62  IMF, (2014), ibid., p. 75, footnote 13. 60

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Box 2.1  (continued) properly designed and executed, were not in a position to ensure financial stability and foster self-correction where needed. This not only has forced regulators and supervisors to rethink the effectiveness of existing policies but has also loudened the need for macroprudential policies. that is, ‘those policies aiming to reduce systemic risks arising from “excessive” financial procyclicality and from interconnections and other “cross-sectional” factors’.63 Requiring macroprudential policies is a good start and is already well underway.64 However, engaging them for the right reasons, rightly implemented and so on, is a different ballgame. As a starting point, it could be argued that macroprudential policies should be used to tackle externalities and market failures that arise from various financial issues, frictions in the system and overall market imperfections, even when the abovementioned legislation is executed perfectly. However, and as always is the case after a decent crisis, the regulator engages in regulatory rewiring not based on principles or empirical testing but out of a need to do something, or as Claessens puts it, ‘generic concerns’.65 A big chunk of the policies currently engaged are reworks or carbon prints of existing microprudential and regulatory tools.66 A number of these tools give the impression, when being evaluated so far, that they seem to have the potential to reduce financial procyclicality and lower overall crisis risks. In particular when applied to real estate markets, some of these instruments (i.e. loan-to-value and debt-­ service-­to-income ratios) seem to be able to manage the bust-and-boom cycle better. However, very little is known67 as to how these tools should be designed and calibrated given certain factual circumstances or which tools to use given certain market structures or imperfections. Also still vague are the costs that such policies trigger, as policies distort behaviors and these trigger costs. Or, put differently, unless these policies target a specific externality or a market failure, those tools and policies have the potential to further dislocate resource allocation in the market or, worse, aggravate systemic risk. Other questions relate to who is best positioned to execute those strategies and tools, that is, the institutional design of these policies. This is due to the fact that there are many institutions out there, already engaged in this field, whose objective will interfere with these tools and which are politically exposed. The political economy of (continued)

 G.A. Akerlof, et al. (Eds.), (2014), What Have We Learned?, Macroeconomic Policy After the Crisis, MIT Press, Cambridge, MA. 64  See extensively: X. Freixas, et al., (2015), Systemic Risk, Crises, and Macroprudential Regulation, MIT Press, Cambridge, MA. 65  S.  Claessens, (2014), An Overview of Macro-Prudential Policy Tools, IMF Working Paper, WP/14/214, p. 3. 66  That is, caps on loan-to-value ratios, limits on credit growth, additional capital adequacy requirements, reserve requirements and other balance sheets restrictions. 67  See G. Galati and R. Moessner, (2014), What do we know about the effects financial macroprudential policy?, De Nederlandse Bank Working Papers, Nr. 440, and historically: D.J. Elliott, (2013), The History of Cyclical Macroprudential Policy in the United States, Office of Financial Research Working Paper Nr. 8 (Washington: US Department of the Treasury). 63

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Box 2.1  (continued) ­ acroprudential tools implies that the market will be more exposed to outside m pressures, enhancing the need for accountability and transparency. Macroprudential tools are used but not always using externalities and markets as a starting point. They can lead to enhanced market deficiencies, although admittedly ‘procyclicality and systemic risks can arise from many factors, including aggregate shocks (e.g., commodity price shocks) and policy deficiencies (arguably, procyclicality and systemic risks mostly largely relate to weaknesses in the conduct of micro-prudential and monetary policies)’.68 Most policy calls (before the crisis) in this direction in recent years however did not particularly take the (relevant) externality as a starting point,69 while others (after the 2008 crisis) did, in particular those externalities that have the potential to give rise to procyclicality and systemic risk.70 Externalities can be classified in many different ways. In this section, I will be adhering to the classification used by De Nicolò et al. For other possible classifications, see the chapter on applying the Pigovian model to a globalizing financial industry. De Nicolò et  al. identify three types of externalities71 (or at least the externalities we know at this stage). These externalities make distinction between those externalities that give rise to procyclicality and those that arise due to interconnectedness: • Externalities related to strategic complementarities that arise from the strategic interactions of banks and other financial institutions and agents, and which cause the buildup of vulnerabilities during the expansionary phase of a financial cycle. They arise during buildups and often relate to many market agents undertaking the same strategy, as the payoff of a strategy increases when many engage in that strategy at the same time. Other sources can be reputational issues and incentive structures for asset managers or the (continued)

 Claessens, (2014), ibid., p. 5.  See for a number of them: (1) C. E.V. Borio, (2003), Towards a Macroprudential Framework for Financial Supervision and Regulation? BIS Working Paper Nr. 128, Bank for International Settlements, Basel; (2) C.E.V. Borio, Claudio, and W. R. White, (2003), Whither Monetary and Financial Stability: The Implications of Evolving Policy Regimes?, Monetary Policy and Uncertainty: Adapting to a Changing Economy, Conference Volume, Federal Reserve Bank of Kansas City; and (3) W.R. White, (2006), Procyclicality in the Financial System: Do We Need a New Macrofinancial Stabilisation Framework?, BIS Working Papers, Nr. 193, Basel. 70  See in detail: (1) M.K.  Brunnermeier, (2009), The Fundamental Principles of Financial Regulation: 11th Geneva Report on the World Economy, CEPR/ICMB; (2) G. De Nicolò et al., (2012), Externalities and Macroprudential Policy, IMF Staff Discussion Notes, Nr. 12/05; (3) F. Allen and E. Carletti, (2011), Systemic Risk and Macroprudential Regulation, mimeo, University of Pennsylvania; (4) Bank of England, (2011), Instruments of Macroprudential Policy, Discussion Paper, December; and (5) D. Schoenmaker, and P.J. Wierts, (2011), Macroprudential Policy: The Need for a Coherent Policy Framework, DSF Policy Paper Nr. 13, Duisenberg School of Finance, Amsterdam, the Netherlands. 71  See supra; cited and discussed in Claessens, (2014), ibid., pp. 5–8. 68 69

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Box 2.1  (continued) ­ ynamics of benchmarking in the financial industry. Finally, they can emerge d from response of market agents to ex post government intervention.72 • Externalities related to fire sales and credit crunches that arise from a generalized sell-off of assets causing a decline in asset prices, a deterioration of balance sheets of intermediaries and investors, and a drying up of financing, especially during the contractionary phase of a financial (and business) cycle. It causes assets to be sold below fundamental value and impacts the value of similar assets in the market having an impact on the stability of the market or the ability to use these assets as collateral and so on. This type of externality is often most associated with shadow banking activities and agents, in particular the dealer-broker and MMF that provide wholesale funding to the traditional banking sector. Buildup of these externalities occurs often in boom periods, although manifestation occurs normally in a downturn.73 (continued)

 See in detail: (1) M. Ruckes, (2004), Bank Competition and Credit Standards, Review of Financial Studies, Vol. 17, Issue 4, pp. 1073–1102; (2) G. Dell’Ariccia and R. Marquez, (2006), Lending Booms and Lending Standards, Journal of Finance, Vol. 61, Issue 5, pp.  2511–2546; (3) G.B. Gorton and P. He, (2008), Bank Credit Cycles, Review of Economic Studies, Vol. 75, issue 4, pp. 1181–1214; (4) R.G. Rajan, (1994), Why Bank Credit Policies Fluctuate: A Theory and Some Evidence, The Quarterly Journal of Economics, Vol. 109, Issue 2, pp. 399–441; (5) V.V. Acharya, (2013), Seeking Alpha: Excess Risk Taking and Competition for Managerial Talent, NBER Working Papers Nr. 18,891, National Bureau of Economic Research; (6) L. Allen and A. Saunders, (2003), A Survey of Cyclical Effects in Credit Risk Measurement Models, BIS Working Papers Nr. 126, Bank for International Settlements, Basel; (7) T.  Adrian and H.  S. Shin, (2010), Liquidity and Leverage, Journal of Financial Intermediation, Elsevier, Vol. 19, Issue 3, pp. 418–437; (8) T. Adrian and H. S. Shin, (2014), Procyclical Leverage and Value-at-Risk, Review of Financial Studies, Vol. 27, Issue 2, pp. 373–403; (9) N. Barberis, (2013), Thirty Years of Prospect Theory in Economics: A Review and Assessment, Journal of Economic Perspectives, Vol. 27, pp. 173–196; (10) N. Gennaioli, et al., (2013), A Model of Shadow Banking, Journal of Finance, Vol. 68, issue 4, pp. 1331–1363; (11) E. Farhi and J. Tirole, (2012), Collective Moral Hazard, Maturity Mismatch, and Systemic Bailouts, American Economic Review, Vol. 102, Issue 1, pp. 60–93; (12) F. Allen and E. Carletti, (2011), Systemic Risk and Macroprudential Regulation, mimeo, University of Pennsylvania; and (13) L. Ratnovski, (2009), Bank Liquidity Regulation and the Lender of Last Resort, Journal of Financial Intermediation, Vol. 18, Issue 4, pp. 541–588. 73  See in detail: (1) F. Allen and D. Gale, (1994), Limited Market Participation and Volatility of Asset Prices, American Economic Review, Vol. 84, Issue 4, pp. 933–955; (2) A. Shleifer and R. W. Vishny, (1992), Liquidation Values and Debt Capacity: A Market Equilibrium Approach, Journal of Finance, Vol. 47, Issue 4, pp. pp. 1343–1366; (3) R. G. Rajan and R. Ramcharan, (2014), Financial Fire Sales: Evidence from Bank Failures, Finance and Economics Discussion Series, 2014–67, Federal Reserve Board; (4) I. Goldstein, et al., (2013), Trading Frenzies and Their Impact on Real Investment, Journal of Financial Economics, Vol. 109, issue 2, pp. 566–582; (5) A. Korinek, 2014, Global Coordination or Currency Wars?, unpublished; Baltimore, Maryland, Johns Hopkins University; (6) S. SchmittGrohe and M.  Uribe, (2012), Prudential Policy for Peggers, NBER Working Papers Nr. 18,031, National Bureau of Economic Research; (7) E.  Farhi and I.  Werning, (2013), A Theory of Macroprudential Policies in the Presence of Nominal Rigidities, NBER Working Papers Nr. 19,313, National Bureau of Economic Research; (8) M. Brunnermeier, et al., (2013), Macroeconomics with 72

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Box 2.1  (continued) • Externalities related to interconnectedness, caused by the propagation of shocks from systemic institutions or through financial markets or networks (‘contagion’). Spillovers can arise because of bilateral balance sheets (interbank) and other exposures, asset price movements or aggregate feedback from the real economy. Financial institutions tend not to internalize the possible effects of fire sales or the risks of interconnectedness, which is particularly important for Systemically Important Financial Institutions (SIFIs).74 An important factor, as already hinted at when pitching and positioning macroprudential tools, is the understanding that these tools continuously interact with other (monetary, fiscal, microprudential and competition) policy domains. Furthermore, some macroprudential policies are meant to correct the distortions by tools used in any of the aforementioned domains. And since macroprudential (continued)

Financial Frictions: A Survey, Advances in Economics and Econometrics, Tenth World Congress of the Econometric Society, New York, Cambridge University Press; (9) A. Manconi, et al., (2012), The Role of Institutional Investors in Propagating the Crisis 2007–2008, Journal of Financial Economics, Vol. 104, Nr. 3, pp. 491–518; (10) C.B. Merrill, et al., (2012), Did Capital Requirements and Fair Value Accounting Spark Fire Sales in Distressed Mortgage-Backed Securities?, NBER Working Paper Nr. 18,270; (11) A. Manconi, et al., (2012), The Role of Institutional Investors in Propagating the Crisis 2007–2008, Journal of Financial Economics, Vol. 104, Nr. 3, pp. 491–518; (12) J. Bianchi, (2010), Credit Externalities: Macroeconomic Effects and Policy Implications, American Economic Review, Vol. 100, Issue 2, pp. 398–402; and (13) C. Merrill, et al., (2012), Did Capital Requirements and Fair Value Accounting Spark Fire Sales in Distressed Mortgage-Backed Securities?, NBER Working Paper Nr. 18,270. 74  See in detail: (1) F. Allen and D. Gale, (2000), Financial Contagion, Journal of Political Economy, Vol. 108, Issue 1, pp.  1–33; (2) D.W.  Diamond and R.  G. Rajan, (2011), Fear of Fire Sales, Illiquidity Seeking, and the Credit Freezes, Quarterly Journal of Economics, Vol. 126, Issue 2, pp. 557–591; (3) E. Perotti and J. Suarez, (2011,) A Pigovian Approach to Liquidity Regulation, International Journal of Central Banking, Vol. 7, Issue 4, pp. 3–41; (4) L. Bebchuk and I. Goldstein, (2011), Self-Fulfilling Market Freezes, Review of Financial Studies, Vol. 24, Isue 11, pp. 3519–3555; (5) D. Acemoglu, et al., (2013), Systemic Risk and Stability in Financial Networks, NBER Working Papers Nr. 18,727, National Bureau of Economic Research (published as D. Acemoglu, (2015), Systemic Risk and Stability in Financial Networks, American Economic Review, Vol. 105, Issue 2, pp. 564–608); (6) W. Wagner, (2011), Systemic Liquidation Risk and the Diversity–Diversification Trade-off, Journal of Finance, Vol. 66, Issue 4, pp. 1141–1175; (7) Ph. Strahan, (2013), Too Big To Fail: Causes, Consequences, and Policy Responses, Annual Review of Financial Economics. Vol. 5, pp. 43–61; (8) F. Allen and D. Gale, (2007), Understanding Financial Crises, Clarendon Lectures in Finance, Oxford University Press, Oxford, UK; (9) G.  Galati and R.  Moessner, (2011), Macroprudential Policy – a Literature Review, BIS Working Papers Nr. 337, Bank for International Settlements, Basel; (10) K. Ueda and B. Weder di Mauro, (2012), Quantifying the Value of the Subsidy for Systemically Important Financial Institutions, IMF Working Paper Nr. WP/12/128; (11) IMF, (2014), How Big Is the Implicit Subsidy for Banks Seen as Too-Important-to-Fail, Global Financial Stability Report, Chapter 3, World Economic and Financial Surveys, April; (12) M. Drehmann and N. Tarashev, (2011), Measuring the Systemic Importance of Interconnected Banks, BIS Working Papers Nr. 342, Bank for International Settlements, Basel; and (13) L. Laeven, et al., (2014), Bank Size and Systemic Risk, Staff Discussion Notes Nr. WP/14/4, IMF, Washington.

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Box 2.1  (continued) policies should be concerned with international spillovers, therefore international coordination75 is required as it might overlap with areas as capital flow management. The most important interaction of macroprudential tools is with monetary policies, although they are both intended for countercyclical management. However, monetary policy primarily aimed at price stability and macroprudential policies primarily aimed at financial stability.76 Given those interactions, three questions become relevant. (1) If macroprudential policies work imperfectly, what are the implications for monetary policy? (2) If monetary policy is constrained, what is the role for macroprudential policies? (3) With institutional and political economy constraints, how can both be adjusted?77 Also, interactions with other domains can be material. For example, when tax policies induce (excessive) leverage or when real estate taxes are capitalized into housing prices.78 Also the interaction with microprudential tools is relevant, although, when conducted properly, objectives on both sides will be aligned; if not, conflicts might arise.79 The macroprudential toolkit is like a house with many rooms as it includes existing microprudential and other regulatory tools, taxes and levies and new tools developed in recent years (or to be developed). Expressed as a grid, the tools should be effective in both the expansionary phase (buildup) and the contractionary phase (distress with fires sales and credit crunch), as well as during the breakout phase of a crisis (contagion and spillover phase). The tools will focus on five distinct areas: (1) restrictions that relate to borrowers, instruments or activities; (2) restrictions on the financial sector balance sheet (assets and/or liabilities); (3) capital requirements, provisioning and/or surcharges; (4) general taxes and/or levies; (5) other measures related to the institutional infrastructure (e.g. accounting, governance, incentives, central clearing, disclosure and transparency).80 The perfect use and calibration of macroprudential policies (continued)

 For a literature review, see Claessens, (2014), ibid., pp. 11–12.  Claessens, (2014), ibid., p. 8. 77  For a review regarding these questions, see Claessens, (2014), ibid., pp. 9–10. 78  See M.  Keen and Ruud De Mooij, (2012), Debt, Taxes and Banks, IMF Working Paper WP/12/48, and P. Van den Noord, (2005), Tax Incentives and House Price Volatility in the Euro Area: Theory and Evidence, Economie Internationale, Vol. 101, pp. 29–45. 79  J. Osiński, et al., (2013), Macroprudential and Microprudential Policies: Towards Cohabitation, IMF Staff Discussion Note 13/05, and P. Angelini, (2012), Macroprudential, Microprudential and Monetary Policies: Conflicts, Complementarities and Trade-offs, Occasional Papers Nr. 140, Bank of Italy. 80  See S.  Claessens et  al., (2013), Macro-Prudential Policies to Mitigate Financial System Vulnerabilities, Journal of International Money and Finance, Vol. 39, pp. 153–185. Other models exist; see, for example, European Systemic Risk Board, Heads of Research, (2014), Report on the Macro-Prudential Research Network (MARS), June, or Committee on the Global Financial System (CGFS), (2010), Macroprudential Instruments and Frameworks: A Stocktaking of Issues and Experiences, CGFS Papers Nr. 38, Bank for International Settlements, Basel. 75 76

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Box 2.1  (continued) (whether and how much) ‘will vary by the degree of amplification in the financial (and real) sector cycles, exposures to systemic shocks and risks, and the effectiveness of (specific) policies. As such, many dimensions come into play, including a country’s structural, institutional and financial market characteristics.’81 The models that will help to calibrate are still under development and many open questions remain regarding the measurement and reliability of systemic risk buildup indicators, timelines and what risks can be identified (and which not). What is clearer are the parameters that matter. They include: ‘the importance of banks versus capital markets, with institution-based measures likely of greater importance than borrower-based measures when most financing comes from a regulated system; the industrial organization and ownership structure, since a more concentrated system makes the application of tools easier, or because domestic, state-owned and foreign banks react differently to policies… International financial integration and exchange rate regime matter as well. Openness affects exposures, both directly, as regards to say capital flows risks, and indirectly, given the strong links between behavior of capital flows and banking vulnerabilities.’82 Many of these factors will naturally vary across countries. Consequently, the best approaches, given specific country conditions and characteristics, remain largely an open question.83 That besides the remaining issues in measuring risk and calibrating macroprudential tools.

The IMF84 did however engage in some econometric analyses itself regarding those shadow banking drivers. Its main findings are as follows: (1) banking regulation and more stringent capital requirements are correlated to stronger growth of the shadow banking sector; (2) liquidity conditions: there appears to be a negative correlation between terms spreads and interest rates and the growth of the shadow banking sector, in particular in the period after 2008; (3) institutional cash pools and financial development: growth of the institutional investor base is often associated with a strong growth of the shadow banking sector; (4) overall growth of the financial sector: countries that experience higher banking sector growth rates tend to experience higher growth rates in their shadow banking segment, implicitly referring to the aforementioned ‘complementarities’. Part of this can be explained by the fact that banks have also sponsored shadow banking activities and

 Claessens, (2014), ibid., p. 13. For model development and experiences, see pp. 14–21.  Claessens, (2014), ibid., p. 14. 83  See in detail: V.V. Acharya, (2013), Adapting Microprudential Regulation for Emerging Markets, in O. Canuto and Swati R. Ghosh (eds.), Dealing with the Challenges of Macro Financial Linkages in Emerging Markets, World Bank, Washington, DC, pp. 57–89, and H.S. Shin, (2013), Adapting Macroprudential Approaches to Emerging and Developing Economies, in Otaviano Canuto and Swati R.  Ghosh (eds.), Dealing with the Challenges of Macro Financial Linkages in Emerging Markets, World Bank, Washington, DC, pp. 17–55. 84  See for details: IMF, (2014), ibid., pp. 75, 79–81. 81 82

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that the size of those institutions combined with deepening of the financial markets in general leads to shadow banking growth.85 It is in this context that the more recent trends in the global shadow banking market need to be observed, which include the following86: 1. increased direct nonbank corporate lending by a wide variety of entities (pension funds, mutual funds, insurance firms, private equity and distressed debt firms), in particular debt with long-term maturities. These sources contribute to the absolute majority (approximately 80%) of leveraged lending in the US; 2. peer-to-peer online lending platforms. This is a relatively new and small segment, but with considerable potential.87 The potential future pain lies in the fact that the current lending (mainly to households and small business) is sought to securitize these loans and expand the activities toward riskier borrowers88; 3. mortgage servicing rights are rights to receive a portion of mortgage interest and fees collected from borrowers in return for administering loans. These rights have often been sold off by banks, due to capital risk weight constraints, to nonbank specialty service firms89; 4. derivative product companies, often incorporated under the form of special purpose vehicles (SPVs) set up by banks and private equity (PE)/hedge funds (often jointly), trade with nonaffiliated counterparties in non-centrally cleared derivatives to avoid higher capital charges on the latter.90 Since they have the potential to be rated higher than their parent banks, they are in a position to engage in business from and transactions with rating-constrained counterparties while at the same time help their parent bank (and other banking clients) reduce their required liquidity buffers; 5. overall rapid growth in emerging economies: China is to be listed upfront here with a shadow banking market hovering around 35–40% of GDP, and of more concern is the fact that the shadow banking market is growing at twice the rate of the traditional banking sector.91  See for an analysis of that line of thought: B.H. Mandel et al., (2012), The Role of Bank Credit Enhancements in Securitization, Federal Reserve Bank of New York Economic Policy Review, Vol. 34, Issue 2, pp. 225–254. 86  See in extenso: IMF, (2014), ibid., pp. 76–78. 87  See in detail: E. Kirby and S. Worner, (2014), Crowd-Funding: An Infant Industry Growing Fast, IOSCO Staff Working Paper 3, International Organization of Securities Commissions, Madrid. 88  See D.  McCrum, (2014), Jumping on the Peer-to-Peer Gravy Train, FT Alphaville (blog) Financial Times, May 21, and Standard & Poor’s (S&P), (2014), As Peer-to-Peer Lending Draws Wider Interest, Does Securitization Lie in Its Future. Standard & Poor’s Financial Services LLC, McGraw Hill Financial, New York, May 2. 89  See in detail: Kroll Bond Rating Agency (Kroll), 2014, Overview of Mortgage Servicing Rights, New  York, Kroll Bond Rating Agency. They indicate further that ‘these rights carry significant short-term risks in terms of compliance and operational factors (such as interruption of servicing or delays in transfers)’; op. cit. IMF, (2014), ibid., p. 77. 90  See C. Whittall, (2014), Banks Eye SPVs to Ease Capital Pain, International Financing Review, April 29. 91  This is a longer-term trend. The Chinese government tries to slow that growth pattern down. Therefore, these trends need to be assessed by the reader in their contemporary context, which is a shifting paradigm. Therefore, it was decided to only refer to numbers and percentages when they illustrate somewhat of a longer-term trend and to avoid a situation in which larger parts of the book would be idle by the time it hits the bookshelves. See also Sect. 5.10. 85

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A more recent phenomenon has been that ‘retail payment platforms recently instituted a method of sweeping cash balances into money market mutual funds that in turn may (partly) invest in short-term commercial paper issued by local government financing vehicles’.92 As discussed in the part on MMFs, they are prone (in a material way) to ‘run risks’, due to the ability for investors to redeem their investment instantly, potentially triggering a fire sale. The growth of ‘Real Estate Investment Funds’ (REITs), especially in some emerging economies such as Mexico, accounts for an exponentially growing part of the domestic equity market. Lending by nonbanking institutions in, for example, South-East Asia is particularly a concern for as most debt issuance is toward (low- and middle-income) household which triggers enhanced credit concern, given the growth rate of this segment and more concerning that household debt in some of these countries is growing to a level experienced in some developed countries (upward of 60% of GDP). The IMF concludes, in line with the FSB’s global shadow banking monitoring report, that the major drivers of the shadow banking market are (1) term spread evolution (in particular after 2008), (2) interest rate evolution, (3) real GDP growth, (4) capital constraints through regulation, bank growth and growth overall in financial assets and (5) growth of the institutional investor segment of the financial market.93 The IMF further examines the role of MMFs and securitization within the framework of the shadow banking growth. They consider that the growth in MMF assets is largely driven by the growth of the aforementioned institutional investor base creating larger cash pools that require allocation. Within the context of securitization it can be observed that in particular the ‘private label securitizations’ are on the rise. These ‘private label’ transactions occur through SPVs that are sponsored or owned by banks. Driver behind those growth patterns is the term spread evolution and in general the search for yield (there is obviously a correlation and even causality between those two items).94 The variety in evolution of the different shadow banking segments, which traditionally are defined globally as being distinct in developed/developing economies95 point at an important feature, that is, that the drivers are different and therefore the evolution (and related risk dynamics) will most likely be different as well. For the developed world regulatory arbitrage, bank restrictions, low interest rates, demand from institutional cash pools and the search for yield are seen as the key drivers in recent times and going forward of a growing shadow banking market. We know from the past that capital requirements (and changes to them) fuel the need for securitized products,96 in particular covering lowrisk loan books, whereby the mezzanine and high-risk tranches stay with the securitizing

 IMF, (2014), ibid., p. 77.  For the data set and the relative contribution of each of the aspects, see IMF, (2014), ibid., p. 79 (Figure 2.7 and Table 2.2). 94  See in detail: IMF, (2014), ibid., p. 80. 95  See in detail: IMF, (2014), ibid., pp. 80–81. 96  See in detail: L. Allen, (2004), The Basel Capital Accords and International Mortgage Markets: A Survey of the Literature, Financial Markets, Institutions and Instruments, Vol. 13, Issue 2, pp. 41–108. 92 93

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institution. That happened with the ­introduction of Basel I and Basel II and is likely to reemerge in the years to come aligned with the introduction of Basel III, adding that the low interest rate environment will act as a catalyst regarding that evolution. The same correlation has been identified between these drivers and the growth of the MMF market. The MMF market responds directly to bank interest rate restrictions (which turn real interest rates negative in times of material inflation).97 In recent times, the demand aspect triggered by institutional cask pools can be added, illustrating the growth in MMF activities. But also the limits of deposit insurance mechanisms (which in a broader sense is also capital regulation) can help explain the MMF segment growth98 as ‘the limits induce large depositors to seek higher-seniority claim status with nonbank institutions that offer liquidity similar to that of bank deposits’.99 So, did the search for yield trigger investors to allocate capital to private equity firms and hedge funds and structured finance and leverage buyouts in general? In emerging markets, heightened restrictions on banking activities (including deposit rates) are seen as an important driver of shadow banking growth. In China, restrictions are material as they were introduced, in 2010, to reduce the growth in bank lending and inflation-related concerns.100 Additionally, the already discussed entrusted loans (in which one nonfinancial company lends to another, with banks serving as intermediaries collecting a fee) were restricted in 2015. In particular, ‘five categories of funds must not be used for entrusted loans, noticeably bank lending to companies and funds those companies have raised from other investors’. The new rules ‘forbid the use of entrusted loans for equity investment’, which will lead to a tightening of liquidity in the market. There is also a relationship with this restriction and the margin lending business discussed above as entrusted loans have become an alternative channel to margin lending from brokerages.101 ‘Entrusted loans are just one of several channels through which non-financial firms offer credit to one another. Other methods include corporate discounting of bank acceptance bills, as well as corporate purchases of trust products, which are usually backed by high-interest corporate loans. Funds of entrusted loans typically flow into risky assets such as property and stocks more than other forms of shadow banking businesses.’102

 C.W. Calomiris, (2013), The Political Foundations of Scarce and Unstable Credit, Presented at the Federal Reserve Bank of Atlanta Financial Markets Conference, Maintaining Financial Stability: Holding a Tiger by the Tail, Stone Mountain, Georgia, April 9. 98  Z. Pozsar, (2011), Institutional Cash Pools and the Triffin Dilemma of the U.S. Banking System, IMF Working Paper WP/11/190, International Monetary Fund, Washington. 99  IMF, (2014), ibid., p. 81. 100  Especially now that the real estate market is weak and not directly an investment destination for savings as it was in the past for many households. 101  L.  Jianxing and P.  Sweeney, (2015), China Issues Draft Rules Restricting Entrusted Loans, Reuters.com, January 18. 102  L. Jianxing and P. Sweeney, (2015), ibid. 97

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Also regulatory arbitrage and government support are a major concern in some e­ merging markets as they fuel the growth of special-purpose nonbank financial institutions (NBFIs). These vehicles or institutions are often ‘specialized in mortgage financing to lower- and middle-income households in the informal sector, and they are subject to less stringent regulations because they do not take deposits’, ‘and the federal government provided them with support and backstopping, allowing their mortgage-backed securities to receive the highest credit rating’.103 New legislation coming in triggered that they converted into different legal entities which were often unregulated.

2.7 H  ow Does the Growth and Dynamics of the Global Shadow Banking Sector Translate in (New) Risks? The discussions earlier in this book have been helpful in understanding the risk elements embedded in shadow banking activities. Roughly and condensed, they could be summarized as being (1) asset maturity risk, (2) asset liquidity risk, (3) credit risk, (4) leverage, (5) interconnectedness and (6) size of the entity and the segment(s) it operates in. These items (except for size) are, when being measured balance sheet risk measures. Indeed, ‘maturity risk (based on whether assets are of long or short duration), liquidity risk (based on whether assets are liquid and easy to trade), credit risk (based on the share of loan assets that carry substantial credit risk), leverage (total assets to equity), and interconnectedness (how these entities are exposed to banks through asset holdings or liabilities) can be inferred from the flow of funds and sectoral balance sheet breakdowns.’104 The IMF did (try to) quantify the risk exposures at each level105 but added that there are many vulnerabilities to such analysis. The pain is always in the ‘micro-macro’ level analyses. Certain risks (such as fire sale and run risks), when being aggregated on sector, level ignore or mask individual entity risk and vice versa. This on top of the fact that certain risks are difficult or impossible to quantify, for example, extent of supervision and regulation and the availability of backstops, and that ‘risk scores of individual sectors may underestimate both interdependence among shadow banking entities and exposure to common factors, which can result in sudden and disproportional deterioration of these entities’ balance sheets’. What is particularly interesting in the IMF analysis is that, despite the imperfections, incomplete or limited granularity in data sets, it reveals significant variations in risk dimensions across activities. Additionally, similar types of activities carry different types of risks across countries and over time.106

 IMF, (2014), ibid., p. 81.  IMF, (2014), ibid., p. 82. 105  IMF, (2014), ibid., p. 83 (Figure 2.10). 106  They indicate that, for example, euro area MMFs seem to be more directly connected with banks and have longer-maturity and less liquid assets than their US and Japanese counterparts (p. 82). For a detailed analysis of their findings, see pp. 82–84. Interesting about the study is that it, as the first 103 104

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Separate from the risk analysis the IMF then conducts the contribution to risk analysis (‘systemic risk’)107 and distress vulnerability of the individual categories of entities involved in shadow banking activities.108 Their approach toward the measurement is as follows: ‘[a]sset prices and size information from each subsector are used to estimate a joint probability distribution of portfolio (systemic) losses. This joint distribution allows computation of a measure of “marginal contribution to systemic risk” (MCSR)109 by each subsector, where systemic risk is measured as the losses to the system that occur with a probability of 1% or less. A related exercise examines “vulnerability to distress,” defined as the risk that distress spills over to banks from other sectors and entities, either because of direct (balance sheet) exposures or indirect (common factor) linkages.’110 The main findings are as follows: • Nonbank financial intermediaries contribute substantially more to systemic risk in the US than in the euro area or the UK. • In the US, the largest MCSR comes from pension funds and insurance companies and shadow banking entities and not the banking sector. • In the euro area and the UK, the banking sector contributes relatively more to systemic risk because of its size and direct and indirect interlinkages. That can also occur through the shadow banking activities engaged in by banking institutions. • The individual segments of the shadow banking sector contribute in a fairly stable tune over time to that systemic risk. • During periods of market distress, the enhanced level of contribution to systemic risk comes predominantly from the asset management sector. • There is an increasing level of systemic risk contribution by the insurance sector. This is to a large degree due to growing similarities in exposure, partly because insurance companies have been engaging more in lending to companies,111 which often was

according to my knowledge, breaks the aforementioned risks down per category (MMFs, securitization, broker/dealers, finance companies, REITs, funds (of a variety of types)). 107  IMF, (2014), ibid., pp. 84–86. 108  See for the methodology in this matter and the review of their findings in the eurozone, the US and the UK: M. Segoviano, et al., (2016), Systemic Risk and Interconnectedness Measures across the Banking and Non-bank Financial Sectors: A Comprehensive Approach, IMF Working Paper, International Monetary Fund, Washington, retaken in F. Cortes et al., (2018), A Comprehensive Multi-Sector Tool for Analysis of Systemic Risk and Interconnectedness (SyRIN), IMF Working Paper Nr. WP/18/14. 109  The MCSR does not measure causality and is therefore of a nondirectional nature. The MCSR methodology is based on the methodology proposed by Tarashev et al.; see in detail: N. Tarashev et al., (2010), Attributing Systemic Risk to Individual Institutions, BIS Working Paper Nr. 308, Bank for International Settlements, Basel. 110  IMF, (2014), ibid., p. 84. 111  The insurance industry is no longer traditional: it now offers products with non-diversifiable risk, is more prone to a run, insures against economy-wide events and has expanded its role in financial markets. See in detail: V.V. Acharya and M. Richardson, (2014), Is the Insurance Industry Systemically Risky? In Modernizing Insurance Regulation, (eds.) by J.H. Bigg and M.P. Richardson, John Wiley & Sons, Hoboken. See also: A. Jobst, (2014), Systemic Risk in the Insurance Sector, The Geneva Papers on Risk and Insurance. Issues and Practices; M. Billio et al., (2010), Econometric Measures of Systemic Risk in the Finance and Insurance Sectors, NBER Working papers, Nr. 16,223; The Geneva

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channeled through the shadow banking system. Insurance companies have also become major buyers of collateralized debt obligations (CDOs).112 • There are significant but declining linkages between US shadow banks and the European banking system.113 The remaining exposure and potential source of crossborder spillovers come from US bond funds seeking exposure to European sovereign debt.

2.8 Drivers of the Shadow Banking System We have discussed shadow banking as an industry and the constituting activities. It already became clear that the shadow banking activities of the period leading up to the 2008 financial crisis were different ones than the ones that drive the shadow market today. That raises the question as to what fundamental drivers are behind the shadow banking system. Undeniably, its relationship with the traditional banking system and its regulation will play a key part, as well as the type and nature of the regulation forced upon the banking system will act as a bench vice that has and will shape the shadow banking market and outlook going forward. Another interesting question is whether the drivers in the short term are different ones than the drivers in the long run. We discussed before that the FSB spares no efforts in collecting data through various sources and has created these five types of activity framework to ensure that emerging activities and trends do not fall off the table when it comes to identifying and monitoring the next domain and type of activity of systemic relevance. We are aware that credit funded through the ‘shadow banking system’, whether nonbank loans funded with uninsured debt or directly issued paper typically bought by money funds, has become more significant over the last couple of decades. There also have been large shifts in the share of debt intermediated by nonbank financial firms. This is important from a financial stability point of view. Commercial paper and debt issued by nonbank financial firms are both vulnerable to financial market shocks and can be procyclical as demonstrated in earlier chapters. The extent to which business finance is funded through securities markets has evolved, reflecting the long-run effects of regulatory arbitrage and financial innovations, as well as short-run financial market shocks. Historically, the following elements have been researched as having contributed to the rise and shape of the shadow banking system114:

Association, (2010), Systemic Risk in Insurance. An Analysis of Insurance and Financial Stability. Special Report of The Geneva Association Systemic Risk Working Group; R.  S.J.  Koijen and M.  Yogo, (2013), Shadow Insurance, NBER Working Paper Nr. 19,568; B.M.  Lawsky, (2013), Shining a Light on Shadow Insurance A Little-Known Loophole That Puts Insurance Policyholders and Taxpayers at Greater Risk, New York State Department of Financial Services; 112  Discussed in the shadow insurance subsegment elsewhere in the book where I spent more time on the material issues regarding shadow insurance. 113  See the annual FSB shadow banking monitoring reports, which document those interlinkages extensively. 114  See for a few in detail: J.V. Duca, (2014), What Drives the Shadow Banking System in the Short and the Long Run, Federal Reserve Bank of Dallas, Working Paper Nr. 1401, pp. 2 ff. As often, one can discuss what caused what exactly.

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• Regulatory requirements encourage the use of alternatives to bank loans. It spurred the growth of money market mutual funds and other alternatives to bank deposits (regulatory arbitrage) • The rise of securitization • Changes in information costs • Demand patterns for safe assets (demand-side drivers) • Hybridization and the extension (often cross-border) of credit intermediation chains • Technological and financial innovation Duca researched them with a view toward understanding the emergence and the shape of the shadow banking system. He empirically analyzed what drove the long-run and short-run movements in the relative importance of shadow bank funding of the short-run credit of nonfinancial corporations over the past five decades. The analysis captures the combined importance of the commercial paper market and nonbank financial intermediaries that comprise the shadow banking system. Consistent with existing literature on ­regulatory arbitrage, the impact is negative when it comes to information costs and ‘positively related to the absolute burden of bank reserve requirements and the relative burden of capital requirements on commercial versus shadow bank credit’.115 Also innovations, such as money market mutual funds, and deregulatory steps, such as the introduction of ‘Money Market Deposit Accounts’ (MMDAs) have been contributing to the rise and shape of the shadow banking system. His findings were also consistent with the existing literature116 that shadow banking is procyclical and vulnerable to liquidity shocks.117 From a longer-term perspective, these results are also consistent with the literature that find that during the Great Depression, the provision of credit shifted toward debt whose funding sources were less vulnerable to liquidity shocks. Duca’s findings yield two general policy implications. First, and discussed before, the evidence indicates that shadow banking is very vulnerable to liquidity shocks and is very procyclical, raising issues for financial and macroeconomic stability. Duca’s results s­ upport

115 116

 Duca, ibid., p. 24.  See for further details:

• T. Adrian and H.S. Shin, (2010), Liquidity and Leverage, Journal of Financial Intermediation, Vol. 19, pp. 418–437; T. Adrian and H. S. Shin, (2009), Money, Liquidity, and Monetary Policy, American Economic Review Vol. 99, Issue 1, pp.  600–609; T.  Adrian and H.  S. Shin, (2009), The Shadow Banking System: implications for Financial Regulation, Banque de France Financial Stability Review Vol. 13, pp. 1–10. • M.K.  Brunnermeier and Y.  Sannikov, (2015), The I Theory of Money, Princeton Working Paper, Original Version 2010. • J.  Geankoplos (2010), The Leverage Cycle, in D.  Acemoglu, K.  Rogoff, and M.  Woodford (eds.), NBER Macroeconomics Annual 2009, Vol. 24, University of Chicago Press, Chicago, 2010, pp. 1–65. • G.B.  Gorton and A.  Metrick, (2012), Securitized Lending and the Run on the Repo, Journal of Financial Economics Vol. 104, pp. 425–451.

 ‘In the short-run, the shadow bank-funded share not only fell when short-run liquidity premia were high, term premia reflected expectations of an improving economy, or event risks occurred in security markets, but also rose when deposit rate ceilings were more binding or short-run regulatory changes favored nonbank relative to bank finance’; Duca, ibid., p. 25. 117

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arguments favoring reform of the money market mutual fund industry to make it more resilient against liquidity and other financial shocks.118 Second, by imposing skin-in-the-game risk exposures to securitized assets and by applying stress tests to systemically important banks and nonbanks, the Dodd-Frank Act (DFA) helped level the regulatory playing field between commercial and shadow demand credit limiting one aspect of regulatory arbitrage while tightening financial regulation. In this respect, DFA has addressed one of the earlier shortcomings of the Basel I accords. In doing so, it has induced a retrenchment in the relative size of the shadow banking system’s participation in providing short-run business credit.119 More generally, Duca’s findings illustrate the need to synthesize roles for information costs, financial regulation, innovation and risk when analyzing the evolution of the relative use of traditional deposit-funded loans and nontraditional sources of credit.120 Duca’s study, by developing a financial architecture model of shadow banking’s role in shortterm business finance and using it to empirically assess the influence of different factors over the past half-century, has contributed to the understanding of the short- and long-­ term drivers of the shadow banking system.

2.9 The Role of Regulation Going Forward As already highlighted on a number of occasions, the challenge for regulators is to minimize systemic risks caused by the shadow banking sector without compromising the benefits of the sector for the economy. Basically, there are two main reasons for regulating (and supervising) the shadow banking sector. First, the fact that they contribute to systemic risk (and the degree to which they contribute should determine the intensity of regulation and oversight). And second, investor protection could be seen as a valid reason. It was demonstrated above that despite the, sometimes material, differences in the nature, size and scope of the shadow banking systems in the different countries and regions of the world, the drivers of growth were fundamentally similar. This is so despite the fact that risk dynamics can be materially asymmetric regardless of similar types of activities. What however should be avoided is that asymmetric regulation in the different countries will lead to regulatory arbitrage pointing at the need for ‘for an encompassing policy framework to minimize the scope for regulatory circumvention induced by the so-called boundary problem’. The boundary problem121 can be the result of tightening of p ­ rudential

 P.E.  McCabe, et  al., (2013), Minimum Balance of 5 Percent Could Prevent Future Money Market Fund Runs, Brookings Papers on Economic Activity, Vol. Spring 2013, pp.  211–278; E.S.  Rosengren, (2014), Our Financial Structures—Are They Prepared for Financial Stability? Conference on Post-Crisis Banking Amsterdam, the Netherlands, June 29, 2012; Journal of Money, Credit, and Banking, 2014, Vol. 12, pp. 395 ff. 119  Duca, (2014), ibid., p. 26. 120  This is in line with a long list of historical literature. See Duca, (2014), p. 24. 121  C.  Goodhart, (2008), The Boundary Problem in Financial Regulation, National Institute Economic Review, Vol. 206, Issue 1, pp. 48–55, and C. Goodhart and R. M. Lastra, (2010), Border Problems, Journal of International Economic Law, Vol. 13, Issue 3, pp. 705–718. 118

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requirements for entities within the regulatory perimeter, which triggers incentives to shift activities outside that area to areas where regulation and supervision are weakest or absent. Nevertheless, it is clear that ‘credit intermediation activities that involve significant maturity or liquidity transformation, imperfect credit risk transfer, or excessive leverage should be subject to additional regulation and oversight’,122 and also to the impact of the interaction of this regulation with other connection regulatory areas such as monetary, fiscal and structural policies. I refer to the above discussion on the matter where I discussed the macroprudential toolbox regarding system risk. The IMF, as institution, sees essentially four tools in their shadow banking toolbox. They indicate that ‘[p]olicymakers have essentially four toolkits at their disposal to address financial stability risks related to shadow banking. First, they may impose regulations on shadow banks or address risks indirectly by targeting banks’ exposure to shadow banks. Second, they may address the underlying causes of the growth of shadow banking. Third, they may, under certain conditions, extend the public safety net to (systemically) important shadow banking markets or entities. Fourth, they may change certain features of bankruptcy laws. Depending on the risks to be addressed, these various toolkits may need to be used simultaneously.’123 In Table 2.1, the interaction and simultaneous use is reflected.124 This table should be interpreted with other (most of them already) mentioned objectives, which include: • Integrate the activity and entity analysis and data granularity with respect to the shadow banking market and its subsegments; • Monitoring, regulation and risk identification should focus on economic functions and activities (as suggested by the FSB in their methodology125), which should help to overcome the boundary problem and reduce the opportunities for regulatory arbitrage,126 in order to account for network effects and to prevent migration of activities within one subsegment of the shadow banking sector or across subsegments for that matter. The entity dimension should focus on aggregate data (sector) and not individual entities and focus on all transactions that fulfill a function. To that effect, the activity dimension should focus on cluster of activities (e.g. funding that relies heavily on short-term funding). • Focus should be on the characteristics of the (different) entities pursuing certain activities that require regulation (e.g. leveraged buyouts, activities acceptable based on level capitalization).

 IMF, (2014), ibid., p. 87.  IMF, (2014), ibid., p. 87. 124  For the extensive write-up of IMF, see (2014), ibid., pp. 87–89. 125  Which is discussed further in this chapter. 126  E.F.  Greene and E.  L. Broomfield, (2015), Dividing (and Conquering?) Shadows: FSB and U.S. Approaches to Shadow Banking at the Dawn of 2014, Included in Shadow Banking Within and Across National Borders (eds. S. Claessens, D. Evanoff, G. Kaufman, and L. Laeven, 2015), World Scientific Studies in International Economics: Volume 40. 122 123

Access to central bank facilities Liquidity shocks managed by lender-­of-­last-resort (LOLR) facilities. Also here there is the potential risk of moral hazards. Explicit public backstops only if appropriate regulatory oversight mechanisms are in place (e.g. also for collateral and governance) as expanding the list of nonbank counterparties who can turn to the LOLR (central bank) for liquidity could have unanticipated collateral effects on operations and functioning of the financial system as such.c Appropriate (market-­based) pricing of emergency funding and heightened regulatory intervention and oversight. If not done appropriately (e.g. providing liquidity without proper oversight), it might shift risk to the LOLR and might obstruct the development of a proper comprehensive public safety net.d Changes to bankruptcy regimes and so on Specific recovery and solution tools needed beyond ordinary insolvency lawsg in order to manage shadow banking systemic risk appropriately (focused around the aspect of eligibility [of access to liquidity]). Would allow authorities to mitigate systemic risk in particular in crisis situations. The FSB already in 2013 inventorized adequate measures in this respect for the shadow banking industry.h Requirement to register transactions with central repository and/or backed by liquid collateral and create an institution that can dispose of illiquid collateral.i

Regulation

Regulating shadow banks directly or indirectly through tailor-made regulation and by extending the regulatory boundaries that would include ‘limiting the ability of banks to support shadow banking activities, or by managing the implicit government guarantees of banks’.a For example, regulatory arbitrage could be curbed using banking regulation such as capital requirements and so on. Management of specific risks through specific tools, for example, redemption limits for collective investment vehicles or restrictions on leverage and maturity or liquidity transformation. Enhancing reporting requirements may raise transparency/better risk monitoring. Managing cross-border spillovers through coordination and direct info-exchange regarding counterparties. Since there is no natural backstop in shadow banking activities, more prudent and conservative regulation is needed.b Addressing the underlying causes Supply- and demand-side measures can be adequate but require intense coordination in the field of monetary, fiscal and structural policies. Demand-side measures would mitigate the growth factors of the shadow banking sector. Poszare suggests that the demand for safe assets by large institutional cash pools can be mitigated by ensuring a sufficient supply of safe public assets (realistic given the size and volume required globally?f) so they don’t have to turn to inherently more risky private sector claims which are more prone to vulnerabilities following aggregate shocks. The system could create moral hazards as the private sector might assume accommodation by the private sector. Monetary policy can help direct orientation and volumes of cash pools.

Table 2.1  The macroprudential toolbox with respect to shadow banking

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a See in detail: S. Claessens and L. Ratnovski, (2014), What Is Shadow Banking?, IMF Working Paper WP/14/25, International Monetary Fund, Washington b For an overview of the measures taken in this respect around the world, see IMF, (2014), ibid., pp. 99–101, Annex 2.4 c See in detail: T. Bayoumi, et al., (2014), Monetary Policy in the New Normal, IMF Staff Discussion Note SDN/14/3, International Monetary Fund, Washington d T.G. Moe, (2014), Shadow Banking: Policy Challenges for Central Banks, Levy Economics Institute Working Paper Nr. 802, Levy Economics Institute of Bard College, Annandale-­on-­Hudson, New York e Z. Pozsar, (2011), Institutional Cash Pools and the Triffin Dilemma of the U.S. Banking System, IMF Working Paper WP/11/190, International Monetary Fund, Washington f The IMF is convinced that it is possible. They indicate: ‘[a] sufficient supply of public safe short-term assets can be achieved in two ways. First, the sovereign could expand its supply of safe assets. Second, improving fiscal policies could increase the share of existing assets that qualify as safe’ (IMF, [2014], ibid., p. 87 footnote 34) g Bankruptcy privileges, such as safe harbor status, allow shadow banks to provide their lenders with safe, money-like assets (similar to insured deposits of regulated banks). General bankruptcy law prohibits a lender from taking action to collect the amount owed by the borrower once a firm files for bankruptcy. Claims enjoying safe harbor privileges are granted an exemption to this rule and afford lenders a position senior to those of other investors; see in detail: (1) D. Duffie and D. Skeel, (2012), A Dialogue on the Costs and Benefits of Automatic Stays for Derivatives and Repurchase Agreements, Research Paper 12–02, University of Pennsylvania, Institute for Law & Economic Research, Philadelphia; (2) E. Perotti, (2010), Systemic Liquidity Risk and Bankruptcy Exceptions, CEPR Policy Insight Nr. 52, Center for Economic and Policy Research, London; (3) E. Perotti, (2013), The Roots of Shadow Banking, CEPR Policy Insight Nr. 69, Center for Economic and Policy Research, London h See for the overview: FSB, (2013), Application of the Key Attributes of Effective Resolution Regimes to Non-Bank Financial Institution, Consultative Document, Financial Stability Board, Basel. After the typical public consultation in 2013, they released their final reporting on this matter in October 2014. See in detail: FSB, (2014), Key Attributes of Effective Resolution Regimes for Financial Institutions Financial Stability Board, Basel i See in detail: V.V. Acharya and T. S. Öncü, (2012), A Proposal for the Resolution of Systemically Important Assets and Liabilities: The Case of the Repo Market, New York University Stern School of Business, New York

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• Since activity- and entity-based reforms influence each other, regulatory circumvention is a moving target which implies constant revision of the framework of both methodologies and regulation whereby the demarcation line between traditionaland shadow banking entities and activities will most likely be (partly) lifted.127 Schwarcz sees two problems with the current design of financial regulation. The first is that it is reactive to previous crises. The second, and more important, argument from a long-term and macroprudential point of view is that ‘financial regulation is normally tethered to the financial architecture, including the distinctive design and structure of financial firms and markets, in place when the regulation is promulgated’. In his understanding, and rightly so, financial regulation must transcend that time-bound architecture. He proposes, for example, regulating the underlying economic functions of the financial system—the provision, allocation and deployment of financial capital—as well as the financial system’s capacity to serve as a network within which those functions can be conducted. Many design and implementation questions remain. Schwarcz indicates further: ‘[s]uch a functional approach to regulating the financial industry is primarily normative as it provides regulatory ordering principles that should have practical utility  — not only as a set of standards to inform actual regulatory design but also as a counterweight to the prevailing view that macro-prudential regulation of systemic risk can be adequately served by an ad hoc assortment of regulatory “tools.”’

2.10 A  nalyzing Different and Comparing Shadow Banking Systems 2.10.1 Introduction You might have been reading between the lines so far, and if you did, you probably picked up the idea that although the term ‘shadow banking’ has been used generically, shadow banking is shaped by a number of factors. Consequently, the shadow banking market today looks very different compared with 2008 or 2005. But also on a different level, there are effects observable. How a shadow banking looks like is a function of banking legislation, the economy of a country, its infrastructure and institutional framework, its monetary policies, its tax laws, its economic policies and

 See: (1) S.L. Schwarcz, (2014), The Functional Regulation of Finance, Unpublished manuscript, Duke University (regarding regulating a dynamic financial environment) and (2) P. Tucker, (2014), Financial Regulation Needs Principles as well as Rules, Financial Times, June 19. Other publications by Schwarcz on the matter include S.L. Schwarcz, (2016), Regulating Financial Chance: A Functional Approach, Vol. 100, Minnesota Law Review, pp. 485–496; and S.L. Schwarcz, (2012), Controlling Financial Chaos. The Power and Limits of Law, Wisconsin Law Review, Vol. 3, pp. 815–840. 127

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facilities it has available to attract foreign investors and so on. The list is pretty much endless and can change over time. The second item on the list should be that in case we have different shadow banking systems around the world, how they can be meaningfully compared with them. There are a number of options. • Additive analysis: you analyze the individual components, asset-backed commercial paper (ABCP), asset-backed securities (ABS), repo,128 MMF. • A subtractive approach: shadow banking is the residual component of a holistic approach of the shadow banking system, that is, after taking out the traditional banking sector. • Activity-based analysis versus entities (involved analysis). • Gross versus net analysis: offsetting transactions in the market against each other when involving the same entities. We used and will use a combination of the different perspectives as we did throughout the book. Each of the perspectives also has its benefits and detriments, and by combining them we can hopefully take out the weakness. The individual analysis has the benefit of a chirurgical analysis per component but might fail to properly analyze the innovation in the system and transactions as well as the systemic risk that is included in the system. The subtractive approach has the problem of categorization and the risk treatment of some of these institutions, that is, leasing companies, nonbank lenders and so on. This is also true from the perspective of regulation needed/required for these entities. Do you identify market activities to be regulated (i.e. securities lending) or rather economic activities (liquidity transformation or collateral i­ntermediation) linked to a market-based credit system,129 that is, money market funding of capital market lending. What is important is to understand the composition of the individual shadow banking systems as well as its interconnectedness. This has to undeniably include the exposure that (financial) institutions in other countries have to the shadow banking sector in other (neighboring) countries. Note that I used the FSB 2012 numbers and framework as a benchmark (although their measurements started before that date). I assume that for contemporary use and analysis, data older than those from 2013 are only useful for historical analysis or long time series and therefore less relevant in this context.130 For the more recent data set and analysis, it can be referred to Sect. 2.12.

 See, for example, FSB, (2013), Global Shadow Banking Monitoring Report 2013, Annex 2, UK Resident Banks’ Repo Books: Mapping and Illustrative Risks, pp. 32–36. 129  P. Mehrling, et al. (2012), Bagehot was a Shadow Banker: Shadow Banking, Central Banking, and the Future of Global Finance, Working paper, mimeo. 130  They are also publicly available through fsb.org. 128

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2.10.2 T  he (Near) Global Marketplace for Shadow Banking131 The FSB has its own take in this. The FSB set out its approach for monitoring the global shadow banking system in its report to the G20 in October 2011. Their take on this is that ‘the primary focus of the monitoring is a “macro-­mapping” based on national Flow of Funds and Sector Balance Sheet data (hereafter Flow of Funds), that looks at all nonbank financial intermediation to provide a conservative estimate which ensures that data gathering and surveillance cover the areas where shadow banking-related risks to the financial system might potentially arise’.132 To narrow the wide scope down, they, starting 2013, have been filtering out nonbank financial activities that have no direct relation to credit intermediation (e.g. equity investment funds) or that are already prudentially consolidated into banking groups but at the same time expand their scope to include new and emerging trends in the nonbank financial system, such as direct lending by nonbanks (e.g. insurance companies, pension funds and private equity funds) to nonfinancial corporates, infrastructure and real estate finance. That package led them to conclude that within their scope of analysis (about 80% of GDP represented in their analysis) the total shadow banking sector accounts to about USD 75 trillion, but only USD 36 trillion (2015)133 when considering the narrow measure. For a jurisdictional breakdown of shadow banking assets, see Table 2.2.

2.10.3 W  hich Are the Actors in the Nonbank Financial Intermediary Space?134 Nine subcategories were identified. The largest subsector was that of ‘other investment funds’ (OFIs). Despite the improving granularity of data sets collected and used by the FSB, the OFI segment continues to be problematic in terms of its opaqueness. It is even more problematic as the OFI segment has been the one growing consistently the fastest in recent years (MMFs, trust companies, fixed-income funds). This has most likely to do with the global low interest rate environment and the drive for investors for higher yields. A global overview is provided for the period 2012–2017135 (percentages) in Table 2.3. As of 2014, the FSB changed its methodology and used its five economic function classification to allocation market agents in the shadow banking segment (infra).

 See FSB, (2013), Global Shadow Banking Monitoring Report 2013, pp. 10–13.  FSB, (2013), Global Shadow Banking Monitoring Report 2013, November 14, Basel, p. 3. 133  USD 352 trillion and USD 52 trillion, respectively, for 2018, see the FSB 2019 nonbank financial intermediation report, February 4, 2019, via fb.org. With respect to the FSB annual shadow banking monitoring reports, please note that year of publication, year of report and year of data tend to be different: for example, the 2019-issued document is the 2018 report covering 2017 data. 134  See in  detail FSB, (2013), ibid., pp.  13–17. FSB, (2014), ibid., pp.  14. For  the  update data for 2013–2014, see infra this chapter under ‘dynamics of the contemporary global shadow banking market’. 135  FSB, (2013), Global Shadow Banking Monitoring Report, Basel, p. 15, and FSB, (2014), Global Shadow Banking Monitoring Report, Basel, p.  14; FSB, (2014), ibid., pp. 6–7, 13–14; FSB, (2015), ibid., pp. 39–40. 131 132

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Table 2.2  Shadow banking assets breakdown for the major jurisdictions Share of assets of nonbank financial intermediaries (%)a (conservative estimates) US Euro area Australia Brazil Canada China Hong Kong South Korea Switzerland UK Japan

2007

2012

2014

2017

41 33 1 1 2 1 1 2 2 11 5

37 31 1 2 2 3 OFIs (USD 117 trillion)>Narrow measure (USD 52 trillion); FSB, (2019), ibid., pp. 7, 13 (Exh. 2.1). 305  See FSB, (2017), Global Shadow Banking Monitoring Report 2016, May 10, Annex 6, pp. 84–86. 303

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the last decade and the number of platforms is equally on the rise. Within the total crowdfunding market, the peer-­to-­peer consumer lending segment is the largest and which provides mainly unsecured personal loans. Other segments on the rise is the smalland medium-sized business finance segment and the factoring segment. These segments have emerged across the different jurisdictions in Europe, but there is quite some heterogeneity in terms of size and business models used. That can be explained by the relatively low barriers to entry to the industry. Also their strategies vary widely ranging from servicing segments underserviced by banks (e.g. by servicing higher-risk profile clients) to competing head-on-head with banks for high-quality clients. The FSB’s interest in the matter mainly stems from the potential stability risks the emerging sector poses. At first glance, the embedded risks are limited as the maturity mismatches are limited and credit risk is passed on to the lenders active on the platform (the platform operates a fee-based model itself for which it screens clients, arranges loan contracts and sources investment opportunities). The implication is that the platform does not intermediate credit on their own balance sheet, and in case credit is intermediated on the balance sheet of the platform, the credit risk is passed on to funders. For the time being, this marketplace is too small to pose actual stability risks. Also, spillover effects vis-à-vis the banking sector are limited as direct exposure to the sector is minimal. Potential risks to observe in the sector are the lowering credit quality with platform source and distribute (originateto-distribute) investment opportunities on their platform. The risk-free based models might incentivize volumes over quality and might trigger moral hazard dilemmas. Alternative risk-seeking and risk avoidance in a procyclical manner might compromise lending condition and lead to boom-bust dynamics. It is not totally unimaginable that over time these lending platforms, in order to boost margins, might get involved in credit intermediation and get exposed to maturity and liquidity transformation or get involved in guaranteed return models.

2.15.3 S  pecific Observations in Niche Segments of the Narrow Shadow Banking Market 2.15.3.1  UK Real Estate Funds306 This experience is based on a period of market stress surrounding the European Union (EU) referendum organized in the UK (June 2016) and the behavior observed of nonbank financial entities and the response of funds holding ­illiquid assets during such events. Tools to meet redemption pressures, such as the ability to suspend redemption, helped to avoid/reduce an escalation of the market shock. Consequently, funds were not forced to engage in fire sales thereby reducing the manifestation of other systemic risks. Although in the UK property and property-related funds can be structured as either open-ended or closed-ended funds, the particular experience with open-ended funds in 2016 was of particular interest. A big chunk of these open-ended funds offer daily

 See in detail FSB, (2017), Global Shadow Banking Monitoring Report 2016, May 10, Annex 3, pp. 73–76. 306

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r­edemptions to their investors.307 Before the referendum, the five largest property funds offering daily redemptions had total assets of £15.5 billion or nearly two-thirds of the total assets held by such funds. As the funds continued to expect net redemptions to continue, they operated on a bid basis the month prior to the referendum month, that is, June. Operating on a ‘bid basis’ implies that redeeming investors would receive the proceeds from selling the underlying assets less any related costs. The funds, in order to meet redemptions, held increasing amount of cash (up to 15% of their assets). After the referendum yielded a ‘leave’, the redemptions continued at an accelerated pace. The open-ended funds experienced cumulative redemptions of 4.1% (average) of the net asset value or NAV (and some up to 8%) during the days after the referendum. After eight full days after the referendum, a sizeable number of funds suspended redemptions, allowing to sell properties and to increase cash positions of up to 20% of NAV to meet future redemptions. Property disposals were executed at discounts ranging 2–3% (no fire sales). Of those funds that suspended redemptions, only half experienced heavier-than-average redemptions during the initial days after the referendum. After the suspension period ended, a number of funds reengaged in redemption but at diluted prices to better reflect market conditions. From a valuation point of view, the post-referendum period was characterized by material uncertainty and fair value adjustments were common (of up to 15%). By September 2016, more than two months after the referendum, the market restabilized and price formation became more transparent. Also unit-linked insurance funds, which invest in open-ended funds to gain exposure to the real estate asset class, were impacted. No further contagion to other funds and asset classes was observed. In terms of market observations based on fund characteristics, it was observed by the Financial Conduct Authority (FCA) that for funds offering daily redemptions net flows stabilized within weeks after the referendum. In contrast, there was limited impact on fund flows that remained open throughout the post-referendum period. I discussed the appropriateness of (daily) redemptions within the context of MMFs and the US experiences in that respect. It should be clear that any regulatory intervention in this field would have to consider many variables including the risk of inadvertently creating systemic risks (or new or amplified risks) in the process.

2.15.3.2  L  iquidity Issues at Irish Money Market Funds and Government Bond Funds308 One of the economic functions used by the FSB to monitor the narrow shadow banking market is the involvement of the CIVs. As discussed above, one of the challenges is to measure the liquidity of funds’ portfolios.309 To that effect, a comparative analysis has

 For details over the strained relationship between illiquid assets and open-ended investment funds, see Financial Conduct Authority, (2017), Illiquid Assets and Open-Ended Investment Funds, Discussion Paper DP17/1. 308  See in detail: FSB, (2017), Global Shadow Banking Monitoring Report 2016, May 10, Annex 5, pp. 81–83. 309  See for a full review of challenges: ESRB, (2016), Macroprudential Policy beyond Banking: An ESRB Strategy Paper, July; ESRB, (2017), A Review of Macroprudential Policy in the EU in 2016, April, as well as further annual updates. 307

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been developed to measure portfolio liquidity using the high-quality liquid asset classification methodology as using within the Basel III remit.310 The Irish authorities categorize the data into three distinct categories: (i) emerging market government bond funds, (ii) nonemerging market government bond funds and (iii) nonemerging market government bond funds with a currency-specific investment focus. A liquidity proxy is calculated for open-ended MMFs and government bond funds which allow daily redemptions, observing criteria as the type of securities they hold, their credit quality and residual maturity. The analysis revealed that currency-specific and nonemerging market government bond funds are predominantly invested in highly rated debt securities. It also showed that those funds that took longer-term positions tend to hold higher credit quality in their portfolio (prime to upper-medium investment grade).311 The conclusion of the study conducted is that a combination of residual maturity, credit rating and security type constitute good proxies for liquidity.

2.15.3.3  The Dynamics of Leveraged Finance312 Due to chasing for yield in a low interest rate environment, the market for leveraged loans (loans to sub-investment grade companies)313 and high-yield bonds314 has been on the rise (again) ever since the end of the financial crisis and have reached pre-crisis levels. Institutional investors tend to participate by selecting which tranches (of an instrument) they want to get access to. Overall, it seems that institutional investors appear to be involved in the more risky tranches. Now since leveraged finance tends to be sub-investment grade investments, the volume of credit risk involved is considerable. Interest rate

310  In this methodology, haircuts are applied to assets to protect against potential adverse price movements in stressed market conditions. Although the methodology is designed for totally different purposes (and continuously monitored by the European Banking Authority or EBA) it provides for a very good proxy when it comes to the liquidity (and changes in liquidity) in the portfolio’s held by open-ended funds. It is referred to as a proxy, as the suggested haircuts might not always be sufficient in all potential stress scenarios. The haircuts vary from 0% (for cash and cash equivalents and certain debt securities covered by governments, central banks and public institutions with a credit rating of at least AA-), 15% (for debt securities guaranteed by sovereigns, central banks, etc. with a credit rating between A= and A- and corporate debt issues by institutions beyond financial institutions with a credit rating of at least AA-) and 50% (for corporate debt securities issued by parties beyond financial institutions with a credit rating between A+ and BBB- and certain common equity shares). 311  MMFs are excluded from the analysis given the stringent quality condition imposed on them by the European directive: Directive 2009/65/EC of the European Parliament and of the Council of 13 July 2009. 312  See in detail: FSB, (2017), Global Shadow Banking Monitoring Report 2016, May 10, Annex 7, pp. 87–90. See also a follow-up case study: FSB, (2019), Global Monitoring Report on Non-bank Financial Intermediation 2018, ibid., pp. 73–78. 313  The specifics/technicalities of what constitutes leveraged loans might differ across jurisdictions. See in detail: ECB, (2017), Guidance on Leveraged Transactions, May. Also for the US: FRB, (2013), Interagency Guidance on Leveraged Lending, March. 314  High-yield bonds are corporate bonds with a sub-investment grade rating.

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risk is limited as this specific risk is shifted to the borrower. However, interest rate changes still have knock-on effects through their impact on repayment capabilities of borrowers. In recent years, the decrease in the price of credit risk has been accompanied by the deterioration of credit standards and the reemergence of covenant-light contracts.315 Sizeable credit volumes, high valuation and declining yield spreads could lead to mispricing of the risk patterns involved and a non-justified move in even more riskier part of the credit market.316Unfortunately, the universe of research in this matter is limited and so macroprudential regulators are flying somewhat blind in this matter.317

2.15.4 T  he Nature of Nonbank Credit Innovation Is Continuously Changing All the examples reflected above point to the fact that nonbank credit is not a static environment but is continuously changing. The rapidly increasing role of online or financial technology (Fintech),318 nonbank entities extending credit or otherwise facilitating credit creation, as well as credit insurance were highlighted in recent years.319 The business models applied differ across jurisdictions and can include the following: (1) matching platform320 (like peer-­to-­peer lending), (2) notarized matching platforms, which are different from the normal matching platforms in the sense that the loans are originated by a partnering bank and later on resold to a variety of creditors (often used when regulatory hurdles constrain lending activities by nonbanks), and (3) balance sheet lenders, which originate and retail loans using their own balance sheet (often funded by hedge funds) and later on securitize their loan book.

 See, for example, B. Becker and V. Ivanshina, (2016), Covenant-Light Contracts and Creditor Coordination, Riksbank Research Paper Series Nr. 149, December. 316  J. Cizel et al., (2016), Effective Macroprudential Policy: Cross-Sector Substitution from Price and Quantity Measures, IMF Working Paper Series, Nr. WP/16/94. 317  S. Kim et al., (2016), Did the Supervisory Guidance on Leveraged Lending Work?, May 16, Liberty Street Economics (newyorkfed.org). 318  IOSCO, (2017), IOSCO Research Report on Financial Technologies (Fintech), February. Also: FSB, (2017), Artificial Intelligence and Machine Learning in Financial Services: Market Developments and Financial Stability Implications, November. The applications of Fintech in shadow banking can include the following: crowdfunding used to raise mortgage down payments, where an electronic platform allows prospective homebuyers to raise money for a down payment on a mortgage; crypto-asset-based lending, where a nonbank provides loans that are collateralized by crypto-assets. In one case, such loans were granted to purchase ‘mining equipment’ (computers that allow users to solve algorithms to mine crypto-assets); or tokenized funds or investment funds that issue proprietary tokens to investors and invest the proceeds in various assets, such as real estate development loans or digital assets. See FSB, (2019), ibid., p. 12. 319  FSB, (2018), Global Shadow Banking Monitoring Report 2017, March 5, Box 1–1, pp. 9–10. 320  A. Samitsu, (2017), Structure of P2P Lending and Investor Protection, Bank of Japan Research Laboratory Series, October. 315

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But even more, the nonbank credit cycle is different across different jurisdictions.321 The answer will further be different depending on whether the focus is on (1) those entities that might be implicated in terms of financial stability risk due to their engagement in maturity/liquidity transformation or applied leverage, (2) those entities active beyond the reach of banking regulation, or (3) the aggregate credit to borrowers from nonbank funding sources. The question about the nonbank credit cycle is important as there is a link between credit cycles and asset prices (i.e. the financial cycle) and risks to financial stability.322The study was performed based on the recurring set of ‘BIS long series database on private non-financial sector credit’323 and used the following measurement to arrive at the amounts of nonbank credits: Nonbank credit to private nonfinancial sector (PNF) ≈ All sector credit to PNF  – (Domestic) Bank credit to PNF  – Total cross-border liabilities of nonfinancial sector (=Nonresident bank credit to PNF). The following conclusions were drawn324: • The size of nonbank credit differs widely across jurisdictions. • Nonbank credit is more important in advanced economies (although some entities channel funds to entities located abroad which might trouble the analysis somewhat). • Nonbank credit is sizeable relative to bank credit; despite which variations exist and, in some, even larger than bank credit.325 • Different models to isolate nonbank credit cycles yield different outcomes.326 • Cycles in bank and nonbank credit growth were very much correlated from the 1950s until the early 1970s. • Between roughly 1975 and the early 1990s, they moved in opposite directions, suggesting a substitution effect between bank and nonbank credits. • Prior to the financial crisis, both bank and nonbank credits were in expansionary phases (bank and nonbank credit cycles reinforcing each other).

 See for an in-depth analysis: Annex A3.1 in FSB, (2018), ibid., pp. 75–79. Footnote 114 (p. 75) refers to the different authors who contributed to the analysis. 322  See recently: Y. S. Schüler et al., (2015), Characterizing the Financial Cycle: A Multivariate and Time-Varying Approach, ECB Working Papers Series, Nr. 1846, September. 323  See for actual data: BIS total credit statistics (via bis.org), update on a quarterly basis. See also and for alternative models: C. Dembiermont, et al., (2013), How Much Does the Private Sector Really Borrow? A New Database for Total Credit to the Private Non-Financial Sector, BIS Quarterly Review, March, pp. 65–81; J. Cizel, et al., (2016), Effective Macroprudential Policy: Cross-Sector Substitution from Price and Quantity Measures, IMF Working Paper, Nr. WP/16/94, April. 324  See also the follow-up study performed in this respect: FSB, (2019), ibid., pp. 79–82 and literature references made. Also see E. Kemp, et al. (2018), The Non-Bank Credit Cycle, FEDS Working Paper Nr. 2018–076, October. 325  This often is the consequence of in-house banks (part of OFI) channeling funds through that country and so the volumes also reflect up to a certain point the investment infrastructure of a particular country. 326  Those models are not discussed here but see: for the different models possible: L. Christiano, and T. Fitzgerald, (2003), The Band-Pass Filter, International Economic Review, Vol 44, Issue 2, May, pp.  435–465; G.  Farrell and E.  Kemp, (2017), Measuring the Financial Cycle in South Africa, November 23, Working Paper, mimeo; D.  Aikman, et  al., (2015), Curbing the Credit Cycle, 321

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• In recent years, the nonbank credit cycle is upward, just like bank credit volumes, although the latter at a slower rate. • Bank credit is a useful indicator for systemic banking crises, while nonbank credit may be helpful to predict currency crises. • Synchronization of bank and nonbank credit cycles, potentially amplifying boom and bust behavior. The relationship between nonbank and bank credit cycles changes over time, and bank credit cycles appear to be more synchronized across jurisdictions than nonbank credit cycles. Another feature that has been studied327 is the relationship between corporate cash holding and the demand for nonbank credit. Or more broadly, we can say something useful about the demand side of bank-like activities by nonbank companies.328 So then the question is, is money out there that might benefit from credit intermediation?329 Cash held by corporations are in place to meet short-term liabilities. Holding too much depresses returns, and holding too little will make you end up in trouble; so, when invested, they tend to focus, besides the adequate time horizon, on safe and liquid products. Less focus is on returns. We know that in recent years corporations and in particular large corporations have been and are sitting on trillions of US dollars in cash and marketable securities.330 The question to ask is ‘whether and how the composition of corporate cash holdings shifted between bank and non-bank financial instruments in recent years’.331 The study, although preliminary and based on a limited number of jurisdictions, concludes that although absolute corporate cash levels have increased materially in absolute terms, they haven’t done so in relative terms (relative to total balance sheet assets). It demonstrates continued conservatisms by treasurers deploying cash but also that there might be a potential need for adequate nonbank instruments. For now, corporate treasurers have not been tempted to reach

Economic Journal, Vol. 125, Issue 585, June, pp. 1072–1109. It should be stressed that we are only in the early stages of developing models to understand nonbank credit cycles and even more so the synchronization of both bank and nonbank credit cycles. Filtering out the impact of a certain financial infrastructure, the link between monetary policy and the aforementioned synchronization, and indicative and predictive values of those cycles for future periods of distress are all topics on which material progress needs to be made. 327  See Annex 3 (Corporate cash holdings as a demand factor for nonbank financial instruments) in FSB, (2018), ibid., pp. 79–84. 328  Most shadow banking research focuses on the supply side of nonbanks. 329  This sounds very much like the discussion we had elsewhere regarding the demand for safe and liquid assets by institutional cash pools. 330  Some cash pools are so huge that firms decide to develop their own asset management firm inhouse to manage that cash: see, for example, Apple and Braeburn Capital managing over 250 billion in AUM. See FSB, (2018), ibid., pp. 79–81, for the evolution of corporate cash balances in market data terms. It is interesting that the trend is similar for listed and nonlisted corporations. 331  FSB, (2018), ibid., p. 79. Pre-crisis corporations reduced their cash allocation into bank instruments relative to nonbank instruments. After the crisis, corporates increased the allocation of their cash to bank instruments more than to nonbank instruments (pp. 82–83). Corporates seem to favor direct investment over nonbank product. MMFs make up about half of non-deposit holdings.

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for higher yields through nonbank financial instruments.332 But things are in flux and with a decades-­long bull market in bonds markets somewhat coming to an end, the tide could be right for new products in the nonbank sphere. Another relation that is closely watched and under subject to continuous change is the relationship between nonbank credit and the housing market. Although generally banks and, to a lesser degree, credit unions account for the majority of mortgages supplied (> 95%), in some market nonbanks credit is material or at least on the rise.333 The involvement of nonbanking institutions (including online platforms) breaks down in two segments: (1) nonbanks that underwrite new loans334 and (2) nonbanks that finance loans originated by others.335 There is very little visibility when it comes to the role of nonbanks in credit supply for cross-border real estate acquisitions.336 Regulatory tools to address systemic risk stemming from nonbank intervention in the housing might be positioned at the level of the lender and/or the borrower. When implemented at the level of the lender, they typically include capital buffers, risk weighting for real estate exposure or retention requirements. When targeting at the level of the borrower, they include all sorts of limits (loan-to-value, debt-to-income, interest-coverage limits, etc.). In both cases, the focus of regulation is on loans provided by banks and not  so much nonbank mortgages. Similar dynamics can be found when evaluating

 They started to use a variety of other existing products however: ‘separately managed accounts; money market demand accounts (a structured bank deposit product that offers a higher interest rate in return for certain restrictions) and other structured bank deposit products; repo and bank collateral products (e.g. direct repos, evergreen repos); bond and cash-strategy ETFs; ultra-short funds; and dynamic discounting (supplier discounts for early payment of accounts payable)’: FSB, (2018), ibid., p. 84. 333  See Bank of England, (2017), Financial Stability Report, Issue 41, June; C. Crowe et al., (2011), How to Deal with Real Estate Booms: Lessons from Country Experiences, IMF Working Paper, Nr. WP/11/91, April; S.  Fisher, (2018), Housing and Financial Stability, Federal Reserve Board of Governors, speech, June, 20. See for an overview: Annex A3.3: Developments and Adaptations in the Housing Finance Markets in FSB, (2018), ibid., pp. 85–87. Remarkable observations in terms of nonbank holdings in mortgages: Canada 11.3%: D. Coletti, et al., (2016), The Rise of Mortgage Finance Companies in Canada: Benefits and Vulnerabilities, Financial System Review, December, pp. 39–52; India: 46.5% through housing finance companies; the Netherlands: 14.4% through pension funds and insurance firms; the UK: 8.6%; the US: 7.9% 334  The underwriting business models vary across jurisdictions: see FSB, (2018), ibid., pp. 87–88 for some examples. 335  See for the trend in the Netherlands: J. Kakes et al., (2017), Verschuivingen in de financiering van hypotheekschuld, Economisch Statistische Berichten, May 11, pp. 69–73. 336  M. Richter and J.G. Werner, (2016), Conceptualising the Role of International Capital Flows for Housing Markets, Intereconomics, May, Vol. 51, Issue 3, pp.  146–154. Regulation might incentivize cross-border lending: D. Reinhardt and R. Sowerbutts, (2015), Regulatory Arbitrage in Action: Evidence from Banking Flows and Macroprudential Policy, BoE Staff Working Paper, Nr. 546, September. 332

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­macroprudential tools.337 Besides the asymmetric nature of these tools implemented, the lack of granular data sets might be a structural problem.338 Property registers and loanlevel credit registers are gradually being put in place.339 It is clear from the examples highlighted that investing in credit outside the banking scene has become commonplace.340 In fact, loan claims tripled at investments funds in the EU, often driven by the ‘search for yield’.341 The identified risks are liquidity/maturity risk (for open-ended funds; in the EU > 80% of funds), credit risk (as 75% of assets invested in are unrated assets and 21% below investment grade) and regulatory arbitrage and imperfect credit risk transfers.

 S. Pool, (2017), Mortgage Debt and Shadow Banks, Presentation November 11, (via bankofgreece.gr); E. Cerutti, et al., (2015), The Use and Effectiveness of Macroprudential Policies: New Evidence, IMF Working Paper, Nr. WP/15/65, March; E.  Cerutti et  al., (2016), Changes in Prudential Policy Instruments  – A New Cross-Country Database, IMF Working Paper, Nr. WP/16/110, June. Also see ESRB, (2016),: Macroprudential Policy Beyond Banking: an ESRB Strategy Paper, July. 338  J. M. Serena and B. Tissot, (2017), Data Needs and Statistics Compilation for Macroprudential Analysis, Irving Fisher Committee on Central Bank Statistics (IFC) Bulletin, Nr. 46, December, pp. 1–12. 339  See FSB, (2018), ibid., pp. 90–91 for an overview of realizations per country. 340  Also see IOSCO (2017): Findings of the Survey on Loan Funds, FR03/2017, February. They distinguish between different types of loan funds: (1) a loan originating fund and (2) a loan participating fund. There are funds like the EU’s alternative investment funds (AIFs) that invest in a variety of credit products. There are two general fund frameworks in the EU: the undertakings for collective investment in transferable securities (UCITS) model and the alternative investment fund managers directive (AIFMD) model. AIMFD covers what is not within scope at the level of the UCITS regulation. AIFs are part of the AIMFD framework. ‘Under EU rules AIFs can originate loans without additional diversification or investment limits, unless they are also authorised under a specific EU common legislation such as the European Venture Capital Fund (EuVECA), the European Social Entrepreneurship Fund (EuSEF) and the European Long Term Investment Fund (ELTIF) Regulations’: FSB, (2018), ibid., p. 95. Loan origination is often possible given portfolio diversification and investment restrictions. 341  See FSB, (2018), ibid., p. 93. For their performance and standard setting, see: ESMA, (2016), Key Principles for a European Framework on Loan Origination by Funds, April 11, and IOSCO, (2017), ibid. See for a comparative analysis of direct lending by funds in the EU: Debevoise and Plimpton, (2017), Direct Lending by Funds: A Comparison of the Key EU Jurisdictions, May 23, pp. 1–11. It needs to be observed that on top of EU law there are national requirements: (1) many jurisdictions required loan origination funds to be structured as closed-end funds, (2) the potential use of leverage in loan origination funds is limited, especially in case marketed to retail investors, and (3) concentration limits so that not more than often 10% of funding can be invested in a single loan asset. 337

3 The EU Shadow Banking Market

3.1 Introduction Undoubtedly, it is clear by now that the shadow banking (SB) sector is all about financial intermediation. The financial sector as such is all about intermediation, as it channels funds to productive investments and fosters, at least in theory, efficient capital allocation in the economy. It also facilitates lifecycle consumption smoothing (timing of investments and consumption) and intergenerational resource transfers.1 Historically, that intermediation used to be performed by banks, but in recent times it has more and more been executed directly vis-à-vis the market (market-based financing). That transition occurred faster and more intense in the US than in Europe. Using financial intermediaries has its advantages: (1) cost savings, (2) risk diversification and liquidity insurance, (3) valuable product information and (4) reducing information asymmetry.2 To safeguard those benefits they have traditionally been intensely regulated. The non-exclusivity of banks in this process is, however, not new; also nonbank intermediaries such as insurers, pension funds and regulated investment funds link providers and users of funds. They tend to cater to specific types of clientele posing often similar characteristics and do not enjoy explicit public safety nets. Nevertheless, ‘these intermediaries are still being regulated to address information asymmetries and other market failures.’3 The historical evolution of shadow banking was already discussed.4 The recent outlook of the shadow banking sector is that of creditors that are not normally identified and regulated as credit institutions. In an EU context it means they are not seen as

 See EU Commission, (2014), European Financial Stability and Integration, pp. 94–95.  EU Commission, (2014), ibid., p. 96. 3  EU Commission, (2014), ibid., p. 97. 4  I will not rehash here the different critiques already discussed that emerged regarding that FSB definition. The critiques involved either the fact that (1) the FSB definition focus on activities ­outside the regular banking system may underestimate the role played by large regulated banking 1 2

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credit institutions in the meaning of Article 4(1) of Regulation (EU) 575/2013. They are not covered by prudential supervision and, ‘due to their number and frequent nonrequirement of any license, they escape the relevant regulation, namely the Directive 2008/48/EC on credit agreements for consumers’.5 The European Commission (EC) entrusted the European Banking Authority (EBA) with a mandate of the frame and shed some light on the legal and supervisory aspects of institutions that do not qualify as credit institutions in the different member states.6 The feedback was not a surprise: given the heterogeneity of entities and the prudential rules they were subject to in the individual member states, it was suggested that ‘there may be merit in conducting further analysis of the sector in order to determine whether or not a legislative proposal should be brought forward to establish common prudential requirements for some or all of these entities’.7 Also in Europe they experienced the trend that credit activity is no longer performed in a single entity with the previously described risk concentration but through a more or less wide web of intermediaries. The shadow credit activity can be simply formalized in three parts: (1) loans origination, (2) warehousing, quality transformation and enhancement and intermediation of loans and securitized products issued from, and (3) externalization of funding and risk-bearing in wholesale market.8 It became clear from the earlier discussion about the demarcation lines and definition of shadow banking that a combination of ‘entity’ and ‘activity’-based measurements9 are required. And even that will not suffice over time, as those components interact and will create new shadow banking dimensions and layers. They will in the initial stage (so not timely) will not (properly) show up on the supervisory and oversight radar. In terms of activity the targeted activities are ‘maturity, credit, and liquidity transformation, but without public backstop’. In terms of entities the FSB uses a wide set of entities, where often the pain is in the tail category of ‘other investment funds’ aka ‘other financial intermediaries’ (OFIs) which is a kind of rest category including all types of entities with often different

groups (something that will be discussed extensively going forward); (2) the FSB definition may cover entities that should not be thought as being part of the shadow banking sector based on a liquidity, maturity, leverage and interconnectedness risk assessment (such as leasing companies, finance companies, corporate tax vehicles); and (3) the FSB definition may not allow to proactively detect new shadow banking activities. Some commentators put the focus on the presence of a backstop or safety net and on systemic risk and propose as an alternative definition for shadow banking ‘all financial activities, except traditional banking, which require a private or public backstop to operate’. 5  EU Commission, (2014), ibid., p. 97. 6  See EBA, (2014), Report to the European Commission on the Perimeter of Credit Institutions Established in the Member States, November. Part three (pp. 16–24). 7  EBA, (2014), ibid., p. 16. 8  P.-N. Rehault, (2013), Understanding Shadow Banking from a European Perspective, Université de Limoges Working Paper, March 7. 9  That distinction was already found back in A. Bouveret, (2011), An Assessment of the Shadow Banking Sector in Europe, ESMA Working Paper.

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activities and risk characteristics. The European Systemic Risk Board (ESRB) aggregates the following entities in the definition10: money market funds (MMFs), bond funds, equity funds, private equity funds, real estate funds, exchange-traded funds (ETFs), financial vehicle corporations (FVCs) engaged in securitization, security and derivative dealers, and financial corporations engaged in lending. The tail category for the European Systemic Risk Board (ESRB) includes ‘MMFs, financial vehicle corporations (financial vehicles engaged in securitization), and other miscellaneous intermediaries (such as securities dealers, venture capital companies, leasing and factoring companies, and financial holding companies)’. In terms of size of the individual categories in the shadow banking pool it can be referred to the discussed FSB global monitoring reports.11 The shadow banking system represents ultimately a broad(er) and global funding system. It operates at the level and as a banking system but also at the level of the funding of the traditional banking sector. That global funding system then created its own shadowy sides and activities.

3.2 T  he Dynamics of the EU Shadow Banking Sector The large components of the EU shadow banking sector12 are pretty much the same as is the case in the US, that is, the securitization market, the MMF segment, the repo market and the securities lending market. And although there are some country specifics as is the case in the Netherlands and Luxembourg due to a concentration of the fund industry in Luxembourg and the use of the Netherlands for tax purposes through specific special purpose vehicles (SPVs) and finance companies, the overall dynamics of the shadow banking sector are the same. And so is the interconnectedness, although that interconnectedness was often, and especially before the financial crisis, between European banks and the US shadow banking sector rather than the European shadow banking sector (in terms of investments). The volumes in the European shadow banking sector have always been traditionally lower. Before the crisis those volumes amounted to 12% of gross domestic product or GDP (US) and 5% in Europe for, say, securitizations. The overall maturity of the European shadow banking sector is therefore less compared to the US.

 ESRB, (2014), Mapping and Risks of the EU Shadow Banking System, non-public 30 January 2014, interim Report. 11  For Europe-specific assessments, see: ESMA (2014), Trends, Risks, Vulnerabilities, Vol. 2, pp. 21–22 with estimations of maturity and liquidity exposures, ESRB, (2014), Mapping and Risks of the EU Shadow Banking System, non-public 30 January 2014 interim report, and K. BakkSimon, (2012), Shadow Banking in the Euro Area: An Overview, ECB Occasional Paper Series Nr. 133, April, and A.  Bouveret, (2011), An Assessment of the Shadow Banking Sector in Europe, ESMA Working Paper. 12  See also: C. Jackson and J. Matilainen, (2012), Macro-Mapping the Euro Area Shadow Banking System with Financial Sector Balance Sheet Statistics, IFC Conference on Statistical Issues and Activities in a Changing Environment, Working Paper, Basel, 28–29 August 2012. 10

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Table 3.1  European securitization statistics (in USD billions, issuance) Segment

2008

2014

2018

Total issuance ABS auto ABS consumer ABS credit cards ABS leases ABS other CDO CMBS MBS mixed RMBS SME

1.209 18.6 36.6 18.2 19.1 5.5 131.2 8.1 7.2 897.0 67.9

287.2 38.4 8.7 9.9 3.6 1.8 19.4 7.9 – 148.4 44.1

269.7 68.7 68.7 68.7 68.7 68.7 51.6 5.8 – 113.3 29.5

The European securitization market has always been smaller than that of the US and has been dragging its feet after the crisis although there is some variation among the different segments, also among the subsequent years. A quick comparison demonstrates the dynamics between the US and the European securitization market: US/European issuance in 2001 was in billions of euros: 2308.4/152.6; for 2004: 1956.6/243.5; for 2007: 2080.5/593.6; for 2010: 1203.7/379.1; and for 2013: 1515.1/180.2. A few anchor numbers13 for evaluation purposes are provided in Table 3.1. The only meaningful category is the residential mortgage-backed securities (RMBS) but only at a fraction of the size before the 2008 crisis. And then the numbers are somewhat deceptive in that the large majority of new issuance after the crisis involved transactions designed to create securities that the bank involved could pledge to its central bank in return for financing. These securitizations were retained rather than being placed with investors. That puts some additional question marks next to the Capital Markets Union (CMU) project and the attempt to revive bank lending through fueling securitization against lower capital requirements.14 In particular the small- and medium-­sized enterprise (SME) segment would need a broader access to capital and many questions have been asked whether securitization will be instrumental in achieving that. Most scholars don’t

 Data source: sifma.org, period 2008–2019, quarterly and annual reports. It was observed that the numbers of SIFMA and AFME do not (fully) match in terms of securitization issuance. See: Afme, (2015), Afme Securitization: Q3, 2015 Data Snapshot, London, p. 1. One can only wonder what caused these (often large) variations as both institutions do not provide details regarding the methodology or granularity of their data set. Similar deviations were observed in historical data sets; see: Afme, (2015), Securitization Data Report, Q2: 2015, London, pp. 3–5. Number don’t add up to 100%, due to miscellaneous unreported group of 0.6 billion (2018). 14  Discussed in the CMU section. It is discussed why SME securitization is lagging and why no plan will really change that unless it includes revising the capital requirements for banks and the SME loan book. Nevertheless, for some EU countries the suggested reform lacks ambition; see M. Stothard and J. Brunsden, (2015), France Warns that EU Securitisation Push Lacks Ambition, Financial Times, October 26. It comes down to the alleged need to have an EU body that will decide on whether securitization products meet the critical standard of ‘simple transparent and standardized’ (and which would allow the issuer to hold lower capital charges against the product). 13

Monitoring and development of risk metrics: The EU relies to a large degree on the proposals developed by the FSB and the ESRB Establishment of the Legal Entity Identifier regulatory oversight committee Template development for more granular data-set development and consistent generation of cross-country data sets (FSB templates) Implementation of short-selling regulation (increased transparency for CDS and banning uncovered sovereign CDS): regulation (EU) Nr. 236/2012 of the European Parliament and of the Council of 14 March 2012 on short selling and certain aspects of credit default swaps (O.J. 24/3/2012, L 86/1- L86/24) Amendments to IFRS 7 regarding certain securitization risks.a Regulation to increase transparency on securities financing transactions and rehypothecation (COM(2014) 40 final).b Securities financing transactions have the propensity to increase the buildup of leverage in the financial system as well as to create contagion channels between different financial sectors. There is a need for a more granular provision of data by SFT market players. Reporting requirements directive for derivative transactions to trade repo (EMIR regulation, partly ongoing) Regulation and harmonized prudential requirements for central securities depositories (CSDs)c Risk monitoring by ESRB working group (ongoing) MiFID revision (MIFID 2)d Amendments regarding IFRS 10-12 (consolidation and disclosure requirements)e Banking sector Capital Requirements Directive (CRD II and III) implementationf Implementation of CRR/CRD IVg (prudential requirements) EBA assessment of scope of credit institutions across EU Member Statesh (ongoing) EBA report on possible limits for bank’s exposure to unregulated counterpartiesi and shadow banking entities in particularj; disclosure standards for central clearing parties (CCPs)k (ongoing). This is still seen as a major topic going forward given its contribution to the overall vulnerability of the EU’s financial sector.l

(continued)

Insurance sector and pension funds Solvency II and Omnibus II (revisions)m Applicable as of 1.1.2016

EU supervisory framework Follows the following frameworks:  ESFS 2013 Framework which included setting up the new EU supervisory authorities including the (1) European Banking Authority, (2) European Securities and Markets Authority and (3) ESFS 2013 Framework  Based on FSB policy recommendation to ‘identify other shadow banking entities’. This is a work in progress as it is refined annually through the FSB annual shadow banking monitoring reports. Information-sharing process between Member States regarding ‘other shadow banking entities’ and review of each other’s policy framework

Transparency of shadow banking (general)

Table 3.2  Regulatory initiatives taken by the EU Regarding the shadow banking market

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Resolution tools for nonbanks FSB methodologies regarding identification SIFIs, G-SIFI, D-SIFI, G-NBNI and insurance firmsq

Asset management Money market fund regulation (in force)n AIFMD implementationo deals with issues surrounding inadequate liquidity and capital (i.e. shock absorbers). AIFs are required to hold sufficient capital. They should have appropriate arrangements in place for risk management, valuation purposes, the assets safekeeping (depositary), the audit and the management of conflict of interests. UCITS review regarding investment techniques and strategiesp UCITS/AIF transactions occur on an ongoing basis. Securitization

a

Commission Regulation (EU) No 574/2010 of 30 June 2010 amending Regulation (EC) No 1126/2008 adopting certain international accounting standards in accordance with Regulation (EC) No 1606/2002 of the European Parliament and of the Council as regards International Financial Reporting Standard (IFRS) 1 and IFRS 7, O.J. L 166, 1.7.2010, pp. 6–8 b EU Commission, (2014), ibid., pp.  121–123. The intended improved transparency would prevent financial intermediaries, including banks, from attempting to circumvent regulation by shifting parts of their activities to the less-regulated shadow banking sector. Throughout 2015 this proposal has been working itself through the legislative grinder with on June 29 endorsement by the Permanent Representatives Committee, October 29 (proposal was adopted by the European Parliament) and on 16 November (adopted by the council of the EU). It was published in the O.J. on 23 December 2015 c EBA, (2015), Final draft Regulatory Technical Standards on certain prudential requirements for central securities depositories under Regulation (EU) No 909/2014 (‘Central Securities Depositories Regulation)’ (the CSD-R), EBA/RTS/2015/10, December 15. Published: Commission Delegated Regulation (EU) 2017/390 of 11 November 2016 supplementing Regulation (EU) No 909/2014 of the European

Derivatives and securities financing transactions Implementation of risk retention criteria through a variety of regulations and directives (CDR, AIFMD) Based on FSB policy recommendations Ongoing design of securitization framework based on FSB, BIS and IOSCO criteria with a view regarding repos and securities lendingu toward designing simple, transparent and high-­quality securitization standardsr Proposal to increase transparency on Proposal of 30 September 2015 for a securitization proposal that will apply to all securitizations and securities financing and on include due diligence, risk retention and transparency rules together with the criteria for STS rehypothecation.v Approved by the s Securitizations. Combined with a regulation to lower capital requirements for certain securitized EU Parliament on 29 October 2015 products.t On 2 December 2015 that proposal was agreed upon by the Permanent Representatives and Council on 17 November 2015. Committee (Coreper) approved. In force since 1 January 2019. Ongoing monitoring through ESRB surveys of financing transaction and rehypothecation practicesw

EU supervisory framework

Transparency of shadow banking (general)

Table 3.2 (continued)

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Parliament and of the Council with regard to regulatory technical standards on certain prudential requirements for central securities depositories and designated credit institutions offering banking-type ancillary services, C/2016/7158, OJ L 65, 10.3.2017, pp. 9–43 d Regulation (EU) No 600/2014 of the European Parliament and of the Council of 15 May 2014 on markets in financial instruments and amending Regulation (EU) No 648/2012 Text with EEA relevance OJ L 173, 12.6.2014, pp. 84–148 e Commission Regulation (EU) No 313/2013 of 4 April 2013 amending Regulation (EC) No 1126/2008 adopting certain international accounting standards in accordance with Regulation (EC) No 1606/2002 of the European Parliament and of the Council as regards Consolidated Financial Statements, Joint Arrangements and Disclosure of Interest in Other Entities: Transition Guidance (Amendments to International Financial Reporting Standards 10, 11, and 12), O.J. L 95, 5.4.2013, pp. 9–16 f Directive 2009/111/EC of the European Parliament and of the Council of 16 September 2009 amending Directives 2006/48/EC, 2006/49/EC and 2007/64/EC as regards banks affiliated to central institutions, certain own funds items, large exposures, supervisory arrangements, and crisis management (Text with EEA relevance) O.J. L 302, 17.11.2009, pp. 97–119; Directive 2010/76/EU of the European Parliament and of the Council of 24 November 2010 amending Directives 2006/48/EC and 2006/49/EC as regards capital requirements for the trading book and for re-securitizations, and the supervisory review of remuneration policies Text with EEA relevance O.J. L 329, 14.12.2010, pp. 3–35 g Directive 2013/36/EU of the European Parliament and of the Council of 26 June 2013 on access to the activity of credit institutions and the prudential supervision of credit institutions and investment firms, amending Directive 2002/87/EC and repealing Directives 2006/48/ EC and 2006/49/EC Text with EEA relevance O.J. L 176, 27.6.2013, pp. 338–436; Regulation (EU) No 575/2013 of the European Parliament and of the Council of 26 June 2013 on prudential requirements for credit institutions and investment firms and amending Regulation (EU) No 648/2012 Text with EEA relevance O.J. L 176, 27.6.2013, pp. 1–337 g See EBA Report to the European Commission on the perimeter of credit institutions established in the Member States, 27.11.2014 i See also BIS, (2014), Capital Requirements for Bank Exposures to Central Counterparties, Basel, Switzerland j EBA, (2015), Limits on Exposures to Shadow Banking Entities Which Carry Out Banking Activities Outside a Regulated Framework Under Article 395(2) of Regulation (EU) Nr. 575/2013, EBA/GL/2015/20, December 14 k BIS, (2015), Public Quantitative Disclosure Standards for Central Counterparties, Committee on Payments and Market Infrastructures, Board of the International Organization of Securities Commissions, Basel, Switzerland l EBA, (2015), Risk Assessment of the European Banking System, December 21, pp. 23–24 m Directive 2009/138/EC of the European Parliament and of the Council of 25 November 2009 on the taking-up and pursuit of the business of Insurance and Reinsurance (Solvency II) (Text with EEA relevance) OJ L 335, 17.12.2009, pp. 1–155; Directive 2013/58/EU of the European Parliament and of the Council of 11 December 2013 amending Directive 2009/138/EC (Solvency II) as regards the date for its transposition and the date of its application, and the date of repeal of certain Directives (Solvency I) Text with EEA relevance O.J. L 341, 18.12.2013, pp.  1–3; Directive 2014/51/EU of the European Parliament and of the Council of 16 April 2014 amending Directives 2003/71/EC and 2009/138/EC and Regulations (EC) No 1060/2009, (EU) No 1094/2010 and (EU) No 1095/2010 in respect of the powers of the European Supervisory Authority (European Insurance and Occupational Pensions Authority) and the European Supervisory Authority (European Securities and Markets Authority), O.J. L 153, 22.5.2014, pp. 1–61 (continued)

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n

The EU passed the MMF Regulation to reduce such risk in money market funds. (Regulation (EU) 2017/1131 of the European Parliament and of the Council of 14 June 2017 on Money Market Funds (MMF Regulation), 2017 O.J. (L 169) 8, EUR-Lex website; Press Release, European Commission, Memo: New Rules for Money Market Funds Proposed – Frequently Asked Questions (Sept. 4, 2013), European Commission website) o Directive 2011/61/EU of the European Parliament and of the Council of 8 June 2011 on Alternative Investment Fund Managers and amending Directives 2003/41/EC and 2009/65/EC and Regulations (EC) No 1060/2009 and (EU) No 1095/2010, L 174, pp.  1–73; EU Commission, (2014), ibid., pp. 117–119 p EFAMA, (2011), The evolving investment strategies of UCITSEFAMA report on the so-called ‘Newcits’ phenomenon, London q FSB, (2014 & 2015), Assessment Methodologies for Identifying Non-Bank Non-Insurer Global Systemically Important Financial Institutions, London; BIS, (2011), Global Systemically Important Banks: Assessment Methodology and the Additional Loss Absorbency Requirement, Basel, Switzerland; BIS, (2012), A Framework for Dealing with Domestic Systemically Important Banks, Basel, Switzerland; FSB/IOSCO, (2014), Assessment Methodologies for Identifying Non-Bank Non-Insurer Global Systemically Important Financial Institutions, London r EC, (2015), Consultation Document, An EU Framework for Simple, Transparent and Standardised Securitisation, February 18 s EC, (2015), Proposal for a Regulation (COM(2015) 472 final) of the European Parliament and of the Council laying down common rules on securitization and creating a European framework for simple transparent and standardized securitization and amending Directives 2009/65/EC, 2009/138/EC, 2011/61/EU and Regulations (EC) No 1060/2009 and (EU) No 648/2012 of 30 June 2015. Final regulation: Regulation (EU) 2017/2402 of the European Parliament and of the Council of 12 December 2017 laying down a general framework for securitisation and creating a specific framework for simple, transparent and standardised securitisation, and amending Directives 2009/65/EC, 2009/138/EC and 2011/61/EU and Regulations (EC) No 1060/2009 and (EU) No 648/2012, OJ L 347, 28.12.2017, pp. 35–80. Many technical regulations followed all the way into 2019 and beyond. See the relevant chapter in Vol. I for further details t EC, (2015), Proposal for a Regulation (COM(2015) 473 final) of the European Parliament and of the Council amending Regulation (EU) No 575/2013 on prudential requirements for credit institutions and investment firms. Currently in force: Consolidated version Regulation (EU) No 575/2013 of the European Parliament and of the Council of 26 June 2013 on prudential requirements for credit institutions and investment firms and amending Regulation (EU) No 648/2012 u FSB, (2013), Policy Framework for Addressing Shadow Banking Risks in Securities Lending and Repos and FSB, (2014), Regulatory framework for haircuts on non-centrally cleared securities financing transactions v EC, (2014), Proposal for a Regulation of the European Parliament and of the Council on reporting and transparency of securities financing transactions, COM(2014) 40 final, January. The proposal was approved by the council in November 2014. The draft regulation introduces measures to improve transparency in three main areas: (1) the monitoring of the buildup of systemic risks in the financial system related to securities financing transactions, (2) the disclosure of information on such transactions to investors whose assets are employed in the transactions and (3) rehypothecation activities, a practice by banks or brokers of reusing for their own purposes collateral pledged by

Table 3.2 (continued)

210  L. Nijs

their clients. The draft takes into account the recommendations released by the European Systemic Risk Board in 2013: see ESRB (A.  Bouveret et  al.), (2013), Towards a Monitoring Framework for Securities Financing Transactions, Occasional Paper Series, Nr. 2. In particular, they develop a set of indicators to effectively monitor the risks in these types of transactions, pp.  4–9. They include (1) facilitation of credit growth, (2) procyclicality of system leverage, (3) maturity and liquidity transformation, (4) interconnectedness and contagion channels, (5) collateral fire sale and concentration, (6) currency mismatches and (7) market structure. Opinion of the European Economic and Social Committee on the ‘Proposal for a Regulation of the European Parliament and of the Council on reporting and transparency of securities financing transactions’—COM(2014) 40 final—2014/0017 (COD), O.J. C 451, 16.12.2014, pp. 59–63. Regulation 2015/2365 on transparency of securities financing transactions and of reuse currently in force. w See for the most recent edition: ESRB (J. Keller et al.), (2014), Securities Financing Transactions and the (Re)use of Collateral in Europe. An Analysis of the First Data Collection Conducted by the ESRB from a Sample of European Banks and Agent Lenders, Occasional Paper Series, Nr. 6, London

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L. Nijs

believe15 that SME loan securitization doesn’t only violate reality (low SME securitization volumes, also in Europe, before the 2008 crisis) but also the fact that securitization could act as a safety valve against asymmetric SME risks for banks and external institutional investors likewise. Their reasoning is as follows: ‘[s]ecuritisation offers banks the possibility of shifting capital intensive assets such as SME loans off balance sheets. For the market to function well, banks must retain enough of the securitisation exposure to ensure that they have an incentive to manage the pool appropriately (i.e., leaving them with “skin in the game”). But, this still would still typically give them scope to sell a significant part of their exposure to outside investors and hence, if the capital rules so allow, to reduce their regulatory capital.’16 The idea that originating SME loans to bundle and offer to external institutional investors with more risk appetite ignores the fact that the real demand (also pre-2008 crisis) has been with the safe tranches of the securitized product and that the mezzanine and junior tranches often stayed behind on banks’ balance sheets with often devastating effects, we learned the hard way. That beyond the fact that SME loans and their intrinsic opaqueness and asymmetric risk profiles will never really qualify as ‘high-­ quality securitization’ as the EBA has in mind. That can only be done by a structural revision of the banking capital charges for SME loans and a total revision of overall capital charge framework. Many hurdles continue to exist and were discussed. In particular the issues of concentration of uncertainty, imperfect credit maturity techniques and opaque SME funding markets remain major obstacles.17 The arguments in favor of securitization, as there are freeing up bank funding to provide credit (at least become less procyclical) and risk ­diversification have not convinced me in their effectiveness. It hasn’t convinced me at all

At this point it is the national regulator who decides on the matter. The argument is that without a consistent approach in this matter only the biggest investors would have the expertise and resources necessary to take part in the market. That would be not sufficient to create the looked for ‘revival’. The EC counterargument is that a centralized approval system would materially slow down the approval process which obviously also doesn’t contribute to a ‘revival’. Although a valid argument in this context, it can be questioned what is different within the larger banking union and its many dark corners where supervision and oversight also have been centralized on an EU level and where in case of an organized unwinding of a banking institution a myriad of mechanisms comes into force that does right to a truly post-modern era. 15  Obviously, the industry lobby in Europe feels different about that AFME, (2013), The Economic Benefits of High Quality Securitisation to the EU Economy, November, p. 21. Please further note that even they indicate that ‘The specific impact of renewed securitisation on growth has not been quantified, but could be significant in terms of GDP’ (p. 2). That is followed by a list of assumptions, abstractions, non-sequiturs, cum hoc ergo propter hoc and so on. See also: AFME, (2014), High Quality Securitization for Europe. The Market at a Crossroads, June; Ignazio Visco, (2015), Investment Financing in the European Union, keynote address by Mr. Ignazio Visco, Governor of the Bank of Italy, at OECD-Euromoney Conference on Long-Term Investment Financing, Paris, 19 November 2015. 16  Risk Control, (2015), How European Securitisation Could Assist SME Financing, Nr. 15.67a, June 16, p. 5. 17  See, for example, P. Francorre, (2014), Revival of Securitisation: Why and How?, Working Paper, mimeo.

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against some of their known drawbacks being asset valuation exuberance (asset bubbles), and assymetric risk concentration. Extra lubrication for liquidity in markets or for the transformation of illiquid in liquid assets isn’t a necessity to lower the cost of funding (that is good as it would be passed on to lenders which has not been the case in a verifiable way). The argument that therefore only plain vanilla securitized products should be allowed seems to ignore the argument that even plain vanilla concentrate uncertainty in an asymmetric way and that they are prone to the same level of opacity and ambiguity that characterizes the more complex securitization products. They therefore trigger, like the more complex instruments, market freezes and fire sales (as well as the timing and duration of them).18 Within the EU securitization19 market asset-backed commercial paper (ABCP) and asset-backed securities (ABS) are the most important forms of securitization in Europe (over half of all securitized products are residential mortgage-backed securities). ABS also account for a large share of the assets held at the Eurosystem as collateral for the repo operations of liquidity provision.20 The covered bond market is essentially no part of the shadow banking infrastructure in Europe21 for a number of technical reasons, the most important being the fact that the investor has recourse on both the asset pool being securitized and the issuing bank. Within the EU, the UK, the Netherlands, Spain22 and Italy are the main securitization locations. Since 2013 France is also back in business and so is Germany. Ireland joined forces in 2014 as well, albeit modestly.23 The interconnectivity between the shadow banking and traditional banking sector is on the rise across Europe but in an uneven way.24 What is still not largely available are granular data regarding the maturity and liquidity mismatches in Europe, by entity type or country. The securitization market, however, continues to be at the central of regulatory, supervisory and compliance attention; see Box 3.1.25

 A.G. Anderson, (2015), Ambiguity in Securitization Markets, Finance and Economics Discussion Series Nr. 2015-033, Divisions of Research & Statistics and Monetary Affairs Federal Reserve Board, Washington, DC, May. 19  See for a generic overview of the European securitization market: ECB, (2011), Recent Developments in Securitization, February, Frankfurt. 20  K. Bakk-Simon et al., (2012), Shadow Banking in the Euro Area. An Overview, Occasional Paper Series Nr. 133, Frankfurt April. See also Deutsche Bundesbank, (2014), The Shadow Banking System in the Euro Area: Overview and Monetary Policy Implications, Monthly Report, March, pp. 15–34. See also the ECB Financial Stability Review 2014 and 2015, Frankfurt. 21  Although they are often reported as being part of it: ECB, (2011), Recent Developments in Securitization, February, Frankfurt, pp. 16–21. 22  O.C. Brañanova, (2017), Shadow Banking in Spain, Working Paper, mimeo, via bis.org 23  See AFME, (2015), Securitization Data Report, Q4 2014, April 8, p. 4. 24  K. Bakk-Simon et al., (2012), ibid., pp. 21–23. 25  This overview is complete with respect to the major legislative documents and policies frameworks developed and enacted. It falls short to be totally exhaustive and include all technical standards and other policy document or delegated legislation enacted. See for a complete overview and update ec.europe.eu. 18

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Box 3.1  Recent Regulatory, Legislative and Policy Initiatives in Europe Regarding Securitization and the Wider Shadow Banking Segment26 • On 14 October 2014, the EBA published a Discussion Paper (DP) on ‘Simple, Standard and Transparent Securitizations’ in which it proposed criteria defining the high-quality securitizations. • On 11 December 2014, the Basel Committee on Banking Supervision (BCBS) issued their long-awaited ‘Revisions to the Securitization Framework’. • The International Organization of Securities Commissions (IOSCO) and BCBS established a joint Task Force on Securitization Markets (TFSM) which has been charged with reviewing the developments in securitization markets. On 11 December 2014, the TFSM issued a Consultative Document on criteria for identifying simple, transparent and comparable securitizations. • On 22 December 2014, the EBA issued an Opinion and supporting Report on ‘securitization retention, due diligence and disclosure requirements’ in which it proposed a new complementary ‘direct’ approach on risk retention. • On 28 January 2015, the BCBS published its final review of the Pillar 3 disclosure requirements. The implementation date is postponed to yearend 2016 financial reporting, from 1 April 2016. • On 3 February 2015, the European Securities and Markets Authority (ESMA) published a consultation on ‘Competition, Choice and Conflicts of Interests in the CRA Industry’. • On 18 February 2015, the European Commission published three consultations that will shape the Capital Markets Union agenda: (1) Green Paper on Building Capital Markets Union; (2) Consultation Document on EU framework for simple transparent and standardized (STS) securitization; and (3) Prospectus Directive review. • On 20 February 2015, the ECB published revised guidelines for the eligibility of assets for ECB open market operations. The ECB ABS Purchase Program (ABS PP) is ongoing. The Eurosystem is purchasing a broad portfolio of simple and transparent asset-backed securities. • On 18 March 2015, the BCBS and IOSCO published a revised framework for margin requirements for non-centrally cleared derivatives. • On 19 March 2015 EBA published its consultation paper seeking feedback on draft guidelines on exposures to shadow banking entities finalized and in force. • On 20 March 2015, ESMA launched a Call for Evidence to collect information from market participants about the approach to disclosure for Structured Finance Instruments originated and/or traded on a private and/or bilateral basis. • On 12 May 2015, the EBA (JC) issued their Joint-Committee report on Securitization. • On 26 June 2015, the EBA issued their advice on criteria and capital treatment for securitization. • On 7/8 July 2015, the EBA issued their report and advice on what constitutes ‘qualifying securitization’. Further reports followed in the period 2016–2018. (continued)

 See AFME, (2015), Securitization Data Report, Q4 2014, April 8, p.  2; and future quarterly annualized reports. Latest included Q1, 2019. 26

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Box 3.1  (continued) • On 6 August 2015, the EC adopted a delegated regulation that makes it mandatory for certain over-the-counter (OTC) interest rate derivative contracts to be cleared through central counterparties (C(2015) 5390 final). • On 30 September 2015, the EC issued their long-awaited initiative regarding the CMU, which is part of a larger investment plan and which aims to tackle investment shortages by increasing and diversifying the funding sources for Europe’s businesses and long-term projects. Part of this proposal was the launch of a proposal for regulation regarding securitization (COM(2015) 472 final) and an aligned change of the capital requirement regulation in order to make the capital treatment of securitizations more risk-sensitive and better reflect its specific features. Part of the same CMU package was a public consultation on the desirability of creating a future integrated European covered bonds framework that could help improve funding conditions throughout the Union and facilitate cross-border investment and issuance in a variety of Member States. • On 2 December 2015, the Council of the EU agreed on the securitization proposal as released on 30 September.27 In force as of 1 January 2019. • Throughout the period 2017–2019, the EBA issues consultation and final papers regarding risk retention, STS criteria and for a variety of securitization categories. • In 2017 the MMF legislation was enacted.

3.3 T  he Broader Perspective on Shadow Banking It must be clearly put upfront that most of the shadow banking regulation that we have seen coming in recent years can all be qualified as being ‘indirect regulation’. That is, setting rigorous standards for banking groups in terms of capital required, limitations on exposures, volumes, nature and type of transactions. Although this was necessary, it wasn’t necesary in it current form, nor sufficient. There is a clear consensus emerging that there is a need for a dual approach to go forward in the EU and beyond. That would include horizontal regulations for some specific activities and to limit or even ban some activities for banks. However, that would need to happen without jeopardizing the banking business models and their role in both the financial and the real economy.28 As will

 EC, (2015), Council of the European Union Agrees on Commission Proposal for Simple and Transparent Securitisation, STATEMENT/15/6239, December 2. 28  See, for example, D. Nouy, (2013), Les risques du Shadow banking en Europe: le point de vue du superviseur bancaire, ACP, Banque de France, Débats économiques et financiers, Nr. 3. See for an overview of the contemporary bank business models and their evolution: R.  Roengpitya et  al., (2014), Bank Business Models, BIS Quarterly Review, December 2014, pp. 55–65. And for the US: M.  Ricks, (2010), The Case for Regulating the Shadow Banking System, Vanderbilt Law School Working Paper, Mimeo, and I.A.  Moosa, (2015), The Regulation of Shadow Banking, Journal of Banking Regulation advance online publication 12 August 2015; doi: https://doi. org/10.1057/jbr.2015.8 27

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be demonstrated shadow banking activities have a natural inclination of being unstable without a self-correcting mechanism in place. Rather than focus on the banking aspect in shadow banking, it might be better to focus on the scoping of the activities as ‘shadow markets’, and so avoid that the focus will lie with those activities that are not banking centered but qualify for the trinity of criteria mentioned above.29 The macroprudential dynamics30 of ‘private money creation’ are often overlooked when assessing individual shadow banking entities and transactions and require a different legal approach.31

3.4 D  rivers of Growth of the EU Shadow Banking System Four drivers have been identified as fueling the shadow banking growth: (1) genuine benefits or efficiencies, (2) the ability to generate allegedly safe assets and additional collateral, (3) regulatory arbitrage and (4) institutional factors.32 • Genuine benefits: the benefits, although generalist in nature and in need of qualification post-crisis, are ‘improved price discovery, enhanced market efficiency, additional credit creation, market liquidity and economic growth, and increased financial stability33’ and ‘to investors from being able to invest in alternative asset classes (allowing risk diversification across geographies and asset types), enjoying greater risk-return flexibility (instruments being better tailored to the investor needs, preferences and profile), and achieving greater insulation from the originator’s credit risk’. • Generate safe assets and additional collateral: shadow banking creates safe, short-term and liquid instruments, that is, quasi-money, from risky, long-­term and illiquid assets. There is increasing demand for safe assets and collateral due to changing regulation, increased counterparty concerns and so on.

 See, for example, Ph. Tibi, (2013), Shadow Banking Versus Shadow Market, Sciences Po-Banque de France, 13 February. 30  J. Weidmann, (2019), Macroprudential policy through the lens of Sherlock Holmes. Welcome address by Dr. Jens Weidmann, President of the Deutsche Bundesbank and Chairman of the Board of Directors of the Bank for International Settlements, at the 5th Annual Macroprudential Conference, Eltville, 21 June 2019, via bis.org 31  See in detail: M. Ricks, (2011), Regulating Money Creation After the Crisis, Harvard Business Law Review, Vol. 1, pp. 75–143. The article describes a variety of legal, accounting and economic contexts in which non-deposit money-claims are treated as functional substitutes for deposit obligations. The system creates investible capital or loanable funds (pp. 99–101). 32  EU Commission, (2014), ibid., pp. 107–108. Many new disclosures and due diligence rules and requirements and skin in the game protocols have been implemented in recent years. 33  Securitization was believed to provide (1) superior balance-sheet management, (2) superior portfolio and risk management, (3) superior funding management, (4) better price discovery by liquefying previously illiquid asset and (5) lower capital requirements. 29

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• Regulatory and tax arbitrage: triggered by the desire of private actors to avoid ­traditional and regulated banking intermediation or to reduce regulatory capital charges. • Institutional factors: the role of institutions and the different nature of financial system intermediation in the EU explain deviations with other parts of the world.

3.5 T  he EU Policy Approach Regarding Shadow Banking Although the individual regulatory and supervisory measures have been discussed elsewhere, I will limit myself in this section to the general policy guidelines as conducted by the EU. Also in the EU there is the understanding that shadow banking intermediation activities can be a positive aspect of the maturing capital markets. They, also given the experiences during the last few years, understand that there are however concerns regarding the stability of the capital markets and the impact and contagion risk that exists when fire sales and subsequent liquidity risks occur. In order to arrive at simple, transparent, stable and effective public capital markets, a number of regulatory interventions have occurred in recent years. They try to, one way or the other, contribute to a market-based financing system that can help foster sustainable economic growth and ensure access to a diversified set of funding sources for nonfinancial corporations. Besides the size of the shadow banking system, there is the interconnectedness between the SB system and the regulated banking system that creates additional vulnerabilities. That interconnectedness tends to run along two lines: (1) ‘banks could move risks that they themselves would ordinarily be exposed to off-balance sheet for reasons of regulatory arbitrage through establishing non-bank entities that perform elements of credit intermediation’; (2) ‘banks are often naturally connected to the broader system of non-bank intermediation, and these connections may represent channels of contagion.’34 Understanding the interconnectivity and contagion channels is, as was illustrated on a number of occasions throughout the book, a ‘work in progress’ that will probably take many years more given the number and varieties of models that have been developed. But given line item one above, the conclusion from Cetorelli and Peristiani35 that the shadow banking system is ‘much less shadowy that we thought’ seems fair and reflecting reality. That is all the more important given the fact that risk transfers (particularly in securitization) were imperfect leading to a concentration of risks in the already levered financial sector.36 The level of interconnectedness was also measured by the ESRB (for the FSB analysis, see the relevant chapter) and concluded that ‘shadow banks provide up to

 EU Commission, (2014), ibid., p. 109.  N.  Cetorelli and S.  Peristiani, (2012), The Role of Banks in Asset Securitization, FRB NY Economic Policy Review, Vol. 18, Issue 2, pp. 47–60. 36  V.V.  Acharya, et  al., (2010), Securitisation Without Risk Transfer, NBER Working Paper Nr. 15730. 34 35

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7% of banks’ liabilities, and banks hold up to 10% of their assets issued by the shadow banking system’.37 Those numbers, however, need to be put in context. The intermediation market in the EU is much more bank-driven than the EU one. That urges for a decent understanding of that nexus. But it goes beyond that as the EU banking system is intimately linked with the US financial system and therefore ultimately the US nonbank part of their capital markets (MMF, ABS, MBS, US commercial paper and repos with US collateral). Although the exposure is less than before the start of the 2008 crisis, it is still material enough to trigger attention. The fact that the EU is a regulatory heterogenic region, regulatory inadequacies, regulatory arbitrage opportunities and regulatory gaps have the potential to drive the growth and size of the EU shadow banking market. That is particularly true realizing that the levels of maturity and liquidity mismatch increase materially outside the traditional regulatory perimeters for the banking sector. The absence of the regulatory framework has led to undercapitalization, and inadequate pricing of tail risk which all lead to ‘overinvesting and underpricing in the boom and excessive collapse of real activity and negative externalities in the financial sector in the bust’.38 That implies that shadow banks can be and are prone to bank-like runs, given the absence of a public backstop. The 2008 ‘run on repo and wholesale funding has given rise to additional procyclicality’ and ultimately instability. That in turn, and with the benefit of hindsight, has created a moral hazard caused by the implicit public safety nets put in place. Public safety nets can be justified only to the degree that it covers ‘(i) activities essential to the economy and (ii) liquidity risk (not solvency risk)’.39 The objective therefore has been to restore an impaired credit intermediation channel. The monetary policy in the EU has definitely not helped as the intermediation chain has not been restored but only heavier regulated and flushed with capital that has to a large degree flown back to euro T-bonds explaining the abnormally low yields. Also the 2015 ambitions to relax the European securitization40 rules (including softening capital and risk retention requirements, but also the skin-in-the-game rule which forces the originator to retain some of the risks himself) to jumpstart lending seem to lead into the wrong direction and a misunderstanding of the real European issues in this sphere. The idea that allowing loans to be taken off the banks’ balance sheet will lead to more credit capacity for the banks seems not to be well grounded in reality. What also has not worked is the absence in Europe of securitization models which could be a structural explanation why securitization pick-up has lagged compared to other parts of the world including the US. That EU STS standard, however, has arrived and has been reviewed.41 Ensuring effective and efficient ­intermediation

 ESRB, (2014), Mapping and Risks of the EU Shadow Banking System, non-public 30 January 2014, interim report. 38  EU Commission, (2014), ibid., p. 111. 39  EU Commission, (2014), ibid., p. 112. 40  A.  Barker and C.  Binham, (2015), EU Seeks to Relax Securitization Rules, Financial Times, February 17. 41  Which is a joint effort of the ECB and the bank of England; see C. Jones and A. Bolger, (2014), BoE and ECB Make Fresh Push to Revive Loan Bundles, Financial Times, May 30. 37

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channel for the long run is a complex endeavor where many regulatory and economic ­features come together. The EU’s objectives in this field have been defined as the following: (1) mobilizing private sources of long-term financing, (2) making better use of public ­funding, (3) developing European capital markets, (4) improving SMEs’ access to financing, (5) attracting private finance to infrastructure, (6) fostering the development of sustainable securitization markets and (7) enhancing the overall environment for sustainable finance.42 The access of SMEs to finance has always been a problem and the chances that enhanced securitization will contribute to solving that problem seem more remote than ever. That on top of the fact that securitization of SMEs’ loans is a technically more challenging exercise (creditworthiness of SMEs, heterogeneity of the businesses and information limitations) compared to the more risky homogenous mortgage loans. The EU’s efforts in the initial year have been focused on the general dynamics that could fuel a revival of the securitization market: ‘(i) differentiation between “high-quality” and other securitization instruments, (ii) prudential treatment, (iii) transparency rules,43 and (iv) risk retention rules’.44 That has led to a consultation round in early 201545 which was based on the discussion paper issued jointly by the ECB and Bank of England (BoE) named46 ‘[t]he case for a better functioning securitisation market in the European Union’ released in mid-2014. The new European securitization model should contribute to: (1) restarting markets on a more sustainable basis, so that simple transparent and standardized securitization can act as an effective funding channel to the economy; (2) allowing for efficient and effective risk transfers to a broad set of institutional investors as well as banks; (3) allowing securitization to function as an effective funding mechanism for some nonbanks as well as banks; (4) protecting investors and managing systemic risk by avoiding a resurgence of the flawed ‘originate-to-distribute’ models.47 Part of the groundwork has been done by the Basel Committee who was mandated to ‘identify

 Communication from the Commission to the European Parliament and the Council on LongTerm Financing of the European Economy, COM(2014) 168 final, via ec.europe.eu 43  Disclosure initiatives introduced by the ECB, which require banks that use their asset-backed securities as collateral for repurchase (repo) financing to report securitized loan characteristics and performance in a standardized format starting from 2013, were used to observe the effect of transparency on loan quality in case of securitization. They find that securitized loans originated under the transparency regime are of better quality with a lower default probability, lower delinquent amount, fewer days in delinquency and lower losses upon default. Additionally, banks with more intensive loan-level information collection on their borrowers and those operating in more transparent credit markets experience greater improvement in their loan quality under the new reporting standards; A. Ertan et al., (2015), Enhancing Loan Quality Through Transparency: Evidence from the European Central Bank Loan Level Reporting Initiative, Working Paper, August, mimeo. 44  EU Commission, (2014), ibid., p. 115. 45   EC, (2015), Consultation Document, An EU Framework for Simple, Transparent and Standardised Securitisation, February 18. 46  ECB and BoE, (2014), The Case for a Better Functioning Securitisation Market in the European Union, A Discussion Paper, Frankfurt/London. 47   EC, (2015), Consultation Document, An EU Framework for Simple, Transparent and Standardised Securitisation, February 18, p. 4. 42

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s­imple, transparent and comparable securitization instruments’, who issued their quasifinal feedback in late 201448 and final feedback in July 2015.49 It led to the securitization regulation as discussed (Vol. I). The other important feature was the capital treatment in case of (different types of ) securitizations. Those were discussed extensively elsewhere. One of the structural issues regarding securitization, however, is the fact that the domain is currently governed by many different regulations.50

3.6 S  hadow Banking and the Impact on the Stability of the Financial Sector Given the growth and the asymmetric nature and volume of the shadow banking market in the EU, the EC has been analyzing the shadow banking market and the impact it has on the financial stability of what has to become one integrated capital market in the EU. Their focus has been on the following sectors and entities: (1) money market funds; (2) private equity firms; (3) hedge funds; (4) pension funds and insurance undertakings; (5) central counterparties, and undertakings for collective investment in transferable

 BCBS, (2014), Criteria for Identifying Simple, Transparent and Comparable Securitisations – Consultative Paper, Basel, Switzerland. I stay short of reviewing the new criteria as it would deviate it too much from the central questions that relate to the risk of securitization instruments in a market-based financing system. However, a few words can be said about the systematic set-up of their analysis: (1) Criteria promoting simplicity refer to the homogeneity of underlying assets with simple characteristics, and a transaction structure that is not overly complex. (2) Criteria on transparency provide investors with sufficient information on the underlying assets, the structure of the transaction and the parties involved in the transaction, thereby promoting a more comprehensive and thorough understanding of the risks involved. The manner in which the information is available should not hinder transparency, but instead it should support investors in their assessment. (3) Criteria promoting comparability could assist investors in their understanding of such investments and enable more straightforward comparison across between securitization products within an asset class. The proposed criteria (14) have been mapped to key types of risk in the securitization process: (1) generic criteria relating to the underlying asset pool (asset risk), (2) transparency around the securitization structure (structural risk) and (3) governance of key parties to the securitization process (fiduciary and servicer risk). 49  BCBS, (2014), Criteria for Identifying Simple, Transparent and Comparable Securitisations, Basel, July. And the implementation of the (lower) capital charges for compliant STS securitized products; see BCBS, (2015), Capital Treatment for ‘Simple, Transparent and Comparable’ Securitisations, Consultative Document, November, Basel. 50  These include the Capital Requirements Regulation for banks, the Solvency II Directive for insurers, and the UCITS and AIFMD directives for asset managers. Legal provisions, notably on information disclosure and transparency, are also laid down in the Credit Rating Agency Regulation (CRAIII) and the Prospectus Directive. There are also elements related to the prudential treatment of securitization in Commission legislative proposals currently under negotiation. Provisions are also included in delegated acts. Non-legislative provisions may also have an important role, especially accounting standards (e.g. IAS 39, IFRS 10, IFRS 7). 48

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securities (UCITS) and exchange-traded funds.51 What is interesting about their analysis was the fact that they not only addressed the risks (credit, counterparty, liquidity, redemption, fire sales risk, etc.) run by each type of nonbank of financial institutions but also the multiplier effect caused by, often external, factors like size, interconnectedness or regulatory influences.52 This framework for analyzing risk ‘distinguishes between causes and proximate causes. Underlying causes relate to the characteristics of individual non-bank financial sectors or connections between a non-bank financial sector and banks/other non-bank financial sectors that bring about the build-up of risks to financial instability. Meanwhile, proximate causes relate to factors that trigger the materialization of these risks.’53 They identified that money market funds, albeit not having caused the 2008 financial crisis, have been instrumental as their instability caused contagion effects in other parts of the market. The withdrawal of funds from these markets created a feedback loop in other segments of the market and exacerbated the size and nature of the crisis. The other segments under review highlighted the following elements of concern: • Private equity: the main risk to financial stability emerged through their involvement in the leverage loan market. • Hedge funds: the nexus between banks and hedge funds is of particular concern and the potential liquidity constraints experienced by hedge funds and the impact of that on the instability of the traditional banking sector through that nexus is of particular concern. • Insurance firms and pension funds: no material concerns emerged regarding their involvement in the financial markets with respect to financial instability or accumulation of risk with the exception of fire sales. When fire sales occur, these organizations reduce exposure and create magnified devaluations and reduced liquidity even further. • Central counterparties (CCPs): the concentration of risk is the major concern. As extensively discussed elsewhere the asymmetry of risk the CCPs are exposed to can create issues for themselves but also for its members. Also their relationship with traditional banks is of concern. • ETFs: the largest stability concern lie in ‘the grouping of tracking error risk with trading book risk by the swap counterparty, which could compromise risk management, collateral risk triggering a run on ETFs in periods of heightened counterparty risk,

 EC, (2012), Non-Bank Financial Institutions: Assessment of Their Impact on the Stability of the Financial System, Economic Papers Nr. 472, November, p. ix. 52  ‘These include size and interconnectedness particularly. That is, the larger the institutions involved, the bigger the effect of any risk to financial stability materialising. Similarly, the more inter-connected the institutions involved the bigger the effect insofar as there are likely to be a greater number of institutions involved. Regulatory features can also act as a multiplier’ (p. ix). 53  EC, (2012), Non-Bank Financial Institutions: Assessment of Their Impact on the Stability of the Financial System, Economic Papers Nr. 472, November, p. ix. 51

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materialization of liquidity risk when there are sudden and large investor withdrawals and increased product complexity and options on ETFs undermining risk monitoring capacity’.54 In terms of activities the traditional repo, securities lending and securitization activities have been identified as being of particular concern. The report also includes a review of the approaches of measurement of financial instability and distress when can be classified into five categories: (1) indicators of financial distress based on balance sheet data, (2) early warning indicators, (3) macro-stress tests, (4) methods for calculating the systemic importance of individual institutions and (5) analyses of interconnectedness.55 They conclude that the following risk-contributing factors require continuous monitoring: (1) an indicator of the appetite for risk taking (e.g. rate of growth of the balance sheet items), (2) an indicator of leverage, (3) an indicator of liquidity risk and (4) an indicator of maturity mismatch.56 What needs to be added to that list are indicators that relate to credit and market risk. The granularity of historical data that avoided deconstruction of the risks is now gradually available and is one of the features on the agenda of the FSB. The European Systemic Risk Board, in its most recent annual reports, indicates that a protracted environment with low interest rates will continue to fuel the shadow banking market also in Europe and that the SB market in Europe is back close to its peak (and beyond) when going into the crisis (+/− 125% of GDP). They also reiterate the debate regarding the role of the asset management industry which reflects now about +11 trillion euro in Europe and which includes their ability to influence financial asset pricing and liquidity conditions as well as serving as an alternative source of finance and credit for the economy. Even more ‘the industry has undergone major structural changes in recent years: extending its cross-border reach and activity across asset classes (particularly vis-àvis less liquid assets); experiencing a process of market concentration; and increasing its reliance on passive management. The financial stability risks emanating from this sector may result from the observed search for yield.’57

3.7 T  he EU’s Regulatory Initiatives in the Field of Shadow Banking Despite the coordination of EU banking initiatives through the G20, each country or region does translate those policy objectives in domestic legislation in specific ways. The EU has been working on strengthening the financial sector as a whole and the shadow

 EC, (2012), Non-Bank Financial Institutions: Assessment of their Impact on the Stability of the Financial System, Economic Papers Nr. 472, November, p. x. 55  EC, (2012), Non-Bank Financial Institutions: Assessment of Their Impact on the Stability of the Financial System, Economic Papers Nr. 472, November, p. xi. 56  EC, (2012), Non-Bank Financial Institutions: Assessment of Their Impact on the Stability of the Financial System, Economic Papers Nr. 472, November, p. xi. 57  ESRB, (2015), Annual Report 2014, pp. 27–29. Also ESRB 2016–2018 via esrb.europe.eu 54

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banking initiatives should be judged against that background. I have attempted to bring together the regulatory initiatives in place or in progress within the EU since 2009. I have done so in a table format with a view toward easier accessibility and traceability (Table 3.1). These initiatives, as was communicated,58 however have been following the five chapters the FSB identified as deserving further attention in the shadow banking market. As a reminder, they included (1) limiting spillovers between shadow banking entities and regulated banks, (2) reducing the vulnerability of money market funds to runs, (3) identifying and controlling the systemic risks from new and unregulated shadow banking entities, (4) assessing and aligning incentives associated with securitization activities and (5) dampening the risks and procyclicality associated with securities lending and repo. The EC remains aware of the fact that the shadow banking market is a dynamic environment and that there is the constant risk that new areas pose potential threats to the system. It therefore also observes evolutions in other markets outside the EU where new areas of potential policy concern have been identified in the areas of leveraged loans, real estate investment trusts (REITs), and reinsurance.59 Already Turner highlights that ‘macroprudential policies are essential, that an expanded regulatory scope is required, and that limits need to be imposed on the total amount of leverage and maturity transformation within the financial system to curtail the excessive procyclicality of the financial system’.60 I have put my own thoughts regarding this matter together in the separate chapter on Pigovian taxes and the financial industry, which also revolves around the question regarding the benefits of tax instruments over ‘command-and-control’ regulation in the financial sector.

3.8 S  ecurities Financing Transactions and Re-collateralization As became apparent from the overview above as well as the specific (sub)chapter devoted to securities financing is that it is a wide, somewhat opaque, segment of the shadow banking market. It makes perfect sense in that context that the regulator as a first-line regulatory defense has been focusing on increasing the ‘transparency’ in that segment. The regulation focuses on (1) the monitoring of the buildup of systemic risks in the financial system61 related to securities financing transactions (SFTs), (2) the disclosure of

 EC, (2013), Communication from the Commission to the Council and the European Parliament, Shadow Banking – Addressing New Sources of Risk in the Financial Sector, COM(2013) 614 final. 59  T. Adrian et al., (2013), Shadow Bank Monitoring, FRB NY Staff Report, NR. 638, NY. 60  A.  Turner, (2012), Shadow Banking and Financial Stability, 14 March, Cass Business School speech and A.  Turner, (2012), Securitisation, Shadow Banking and the Value of Financial Innovation, Rostov lecture on international affairs, School of Advanced International Studies, Johns Hopkins University, 19 April. EU Commission, (2014), ibid., p. 123. 61  See for a permanent evaluation model for systemic risk in the EU the quarterly ESRB Risk Dashboard (www.esrb.europa.eu/pub/rd). The first item of the dashboard is often ‘Interlinkages and composite measures of systemic risk’. 58

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i­ nformation on such transactions to investors whose assets are employed in the t­ ransactions and (3) rehypothecation activities, a practice by banks or brokers of reusing for their own purposes collateral pledged by their clients. The European Systemic Risk Board was mandated, as indicated earlier, to identify a set of ‘red flags’ that help us understand and identify systemic risk contributors, but also engaged in the exercise of data collection for SFT and related re-collateralization. That was long overdue, as a decent understanding of the structure of the SFT was lacking. The structure of this subsegment of the shadow banking market in itself can be a source of systemic risk and need to be linked to the macroprudential policy in Europe. The analysis by the ESRB also aligns with the FSB’s recommendation62 to get a better and more granular insight into the collateral management insights and links directly to the EC 2014 regulation regarding the reporting of SFTs to trade repositories as part of the transparency regulation.63 Their main findings64 can be summarized as follows: 1. There is a widespread use and reliance on SFTs by both banks and nonbanks.65 Collateral flows to and from banks account for about 15% of their total balance sheet. SFTs account for 88% of collateral posted (70% come from collateral repo accounts and 18% from collateral from securities lending). In terms of collateral there is extensive reliance on government debt (61%), equities (13%) and debt securities issued by financial institutions (8%). 2. Collateral Reuse66: Around 94% of collateral received by banks is eligible for reuse. The average reuse multiplier, that is, how often to banks reuse the collateral posted with them, is around 2. The banks reuse their collateral once for the full amount. 3. Interconnectedness and Cross-Institutional Exposures67: Most of the SFTs in Europe are conducted directly between banks and only to a minor degree through CCPs. Nevertheless, there seems limited interconnectedness between those institutions whereby hedge funds qualify as the largest providers of collateral to banks (through their prime brokerage divisions) and central banks and MMFs qualify as net receivers of collateral. There is, however, a certain level of concentration, despite the diversified nature of their exposure to their counterparties, observed in the market as only nine participants (in a total pool of 38) account for about 30% of the volume.

 FSB, (2013), Strengthening Oversight and Regulation of Shadow Banking: Policy Framework for Addressing Shadow Banking Risks in Securities Lending and Repos, August, Basel. 63  ESRB (J. Keller et al.), (2014), ibid., pp. 6–8. 64  ESRB (J. Keller et al.), (2014), Securities Financing Transactions and the (Re)use of Collateral in Europe, An Analysis of the First Data Collection Conducted by the ESRB from a Sample of European Banks and Agent Lenders, ESRB Occasional Paper Series, Nr. 6, September, pp. 3–6, 51–55. 65  See in detail: ESRB (J. Keller et al.), (2014), ibid., pp. 10–12. 66  See in detail: ESRB (J. Keller et al.), (2014), ibid., pp. 12–21, 40–42. 67  See in detail: ESRB (J. Keller et al.), (2014), ibid., pp. 21–26. 62

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4. Collateral and Maturity Transformation68: There seems to be modest liquidity risk on aggregate in the repo business. That, however, doesn’t exclude the fact that at the level of individual institutions there are some enhanced levels of liquidity risk, but with a limited maturity mismatch. Most institutions as well build liquid asset buffers, in particular when they trade larger amounts of liquid assets. Overall, the maturity mismatch is modest. 5. Their overall conclusion is that systemic risks and vulnerabilities in the EU stemming from securities lending transactions and cash collateral activities are limited.69 That general conclusion can be broken down into the following observations: • The EU securities lending market facilitates credit growth and the buildup of leverage. They do so by allowing lenders to obtain funding easily against their own assets and the fact that cash collateral obtained from securities lending transactions is often reinvested in reverse repos, pushing toward reliance on short-term funding. • There is, albeit modestly, some level of maturity transformation, which can lead to both redemption and liquidity risk.70 • There are different exposures observed between the different market agents, based on information asymmetry, which can lead to anomalies and the formation of possible contagion channels. The interconnectedness risk typically occurs when agents lend securities on behalf of clients and who engage in a securities lending transaction with another institution and reinvest the cash collateral in reverse repos with yet another entity. • There is some level of currency mismatch71 observed in the securities financing market. Most of the transactions of securities lending and cash collateral received are denominated in hard currencies (USD, euro, GBP or JPY). The mismatch is therefore not observed at the aggregate level but at the micro-institutional level where some level of currency mismatch concentration was observed. It needs to be observed that no data were collected regarding SFT margins and haircuts. That is an important caveat as fire sales however are less of a risk for SFTs collateralized with cash, but reverse repo financing owing to the reinvestment of cash collateral indicates that the counterparties of the lenders bear effectively the risk of potential losses. It also needs to be observed from a general perspective that the scope of reuse of collateral can materially be different in the EU compared to, for example, the US. The permissibility to reuse collateral depends on the legal structure of the specific transaction. Collateral received in derivative transactions is normally not eligible for reuse which restricts many hedge funds in their ­dealings vis-à-vis prime brokers.

 See in detail: ESRB (J. Keller et al.), (2014), ibid., pp. 40–42.  But with material differences when observed at the micro-level of individual financial institutions (FIs); see in detail: ESRB (J. Keller et al.), (2014), ibid., pp. 26–37. 70  See in detail: ESRB (J. Keller et al.), (2014), ibid., pp. 42–49. 71  See in detail: ESRB (J. Keller et al.), (2014), ibid., pp. 49–51. 68 69

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There are many particularities when it comes to reuse of collateral, in p ­ articular when those collaterals are mortgages. Many of these issues are of a legal and/or moral hazard nature. I did comment on those specifically in the chapters on taxing the shadow banking industry (subsegment shadow banking, rehypothecation). In a typical repo transaction, the legal ownership of the (cash) collateral is transferred to the lender while the economic benefits stay with the original owner of the collateral. That lender can sell the securities or post them as collateral as the lender is now considered the legal owner. The borrower, however, still has a contractual claim on the lender for redelivery when the borrowers completed the contractual duties. In case of insolvency of the lender, the borrower becomes an unsecured creditor. To avoid that the alternative pledge model can be used, where the lender doesn’t become legal owner of the pledged assets and cannot dispose of them or otherwise. When the reuse of assets involves mortgages, the technique is called rehypothecation and where the agent reuses the collateral posted by clients (that reuse is often allowed under the prime brokerage or mortgage agreement). In order for the prime broker to be able to reuse the rehypothecation technique the ownership of the assets needs to be transferred fully to the agent; if not, the assets should be held in escrow or segregate client accounts, based on the MiFID Directive. When the agent lenders become insolvent before the end of the transaction, the claim of the borrower equals an unsecured creditor position. Therefore, often limits are put on the maximum reuse of the lender regarding the assets posted as collateral by the borrower (e.g. 140% of net borrowings). It should also be observed that the obligation for the lender to return the assets is fungible; that is, ‘the collateral receiver is only obliged to return “equivalent securities” when the transaction expires. “Equivalent securities” are typically defined as securities issued by the same entity in the same issue’. That in itself triggers another complication from an assessment perspective: ‘the fungible nature of collateral means that many firms struggle to identify how much collateral they have reused. This is because securities received as collateral are managed together with securities held outright on the balance sheet in a large pool of assets and they cannot be distinguished from one another.’72

3.9 T  he Interconnectedness Between the Shadow Banking System and the Traditional Banking System The connectedness between the shadow banking system and the traditional banking system is one of concern, not only because of the potential spillover effects but also because of magnifying multiplier in case of contagion risk. The persistent lack of non-transparency insofar as to what degree (offshore) investment funds and dedicated investment vehicles are owned or controlled by the traditional banking sector is an area of ongoing concern. The systems are

 See in detail: ESRB (J. Keller et al.), (2014), ibid., pp. 55–56.

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linked through a variety of channels and each displaying their own dynamics. The most important one is the provision of funding by the shadow banking system to the traditional banking system, in particular in the form of short-­term funding. The other one is the holding by shadow banking entities of traditional banking assets, in pure or securitized format. In both cases, financial risk is spread over multiple balance sheets, of which some are unregulated or unsupervised. As a reminder, the FSB73 already in 2011 defined the main channels that constitute the (direct) interconnections between the two banking systems. Those are as follows: (1) regular banks may be part of the chain of the SB system; (2) regular banks can provide support to the SBS through temporary exposures (warehousing), provision of funds, contingent credit lines; (3) regular banks can invest in financial products issued by the SB system; (4) regular banks can be funded by money market mutual funds or other entities that are part of the SB system. Beyond the direct relations, there are indirect relations that can cause widespread contagion such as the massive sale of assets (e.g. by asset managers, who tend to be known for concentration among firms74) at, for example, distressed price levels. The interconnectedness as such can be measured75 by observing the banks’ credit exposures to shadow banking entities and banks’ dependence on funding from shadow banking entities (and vice versa). The effective interconnectedness obviously differs from country to country as is co-defined by the regulatory regimes applicable in the different eurozone countries. The observation76 in recent years is that the interconnectedness in the eurozone is larger than in the US.77 See for EU details the global overview (Chap. 2).

3.10 S  izing the European Shadow Banking Market 3.10.1 Introduction The size of the European shadow banking market and its evolution were discussed in the section on the FSB monitoring of the shadow banking market worldwide as well as drivers. We also discussed the different methodologies used to measure the size and the different components of the shadow banking market, and this with a view to better understand

 FSB, (2011), Shadow Banking: Scoping the Issues, Financial Stability Board.  Especially now that a large chunk of the increasing global wealth is managed by a select set of very large global asset managers. 75  As defined by the FSB in: FSB, (2012), FSB, Global Shadow Banking Monitoring Report 2012, p. 20. 76  See, for example, E. Jeffers and C. Baicu, (2013), The Interconnectedness Between the Shadow banking System and the Regular banking System. Evidence from the Euro Area, Cityperc Working Paper Series, Nr. 2013/7. They focus on data up till 2012. 77  That is also true for the UK relative to the US. 73 74

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the segments of the SB market that is most interconnected with the t­raditional shadow banking sector but also, given its wide variety of entities and activities involved, it is an ongoing process to identify ex ante where the potential triggers and contagion risks might emerge. Size is therefore important, but not in its own right, but to understand how big the problem might become once there is a ‘fire in the hole’ somewhere in the SB system. Therefore that the FSB’s methodology in their shadow banking monitoring report adjusts and refines every year. That in line with the advancement of understanding about the SB market and its dynamic interconnectivity. Many critiques therefore emerged that question the FSB’s methodology, its ability to see linkages, or that don’t sufficiently focus on the contagion effects, or their willingness to be led by the way granular data are provided and interpreted by national authorities and so on who ultimately feed into the global monitoring report. One of these critiques involved the unwillingness or inability of the FSB to reflect on the size of the offshore SB market and the fact that a large portion of that market is owned or facilitated by Western-based investment banks and investment houses. It is correct, as it becomes clear from the reading of the Asian and Americas (sub)chapters in this book, that the offshore locations often account for sizeable portions of the regional SB markets and are typically very large relative to their local economies. Other critiques involve the fact that many hedge funds and other OFIs are also controlled by Western financial institutions. Those firms are to a large degree located in the UK/US. Tyson and Shabani78 assessed the impact of including (offshore) OFIs into the UK shadow banking market and conclude that off-balance sheet assets add another 26% to the size of the UK shadow banking market.

3.10.2 H  ow Does the European Shadow Banking Market Compare to Those Elsewhere? While those systems are often very different, the question that is relevant for all those systems and should be at the heart of every comparability analysis is the question about systemic risk. Systemic risk can be described as ‘the risk that an event will trigger a loss of economic value or confidence in, and attendant increases in uncertainty about, a substantial portion of the financial system that is serious enough to quite probably have significant adverse effects on the real economy’.79 The European shadow banking market is very different as could be observed from reading the two relevant section dealing with these two regions. The sophistication as such leads predominantly to one specific issue: sophistication leads to higher levels of interconnectedness and systemic risk. Less developed systems, like the Chinese one, are also known for their fair share of risk but are much

 J.  Tyson, and M.  Shabani, (2013), Sizing the European Shadow Banking System: A New Methodology, City University London (Cityperc) Working Papers, Nr. 2003/1, p. 6. 79  Group of Ten, (2001), Consolidation in the Financial Sector, via bis.org 78

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more dispersed and will lead to localized concentrated risk in certain SB segments but not (so far) to systemic risk.80 Hsu et  al. compared the systemic risk between the European and Chinese shadow banking system, and this along two lines: (1) liquidity risk and (2) solvency risk. Systemic risk may emerge due to the structure of banks’ balance sheets, the interconnectedness of financial institutions and the nature of the financial contracts involved. The different nature between the two shadow banking markets analyzed also shows up when observing the effects of the shadow banking markets versus the real economies during the 2008 crisis. In Europe the financial sector endured much more duress compared to the real economy during the crisis whereas in China that was the other way around. The robust nature of the Chinese shadow banking industry is explained by referring to the fact that it exists out of many different segments which have existed for decades (and only some segments are new) and comprises of many different actors. That is explained by the fact that the Chinese financial sector has evolved slowly in terms of modernization. That has led to a variety of what we now call SB segments. Risk is therefore greatly dispersed across the system that consists of three layers: ‘[t]he first part contains commercial banking and investment banking, including bank-trust cooperation in financial products, investment banks, financing leasing companies, and insurance brokerage firms and their products. The second part includes quasi financial institutions such as micro loan companies, financing guarantee companies, and pawn shops. The third part consists of informal financial institutions.’81 That is in contrast to the European system that is typically characterized as being a long chain of credit intermediation where systemic risk occurs throughout those opaque chains and its interconnectedness with the traditional banking sector. Also the nature of the transactions and the type of vehicles and the legislation they are subject to (repos, constant net asset value [NAV] MMFs, securitized products and re-collateralization). An assessment of the Chinese SB market leads to the conclusion that ‘Most of the non-bank related shadow banking is further segmented by geographical region, fund sources, and even between institutions or individuals. Although financial segmentation is a mark of financial underdevelopment, in this case, the coexistence with low-level forms of shadow banking along with high-level forms of shadow banking has served to protect the real economy from financial contagion.’82 In other words, what makes the Chinese shadow banking market so particular is the fact that the shadow banking market is much more related to the real economy than it is to the traditional banking sector. Or put differently, ‘we find that informal lenders such as money lenders, private equity funds, pawn shops, and rotating credit associations are based to a large extent on personal relationships and engage almost solely in lending and borrowing to/from small and medium enterprises

 S. Hsu, et al., (2013), Shadow Banking and Systemic Risk in Europe and China, City University London, Cityperc Working Paper Series, Nr. 2, p. 1. 81  Hsu et al., (2013), ibid., p. 6, and J. Li, et al., (2012), The Annual Report of China Shadow Banking System. Project Sponsored by the National Natural Science Foundation of China, Project Number 71173246. 82  Hsu et al., (2013), ibid., p. 8. 80

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and individuals, rather than in riskier or more highly leveraged forms83 of financial activity. Lenders know their borrowers, and borrowers are obligated by social relations to repay the loans’84 and ‘[i]n China, systemic risk in the shadow banking system does not arise from the process of credit asset securitization, because the scale of securitization is very small. Risks may come from wealth management products, since these have been increasing in volume.’85 The systemic dynamics of the European and Chinese model are very different: While the European shadow banking system is better developed than the Chinese shadow banking system, herd behavior and other factors in European markets create systemic risk, which contributed in part to the financial crisis. ‘Dispersion of risk across the “under-developed” shadow banking system in China has led to some cases of localized, concentrated risk, but not to systemic risk.’86 That is in contrast to the European shadow banking system where ‘the largest financial linkages can be found between credit institutions such as banks and other financial institutions (non-bank financial institutions), and between credit institutions and financial vehicle corporations. Hence strong linkages are directly between banking and shadow banking entities.’87

3.11 C  omparison Between the US and European Shadow Banking Segment88 The many different definitions of the shadow banking market reviewed at the beginning of this book demonstrates that, despite some common features in those definitions, the SB segment can be anything to anybody as it includes aspects of ‘unregulated’, ‘uninsured’, ‘highly levered’ and ‘outside the regular banking sector’. Also in terms of the objectives of the SB market there are some commonalities to be found in the definitions and practices around the world which include: (1) bank-like activities which include liquidity-, maturity- and credit transformation; (2) no access to liquidity window of shadow bank, lender of last resort facilities or deposit guarantee system; (3) not covered by prudential banking regulation, supervision and capital requirements; (4) using material amounts of leverage and (5) often using regulatory arbitrage as part of their business

 Although the size of that segment has been materially rising after the many rate cuts by the Chinese central bank in 2014–2015 to keep the real economy going. 84  Hsu et al., (2013), ibid., pp. 8–10. 85  Hsu et al., (2013), ibid., p. 15. 86  S. Hsu et al., (2013), ibid. 87  Hsu et al., (2013), ibid., p. 13. 88  See for a comparison between the regulatory efforts between the EU, US and the FSB: E.F. Greene and E.L. Broomfield, (2013), Promoting Risk Mitigation, Not Migration: A Comparative Analysis of Shadow Banking Reforms by the FSB, USA and EU, Capital Markets Law Journal, Vol. 8, Nr. 1, pp. 6–53. 83

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model. Although it is possible to define the shadow banking sector either in an additive way (by adding the different components of the SB market together) or in a subtractive or residual way (what remains after the traditional banking sector is excluded), many differences continue to exist in terms of activities and entities involved and also in the comparison between the US and Europe. Besides the fact that the US shadow banking market has always been (somewhat) larger than the European counterpart, the shape and size of the US shadow banking market reflect the fact that the US has a more market-­based financial framework and capital markets infrastructure than the EU.  Content-wise repo, securitization and securities lending account in both cases for the largest part of the market. The differences between the US and European shadow banking markets are partly linked to the institutional framework and differences in the structure and nature of the economies involved. In itself, the European shadow banking market didn’t collapse in the crisis but the interconnectedness between the US shadow banking market and the traditional European banking sector, the US-induced crisis spread that way to Europe. That interconnectedness occurred due to the fact that European banks receive(d) their (short-term) US dollar funding from the US shadow banking sector89 and when that sector dries/dried up they reduced their exposure to the European banking system. Other exposures were through the holdings of securitized products, in particular US ABS, ABCP and MBS. That understanding does not only put focus on the nature of the supervisory regulation but also puts the focus on the fact that even with the most brilliant regulation in place in the different parts of the world, regulatory arbitrage, will still be possible, and the interconnectedness between the different shadow banking systems in the world can be sufficiently material to cause fire sales and meltdowns for the simple fact that the systems are not seamlessly connected which caters to contagion, and the shift from ‘information insensitivity’ to ‘information sensitivity’. The globalized financial industry will always demonstrate features of a vessel without waterproof compartments (or at least incomplete waterproof compartments).

3.12 T  he Dynamics of the Shadow Banking Sector and the EU Financial Stability The European Commission identified the most straightforward elements of systemic risk as being critical aspects to monitor from a shadow banking point of view. Those include interconnectedness, contagion, leverage and the overall level of complexity (let’s rephrase that into ‘opaqueness’), all leading to a magnified domino effect. Harford therefore argues that ‘any sufficiently complex, tightly coupled system will fail sooner or later; the answer

 When hell broke loose in 2008/2009, the European central banks provided USD liquidity to ailing European banks as they in turn, through the ECB, have a USD swap line with the US Federal Reserve Bank. 89

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would be to simplify the system, decouple it, or reduce the consequence of failure’.90 The financial system is in fact a ‘system of systems’ (i.e. multiple, interacting layers each a complex system in its own right) as Haldane indicates.91 Also the EU and the eurozone financial infrastructure92 are characterized by that opaqueness and interconnectedness.93 The EC distinguish three financial channels: (1) organized markets who issue bonds, shares and facilitate private placements, (2) financing channeled through the direct interaction of a firm with its stakeholders in the form of equity, loans or advances and (3) financing is provided by financial institutions, ‘which provide an intermediation service of connecting the resources of savers and depositors with those of borrowers and investors and of adapting the features of savings to the needs of investors through what is called maturity transformation’.94 No particular statements are made, however, regarding the systemic risk that the shadow banking market poses besides comments aligned with the regulation that has been issued and/or proposed in recent years (e.g. money market funds and investment funds regulation). Nevertheless, it can be assessed that the interconnectedness and the many different channels linking the different segments in the EU are large and deep enough to facilitate a shock or crisis on its own terms.95 Within the EU capital requirements regulation (CRR) the EBA was mandated to develop guidelines to set appropriate aggregate limits or tighter individual limits on exposures to shadow banking entities which carry out banking activities outside a regulated framework. Since the European legislation doesn’t define shadow

 T. Harford, (2011), What We Can Learn From a Nuclear Reactor, Financial Times, 11 January.  A.G. Haldane, (2015), On Microscopes and Telescopes. Speech at the Lorentz Center workshop on socio-economic complexity. Leiden, Netherlands, March 27. Haldane identifies four layers: (1) the ‘microprudential’ layer of individual firms, (2) the ‘macroprudential’ layer of the financial system, (3) the ‘macro-economic’ layer of the national economy, monitored through monetary policy, and (4) the ‘telescope’ layer of the global economic and financial system which is managed through the international financial architecture; see EC, (2015), Commission Staff Working Document. European Financial Stability and Integration Review, April 2015, pp. 61–62. See also: G. Hautony, and J.C.  Héamz, (2014), How to Measure Interconnectedness between Banks, Insurers and Financial Conglomerates? Autorité de Contrôle Prudentiel et de Résolution (France); O. Castrén and M. Rancan, (2013), Macro-Networks. An Application to the Euro Area Financial Accounts, ECB Working Paper Nr. 1510, Frankfurt. 92  See extensively on the dynamics and segments of the EU financial infrastructure: EC, (2015), ibid., pp. 35–114. Questions answered are: who is providing credit, who is using this credit, in which form the credit is formalized or through which channels financial resources flow? Also reviewed are the ‘preferences of markets participants as reflected in the mix of products they choose to invest in or to use as a source of funding. These customer preferences in the provision and use of funding determine the importance and role that the financial sector, and its different segments, is to play in the European economy’ (p. 8). 93  See for the interconnectedness and the amounts flowing through the linkages between the different segments of the European financial infrastructure: EC, (2015), ibid., p. 60. 94  EC, (2015), ibid., p. 8. The since 2016 launched ESRB annual shadow banking SB monitor, documents and details and changes of the different segments; The ECB also reports some of its findings in the bi-annual financial stability report. 95  See in particular EC, (2015), ibid., pp. 59–60. 90 91

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banking the EBA suggested96 creation of a target group using two limbs97: (1) the entity carries out one or more ‘credit intermediation activities’,98 and (2) the entity is not an ‘excluded undertaking’. The EBA suggested a ‘fallback approach’, that is, a limit of 25% of the institution’s eligible capital to the aggregate exposures to shadow banking entities in case institutions are not able—due to insufficient information about the activities of shadow banking entities or to the lack of effective processes to use that information—to apply the principal approach. The principal approach involves setting aggregate exposure limits while taking into account a number of variables (business model, risk management system and risk appetite and it should take into account whether the shadow banking entity is subject to prudential requirements or supervision, its financial situation, its portfolio, vulnerabilities, interconnectedness, etc.).99 Given the latter variable additional and lower individual limits might be warranted. Nevertheless and as demonstrated and to be demonstrated, the shadow banking segments in the European Union are very asymmetric. The OFI segment is to a large degree a phenomenon in Ireland, the Netherlands and Luxembourg.100 Nevertheless, the EU issued specific guidelines to monitor and facilitate ‘significant credit risk transfers’ under the CRR directive, which in practice mainly apply to securitization activities.101 Data granularity is still somewhat of a problem, but is being worked on by the FSB who provides templates and models for data collection and aggregation.102 That data granularity will be an absolute necessity. In recent times it became clear that although the amount of ‘leverage’ in the traditional banking sector is in check, ‘signs of increasing leverage have started to emerge in securities markets and among shadow banking entities’.103 The gradual shift from a banking-based to a market-based financial model

 See for more details: EBA, (2015), Draft EBA Guidelines on limits on exposures to shadow banking entities which carry out banking activities outside a regulated framework under Article 395 para. 2 Regulation (EU) Nr. 575/2013, EBA/CP/2015/06, March 19. Final guidelines were issued 14 December 2015 under reference EBA/GL/2015/20, via eba.europe.eu 97  The intention is to focus on institutions’ exposures to entities that pose the greatest risks in terms of the direct exposures institutions face and also the risk of credit intermediation being carried out outside the regulated framework. 98  ‘Credit intermediation activities’ are defined as bank-like activities involving: (1) maturity transformation, (2) liquidity transformation, (3) leverage, (4) credit risk transfer or (5) similar activities. 99  In fact the EBA initially left two options open: (1) apply the 25% limit to the sum of all exposures to shadow banking entities, (2) apply the 25% limit only to the sum of the exposures to shadow banking entities to which the institution is not able to apply the criteria defined in the guidelines (and apply the principal approach to set out individual limits for the remaining exposures and to set out an aggregate limit for all exposures). 100  See, for example, Deutsche Bundesbank, (2014), The Shadow Banking System in the Euro Area: Overview and Monetary Implications, Monthly Report, March, pp. 21–22. 101  EBA, (2014), Guidelines on Significant Credit Risk Transfer relating to Articles 243 and Article 244 of Regulation 575/2013, EBA/GL/2014/05, July 7. 102  See, for example, on securities financing: FSB, (2014), Standards and Processes for Global Securities Financing Data Collection and Aggregation, Consultative Document, Basel, November 13. 103  ECB, (2014), Financial Stability Review, November 2014, Frankfurt, p. 9. 96

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implies that risks are shifting to that segment. That is particularly true for those SB ­segments that became more concentrated over time which is the case, for example, with asset managers.104 Also the structure of the SB industry is prone to constant evolution. As it appeared, half of the Euro European shadow banking business is now covered by investment firms (including MMF and non-MMF investment funds). Most of these euro area investment funds are open-ended funds and therefore typically subject to early redemption claims, although, as the ECB indicates, ‘they predominantly invest in less liquid assets as reflected in a preponderance of structures with an investment policy linked to commodities, other assets and equities’.105 Although the shadow insurance sector appeared on the radar of the ECB as they highlight ‘most concerns come from the use of captive life reinsurers for life insurance reserve financing and the use of inter-company loans’.106 The prospective stress and possible contagion effects in a rapidly growing shadow banking segment continued to be on the radar in 2015 and beyond. The ECB in that respect highlights ‘possible channels of risk contagion and amplification include correlated asset exposures as well as mutual contractual obligations in securities lending and derivatives markets’ … ‘The greater the leverage, liquidity mismatch and size of certain intermediaries, the more likely they are to amplify shocks and impose externalities on other parts of the financial system, such as those resulting from fire sales of demandable equity’.107 A liquidity constraint is always on the list of concerns, especially in case the investment fund sector grows like gangbusters and when even a small market correction can trigger so-called liquidity spirals if funds were to be confronted with high redemptions or increased margin requirements. Relatively new on the list of concerns, besides the explicit use of leverage, is the implicit use of leverage, that is, through contingent commitments created by positions in swaps, futures and other derivative positions which potentially contribute to systemic risk when sector-wide redemptions occur. Although the largest segments of the European shadow banking industry are known, half of the shadow banking sector is characterized by the fact that no breakdown is readily available. The known and documented parts are obviously the MMF segment, nonmoney market investment funds and the financial corporations.108 All segments109 are gaining pace and at double-digit rates. That reiterates the abovementioned vulnerabilities and systemic risk concerns.110 Part of those concerns stems from the strong linkages between the traditional and SB segment in Europe. A shadow banking spillover effect is

 ECB, (2014), ibid., p. 10.  ECB, (2014), ibid., pp. 43–44. 106  ECB, (2014), ibid., p. 80. 107  ECB, (2015), Financial Stability Review, April 2015, Frankfurt, pp. 12–13. 108  ECB, (2015), ibid., p. 87. 109  For a review of the European banking sector and characteristics and individual segments, see ECB, (2015), ibid., pp.  87–99, and EC, (2015), European Financial Stability and Integration, April, pp. 85–86. 110  ECB, (2015), ibid., pp. 88–89. 104 105

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clearly on the radar and the potential effect of distress in the shadow banking sector on asset prices and the reduction in bank funding it would cause.111 There is clear concern for a ‘waterbed effect’ where tighter traditional banking regulation will cause regulatory arbitrage and pave the way for credit growth in the non-regulated (shadow) banking sector.112 At that point the question boils down to what degree and in what way monetary policy impacts bank risk. We already know that relatively low levels of interest rates over an extended period of time contributed to an increase in bank risk which typically translates into liquidity risk over time,113 and that shadow banking because of some intrinsic qualities doesn’t have a stable and sustainable momentum working for it.114 Toward the end of 2015 the ECB, in its year-end financial stability review, highlighted the increasing trend that shadow banking entities and transactions contribute an increasing risk to systemic risk, fueled and amplified by predominantly spillover and liquidity risk.115 A closer look depicts the following situation116: the EU broader shadow banking market has continued to grow in the recent years, particularly through non-MMF investment funds (adjusted for valuations), whereas the MMF segment grew slightly with only EUR 17 billion inflows (2015). The two largest components of that are the non-­MMF segment and an even larger segment for which no breakdown is available. The ECB developed some macro-financial scenarios, of which a spillover coming from the shadow banking segment is one of the scenarios.117 They explain: ‘the shadow banking spillover scenario considers the spillovers from the non-bank financial sector to the EU banking sector via the funding channel and lower asset valuations. It is assumed to be triggered by an abrupt drop in returns on investment in shadow banks, which would lead to heightened redemptions. That initial drop in the valuation of the shadow banking sector would correspond to the 1% probability level. Forced sales of assets by that sector would reduce asset prices and the supply of funding to the banking sector. Consequently, the bank funding costs would increase.’ This scenario differs twofold from the other models in terms of its effect on asset prices, but overall impact was budgeted to be 0.7% of GDP. We can easily assume that this is a narrow measurement and is limited to the direct costs. Additionally, it is identified that a private debt crisis would have a very material impact on bank solvency, only bypassed by a broad-based global risk aversion scenario with ­typical reversal of risk

 For an evaluation of the implications, see ECB, (2015), ibid., pp. 102–104.  ECB, (2015), ibid., pp. 126, 132. 113  Y.  Altunbas et  al., (2014), Does Monetary Policy Affect Bank Risk, International Journal of Central Banking, March, pp.  95–135, and C.  Gauthier et  al., (2014), Introducing Funding Liquidity Risk in a Macro Stress-Testing Framework, International Journal of Central Banking, December, pp. 105–141. 114  G.  Ordoñez, (2015), Sustainable Shadow banking, Working Paper, January and O.  Lucius, (2014), In Search of Financial Stability – the Case of Shadow Banking, Managerial Economics Vol. 15 Nr. 1, pp. 63–81. 115  ECB, (2015), Financial Stability Review, November, pp. 6, 13–15. 116  See in detail: ECB, (2015), Financial Stability Review, November, pp. 97–107. 117  ECB, (2015), ibid., pp. 102–103. 111 112

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premia.118 The ECB clarifies: ‘[c]redit risk appears to be the most important driver of the decline in net asset values under all the considered scenarios except the weak growth scenario. Although the degree of vulnerability to the materialization of macro-financial risks differs across individual insurance groups, the impact of a widening of credit spreads is similar across the three scenarios (including the shadow banking spillover model ed.) where a significant credit-related impact is observed.’119 Credit risk is by far the largest contributor to the change in asset prices in case of a shadow banking spillover scenario. In contrast to interest rate risk, lapse risk, equity and property risk all have a moderate effect in this scenario.

3.13 C  entral Clearing: Also Systemic Risk in the Making in Europe? It was already discussed how central clearing should make systemic risk a little less of a concern by reducing counterparty risk. It was to that effect that the EU adopted the European Market Infrastructure Regulation (EMIR),120 a piece of legislation that is continuously subject to refinement, after regular update and efficiency reports but also following technical suggestions and technical standards121 brought to the table by the EBA and the ESMA.122 Through the EMIR regulation (and updates) Europe adhered to the technical standards of the IOSCO and the BCBS regarding the clearing of OTC derivatives (non-centrally cleared derivatives)123 and the margin requirements as well as the IOSCO-approved risk management standards for non-centrally cleared

 See ECB, (2015), ibid., p.  104, for a comparison and benchmarking against the other scenarios. 119  ECB, (2015), ibid., p.  106. Credit risk implies a decline of about 1.5% in net asset values expressed as a percentage of total assets. This outcome is driven mainly by corporate credit risk. 120  Regulation (EU) No 648/2012 of the European Parliament and of the Council of 4 July 2012 on OTC derivatives, central counterparties and trade repositories, O.J. L 201 pp. 1–59 of 27.7.2012. 121  There have been standards issued so far regarding the following topics and issues: (1) regulatory technical standards on capital requirements for central counterparties; (2) regulatory technical standards on requirements for central counterparties; (3) regulatory technical standards on indirect clearing arrangements, the clearing obligation, the public register, access to a trading venue, nonfinancial counterparties, risk mitigation techniques for OTC derivatives contracts not cleared by a CCP; (4) regulatory technical standards on the minimum details of the data to be reported to trade repositories; (5) regulatory technical standards specifying the details of the application for registration as a trade repository; (6) regulatory technical standards specifying the data to be published and made available by trade repositories and operational standards for aggregating, comparing and accessing the data. 122  See, for example, recently for the clearing of interest rate swaps and other interest rate derivatives: ESMA, (2015), Consultation paper Nr. 4 on the clearing obligation under EMIR, Nr. 2015/807 of May 11. 123  IOSCO/BCBS, (2013), Margin Requirements for Non-centrally Cleared Derivatives, Basel, September. 118

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­derivatives.124 But also in Europe the question has always been to what degree central clearing through a CCP will produce systemic risk for a variety of reasons discussed often due to limited netting benefits or asymmetric information, mutualization of losses and the interconnectedness of the CCPs business model (with members and other CCPs) might cause or enhance systemic risk, and so on.125 Boissel et  al. concluded that CCPs provide only some protection during periods of modest distress in the market (sovereign risk was not transmitted to the repo market despite the fact that counterparty risk was high) but provide very little solace and are ineffective under enhanced or peak stress.126 Even in the safest part of the European repo market, that is, the European sovereign repo market, the repo rates respond to movements in sovereign risk and behaved as if the probability of CCP default (conditional on sovereign default) was very large, and did not react to increases in haircuts.127 Their findings also underscore the fact that haircuts (of the CCP) are unable to stabilize even when haircuts are raised to reduce the riskiness of the repo transaction. They find that in 2011, haircut changes had no effect on the relation between sovereign credit default swap (CDS) spreads and repo rates. Interesting in this respect is the question to what degree the repo rate-to-CDS spread sensitivity is affected by counterparty default risk and/or CCPfailure risk. Boissel et al. in their data set find that the estimated counterparty default risk is not high enough (in 2011) to explain the repo-to-CDS spread sensitivity. Even more repo rates in bilateral trades were not more sensitive to CDS spreads than in CCP-based trades their findings indicate, despite the supposedly higher protection against counterparty risk in CCP-cleared models (‘investors behaved as if the CCP did not offer any protection against counterparty default’).128 That has far-reaching

 IOSCO, (2015), Risk Mitigation Standards for Non-centrally Cleared OTC Derivatives, FR01/2015, January 28. 125  See, for example, E.N. White, (2007), The Crash of 1882, Counterparty Risk, and the Bailout of the Paris Bourse, National Bureau of Economic Research (NBER) Working Paper Nr. 12933; B. Coeuré, (2014), The Known Unknowns of Central Clearing, Speech at the meeting on global economy and financial system hosted by the University of Chicago Booth School of Business Initiative on Global Markets at Coral Gables, Florida, March 29. 126  C. Boissel et al., (2014), Systemic Risk in Clearing Houses: Evidence from the European Repo market, Working Paper, December 4, mimeo. They examined the European sovereign repo market which is considered the safest segment of the European repo market in which the CCP assumes counterparty default risk. 127  There is an obvious relation between repo rates and a country’s CDS spread, which can be used as a proxy for the intensity of sovereign stress (repo rate-to-CDS spread sensitivity). Boissel et al. find a strong positive relation between the CDS spreads of sovereign debt issued by European countries and the rates of repo transactions using the same sovereign debt as collateral. This relation is the strongest at the peak of the sovereign debt crisis in the eurozone, in 2011, and is concentrated in the countries that were affected the most by the crisis (GIIPS). 128  C. Boissel et al., (2014), ibid., pp. 3–5, 20–22, 24–33; also see A.J. Menkveld, (2014), Crowded Trades: An Overlooked Systemic Risk for Central Clearing Counterparties, VU University Amsterdam Working Paper and A.J.  Menkveld, (2014), Systemic Liquidation Risk: Centralized Clearing, Margins, and the Default Fund, VU University Amsterdam Working Paper. 124

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i­mplications as an important difference between the European and the US markets is that banks are very active in repo markets in Europe, while the US repo market mostly serves to finance the shadow banking system.129

3.14 T  he Capital Markets Union and the Securitization Sector 3.14.1 Introduction and Context The CMU package proposed at the end of September 2015 and its underlying action plan130 is built around four essential pillars containing in total 33 initiatives131: • Creating more opportunities for investors: the CMU should help mobilize capital in Europe and channel it to companies, including SMEs, and infrastructure projects that need it to expand and create jobs. It should give households better options to meet their retirement goals. • Connecting financing to the real economy: the CMU is a classic single market project for the benefit of all 28 Member States. Member States have a lot to gain from channeling capital and investment into their projects. • Fostering a stronger and more resilient financial system: opening up a wider range of funding sources and more long-term investment, ensuring that EU citizens and companies are no longer as vulnerable to financial shocks as they were during the crisis. • Deepening financial integration and increasing competition: the CMU should lead to more cross-border risk sharing and more liquid markets which will deepen financial integration, lower costs and increase European competitiveness. A key aspect in that context is securitization. By creating a transparent, stable and Europe-wide securitization market, the EC hopes to facilitate that banks can free up balance sheet capacity to lend to the more vulnerable segments of the market, and in particular the SME market. Surprisingly enough it has been the EC, through its Basel III  L. Mancini, et al., (2014), The Euro Interbank Repo Market, Working Paper, mimeo; A. Martin, et al., (2014), Repo Runs, Review of Financial Studies Vol. 27, Issue 4, pp. 957–989. The other fact is that both markets differ significantly in composition: in Europe approximately 56% of the market consists of transactions conducted on electronic platforms offering clearing services via a CCP, 33% of bilateral (non-CCP) transactions and only roughly 11% of tri-party repos: ECB, (2012), European Money Market Survey. European Central Bank/Eurosystem (December). 130  See for an annual update on the status of the CMU project the Financial Stability and Integration Review, via ec.europa.eu. 131  EC, (2015), Capital Markets Union: An Action Plan to Boost Business Funding and Investment Financing, Press release, Brussels, September 30. That was following the fact that the EBA provided an opinion on a European Framework for Qualifying Securitizations; EBA, (2015), Opinion of the European Banking Authority on a European framework for qualifying securitisation, EBA/ Op/2015/14 of July 7, and EBA, (2015), EBA Report on Qualifying Securitization. Response to the Commission’s Call for Advice of January 2014 on Long-Term Financing. 129

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implementation, that had created material constraints for banks to segments to pose material risk to the banks’ funding structure and balance sheet solvency. It needs to be put straight upfront that the securitization market has never been as large and liquid as its US counterpart. Only in 2008 the issuance of securitized products was larger in Europe than in the US. ‘Securitization’ is the term used to refer to a transaction that enables a lender—often a bank—to refinance a set of loans/assets (e.g. mortgages, auto leases, consumer loans and credit cards) by converting them into securities that others can invest in. The lender pools a portfolio of its loans into a set of securities tailored to ­different investor risk/reward characteristics. End investors are then repaid by the cash flows generated by the underlying loans.132 Soundly structured, securitization is an important channel for diversifying funding sources and enabling a broader distribution of risk by allowing banks to transfer the risk of some exposures to other banks, or long-term investors such as insurance companies and asset managers. The EU is particularly concerned that while 75% or more of funding for businesses (in particular SMEs) and households is derived through the banking sector and so are too dependent on a single funding channel. However, after the crisis the rebound of the European securitization sector has been subdued which is considered to be mainly due to the stigma still attached to this asset class, macroeconomic conditions (e.g. limited growth prospects), the availability of cheaper refinancing sources and regulatory uncertainties. The slow recovery in EU securitization markets reflects concerns among investors and prudential supervisors about the risks associated with the securitization process itself. Securitization of subprime mortgages created in the US contributed greatly to the financial crisis of 2008. Securitizations, which according to their credit ratings (AAA) should have had a 0.1% probability of defaulting, defaulted in 16% of cases and generated sizeable losses across the globe. As a consequence, investors lost trust in all securitizations.133 Problems were, however, mostly limited to US markets and can be explained by a series of shortcomings134: • Giving loans and then selling them to third parties became a widespread practice. Therefore, the creators of such loans had no incentives to properly monitor the creditworthiness of the borrowers to whom they were giving credit. As a consequence, the riskiness of loans packaged in US securitizations increased in the run-up to the crisis. This ‘originate-to-distribute’ model has been identified as a key factor in the US securitization crash. • The creation of ever-more complex securitization structures (e.g. collateralized debt obligations [CDOs]) limited investors’ understanding of such products and the risks attached to them. This, in turn, pushed investors toward relying excessively on credit ratings as the ultimate measure of riskiness. Credit rating agencies, for their part, were

 Based on EC, (2015), A European Framework for Simple and Transparent Securitisation, September 30, via ec.europe.eu 133  Ibid. 134  Ibid. 132

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being paid to provide ratings for products whose complexity—as the 2008 events showed—defied their rating methodologies. Issuers, who charged high fees for issuing these products, had strong incentives to peddle such complex products. Limited disclosure of the details of the securitization products made it even harder for investors to understand such complex products, further fostering overreliance on credit ratings. The shortcomings highlighted above were not prevalent in EU markets. For example, EU issuers tended to retain a big part of the portfolio of the loans they packaged in a securitization. Originate-to-­distribute practices were almost non-existent in the EU. Overly complex structures such as CDOs and CDOs-squared were also rare in the EU, while widespread in the US. Such differences between US and EU practices had a clear effect on the performance of US and EU securitization products during the crisis. The worst-performing EU securitization products rated AAA defaulted in only 0.1% of the cases at the height of the crisis. In comparison, their US equivalent defaulted in 16% of cases. Riskier (BBB-rated) EU securitization also performed very well, with the worst-performing classes defaulting in only 0.2% of the cases at the height of the crisis. By contrast, the default rate of BBB-rated US securities reached 62%. As a consequence, the losses incurred by investors in EU securitizations were a fraction of those incurred by investors in US deals. The drop in EU issuance cannot be ascribed to losses generated in Europe but rather to a combination of factors: stigma attached to securitization, postcrisis tightening of the regulatory treatment of securitized products and cheaper funding alternatives for banks (central bank liquidity).135 However, neither in the green paper on the CMU nor in the memorandum to the September 2015 Securitization proposal136 it was highlighted what caused the financial crisis in 2008 to show up that differently in the US versus Europe. And there is a reason (in fact two reasons) for that different show-up and it is of a legal nature. It also explains why the European market prefers the covered bond model rather than securitized products. It all has to do with ‘full recourse’ versus ‘partial/no recourse’ of mortgage loans. In case of recourse, the holder of securitized product has a claim vis-à-vis the issuer of the securitized product as well as the mortgage holder. In case of limited or no recourse that is not the case (or only limited). Its full recourse provides an additional layer of security. The second is described by Engelen and Glassmacher when they indicate: ‘[w]hereas in the EU all mortgage loans are full recourse loans, meaning that the contract gives the creditor full legal protection against payment shortfalls, in the US most mortgage contracts are non-recourse contracts, meaning that the owner-occupier can simply walk away from his mortgage obligations, resulting in a factual default and a quick decrease in value of the mortgage security in question if the scale of default is widespread enough.’137 They conclude that ‘claiming success for

 Ibid.  Proposal for a Regulation of the European Parliament and of the Council laying down common rules on securitisation and creating a European framework for simple, transparent and standardised securitisation and amending Directives 2009/65/EC, 2009/138/EC, 2011/61/EU and Regulations (EC) No 1060/2009 and (EU) No 648/2012 COM(2015) 472 final, September 30. 137  E. Engelen and A. Glassmacher, (2015), The Trojan Horse of Europe’s Capital markets, via Ftm. nl, September 30. 135 136

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European securitizations is committing the fallacy of composition. That individual European securitizations upheld their value throughout the crisis is not to say that securitization as such did not severely harm the long term interests of households, SMEs and national economies’. Securitization markets in the US have recovered more strongly than in the EU. This has been mainly driven by the publicly sponsored segments: almost 80% of securitization instruments in the US benefit from public guarantees from the US government– sponsored enterprises (e.g. Fannie Mae and Freddie Mac). Banks investing in these products consequently also benefit from lower capital charges. One can wonder however to what degree it makes sound financial policy to help revive a sector that only seems to rebound based on public policy, especially when the rebound is asymmetric and not covering the weaker parts of the bank funding channels, that is, the SME sector. Securitization issuance in Europe amounted to some EUR 216 billion in 2014 compared to EUR 594 billion in 2007. The issuance level of SME securitizations is only roughly half the amount prior to the crisis (EUR 77 billion in 2007 compared with EUR 36 billion in 2014). However, and as discussed in the securitization chapter, there are ongoing concerns about the concentration of wrong-way risks in securitized products despite the standards of simple and transparent products and despite the risk retention protocols. Also the claim that a rebound in the securitization market would free up funding on bank balance sheets seems to be based on a critical misunderstanding of the relationship between a bank’s incoming and outgoing funding models. It seems also clear that the EU, although rehashing that claim in every single securitization document, never explains or supports that statement with research or otherwise. It seems to be copied from one of the countless lobby presentations held in recent years.138 In the summary of the stakeholder feedback, the EC comments that their proposal ‘would help the recovery of the European securitization market in a sustainable way providing an additional channel of financing for the EU economy while ensuring financial stability’. Given that the securitization market in the EU has largely been about mortgage instruments, the European economy seems to read as European real estate, and that given the complexities of repackaging SME loans nothing much, or nothing at all, seems to be expected here. That on top of the fact that loan instruments originated-to-distribute have a far higher

 Many positions in the EC memorandum regarding the securitization proposal seem to reflect thoughts and opinions found back in the BCG report ‘Bridging the Growth Gap’ commissioned by the Association for Financial Markets (AFME), the largest Brussels-based financial lobby group. All the more suspicion is justified when reading in the most recent AFME report (p. 4): ‘[s]ince June 2015, we have undertaken an outreach program to meet with key policymakers and opinion formers on CMU – including Commission officials, finance ministries and central banks, MEPs and think-tanks…’ ‘We will continue to be active and closely engaged across the CMU agenda, including in areas such as infrastructure, securitisation and SME funding, which are vital to promoting growth. In December 2015, together with Euromoney and ICMA, we will hold a conference in Brussels on CMU. Commissioner Hill is confirmed as keynote speaker, and this event should provide the opportunity for the industry to respond in detail to the Commission’s action plan.’ The fruitful interaction between all stakeholders and the EC in the run-up to this proposal seems to turn out being that 110 of the 120 representatives were industry parties. 138

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default rate than the originate-to-­ mature instruments,139 a typical example of an agency conflict. Whatever it may be, the proposal was issued and was based on a number of opinions and advices issued prior to releasing the proposal.140 It resulted in the securitization legislation as it was discussed (chapter 3, Volume I). The main objectives of the securitization regulation are: • To revive markets on a more sustainable basis so that STS securitization can act as an effective funding channel to the economy. • To allow for efficient and effective risk transfers to a broad set of institutional investors. • To allow securitization to function as an effective funding mechanism for some nonbanks (such as insurance companies) as well as banks. • To protect investors and to manage systemic risk. • To create a standardized securitization environment. The Commission aims to differentiate between simpler and more transparent securitized products and those that don’t satisfy such criteria. • To create deep and liquid securitization markets which are able to attract a broader and more stable investor base to help allocate finance and that will allow banks to free up capital that can be used to provide loans to firms, and SMEs in particular. Some observations regarding these ambitions, some of which have been also hinted at in the securitization chapter (Vol. I, chapter 3), are as follows: • The fact that a deep and liquid securitization market contributed to growth in the real economy and enhance job levels is without any empirical evidence.141 SME loans were hardly represented pre-crisis in the securitization product catalog. On a total of 1700 billion in securitized products at the end of 2008, asset-backed s­ ecurities accounted for

 See the securitization chapter for references.  Those include: (1) ECB/BoE, (2014), Synthesis of the consultation on securitization, October, (2) The BCBS-IOSCO consultative Document on Criteria to Identify, Transparent and Comparable Securitisation Instruments, Consultative Document, December, (3) the EBA Discussion Paper (2014) on Simple and Transparent Securitizations, October, (4) BCBS, (2014), Revisions to the Securitization Framework, December, (5) the EC Communication (2014) from the Commission to the European parliament and the Council on Long-Term Financing of the European Economy COM(2014)168 final of 27 March. They are discussed in the dedicated securitization chapter. 141  The EU comments on the issue of how securitization contributes to economic growth and job creation as follows: ‘[t]he new, more risk-sensitive provisions on regulatory capital requirements and the introduction of specific criteria for STS securitization will make investing in safer and simpler securitization products more attractive for credit institutions established in the Union and release additional capital for lending to enterprises and households. Historically, credit institutions have been the main investors in European securitizations. In the future, the CMU’s objective is to expand the investor base of Union securitization markets by making it more attractive for non-bank investors to fund securitization exposures. Nevertheless, it is likely that credit institutions will form a large part of securitization’s investor base in the EU’; EC, (2015), A European Framework for Simple and Transparent Securitisation, September 30. 139 140

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192 billion, and those include mainly car loans, student loans and credit card debts.142 In the chapter on securitization it was already indicated why SMEs are so underrepresented and will explain why they stay underrepresented. Securitized products work well (and are profitable) for all parties involved when the loans going in are synchronic (standardized) in terms of the nature and volume of risk they represent, The more synchronic, the easier it is to price risk and to generate returns. The SME market is pretty much the opposite. Somewhat opaque, with different risk profiles, higher impact of country and regulatory risk, higher variations of industry risk (SMEs are often a 1 country and/or 1 product/service businesses than larger companies), they are an absolute nightmare to price and assess their true risk profile when bundled. The chances of ending up with a concentration of wrong-way risk is very material. That explains their no-show in the securitization tables and also explains why mortgages are, as they pose all the right attributes. Since the proposal does not take away these concerns, and even if they tried they could not, most of the attention will go back to mortgages leading to a reflation of housing prices and the creation of asset bubbles (see securitization chapter for further references on this matter, also regarding the devastating drag a housing bubble collapse can be on the rest of the economy when deflating). The endgame is clear: financial instability (externalities), as risk is not properly priced when credit expansion is artificially fueled. And to make things worse it has become clear that banks do not increase their propensity to lend (to those areas in the market that matter to economic growth and job creation). Reducing the bank’s cost of lending doesn’t have a material impact on the propensity to lend. Agarwal et al. observed, after having analyzed the banks’ marginal propensity to lend (MPL) following a decrease in their cost of funds. They conclude that for the lowest credit score (FICO) households, higher credit limits quickly reduce marginal profits, limiting the pass-through of credit expansions to those households. They estimate that a 1 percentage point reduction in the cost of funds raises optimal credit limits by USD 127 for consumers with FICO scores below 660 versus USD 2203 for consumers with FICO scores above 740. They further conclude that the banks’ marginal propensity to lend is lowest exactly for those households with the highest marginal propensity to borrow (MPB), limiting the effectiveness of policies that aim to stimulate the economy by reducing banks’ cost of funds.143 • Non-transparent dispersion of risk: even when standardized loans are bundled the risk of concentration of risks is very material, as evidenced in the chapter on securitization. Allowing banks to transfer risk off their balance sheets to free up capital is not only not needed and based on fallacies, but also doesn’t contribute to a better risk dispersion among investors. The senior tranches are often held back by the issuing banks and the institutional investors interested are all looking for just those (AAA) tranches as they are often risk-averse public money managers (pension funds, endowments and

 Data set EU Securitization Forum  S. Agarwal et al., (2015), Do Banks Pass Through Credit Expansion? The Marginal Profitability of Consumer Lending During the Great Recession, Berkeley University, Haas School of Business Working Paper, August 30. Later on adjusted and published as S. Agarwal et al., (2018), Do Banks Pass through Credit Expansions to Consumers Who want to Borrow, The Quarterly Journal of Economics, Vol. 133, Issue 1, pp. 129–190. 142 143

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i­nsurance firms). They don’t prefer the junior tranches as the risk/return profile is less attractive relative to other options (leveraged loans, equities and the likes). Lower operational and informational searching costs will be generated only in those segments that perform just fine even without the additional securitization support. • Mingle where there is no issue; ignore where there is an issue: The EC wants to create a simple transparent and standardized securitization market which is Chinese walled from the rest of the securities markets. Not losing ourselves which standards can create guarantees across such a wide areas of debt instruments to be securitized, the real issues is that the EC has focused on the wrong side of the fence. To be specific, those simple transparent and standardized rules apply to the creation and distribution of securitized products (structure) in Europe. In particular the uniformity of the prospectus, lowering administrative costs, disclosing all relevant information for end buyers’ spells as information regarding the prospectus, cash flow data and credit assessments using standardized templates are included. But where the focus should have been is on the origination side of the securitization business, as that is where things went wrong initially pre-crisis. This is all the more the case given the higher level of default for originate-­to-­distribute loan relative to their originate-to-mature counterparts. The current proposal keeps end buyers in the dark about the origination part of the securitization chain and thus implicitly the risk assessments used within the originating banks regarding the ‘to be securitized’ loan portfolio. That is all the more important as the risk assessments are often internally (by the bank) generated models and therefore not publicly available. The more technical STS provisions only exclude the worst clauses known from the past such as reverse-seniority clauses and refilling clauses and therefore will trigger minimalist interpretations on behalf of the banks in terms of the information they will provide. • The EC has never made it a secret that its true ambition was to lower the capital charges for banks vis-à-vis securitized products. The European Banking Authority in June 2015 already cleared the way by advising positively on lower capital charges for banks regarding their (most safe) securitized products144 although they obviously will have to stay within the prudential perimeters foreseen by the new international Basel III standards. Within the EU there was and is broad support for lower (or in their language ‘more risksensitive’) capital charges with respect to securitized products. That seems like a nonsequitur given what we know about the pre-crisis situation under Basel II where banks could internally design their own risk models leading to severe undercapitalization. Basel III as enacted post-crisis drummed up capital charges for different assets and puts material limits on the ability of banks to use proprietary developed internal risk models. From a macroprudential point of view it was clear that risk management on a micro- and macro-level can lead to materially different perceptions and realities. That impacted also the EU securitization markets which was no longer profitable or at least not to the degree the industry had in mind themselves. It therefore became a supply and not demand-led  EBA, (2015), Opinion of the European Banking Authority on a European framework for qualifying securitization, July 7, and in particular EBA, (2015), EBA Technical Advice on Qualifying Securitisations, 26 June, London. See also, (2014), EBA Report on Qualifying Securitisation, December, London. It was written in parallel legislation with the securitization directive. See for the details the securitization chapter (Vol. I, chap. 3). 144

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slump (the same is by the way true regarding the macroeconomic perspectives in Europe post-crisis). Lowering capital charges (which are included in the securitization regulation proposal package145) will help the banks to revive the market in a profitable way. Apparently it was forgotten what an enormous amount of damage a real estate bubble causes to the real economy and the STS criteria146 are by far not convincing and ignore the ­persistent concentration of wrong-way risk distribution within securitized products. Not a single STS can take that away and only therefore the product should be abandoned. Opening the securitization route again is a sideshow for the fact that the contemporary business model is broken, and to which the Basel rules have contributed. What isn’t mentioned is the fact that Basel III allows to have a 0% capital charge to be held against so-called safe treasuries, while the capital charge for issuing loans to SMEs and households has materially gone up in recent years. A higher and non-risk-weighted Basel capital requirements model would help much more unlocking lending potential to the real economy, but would also make banks a lot less profitable. Overall, and also in this piece of legislation, banks have learned their lesson that they can get away with pretty much anything. And not to forget that most securitized products are not only used to be sold to investors but are largely used for funding purposes of the bank itself (as collateral). That then in itself magnifies (or has the potential to) increase systemic risk and contagion risk materially, with only a public backstop as game changer. Although securitization as a technique in itself can do no harm we have not mastered the (continuously) changing financial reality to such a degree that we can set it free in a free private market without material constraints and realizing only a public backstop is powerful enough to halt a potentially falling knife along the way.

 To be precise: Proposal for a Regulation of the European Parliament and of the Council amending regulation No 573/2013 on prudential requirements for credit institutions and investment firms, COM(2015)473 final, 30 September. 146  According to the Memorandum accompanying the securitization proposal STS implies: (1) assets packaged in securitization must be homogeneous loans/receivables (e.g. car loans with car loans, residential mortgages with residential mortgages); (2) no securitization of securitizations is allowed; (3) loans must have a credit history long enough to allow reliable estimates of default risk; (4) the ownership of a loan must have been transferred to the securitization issuer (i.e. they must be sold by the creator of the loans to the entity that will issue the securitization); (5) loans packaged in securitization must have been created using the same lending standards as any other loan, no ‘cherry-picking’ allowed; (6) At least 5% of the loans portfolio must be retained by the originator; (7) documents must provide details of the structure used and the payment cascade (i.e. the sequence and amount of payments to each tranche); (8) data on packaged loans must be published on an ongoing basis and (9) the contractual obligations, duties and responsibilities of all key parties to the securitization must be clearly defined. The issuing bank is legally responsible for any misrepresentation. The Commission’s proposal includes precise disclosure requirements from the originator, the sponsor and the issuer. These will be jointly responsible for providing to the investors all the relevant information needed to perform proper due diligence and assess the securitization’s riskiness. Synthetic securitizations carry additional legal and counterparty risks that need to be taken into consideration, and. As a consequence, some of the more complex synthetic products generated much higher losses than those generated by simple and transparent structures. Precise criteria to identify more simply synthetic securitizations are being developed by the European Banking Authority and the Commission stands ready to consider the inclusion of any such criteria developed. 145

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It can only be concurred with Brunsden and Hale who wonder ‘[h]ow has securitization gone from the bête noire of recent financial history to a perceived panacea for an ailing European economy? And can it be revived in the way regulators intend?’147 Reviving a moribund securitization market is not only about creating a framework and lowering capital charges for banks. It means getting a grip on a myriad of technically interwoven aspects such as risk management protocols at banks, a clear demarcation line which securitized products qualify and which not. But also the global current low interest rates and their envrionemtn, will limit the pool of loans that can be bundled. Both aspects are beyond the EC’s influence. Another element that might prove this initiative to be stillborn is the fact that even under current rules securitization is treated as less attractive than issuing covered bonds.148 Even Hill is uncertain about the outcome of all this when he indicated: ‘we will only know if it works when we try’. What he does know for sure is that the banks are, not surprisingly, ‘keen supporters of the idea’.149

3.14.2 T  he Structure and Content of the Securitization Regulation150 The regulation from a general perspective falls apart in two large segments151: the first part is devoted to rules that apply to all securitizations, while the second part focuses only on STS securitization. The first part provides a common core of rules that apply to all securitizations, including STS securitizations. Whereas existing EU law provides in the credit institutions, asset management and insurance sector already for certain rules, these are scattered among different legal acts and they are not always consistent. The first part of the regulation therefore puts the rules in one legal act, thus ensuring consistency and convergence across

 J. Brunsden and T. Hale, (2015), EU Plan to Revive ABS Faces Challenges, Financial Times, September 30. 148  Ibid. ‘A similar security that provides bank funding, but does not involve moving assets off bank balance sheets — and the securities would still face tougher capital requirements compared with the underlying assets, had they been left unbundled.’ 149  P. Teffner, (2015), Hill, Capital Markets Union Will Not Swing EU Referendum, EUobserver. com, November 5. 150  This section is put in place only for introductory purposes. For detail and analysis, see the securitization chapter (Vol. I, chap. 3). It is based on the preamble of the STS regulation: REGULATION (EU) 2017/2402 OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL of 12 December 2017 laying down a general framework for securitization and creating a specific framework for simple transparent and standardized securitization, and amending Directives 2009/65/ EC, 2009/138/EC and 2011/61/EU and Regulations (EC) No 1060/2009 and (EU) No 648/2012, O.J. L 347/35 ff. of 28 December 2017. 151  Based on Proposal for a Regulation of the European Parliament and of the Council laying down common rules on securitization and creating a European framework for simple transparent and standardized securitization and amending Directives 2009/65/EC, 2009/138/EC, 2011/61/EU and Regulations (EC) No 1060/2009 and (EU) No 648/2012 COM(2015) 472 final, September 30, pp. 13–18, and its final version: Regulation (EU) 2017/2402 of the European Parliament and of the Council of 12 December 2017 laying down a general framework for securitisation and creating a specific framework for simple, transparent and standardised securitisation, and amending Directives 2009/65/EC, 2009/138/EC and 2011/61/EU and Regulations (EC) No 1060/2009 and (EU) No 648/2012, OJ L 347, 28.12.2017, pp. 35–80. 147

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sectors, while streamlining and simplifying the existing rules. As a consequence the ­sector-specific provisions on the same topic would be repealed. The second part contains the criteria that define STS securitizations. In the Liquidity Coverage Ratio (LCR) Regulation and the Solvency II Regulation (for the insurance industry) the Commission has already laid down, for specific purposes, criteria similar to those in this proposal, but the Securitization Regulation will create a general and cross-sectoral regime. The revision of the Capital Requirement Regulation and the future amendment of the Solvency II delegated act will provide for a more risk-­sensitive prudential treatment for banks and insurers investing in STS securitization. Specific criteria related to liquidity features of securitization will be specified in the amended delegated act. The regulation follows a typical structure starting with definitions (article 2) which are to a large degree taken over from the capital requirements regulation to ensure that the same definitions apply across financial sectors even when those sectors are not covered by the CRR. Since securitizations are not always the simplest and most transparent financial products and can involve higher risks than other financial instruments, institutional investors are subject to due diligence rules (article 3). The existing rules can be found back in the CRR and Solvency II regulations which will be repealed and for which a common description will be used. From a more material point of view the proposal in article 4 focuses on the risk retention issue. Risk retention by originators, sponsors or original lenders of securitizations ensures alignment of interest between such actors and investors. Existing sector-specific regulations (CRR, Solvency II Directive and AIFM Regulation) already establish risk retention requirements, but use the so-called indirect approach: the originators, sponsors or original lenders are not directly subject to such requirements, but the investor should check whether the o­ riginator, sponsor or original lender has retained risk. This, however, places a burden on the investor, which has no direct access to the information necessary to perform such check. The propoal and final version imposes a direct risk retention requirement and a reporting obligation on the originator, sponsor or the ­original lenders. Investors will thus in a simple manner be able to check whether these entities have retained risk. For securitizations notably in situations where the originator, sponsor or original lender is not established in the EU, the indirect approach will continue to fully apply. This existing approach ensures a level playing field at global level. In accordance with existing EU law, certain exceptions should be made for cases when securitized exposures are fully, unconditionally and irrevocably guaranteed by in particular public authorities. In case support from public resources is provided in the form of guarantees or by other means, any provisions in this regulation are without prejudice to state aid rules. The proposal and final regulation take into account the EBA recommendation to close a potential ­loophole in the implementation of the risk retention regime whereby the requirements could be circumvented by an extensive interpretation of the originator definition. To this aim, it is specified that for the purposes of article 4 an entity established as a dedicated shelf for the sole purpose of securitizing exposures and without a broad business purpose cannot be considered as an originator. For instance, the entity retaining the economic interest has to have the capacity to meet a payment obligation from resources not related to the exposures being securitized. Transparency requirements on securitizations and underlying exposures allow investors to understand, assess and compare securitization transactions and not to rely solely

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on third parties, such as credit rating agencies. They allow investors to act as prudent investors and do their due diligence. The proposal, in article 5, ensures that investors will have all the relevant information on securitizations at their disposal. It covers all types of securitizations and applies across sectors. Above we have expressed concerns about the solidity of these transparency rules. At the heart of the regulation are the STS securitization aspects. The ‘STS standard’ does not mean that the securitization concerned is free of risks, but means that the product respects a number of criteria and that a prudent and diligent investor will be able to analyze the risk involved. There will be two types of STS requirements: one for long-term securitizations and one for short-term securitizations (ABCP). To a large extent the requirements are, however, similar. The requirements are developed on the basis of existing requirements in the Liquidity Coverage Ratio and Solvency II delegated acts. This proposal allows only ‘true sale’ securitization to become STS. In a true sale securitization the ownership of the underlying exposures is transferred or effectively assigned to a securitization special purpose entity. In synthetic securitizations the underlying exposures are not transferred to such an entity, but the credit risk related to the underlying exposures is transferred by means of a guarantee or derivative contract. This introduces an additional counterparty credit risk and potential complexity related in particular to the content of the contract. Until now neither on an international level (BCBS-IOSCO), nor on a European level (EBA), have STS criteria been developed for synthetic securitization. Thus at this moment there is insufficient clarity on which synthetic securitizations should be considered STS and under which conditions. The Commission will further consider this issue and will assess whether some synthetic securitizations that have performed well during the financial crisis and that are simple transparent and standardized should be able to meet the STS requirements. Post-closing of the manuscript the EBA has started consulting on the matter. As it is ongoing at this stage (March 2020), further details and analysis will be included in the first update review provided. See for details the book website. A specific category of SME transactions undertaken alongside public authorities or public guarantee schemes (i.e. ‘tranched cover’) has been singled out and will be granted the STS prudential treatment in the CRR under specific conditions. Originators, sponsors and securitization special purpose entities (SSPEs) should be jointly responsible for the compliance with the STS requirements and for the notification to ESMA. This will ensure that originators, sponsors and SSPEs take responsibility for their claim that the securitization is STS and that there is transparency on the market. Originators and sponsors shall be liable for any loss or damage resulting from incorrect or misleading notifications under the conditions stipulated by national law. Investors will, however, still have to perform due diligence but may place appropriate reliance on the STS notification and the information disclosed by the originator, sponsor and securitization special purpose entity on STS compliance. The STS criterion is key and full of complexities.152 And toward the end of the regulation, there is obviously a great deal of attention for supervision (article 29 ff.). To safeguard financial stability, ensure investors’ confidence and promote liquidity, a proper and effective supervision of securitization markets is  See in detail: T. Hale, (2015), Complexity Lurks in EU Simpler Securitization Plan, Financial Times, October 27. 152

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essential. To this aim, the regulation requires Member States to designate competent authorities in accordance with existing EU legal acts in the area of financial services. As is currently the case under existing provisions of EU law, for the supervision of compliance with the article on due diligence Member States should designate the competent authority of the relevant institutional investor. This supervisor should have the powers that are granted to it under the relevant financial services legislation. For the supervision of Articles 4–14 (dealing with risk retention, transparency and the application of the STS criteria) of the regulation, when the parties involved are regulated under the EU financial services legislation, the competent authority for the relevant regulated entity should be designated by Member States. For instance, when the entity concerned is a credit institution the relevant banking supervisor should be designated by Member States. In case the credit institution is a significant credit institution under Regulation (EU) No 1024/2013 the Single Supervisory Mechanism should be designated. Where the party concerned is not a regulated entity under EU financial services legislation, for instance an SSPE, Member States may decide which authority should be the competent authority. In this manner the supervisory arrangements for this regulation are as much as possible aligned with the existing arrangements. For entities that are currently not regulated by EU law Member States must designate one or more competent authorities. Member States should provide the competent authorities with the supervisory, investigatory and sanctioning powers that are normally available under EU financial services legislation. In view of the cross-border nature of the securitization market cooperation between competent authorities and the ESAs is crucial. Information exchange, cooperation in supervisory activities and investigations and coordination of decision-taking are a basic requirement. In view of the impact of the STS classification on the capital treatment of such products, some specific rules are necessary. For instance, two insurers from two different Member States could invest in the same STS securitization from another Member State. The competent authority with oversight on the first insurer could come to the conclusion that the securitization instrument does not satisfy the STS requirements, while the competent authority with oversight on the second insurer might conclude it does satisfy the STS requirements. Persistent use of different approaches could negatively impact the credibility of the STS approach and lead to regulatory arbitrage. To ensure a credible approach for STS securitization, some specific rules have therefore been introduced in the regulation. Where a competent authority has evidence that originators, sponsors and SSPEs have made a materially incorrect or misleading STS notification, it should immediately inform ESMA, EBA or the European Insurance and Occupational Pensions Authority and the competent authorities of the Member States concerned to discuss its findings. Where they cannot come to an agreement, there should be binding mediation in accordance with the appropriate ESMA Regulation. The regulation in fine (articles 38 ff.) also deals with many of the other EU acts that need adaptation (UCITS, Solvency II, EMIR and AIFM directives). These changes are necessary to reflect the creation of a harmonized securitization framework in this proposal. The amendments to the EMIR Directive provide that OTC derivative contracts entered into by covered bond entities and securitization special purpose entities should not be subject to the clearing obligation provided that certain conditions are met. The exemption is justified by that fact that counterparties to OTC derivative contracts are secured creditors under covered bond and securitization arrangements and adequate

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­ rotection against counterparty credit risk may already be provided for. In such cases, an p obligation to centrally clear could therefore impose unnecessary duplication of risk mitigation techniques and would interfere with the structure of the asset. This regulation provides essentially for a system that is open to ‘third country’ securitizations. EU institutional investors can invest in non-EU securitizations and will have to perform the same due diligence as for EU securitizations, which includes a check whether the risk is retained and whether the originator, sponsor and SSPE make available all the relevant information. Moreover, non-EU securitizations can also meet the STS requirements and the originator, sponsor and SSPE may also submit an STS notification to ESMA. There is also no requirement that the underlying exposures are located in the EU.

3.14.3 L ower Capital Requirements for Securitization Products In order to contribute to the overarching objectives of the Commission Regulation for a securitization regulation of restarting securitization markets on a more sustainable basis and making this a safe and efficient instrument for funding and risk management, the regulatory capital requirements for securitizations in the CRR are also amended in order to (1) implement the regulatory capital calculation approaches set out in the Revised Basel Framework and (2) introduce a recalibration for STS securitizations, consistent with the recommendation of the EBA. Guidelines were provided in terms of hierarchy, impact assessment and applications.153 It put additional emphasis that the ultimate goal of securitization is to free up bank capacity and lower capital charges rather than diversification of risk among relevant market participants. Back-to-back with the securitization proposal and within the context of the CMU the EC launched a public consultation regarding the use of covered bonds. Covered bonds154 are in Europe a direct alternative for securitizing loan portfolios but with a

 See the Explanatory Memorandum accompanying the Proposal for a Regulation of the European Parliament and of the council amending Regulation (EU) No 575/2013 on prudential requirements for credit institutions and investment firms of 30 September 2015 (COM(2015)473 final), pp.  2–11 and the final regulation (preamble): Regulation (EU) No 575/2013 of the European Parliament and of the Council of 26 June 2013 on prudential requirements for credit institutions and investment firms and amending Regulation (EU) No 648/2012 Text with EEA relevance OJ L 176, 27.6.2013, p. 1–337. The most significant changes are: a new hierarchy of risk calculation methods and lower capital requirements for STS, to lower costs for credit provision and unlock additional sources for long-term finance, especially to SMEs. The Council agreed on a general approach on 7 December 2015. There was a lengthy debate between EP and the Council on a number of issues including the hierarchy of approaches and securitization of SME loans. The European Parliament and the Council reached an agreement on 30 May 2017 on this and the related STS topic. The compromise entails a preferential capital treatment for STS securitization, a new hierarchy for risk calculation methods, including a differentiation between STS and non-STS and between senior and other tranches, as well as easing financing of SMEs via a specific treatment for the safer forms of synthetic securitizations of SME loans. 154  Based on EC, (2015), Consultation Document Covered Bonds in the European Union, September 30, pp. 3 ff. 153

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distinct number of characteristics for both buyer and securitizing bank. Covered bonds are debt obligations issued by credit institutions and secured on the back of a ringfenced pool of assets referred to as ‘cover pool’ or ‘cover assets’. Bondholders have direct recourse to the cover pool as preferred creditors, while remaining entitled to a claim against the issuing entity or an affiliated entity of the issuer as ordinary creditors for any residual amounts not fully settled with the liquidation of the cover pool. This double claim against the cover pool and the issuer is denominated the ‘dual recourse’ mechanism. The issuer is normally under the obligation to ensure that the value of the assets in the cover pool at least matches at all times the value of the covered bonds and replace assets that become non-performing or, otherwise, stop meeting relevant eligibility criteria. Lastly, the cover pool comprises high-quality assets, typically, but not exclusively, mortgage loans and public sector debt. Although covered bonds have a long history in some Member States, issuance levels have increased more notably in recent years. From an issuer perspective, these instruments have proved a successful countercyclical source of funding which remained resilient against the background of stressed market conditions, in particular when compared in issuance volumes to unsecured debt and assetbacked securities. Notwithstanding this relative success, covered bonds were not immune to broader market trends and the challenges faced by the financial crisis in the form of investor retrenchment to their domestic jurisdictions and spread widening. In the words of the Commission’s ‘European Financial Stability and Integration Report’ of 2014, the European banking sector faced two major challenges: (1) fragmentation between credit institutions from ‘core and non-core countries’. The Report illustrated this fragmentation by looking at the maturity structure of bank debt, in the light of which it concluded that ‘banks from core countries benefit from the strength of their sovereigns by being able to finance short term to a larger extent than banks from non-core countries’, trend which had only widened throughout the crisis; and (2) difficulties to access liquidity which became available only against collateral either in private repo transactions, by issuing secured instruments such as covered bonds, or by pledging assets to central banks, and as a result of which a significant proportion of banks’ assets became encumbered.155 Tackling fragmentation and market inefficiencies is at the core of the Capital Markets Union project. As it was acknowledged in the CMU Green Paper, ‘capital markets today remain fragmented and are typically organised on national lines’ and, while progress has been made, ‘the degree of financial market integration across the EU has declined since the crisis, with banks and investors retreating to home markets’. In March 2018, the Commission proposed a dedicated EU framework for covered bonds, consisting of a directive and a regulation (see below). In April 2019, the European Parliament endorsed  Regarding the aspects of encumbered and unencumbered assets see in detail: EBA, (2014), Guidelines on disclosure of encumbered and unencumbered assets, EBA/GL/2014/03, London, June 27. Encumbered assets are assets, most often on bank balance sheets. Encumbered assets are assets owned by a party but to which other parties hold legal or economic claims or liens. In many cases these encumbered assets cannot be sold until any outstanding debt or claims belonging to the owner of the assets are paid to the lender or claimholder who holds a claim or loan against or secured by these assets. 155

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the legislation setting the building blocks of a Capital Markets Union, including the EU framework for covered bonds156 and a Regulation amending the CRR with the aim of strengthening the conditions for granting preferential capital treatment to covered bonds by adding further requirements.

3.14.4 W  ill the CMU Project, and in Particular the Securitization Initiative, Make a Real Difference? It is to be expected that the harmonization as such of the covered bond regime within the EU will contribute to a further development and refinement of the model. It is also expected that it, given the dual recourse, will be an instrument preferred by investors over the securitization model. Having said that, given the fact that third-party issuers can participate, a material amount of securitized US products might end up in Europe. Although the rules there also have been tightened, they are not comparable to the standards not on the radar in Europe. Keeping in mind that the only meaningful category of securitized loans has been, even before the crisis, mortgage loans, it is to be expected that relaxing securitization rules will lead to an increased profitability for financial institutions to engage in this segment, thereby in particular helped by the lower capital charges. But in order to create a true capital Union, where bank funding will become less dominant and reliance on bank funding partially replaced by market-based funding, an integration of the capital market structure will be needed, a proper endorsement (with limited compliance and maybe partial exemption of the IFRS rules) of the alternative exchanges in many European countries, who now are often in dire straits due to low volumes and subsequent de-listings and therefore not interesting for Euronext and the likes. But there is more: SME financing is more complicated for a reason. Financing large multi-country and multi-service/product type of businesses means there is a natural spreading of the credit risk involved. That aspect doesn’t come natural when financing SMEs who are often one-­ country- and/or one-product-based. The implication is that meaningful credit decisions are much more information-sensitive for small- and medium-sized enterprises than for multinational enterprises. That all has to do with weak enforcement of debt claims and access to collateral (in the case of SMEs) as well as overall information asymmetry, weak financial reporting requirements and lack of harmonized data available. The absence of clean pooling conditions and the difficulty to commoditize SME loans all contribute to information opacity and disfavored interest margin on SME securitized assets. Investors  Proposal for a DIRECTIVE OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL on the issue of covered bonds and covered bond public supervision and amending Directive 2009/65/EC and Directive 2014/59/EU, COM(2018) 94 final, 2018/0043 (COD), 12 March 2018; Proposal for a REGULATION OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL on amending Regulation (EU) No 575/2013 as regards exposures in the form of covered bonds, COM(2018) 93 final 2018/0042 (COD), 12 March 2018; EC, (2019), Press release IP/19/2130, of 18 April that the EP backed, among others, the covered bond proposals (also IP/19/1435 of 26 February 2019). 156

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will be interested only if the interest margin is sufficiently interesting relative to the riskiness of the assets. However, it can be difficult for a bank to create a high-yielding asset with adequate differentiation between tranches from a heterogeneous pool of SME loans that are costly to securitize and generate relatively low returns (due to a high degree of collateralization).157 That in itself is a problem, as I argued before, that debt markets in itself are informative-insensitive, in contrast to equity markets. Would they have been information-sensitive they would never have been as large, deep and liquid as those we know now. Before the 1980s, banks were the financial fuse box of economies. They had deep sector knowledge, country knowledge, and that gave them an edge when lending money to businesses. Besides the fact that a contemporary bank only has a fraction of his balance sheet geared toward real economy lending, a big chunk of that is toward mortgages since the 1980s. That is the case to such a degree, that they have become mortgage factories rather than institutions that have an edge over competitors, because of their industry-based knowledge selection skills. The banks business model and focus will never allow for a large SME securitization market to emerge since they cannot facilitate under risk-adjusted and with decent levels of profitability. Even in the US, who benefits from economies of scale in this respect, the SME securitization market has been tiny compared to the other securitization segments, even before the financial crisis. Whether the lowering of capital charges will make a difference remains to be seen. There will always be demand for higher-­yielding fixed-income products. The only true question will be whether things will be swift, transparent and straightforward enough, in particular the use of risk models and which ­securitized products fall in which category will be absolutely key. But the outlook for SME securitization, as said, is grim159 and the stakes are built against a successful end of this.158 Elliott comments in this respect: ‘the benefits for SMEs are being oversold’ … ‘Banks, and other financial intermediaries, are actually in a better position than financial markets to make the investment in building the relationships and knowledge of SMEs that is necessary for sound credit decisions. That knowledge is important because SMEs vary

 S. Aiyar et al., (2015), Revitalizing Securitization for Small and Medium-Sized Enterprises in Europe, IMF Staff Discussion Note, SDN/15/07, May, pp. 17–19. 158  There are already many official instruments available for SMEs and without material success so far; see: S. Aiyar et al., (2015), Revitalizing Securitization for Small and Medium-Sized Enterprises in Europe, IMF Staff Discussion Note, SDN/15/07, May, pp. 11–12. 159  Aiyar et  al. propose a multifaceted strategy combining regulatory reforms and infrastructure development with targeted and time-bound official sector support to help revitalize the SME securitization market in Europe. This strategy involves (1) encouraging greater regulatory differentiation among securities of varying underlying asset quality and structures, (2) developing the right market infrastructure and facilitating cross-border investment through EU frameworks for harmonized credit reporting and insolvency regimes and (3) enhancing the scope of current EU initiatives for SME finance together with introducing a more nuanced treatment of SME-related collateral for refinancing with the Eurosystem. That could be complimented by a pan-European definition of high-quality securitization (HQS) comprising simple, transparent and efficient asset structures that can receive preferential regulatory treatment and official-sector support; see S. Aiyar et al., (2015), Revitalizing Securitization for Small and Medium-Sized Enterprises in Europe, IMF Staff Discussion Note, SDN/15/07, May, pp. 13–19. 157

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hugely in their business prospects and risks, particularly when compared across countries. Banks are also in a better position than markets to intervene with borrowers who run into trouble, especially through their own mistakes. Loan covenants give banks rights to step in and force actions in a way that is very difficult to do through markets. Further, relationships built over years give banks informal clout to encourage action.’160 To put it differently, a sound bank system and pro-growth policies are more relevant for SMEs than a Europe-wide Capital Markets Union.161 The securitization regulation proposal also leaves the door open for synthetic securitizations. They will not help SMEs as they effectively don’t finance anything (as the underlying assets aren’t loans but credit default swaps), but amplify the losses in case of a default on the loans covered by the CDSs. And last but not least, there is a body of literature emerging that securitization, measured by the amount by which a particular bank was active in securitization, didn’t have a material impact (‘very limited’) on lending volumes or narrowing lending spreads (or lending rates). What was more important was the position in the credit cycle. Securitization doesn’t lead to more lending to the (SME) market,162 but it does lead to poorer monitoring standards and subsequent poorer credit/asset quality.163 Cortes and Thakor have been digging a little deeper into the issue and ask the question, ‘How does securitization affect the risk of the loans that are originated for securitization?’ They start from the existing balance identified in literature that the originate-to-distribute (OTD) model weakens the originator’s screening incentives and leads to higher risk. Theories on reputation suggest that an originator’s concern about its ability to return to the market would prevent lax screening (the bank’s screening incentives are endogenized and affected by reputational concerns). In a model with reputational concerns, OTD model of securitization and pooling of loans, they analyze how loan securitization dilutes reputationdriven incentives to screen. With sufficiently strong reputational concerns there may be an overinvestment in screening even relative to the no-securitization case, so the OTD model does not suffice for securitization to increase risk. But they conclude: ‘[h]owever,

 D.J. Elliott, (2015), Capital Markets Union in Europe: Initial Impressions, Brookings Institute Research, February 23, via brookings.edu. He advances: ‘[g]ood market structures can aid banks and therefore indirectly help the SMEs, such as by facilitating securitization of SME loans. However, it will be important to ensure that banks retain a very considerable portion of the risk and reward from these loans, so that they will have sufficient incentives to do a good job of analyzing the credit risk of each loan and to intervene appropriately if necessary when things go wrong at the firms.’ 161  Z. Darvas, (2013), Paper for European Parliament, Banking System Soundness is the Key to More SME, Bruegel, July, IP/A/ECON/NT/2013–02, mimeo. 162  See, for example, for an excellent study: A. Kara et al., (2015), Securitization and Lending standards: Evidence from the European Wholesale Loan Market, Board of Governors of the Federal Reserve System, International Finance Discussion Papers, Nr. 1141, August. See a contrario: T.  Berg et  al., (2015), Real Effects of Securitization, BAFFI CAREFIN Centre Research Paper Series Nr. 2015–14, June 8. 163  A.  Kara et  al., (2015), Securitization and Credit Quality, Board of Governors of the Federal Reserve System International Finance Discussion Papers, Nr. 1148, November, Washington. See also Y. Wang, and H.  Xia, (2015), Do Lenders Still Monitor When They Can Securitize Loans? Review of Financial Studies, Vol. 27, pp. 2354–2391. 160

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when multiple loans are pooled together and securitized, reputational incentives to screen become weaker with an increase in the size of the loan pool being securitized. Moreover, there is a mutually reinforcing feedback164 effect between the originator’s screening incentives and the incentives of investors to acquire information about the quality of the loan pool, so investors are also less informed about larger loan pools. For sufficiently large loan pools, securitization reduces idiosyncratic risk but increases systematic risk.’165 So, the bottom line then becomes: the diversification associated with the pooling of loans reduces the risk of the pool and that of the security collateralized by the pool, which diminishes the benefit of screening precision. The whole EU initiative should also be seen and judged in the context of a 360-degree turn by the transnational supervisors and regulators in Europe. Whereas after the crisis it was well understood that securitized product, private money creation, cannot stabilize itself without a public backstop and therefore is inherently unstable and a threat to the real economy. The FSB has made a decent swing in its communication, scoping and analysis regarding shadow banking in general and securitization in particular. From acknowledging that financial intermediation outside the banking sector has intrinsic risk, to including nonbank credit providers, who (mostly in emerging economies) supplement nascent banking systems and immature capital markets, is a full reversal of its initial position when indicating that Europe cannot rely on bank funding only and needs a market-based (second) funding channel to the real economy.166 It has been explained and confirmed later on, referring to the fact that developing market-based systems, parallel to the banking system, has always been part of the thinking process when designing international financial systems. Strange, however, is the fact that this has never been mentioned in any of the previous FSB reports, and also the fact that it has never been evidenced that market-based funding channels are robust and sustainable funding channels to the real economy thereby contributing to real market value creation. That despite the fact that this is one of the ambitions of the FSB and financial regulation in general. The debunked banking model can be replaced (to a large degree) by market-based financing. Is it so that the experiences of the financial crisis and the aftermath in terms of moral hazard (‘too big to fail’) have driven supervisors straight into the hands of any alternative, that just even on the surface looks better, would be preferred over a continuation of what has become to be appreciated as a debunked model? The unquestioned appreciation of this alternative has more to do with the fact that the overall financialization of societies made any move in the direction of market-based finance all the more accepted.167

 A weakening of the bank’s screening incentives leads to weaker incentives for investors to become informed and a higher valuation uncertainty, creating a feedback effect that further weakens the bank’s screening incentives. 165  F.  Cortes and A.  Thokar, (2015), Does Securitization Increase Risk? A Theory of Loan Securitization, Reputation, and Credit Screening, Working Paper, December 5, mimeo. 166  M. Carney, (2014), Taking Shadow Banking out of the Shadows to Create Sustainable MarketBased Finance, Financial Times, June 16. 167  See in detail: E. Engelen & M. Aalbers, (2015), The Political Economy of the Rise, Fall and Rise Again of Securitization, Environment and Planning A, Vol. 47, Issue 8, pp. 1597–1605. 164

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It points at an absolute lack of leadership in the financial sector and on the regulatory level. Throughout the book I detailed more on this matter and so did Kay in his recent manuscript.168 He urges to go back to basics when he reflects, ‘What is it all for? What is the purpose of this activity?’ He indicates, ‘ it will be necessary to examine the activities of the finance sector and the ways in which it does, or might, make our lives better and our businesses more efficient. Assessing the economic contribution of the industry is complex, because there are many difficulties in interpreting reported information about the output and profitability of financial sector activities. But I will show that its profitability is overstated, that the value of its output is poorly reported in economic statistics, and that much of what it does contributes little, if anything, to the betterment of lives and the efficiency of business.’ When judging finance, just like any other business and industry, the question pops up: ‘[w]hat it is for?’ Well in the case of finance there are four anchor functions: ‘[t]hese four functions – the payments system, the matching of borrowers and lenders, the management of our household financial affairs and the control of risk – are the services that finance does, or at least can, provide. The utility of financial innovation is measured by the degree to which it advances the goals of making payments, allocating capital, managing personal finances and handling risk.’ In order to ensure this happening, we need structural reform, not regulation, Kay argues, together with many others in the academic finance field. Just like I do throughout this book, he argues that regulation which has been applied with more and more intensity and less and less effect through the era of financialization is part of the problem—a major part—not part of the solution. There has not been too little regulation, but far too much. What is needed is an entirely different regulatory philosophy. We need to give attention to the structure of the industry, and the incentives of the individuals who work in it, and to address the political forces that have prevented the application of regulatory and legal sanctions that have existed for decades, even centuries. He concludes, ‘[t]he objective of reforming the finance industry should be to restore priority and respect for financial services that meet the needs of the real economy. There is something pejorative about the phrase “the real” – meaning the non-financial – economy, and yet it captures a genuine insight: there is something unreal about the way in which finance has evolved, dematerialised and detached itself from ordinary business and everyday life.’ Finally, there is some evidence that credit expansion isn’t passed on by banks, at least not to those segments of society that need it. Agarwal et al. have been digging into things (on the side of households) and conclude that banks’ marginal propensity to lend is still the lowest (and unchanged during periods of credit expansion) for those households with the highest marginal propensity to borrow. That understanding translates into the fact that the effectiveness of policies that aim to stimulate the economy by reducing banks’ cost of funds is limited or close to zero.169 Asymmetric information can reduce banks’

 J. Kay, (2015), Other People’s Money. Master of the Universe or Servants of the People?, Profile Books, London. 169  S. Agarwal et al., (2015), Do Banks Pass Through Credit Expansion? The Marginal Profitability of Consumer Lending During the Great Recession, Working Paper, August 30, mimeo. That is in line with earlier research: A. Sufi, (2015), Out of Many, One? Household Debt, Redistribution and 168

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incentives to expand credit. That is the argument that should explain the situation, also for why SME lending is so troublesome. Something tells me that asymmetric information for SMEs at least is due to the fact that banks have focused too much on synchronic risk exposure through mortgages and therefore have lost their edge as a central node when it comes to info collection regarding economies and industries. It also explains the dismal position of SME loans books in the securitization industry, where asymmetric risk exposure reduces the likelihood of an efficient risk tranching and allocation. And now we ignore the past for a minute. There is still a large amount of loans outstanding that the system for a variety of reasons (legal, tax, information asymmetry, etc.) seem not be able to clear independently and which essentially qualify as non-performing loans (NPLs). Clearly those loans hold back economic growth and credit growth.170

3.14.5 EU Capital Markets and the CMU Project While much regulation has been enacted in response to these crises, the way in which debt transactions in capital markets are designed and entered into remains largely unregulated. Moreover, regulators have so far neglected the role that leverage and debt creation play in the economy and their consequences for the wider social context.171 And so does the CMU project. At its core is the disintermediated market-based form of finance. It is designed to represent an alternative to the traditional and dominant bank-based finance financing model in Europe. Although there is a lot of attention for the creation of the CMU, very little is given to a suitable architecture to regulate and stabilize such a Unionwide disintermediated capital market. The actual need, however, is there as research structurally indicates that market-based financing systems are inherently more unstable in times of market stress then bank-­based financing models.172 A combination of both channels is preferred at the level of an economy. Some countries have achieved that balance; others like the EU countries and Japan are still very reliant on bank intermediation. From a policy point of view, the US and, in recent years, the EU and increasingly Asia have put

Monetary Policy During the Economic Slump, Andrew Crockett Memorial Lecture, BIS; J.B. Taylor, (2014), The Role of Policy in the Great Recession and the Weak Recovery, The American Economic Review, Vol. 104, Issue 5, pp. 61–66; C. Goodhart, (2015), Why Monetary Policy has been Comparatively Ineffective, The Manchester School, Vol. 83, pp. 20–29. 170  See for a comprehensive overview of the issues at hand: S. Aiyar et al., (2015), A Strategy for Resolving Europe’s Problem Loans, IMF Staff Discussion Note, September, SDN/15/19. Just before closing of the manuscript the first signs started to appear that levels of NPLs are on the decline, although with variation based on jurisdiction. EC, (2019), Banking Union: Nonperforming loans in the EU continue to decline, Press Release IP/19/2932, June 12. 171  V. Bavoso, (2017), Capital Markets, Debt Finance and the EU Capital Markets Union: A Law and Finance Critique, ECMI Working Paper Nr. 5, October. See for a historical run-up to the CMU project pp. 1–4. 172  Bank-based financing models have their own detriments which have been discussed and which mainly revolved around cost of funding and availability of credit at any given time during the business cycle. See the discussion later in this book as well as V. Bavoso, (2017), ibid., pp. 4–6.

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focus on the role of market-based finance to facilitate capital needs of an economy. It would be easier to facilitate capital raising, risk management and risk diversification and distribution and price discovery, and ultimately would lead to a lower cost of funding. The market is more efficient (and information-sensitive) in allocating capital, capital providers need to compete on terms and there is no issue with bank intermediaries who have own strategy on how to deploy capital and which is not necessarily aligned with the needs of an economy.173 Nevertheless, and as said, the EU remains largely dependent on bank intermediation.174 There are many historical, sociological and country-specific arguments for this which are beyond the scope of this book. However, it must be clear that their dominant position in Europe stems from their immense lobbying capacity (instrumental power) and the financial sector’s central position in the economy (structural power). Increasingly, however, finance also enjoys infrastructural power, which stems from entanglements between specific financial markets and public sector actors, such as treasuries and central banks, which govern by transacting in those markets.175 Policy makers in Europe already felt the need for some time to push through and realize a more integrated Capital Markets Union to support the internal EU market as the evidence of misallocation of capital within the Union was mounting.176 And that despite the  But even a market-based model is recurring allocation issues. Besides the living proof called the financial recession of 2007–2009 there are thematic issues that return at frequent intervals dealing with the question on how to finance evolution in industries. See, for example, EIB, (2018), Financing the Next Wave of Medical Breakthroughs – What Works and What Needs Fixing?, EIB Research Paper Nr. 2018/03, March; EIB, (2018), Financing the Deep Tech Revolution: How Investors Assess Risks in Key Enabling Technologies (KETs), EIB Research Paper Nr. 2018/02, March; A.  Ferrando and C.  Preuss, (2018), What Finance for What Investment? Survey-Based Evidence for European Companies, EIB Working Papers Nr. 2018/01, January; A. Ferrando and S. Ledpek, (2018), Access to Finance and Innovative Activity of EU Firms: A Cluster Analysis, EIB Working Paper Nr. 2018/02, January. 174  See in detail: SWBI-ESBG, (2015), Financial Systems in Europe and in the US: Structural Differences Where Banks Remain the Main Source of Finance for Companies, Working Paper, September (via wsbi-esbg.org); S. Langfield and M. Pagano, (2015), Bank Bias in Europe: Effects on Systemic Risk and Growth, ECB Working Paper Series Nr. 1797, May; EIB, (2014), Unlocking Lending in Europe, EIB Working Paper Nr. 10/2014, in particular pp. 2–10. For the reasons why Europe experienced a negative growth rate of bank lending to nonfinancial corporations, see pp. 10–20; EIB, (2013) Investment and Investment Finance in Europe, EIB Working Paper Nr. 11/2013, in particular pp. 171–276; EIB, (2017) Investment and Investment Finance in Europe, EIB Working Paper Nr. 02/2017; J. Bats and A. Houben, (2017), Bank-Based Versus Market-Based Financing: Implications for Systemic Risk, DNB Working Paper Nr. 577, December. 175  See in detail: B. Braun, (2018), Central Banking and the Infrastructural Power of Finance: The Case of ECB Support for Repo and Securitization Markets, Socio-Economic Review, (published online February 20). 176  In detail: E. Gamberoni et al., (2016), Capital and Labour (Mis)allocation in the Euro Area: Some Stylized Facts and Determinants. ECB Working Paper Nr. 1981; G. Gopinath et al., (2017), Capital Allocation and Productivity in South Europe, Quarterly Journal of Economics, Vol. 132, Issue 4, pp. 1915–1967; Y. Gorodnichenko, et al. (2018), Resource (Mis)allocation in European Firms: The Role of Constraints, Firm Characteristics and Managerial Decisions, EIB Working Paper Luxembourg; F. Hassan et al., (2016), Bank Credit and Productivity Growth in the EU, EIB Working Paper Nr. 2016/05, December. 173

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still suboptimal experiences with the euro177 against the backdrop of a non-optimal currency union,178 the absence of a political or fiscal union and heterogeneity of the underlying economies in the different member states. A lot has been said about the good, the bad and the ugly regarding this project.179 That includes the recognition that the size and development of a capital market union-wide does not necessarily depend only on size, volumes or liquidity but that there are a large number of regulatory and institutional preconditions that matter just as much.180 The financial crisis of 2007–2009 also helped us learn that capital misallocation is not just a matter of the banking channel but intrinsically linked to a market-based model. Even more, due to the interconnectivity of parties within the open market space, contagion effect and systemic risk become dominant concerns. The destabilizing effect that banks can have in the banking channel when a financial ‘short circuit’ emerges has its equivalent in the market channel through the inherent instability, trending or momentum dynamics characterizing a marketbased financial model. Another concern is the fact that a market-based model does not necessarily focus on financing the underlying economy but can develop their own layer of financial economy disconnected from the ‘real’ economy it was supposed to serve.181 Despite all that, the EC has developed its arguments in favor of a CMU along the following lines182: • Diversification of sources of finance and the optimal allocation of funds across the EU. • The overreliance on the banking sector was the determining factor that impaired the quality of European banks’ balance sheets and resulted in the financial crisis. • The fact that banks couldn’t meet demand post-crisis worsened the crisis.

 See, for example, M. Höpner and M. Lutter, (2018), The Diversity of Wage Regimes: Why the Eurozone Is Too Heterogeneous for the Euro, European Political Science Review, Vol. 10, Issue 1, pp. 71–96. 178  See recently F. W. Scharpf, (2017), Vom asymmetrischen Euro-Regime in die Transferunion – und was die deutsche Politik dagegen tun könnte, MPIfG Discussion Paper Nr. 17/15 Max-PlanckInstitut für Gesellschaftsforschung, Köln, August. His earlier works on this matter can equally be recommended, just like the works on this matter of his colleague W. Streeck engaged with the same Max Planck Institute (www.mpifg.de). 179  See, for example, N. Anderson et al., (2015), A European Capital Markets Union: Implications for Growth and Stability, Bank of England Financial Stability Paper Nr. 33; C.  Kaserer and M.  Rapp, (2014), Capital Markets and Economic Growth  – Long-Term Trends and Policy Challenges, Research Report, March (via europeanissuers.eu). 180  See for an analysis of capital market finance–related issues: V. Bavoso, (2017), Capital Markets, Debt Finance and the EU Capital Markets Union: A Law and Finance Critique, ECMI Working Paper Nr. 5, October, pp. 9–23. One of the elements he focuses on is the excessive debt creation in a market-based channel and why market-based channels lead to increases in leverage (pp. 14–19). 181  S. Cecchetti and E. Kharroubi, (2015), Why Does Financial Sector Growth Crowd Out Real Economic Growth?, BIS Working Paper Nr. 490, February; R. Sahay et al., (2015), Rethinking Financial Deepening: Stability and Growth in Emerging Markets, IMF Staff Discussion Note Nr. SDN/15/08, May. See the last chapter for an extensive coverage of this topic. 182  See the EC Factsheet: Delivering on the Capital Markets Union, 15 March 2019 via ec.europe.eu. See for updates on the progress of the project ec.europe.eu. 177

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• Market-based channels of finance would be key to improving access to finance for small- and medium-sized enterprises across Europe. • Securitization is key to unlocking breathing space on banks’ balance sheets. Many of those arguments make no economic sense or sense otherwise.183 Bavoso184 highlights the fact that the EC paints, as they so often do, a one-­sided analysis of reality or is intentionally selective in demonstrating the need to endorse certain actions that need to be taken in their understanding. He concludes that the CMU proposal and all aligned initiatives will lead to ‘more financialized economies, to increased debt in the financial system and inevitably to higher levels of leverage’ and that ‘the push to revive both securitization and the repo market […] shows that there is a real possibility to see a new emergence of the securitized banking model’.185 Ultimately, there are limitations to what incoming regulation can do as long as the underlying financial system is flawed and triggers adverse consequences at regular intervals. Market discipline is not a permanent state and the dislocation it can cause is material and the systemic risk it brings along has proven to have the potential to create lasting damage to the underlying economy.186 Credit-induced growth brings along fragility of the economic infrastructure and is clearly not the preferred model to build productive capital investments.187 Just like every economy knows its business cycle, so does every financial system knows its credit cycle. The larger the indebtedness, the more material the impact. That material impact stems from the issues of rolling over large volumes of debt, the still problematic nature of bankruptcy laws, the swing in assets prices and the panic it tends to cause and not to forget the inefficient government intervention that typically follows a credit cycle.188As long as the system does not allow for the ‘internalization’ of risks, a regulatory framework like the CMU will not yield what was envisaged.  I will not argue each of the individual elements here as that is done throughout the two volumes of this book and in particular the last chapter of volume two. 184  See V. Bavoso, (2017), Capital Markets, Debt Finance and the EU Capital Markets Union: A Law and Finance Critique, ECMI Working Paper Nr. 5, October, pp. 6–9, for an overview of the arguments and analysis. 185  V. Bavoso, (2017), ibid., p. 31. 186  In many countries it took the respective economies more than ten years post-crisis to close the ‘output gap’ being the difference between actual and potential output levels of an economy. The CMU is claimed to offer the best available solution to the structural capacity gap in the area of macroeconomic stabilization. At least that I one view. The other points at the CMU as ‘a smokescreen to obscure a different, hidden policy agenda, namely the preferences of financial market actors’. See for that: B. Braun and M. Hübner, (2017), Fiscal Fault, Financial Fix? Capital Markets Union and the Quest for Macroeconomic Stabilization in the Euro Area, MPIfG Discussion Paper Nr. 17/21, MaxPlanck-Institut für Gesellschaftsforschung, Köln, December, pp. 16–17. Regarding the dynamics of actual versus potential output gap see in particular: Ph. Heimberger and J.  Kapeller, (2017), The Performativity of Potential Output: Pro-cyclicality and Path Dependency in Coordinating European Fiscal Policies, Review of International Political Economy, Vol. 24, Issue 5, pp. 904–928. 187  A. Turner, (2016), Between the Debt and the Devil, Princeton University Press, Princeton, NJ. 188  Geanakoplos discusses at length the detriments of a magnified credit cycle. See J. Geanakoplos, (2014), Leverage, Default and Forgiveness: Lessons from American and European Crises, Journal of Macroeconomics, Vol. 39, pp. 313–333. He reports eight reasons why credit cycles are bad for the underlying economy. That doesn’t seem to go hand in hand with the ambitions regarding 183

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Not surprisingly, some scholars see the CMU as a result less of financial policymaking than of macroeconomic governance in a politically fractured polity. The current governance structure of Economic and Monetary Union (EMU) severely limits the capacity of both national and supranational actors to provide a core public good, macroeconomic stabilization, Braun and Hübner report.189 Even more, they highlight ‘the European polity lacks the fiscal resources necessary to achieve stable macroeconomic conditions190: smoothing the business cycle, ensuring growth and job creation, and mitigating the impact of asymmetric output shocks on consumption.’ Capital Markets Union, they argue, is an attempt by European policy makers to devise a financial fix for this structural capacity gap. The EC and ECB use their regulatory powers to harness private financial markets and instruments to provide the public policy good of macroeconomic stabilization.191 The EC, backed by the ECB, ‘established market-based finance as a solution to the intractable problem of smoothing intra-euro area output shocks or, in technical terms, risk-sharing’. The CMU is thus a framework to support the goal of macro­economic stabilization.192 The point made is regarding the state-finance nexus in the CMU project. It concerns the structural relationship between technocratic economic governance and financialization. Braun and Hübner argue that a policymaking process, where finance is used for macroeconomic governance purposes, is characterized by a certain pattern, that is, that of state-led financialization.193The quest for perfecting private financial markets whereby the role of the state is reduced to a

s­ustainable finance as proclaimed. See Vice President Valdis Dombrovskis speech on sustainable finance at the European Parliament, Brussels, June 6, via ec.europa.eu). 189  B. Braun and M. Hübner, (2017), Fiscal Fault, Financial Fix? Capital Markets Union and the Quest for Macroeconomic Stabilization in the Euro Area, MPIfG Discussion Paper Nr. 17/21, Max-Planck-Institut für Gesellschaftsforschung, Köln, December. Also published in Competition and Change (2018), pp. 117–138. 190  A supranational fiscal capacity, which would be a key building block of a complete monetary union, remains out of reach due to diverging member state preferences and the complexities of the multilevel EMU governance regime. See B. Braun and M. Hübner, (2017), ibid., 16. Also see P. de Grauwe, (2017), The Limits of the Market: The Pendulum Between Government and Market, Oxford University Press, Oxford, p. 127. The result has been an institutionally ingrained, structural capacity gap that leaves the European polity—at both the national and the supranational levels— unable to provide the public good of macroeconomic stability. 191  The structural and instrumental power of finance in the European political process is well documented: D. Gabor, (2016), A Step Too Far? The European Financial Transactions Tax on Shadow Banking, Journal of European Public Policy, Vol. 23, Issue 6, pp. 925–945; C. Woll, (2016), Politics in the Interest of Capital: A Not-so-Organized Combat, Politics and Society, Vol. 44, Issue 3, pp. 373–391; K. Young et al., (2017), Capital United? Business Unity in Regulatory Politics and the Special Place of Finance, Regulation and Governance, Vol. 11, Issue 1, pp. 3–23; L. Kastner, (2017), Business Lobbying Under Salience: Financial Industry Mobilization Against the European Financial Transaction Tax, Journal of European Public Policy, published online August 9. 192  See B. Braun and M. Hübner, (2017), ibid., 16. 193  See B. Braun and M. Hübner, (2017), ibid., p. 17. They refer to the works of Quinn and Krippner regarding the US market and conclude that ‘the political power of finance appears deeply embedded in modern governmental strategies and technologies’. Managing the economy indirectly through market mechanisms follows a well-trodden path and not without alternatives as the EC often claims.

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pure regulatory and supervisory function is based on the paradigm that ‘deep and liquid financial markets offer the best way of sharing risks ranging from individual-level risks to the macroeconomic risks faced by entire societies’.194 On the other hand the ‘finance franchise’, which essentially is a public-private project,195 deserves a stronger role for government to allocate credit and absorb financial risk in order to yield economic outcomes (in equity and efficiency terms) and financial stability. The short-term nature and average risk-averseness of private agents cast doubts on the ability of a predominantly private finance market to function effectively as a risk-sharing mechanism society needs. The CMU project from this end is one-dimensional196 and is characterized by severe political, ideational and instrumental constraints.197 The technocratic bricolage erases the typical distinction between ‘powering’

 See B.  Braun and M.  Hübner, (2017), ibid., p.  18. Also see F.  Fernandez and M.B.  Aalbers, (2017), The Capital Market Union and Varieties of Residential Capitalism in Europe: Rescaling the Housing-Centred Model of Financialization, Finance and Society, Vol. 3, Issue 1, pp. 32–50. 195  See regarding the matter of the public-private partnership of money: K. Koddenbrock, (2017), What Money Does. An Inquiry Into the Backbone of Capitalist Political Economy, MPIfG Discussion Paper Nr. 17/9, Max-Planck-Institut für Gesellschaftsforschung, Köln, May. It includes a discussion on the role of capitalism as a perpetual model for ever-increasing profit and accumulation. Koddenbrock highlights: ‘[o]ur money-based capitalist political economy will always generate new money forms, greasing the machine of capital accumulation. Which importance these forms of money are allowed to gain and how complex they become depends on the willingness of the state to accommodate them, as money and moneyness continue to be public-private partnerships, driven largely by private profit desires’ (p. 19). ‘Capitalist money has entrenched a social distribution of power that is heavily skewed towards those who are able to create, mobilize, and control large swathes and chunks of money’ (p. 20). That public-private project has turned one-dimensional into a debt-laden economy and society. The sovereign is there simply to act as a backstop to ensure continued capital accumulation by a select group of private actors. See also on this matter: K. Judge, (2017), The Importance of Money: Book Review of The Money Problem: Rethinking Financial Regulation by Morgan Ricks, Harvard Law Review, Vol. 130, Issue 4, pp. 1148–1181; and in relation to shadow banking, see S. Murau, (2017), Shadow Money and the Public Money Supply: The Impact of the 2007–2009 Financial Crisis on the Monetary System, Review of International Political Economy, Vol. 15, Issue 4, pp. 1–37. 196  D.  Camaradi, (2017), Will vs. Reason: The Populist and Technocratic Forms of Political Representation and Their Critique to Party Government, American Political Science Review, Vol. 111, Issue 1, pp. 54–67. 197  R.C. Hockett and S.T. Omarova, (2017), The Finance Franchise, Cornell Law Review Vol. 102, pp. 1143–1218; D. Mertens and M. Thiemann, (2017), Building a Hidden Investment State? The European Investment Bank, National Development Banks and European Economic Governance, Journal of European Public Policy, published online October 2; D. Mertens and M. Thiemann, (2018), Market-Based but State-Led: The Role of Public Development Banks in Stabilising MarketBased Finance in the European Union, Competition and Change, Vol. 22, Issue 2, pp. 184–204; M. Mazzucato and C.R. Penna, (2016), Beyond Market Failures: The Market Creating and Shaping Roles of State Investment Banks, Journal of Economic Policy Reform, Vol. 19, Issue 4, pp. 305–326; S. Griffith-Jones and G. Cozzi, (2017), The Roles of Development Banks: How They Can Promote Investment, in Europe and Globally, In Efficiency, Finance, and Varieties of Industrial Policy: Guiding Resources, Learning, and Technology for Sustained Growth, (eds.) Akbar Noman and Joseph Stiglitz, pp.  131–155, Columbia University Press, NY; P.A.  Hall, (2018), Varieties of Capitalism in Light of the Euro Crisis, Journal of European Public Policy, Vol. 25, Issue 1, pp. 7–30. 194

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and ‘puzzling’.198 Let’s be fair, if macroeconomic stability is the objective, the market-based finance was not the most obvious solution. Randomly using regulatory instruments for asymmetric objectives is ‘bricolage pur sang’. And more importantly, regulatory bricolage comes with more, not less, uncertainty. Untested uses of regulatory instruments result in protracted uncertainty. Technocratic persuasion blends and blurs knowledge and expertise with policy and ideological preferences. There is zero, I repeat zero, evidence that, for example, securitization will lead to improved SME funding.199 Or that market-based finance will lead to a better distribution of risks and credit availability for those segments that are now in need for credit. The studies that technocrats and thus in this case the EC come up with are garbled gobbledygook or scientific gibberish. Often undirected and not pointing at the objectives required or aimed for. When Heclo’s puzzling becomes powering, objectives get replaced by pre-existing ideas, policies and preferences or consensus, often supported by private sector research used as a channel to further particular interests.200 International finance is a perfect space where that recurrently happens.201 Deregulation has played its role and it came at a cost, and this both from a financial and an industrial point of view.202 Baccaro and Powell link ‘the liberalization of industrial relations to “secular stagnation” – i.e., to the growing difficulty that all advanced economies have in generating adequate levels of aggregate demand. It argues that strong unions and centralized collective bargaining were cornerstones of the wage-led Fordist model, and that the liberalization of industrial relations has undermined a crucial institutional channel for transmitting productivity increases into real wages and aggregate demand. Post-Fordist growth models are based on alternative drivers of growth, but they are all fundamentally unstable.’ We can conclude not only that regulatory instruments are used for different purposes than they are intended and that technocratic bricolage is often a way protect vested interests and ideological and policy preferences that exist but also that the CMU is not a goal in itself but that it rather represents an e­ xercise in ‘governing through financial markets’. Pioneered in the US, governing through financial markets is a political strategy adopted

 H. Heclo, (1974), Modern Social Politics in Britain and Sweden, Yale University Press, New Haven. 199  See the last chapter of Vol. 2 of this book for a detailed analysis. 200  You sometimes wonder why brand-name research houses or consultancies are willing to lend their name to such studies. However, the expert-powered EU policymaking style provides ample opportunities for private sector actors to become involved and mobilize expert knowledge to advance their own interests. See, for example, J. Richardson, (2012), Supranational State Building in the European Union, in Constructing a Policy-Making State? Policy Dynamics in the EU, edited by J. Richardson, Oxford University Press, Oxford, pp. 3–28, p. 6. 201  R. Mayntz, (2018), Sovereign Nations and the Governance of International Finance, in J. Pixley and H. Flam (Eds.), Critical Junctures in Mobile Capital, Cambridge University Press, Cambridge, pp. 38–51. 202  L. Baccaro and C. Howell, (2017), Unhinged: Industrial Relations Liberalization and Capitalist Instability, MPIfG Discussion Paper Nr. 17/19, Max-Planck-Institut für Gesellschaftsforschung, Köln, November. A generalized liberalization trend in industrial relations, affected not just ‘liberal’ but also ‘coordinated’ forms of capitalism. They indicate, ‘liberalization has not taken place primarily through outright deregulation, but has involved alternative mechanisms that increase employer discretion without fundamentally altering the form of existing institutions.’ 198

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by state actors in pursuit of policy goals that exceed their institutional capacity.203 Heclo’s from puzzling to powering became ‘from playing the market to governing through markets’.204 The basis on that theoretical construct is that the EU integration is used as a vehicle for the neoliberal restructuring of European finance, thereby shortcutting the actual policymaking process. Also here the state-­finance nexus emerges again. Governing through financial markets implies a form of economic governance aiming to achieve public policy goals by using policy tools to ‘function by inducing another entity into action toward a desired end’.205The theory embodies two dimensions: the first is to engineer financial instruments and markets to achieve economic policy goals at minimum fiscal cost and secondly it engages the idea of ‘governing at a distance through the market’.206 Governing at a distance is often used as a technique to depoliticize conflicts over the distribution of scarce resources without reducing the economic steering capacity of the state.207 Budgetary constraints limit state power, and thus reigning through markets allows to generate outcomes that are positioned outside the institutional capacity of the sovereign. European integration is for a supranational system without real fiscal competency a challenge. On the other hand it covers the workings and development of the internal market. Policy innovation then forces the EU to create systems that are marketbased rather than policy-based. This isn’t a political process in isolation but involved policy makers, technocrats and private sector interests.208 Regulatory bodies will always lack specific and relevant information and will involve third parties to ‘persuade’ the preferred policy direction. On the other hand the ECB has never used its mandate to question the financial stability concerns surrounding the CMU project.209 Following the financial crisis of 2008–2009, policy makers and politicians have been more vocal in their demands for a fiscal union within the EU. The reasons are that it  B.  Braun et  al., (2018), Governing Through Financial Markets: Towards a Critical Political Economy of Capital Markets Union, Competition and Change, Vol. 22, Issue 2, pp. 101–116. 204  B. Braun et al., (2018), ibid., in particular pp. 103–107. 205  First reported by Quinn in 2010: S.  Quinn, (2010), Government Policy, Housing, and the Origins of Securitization, 1780–1968, PhD Thesis, University of California, Berkeley. Later reworked in S.  Quinn, (2017), The Miracles of Bookkeeping: How Budget Politics Link Fiscal Policies and Financial Markets, American Journal of Sociology, Vol. 123, Issue 1, pp. 48–85. 206  G.R. Krippner, (2007), The Making of US Monetary Policy: Central Bank Transparency and the Neoliberal Dilemma, Theory and Society, Vol. 36, Issue 6, pp. 477–513, and later on more extensively G.R. Krippner, (2011), Capitalizing on Crisis: The Political Origins of the Rise of Finance, Harvard University Press, Cambridge, MA. 207  See, for example, recently S. Quinn, (2017), The Miracles of Bookkeeping: How Budget Politics Link Fiscal Policies and Financial Markets, American Journal of Sociology, Vol. 123, Issue 1, pp. 48–85. 208  The CMU project has enjoyed the intention and engagement of not only the EC but also financial sector associations, such as the Association for Financial Markets in Europe (AFME) or the European Banking Federation, were part of the CMU agenda-setting process via various consultations and other communication channels. Bruegel or the Centre for European Policy Studies (CEPS) can be added to that list, and many others. 209  See B. Braun et al., (2018), Governing Through Financial Markets: Towards a Critical Political Economy of Capital Markets Union, Competition and Change, Vol. 22, Issue 2, pp. 107–108, also for additional literature references. 203

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would be easier to manage an EU-wide banking union, manage and steer issues surrounding national budget and access to capital markets for sovereigns that are in some sort of problem. The central concept here is ‘risk sharing across EU countries’. Many of these issues are beyond the reach of this book. It can therefore however be limited to commenting briefly on the matter of international risk sharing and the effectiveness of a fiscal union in achieving that objective. Gadatsch et al.210 raised the question what exactly the short- and long-term effects are of three different forms of a fiscal union, ascending in the degree of fiscal integration: (1) a per-capita public revenue equalization scheme, similar to the German Länderfinanzausgleich, (2) tax harmonization, where labor income tax and social security c­ ontribution rates are harmonized, and (3) a supranational/centralized fiscal authority at the European level, where both revenue and expenditure-side fiscal instruments and public debt are centralized. Their analysis shows that all three fiscal union scenarios considered do not improve international risk sharing significantly. Hence, none of the EU Member States would benefit on a considerable basis from introducing any of these integration steps. Even when introducing risk premia on government bonds in case the debt-to-GDP ratio deviates from target,211 this general finding is not changed— although risk premia per se decrease welfare notably.212 In the long run, redistribution generates winners and losers depending on the degree of integration and how key macroeconomic variables adjust.213

3.15 S  hadow Banking Is Now a Structural Aspect of the European Financial Infrastructure 3.15.1 Introduction The broad measure of shadow banking (including all financial intermediaries except banks and Insurance Corporation and Pension Funds) and a more narrowly defined measure (investment funds, ([MMFs and FVCs only) is applied in this context. The annual report on financial structures 2015 reports: ‘[t]he shadow banking sector has continued to grow over the past year, driven primarily by non-MMF investment funds, which expanded owing to net inflows and rising valuations. The weakening of the euro vis-à-vis  N.  Gadatsch et  al., (2016), Thoughts on a Fiscal Union in EMU, Deutsche Bundesbank Discussion Paper Nr. 40, Frankfurt am Main. 211  A common argument for introducing a fiscal union often made in practice is that it alleviates the burden of (unjustifiably high) movements in risk premia (ibid., p. 19). 212  Ibid., p. 2, (‘[w]ith regard to welfare, it is possible to establish according to our simulations that the welfare gains that would materialize in a fiscal union are likely to be small’), pp. 17 ff. 213  See also G. Corsetti, et al., (2013), Sovereign Risk, Fiscal Policy, and Macroeconomic Stability, The Economic Journal, Vol. 123, F99–F132; M.P. Evers, (2015), Fiscal Federalism and Monetary Unions: A Quantitative Assessment, Journal of International Economics, Vol. 97, pp. 59–75; N. Gadatsch, et al., (2016), Fiscal Policy During the Crisis: A Look on Germany and the Rest of the Euro Area with GEAR, Economic Modelling, Vol. 52, pp. 997–1016. 210

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other currencies contributed to this, as the share of assets invested outside the euro area amounts to 40%. Euro area MMFs expanded as well, following a protracted period of decline, with net flows into these funds having stabilized since mid-­2014. By contrast, euro area FVCs have continued to decline over the past year owing to continued weak loan origination and securitization activity by euro area credit institutions. Available data for the FVCs also suggest a notable decline in the relative share of liquid assets, while the issuance of short-term liabilities has remained constant over the past year.’214,215 Non-MMFs account for more than 40% of the total shadow banking FVCs (8%) and MMFs (4%). For more than 50% of the sector’s total assets, a breakdown is not available.216 While FVCs and MMFs have struggled to cope with the collapse in demand for securitized products and the low interest rate environment respectively, the non-MMF investment fund industry has witnessed a rapid expansion amid an intense search for yield among global investors since the global financial crisis.217,218 It is clear that banking regulation in the EU is having its impact on where capital is flowing, even when adjusting for enhanced valuation effects. Assets managed by investment funds other than MMFs have expanded rapidly over the past few years. Since the end of 2009, total assets have almost doubled from EUR 5.4 trillion to EUR 10.5 trillion in 2015 and beyond.219 The expansion of the sector has been broad-based and all types of funds have contributed to growth. Concentration is high in the fund sector, with more than 90% of assets under management domiciled in Luxembourg, Germany, Ireland, France and the Netherlands.220 Total assets measured in euro amount to more than EUR 1 trillion in the first quarter of 2015 for MMFs who are clearly on the rebound. These are predominantly domiciled in Ireland, Luxembourg and France. The geographical concentration of the euro area MMF sector is high, with Ireland accounting for 43%, France for 30% and Luxembourg for 24% of total assets held by euro area MMFs in 2015.221 There is a high degree of interdependence with the regular euro area banking sector, as more than 40% of MMF assets are either holdings of euro area MFI debt securities or loans to euro area MFIs (monetary financial institutions). Bank debt securities remain by far the most important asset class held, accounting for three quarters of the MMF balance sheet. Other the other hand FVCs are on the decline and measured by total assets, FVCs have shrunk by 23% since the end of 2009. The decline in FVC assets can be explained by a weakening of loan origination and securitization activity by euro area credit institutions over the past few years, which in turn was largely driven by a reduced securitization

 ECB, (2015), Report on Financial Structures, October, p. 46. See also the more recent reports ECB, (2017), Report on Financial Structures, October. 215  See also ECB, (2015), Financial Stability Review, Structural Features of the Wider Euro Area Financial System, May pp. 87–99. 216  See in detail ECB, (2015), Report on Financial Structures, October, ibid., p. 47. 217  ECB, (2015), ibid., p. 47. 218  ECB, (2015), ibid., p. 48. 219  See ECB, (2017), Report on Financial Structures, October, pp. 6–21. 220  ECB, (2015), ibid., pp. 49–50. 221  ECB, (2015), ibid., p. 52. Also see ECB, (2017), ibid., pp. 22–44. 214

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of loans to households. Much of the securitization activity following the crisis has been in retained deals, that is, deals that are not placed on the market but are used for collateral purposes—for example, in central bank refinancing operations. However, with EUR 1.8 trillion of total assets, FVCs remain an important channel for the intermediation of credit to euro area households.222

3.15.2 Country Specifics in the EU Banking Sector223 Belgium224  There are about 20 MMFs active in Belgium with limited amounts.225 More importantly, the Belgian MMFs are all variable net asset value (VNAV) funds and hence do not exhibit run-prone features (constant net asset value [CNAV] funds are not allowed in Belgium). There are no credit hedge funds active in Belgium. Other shadow banking entities that require monitoring are real estate investment trusts (REITs, Sicafs, Bevaks). Other shadow banking activities are credit insurance firms and finance companies (mortgage companies). What was more material is the exposure of Belgian banks to the foreign shadow banking system. Also that seems to have been reduced materially. Securitization is limited while some of it occurred before the crisis with banks being the originator. The residual OFI market is material,226 which seems to conflict somewhat with Keller’s data. On both counts, these vehicles are well regulated and pose no systemic risk. Regulatory overkill is still a threat and was caused by the material exposure of Belgian banks to foreign shadow banking systems and products. Tighter rules than Basel III norms are applicable in many shadow banking tainted fields.227

 ECB, (2015), ibid., pp. 53–54. Also see ECB, (2017), ibid., pp. 56–65, passim.  Those countries not mentioned in the list have no specifics going on their shadow banking markets. General data regarding those markets (and those markets discussed) can be retrieved through the annual FSB global shadow banking monitoring report and the bi-annual ECB financial stability report, as well as through the domestic financial stability reports of their respective central banks. For statistics I can refer to the already discussed annual FSB global shadow banking/nonbank financial intermediation reporting, via fsb.org. 224  See J. Keller, (2012), NBB Financial Stability Report: The Shadow Banking System: Economic Characteristics and Regulatory Issues, pp. 120–134, in particular p. 128. 225  Updated volumes to be consulted via the bi-annual EU’s Financial Stability Reports and the National Bank of Belgium. 226  ECB, (2015), Financial Stability Review 2014, Frankfurt, May, pp. 98, passim. 227  Other than regulatory threats for Belgium are listed in CSFI, (2014), Banking Banana Skins 2014. Inching Towards Recovery, New York; see also: M. Chang and E. Jones, (2014), Belgium and the Netherlands: Impatient Capital Market-Based Banking and the International Financial Crisis (eds.) by I. Hardie and D. Howarth, Oxford University Press, Oxford, pp. 79–10, and in particular pp. 86–87. They indicate that both Belgian and Dutch banks were most exposed to foreign shadow banking products which were allowed to issue more credit than would be allowed had they been forced to list them on their balance sheets. Belgium and the Netherlands were the most exposed countries in Europe measured against their GDP during or before the 2008 crisis. 222 223

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In recent times, the Belgian shadow banking market was assessed at being a­ pproximately EUR 320 billion (or 79% of GDP).228 That includes money market funds, non-money market non-equity investment funds, OFIs and other financial auxiliaries.229 Above and beyond the international measures which have been implemented in Belgium, the national bank decided to impose a capital surcharge on trading activities above a certain threshold. This measure is part of the structural reforms implemented in the banking law.230 As indicated AUM in MMFs is very small, but more sizable are the OFI and non-­ MMF investment funds. Most of them are obviously not directly prone to liquidity or maturity transformation.231 In September 2017, they reported232 on the position of their asset management industry. They qualify the risk as moderate as investment funds with a potentially higher-risk profile are targeted at professional investors and account for only a very small share of the Belgian investment fund universe. As regards the liquidity risk in open-ended investment funds, the risk was qualified as moderate given the regulatory eligibility rule, the regular stress tests conducted and the risk mitigating tools available. There is a seemingly large OFI sector,233 which is confirmed by the most recent FSB monitoring reports. See for a recent overview regarding the breakdown of the SB sector in Belgium.234 Ireland  The total assets of the Irish in recent years has been around EUR 4 trillion, of which only approximately 30% took place within the regulated banking sector. Although data are available for the larger categories within the shadow banking sphere,235 the lack of granularity troubles the view somewhat. It is also unclear how much interwovenness there is between the regulated and shadow banking sector due to the lack of granularity of data. The main attention goes to FVCs and SPVs as they have material relations to the banking sector in

 NBB, (2015), Financial Stability Review, June, pp. 40–42 (also for a breakdown).  NBB, (2015), Financial Stability Review, June, p. 24. 230  Ibid., pp. 11–12. 231  See also fragmented in the Report of the High Level Expert Group Established on the Initiative of the Minister of Finance of Belgium, (2016), The Future of the Belgian Financial Sector, January 13. 232  NBB, (2017), Report on Asset Management and Shadow Banking, September, via nbb.be., with an update in September 2018, via nbb.be. The SB sector represents approximately EUR 147 billion. 233  M. Druant and S. Cappoen, (2017), Belgian Shadow Banking Sector with a Focus on OFIs, Paper for the IFC-NBB Workshop ‘Data needs and statistics compilation for macroprudential analysis’ (18–19 May 2017), via bis.org 234  NBB, (2019), Financial Stability Report 2019, June, Section 6.2, pp.  36–40; NBB, (2018), Financial Stability Report, June, Section 2.4, pp. 29–31. 235  See B. Godfrey and B. Golden, (2012), Measuring Shadow Banking in Ireland Using Granular Data, Central Bank Quarterly Bulletin, Nr. 4, pp. 82–96 and B. Godfrey and C. Jackson, (2011), Meeting the Statistical Challenges of Financial Innovation: Introducing New Data on Securitisation, Central Bank Quarterly Bulletin Q3, pp. 109–122. 228 229

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Ireland as well as its real economy.236 There are about 1300 of them registered in Ireland in recent years and are engaged in a broad array of activities including investment transactions, securitization transactions, distressed debt transactions, balance sheet management and fund-raising. The Irish domiciled FVCs and SPVs also have significant interconnectedness with the regulated banking system. The local regulator has already indicated that ‘while existing and new financial services regulations will improve oversight and transparency of this sector, some SPVs may remain fully or partially outside the regulatory perimeter’.237 The other shadow banking component receiving recent attention is the MMF segment. Irish MMFs accounted for 41% (EUR 405 billion) of the total assets (EUR 986 billion) of the euro area MMF population in June 2015. Since end-December 2014, MMFs resident in Ireland have been required to report their securities’ assets and liabilities monthly on a security-by-security basis, for both stock and transactions. The net asset value of MMFs resident in Ireland grew by over 6% from end-December 2014 to end-July 2015, rising to EUR 409 billion from EUR 387 billion. Apart from debt security holdings, MMFs also act as an important source of direct lending to other entities. Deposits and loan claims of EUR 106 billion in July 2015 included EUR 26 billion attributable to securities borrowing, which essentially comprises short-term loans provided to banks with securities acting as collateral.238 There has also been an increase in the average maturity of debt securities held by MMFs. Total assets of FVCs expanded during Q2 2015 to EUR 418.9 billion, despite a decrease in the FVC population to 769 as investors return to the securitization market seeking higher returns in the current low-yield environment. As discussed, Ireland has a significant OFI sector relative to GDP which includes a broad array of entities and activities. The majority of the sector falls under Economic Function 1 (collective investment vehicles with features that make them susceptible to runs), Economic Function 5 (securitization-based credit intermediation and funding of financial entities) and the residual, unidentified OFI sector (taken from flow of funds data). The majority of the assets and liabilities of these entities are located outside of Ireland.239 From a regulatory perspective, the majority of investment funds fall within the regulatory perimeter (through either the UCITS or the AIFMD regimes) whereas securitization vehicles fall on or outside the regulatory perimeter. Of the approximately  See B. Godfrey et al., (2015), Data gaps and Shadow Banking: Profiling Special Purpose Vehicles’ Activities in Ireland, Central bank Quarterly Bulletin, Nr. 3, pp. 48–60 (particularly interesting are the technical features of the vehicles discussed in 4.1 [pp. 52 ff.]: they include the use of ‘limited recourse’ and ‘non-petition’ covenants within the legal contracts. ‘Limited recourse’ means that creditors of the vehicle only have a claim on what the entity is paid. ‘Non-petition’ refers to a situation whereby creditors give up the right to petition for liquidation of the vehicle. Many of the contracts underpinning the incorporation and activities of these vehicles are governed by UK or US law even though the entities are registered in Ireland. See also the case studies pp. 54 ff.); also see Central Bank of Ireland (2014), Box 6: Monitoring FVC and SPV Activity in Ireland, Macro-Financial Review, p. 39, December. 237  B. Godfrey et al., (2015), ibid., p. 59. 238  Ireland Central Bank, (2015), Financing Developments in the Irish Economy, CB Quarterly Bulletin Q4, pp. 37–45, in particular pp. 42–45. 239  That is based on the five-category methodology as developed by the FSB in 2013 and applied in their analysis since their 2015 global shadow banking monitoring report. 236

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EUR 4 trillion in the SB segment in Ireland, credit institutions accounted for EUR 773 billion while the remaining 81% of activity is outside of the regular banking system. Investment funds make up the largest component with approximately EUR 1634 billion in assets, while MMFs and FVCs are roughly of equal size and each represents approximately EUR 400 billion in assets. Corporations and pension funds together account for approximately EUR 350 billion in assets. There is a very sizeable residual OFI segment left for which no or limited data sets are available.240 Limited exposure, however, exists between the SB segment and the local economy. The remainder of the OFI sector comprises treasury companies, finance leasing companies, holding companies and SPVs that are not primarily engaged in securitization activities, for which granular balance sheet data on these entities are currently not available. However, a simple run risk test was applied to investment funds to target run risk more precisely. Investment funds were stressed by seeing if they could meet both a 10% investor redemption request and the withdrawal of leverage callable within one week at current market prices. Investment funds that are either significantly leveraged or that engage in liquidity transformation may not have sufficient liquid assets (defined here as sellable241 within seven days) to be able to meet their redemption requests. The analysis shows that funds which fail the run risk test account for 6% of the total investment fund industry in Ireland.242 In recent times they conducted a number of stress tests and statistical exercises and concluded that while risks appear to be relatively contained, international cooperation is required to undertake a complete risk assessment. Within these special purpose entities (SPEs), risks are the most prominent for entities engaged in loan origination, banklinked portfolio investment or external financing activity. The level of cross-border interconnectedness is high and a full understanding of risks requires an overview of the entire structures, which typically spans more than one jurisdiction.243 There is, however, concern that the large SB sector in the country crowds out other economic activities.244 Italy245  The objective of the domestic regulator is to ‘create a set of c­onsistent, organic measures based on the assumption that only with a comprehensive (“holistic”) approach

 See extensively: FSB, (2015), Global Shadow Banking Monitoring Report, Annex 2, pp. 48–52.  Sellable means that an asset can be disposed of at a price within 10% of its current market price. 242  FSB, (2015), Global Shadow Banking Monitoring Report, Annex 2, pp. 50–52. 243  B.  Golden and E.  Maqui, (2018), Shadow Banking Risk in Non-securitization SPEs, CBI Economic Letter, Nr. 12, via centralbank.ie; CBI, (2018), Macro-Financial Review 2019, II, pp. 55. 244  D. O’Donovan, (2018), Irish Shadow Banking Dwarfs More Traditional Sectors, Independent, March 6, via independent.ie. 245  Bank of Italy, (2015), Lo shadow banking e la regolamentazione italiana, Intervento di Carmelo Barbagallo Capo del Dipartimento Vigilanza Bancaria e Finanziaria Banca d’Italia, NIFA – New 240 241

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will it be possible to contain current and future shadow risks’.246 What is known is that the credit intermediation also in the EU has shifted from the traditional to the shadow banking segment, and this amid historically low interest rates. Italy has a shadow banking system of about EUR 1.2 trillion and largely populated by OFIs and financial vehicle companies.247 Recent reporting included the securitization market,248 and a discussion regarding some of the open questions regarding the nature of adequate regulation to tame nonbank finance.249 Lithuania  According to data available to the Bank of Lithuania, in 2010 liabilities of the shadow banking sector accounted for about one-tenth of the liabilities of all banks, that is, nearly LTL 8 billion. About 90% of this amount is represented by the liabilities of companies engaged in traditional activities, such as leasing or factoring. There is a much greater concern, especially in terms of consumer protection, linked to the activities of companies providing small (fast) consumer loans. They have become an alternative to borrowing from banks and other credit institutions. The small consumer loan market is highly concentrated, with only three lenders holding 75% of the market. Other segments of the shadow banking segment are non- (or near-non)existent.250 There is limited overall insight into the shadow banking markets in central and Eastern Europe.251The same holds true for the shadow banking market in Russia.252 Sweden and the Nordics  Also here the shadow banking market is relatively small. The size of the OFI, measured in asset term, equals 90% of Swedish GDP and account for about 30% of the Swedish banking sector, when excluding foreign operations in Sweden. Although OFIs have grown in Sweden over the past decade, they have largely remained International Finance Association World Finance Forum 2015 ‘La rinascita economica e finanziaria in Europa e in Italia’, Milan, March 5. 246  C. Barbagallo, (2015), Shadow Banking and Italian Regulation, Italy, p. 24. See also their official feedback to the EC green paper on shadow banking: ABI, (2012), ABI Response to the Commission Green Paper on Shadow Banking, Associazione Bancaria Italiana, Milan. 247  ECB, (2015), ibid., pp. 98, passim 248  G. Nuzzi, (2017), A Critical Review of the Statistics on the Size and Riskiness of the Securitization Market: Evidence from Italy and other Euro-Area Countries, Bank of Italia Working Paper Nr. 403, October. 249  L.F. Signorini, (2018), The Regulation of Non-Bank Finance: the Challenges Ahead, Speech by Deputy Governor of the Bank of Italy L.  F. Signorini, November 16, via bancaditalia.it. Also: C. Gola et al., (2017), Shadow Banking out of the Shadows: Non-Bank Intermediation and the Italian Regulatory Framework, Bank of Italy Occasional paper Series Nr. 372, February. 250  LLB, (2013), Financial Stability Review, Vilnius, p. 9. 251  There is one good paper providing a recent overview: M. Hodula, (2018), Off the Radar: Exploring the Rise of Shadow Banking in the EU, Czech National Bank Working Papers Nr. 2018/16. 252  See for an introductory article regarding shadow banking in Russia: P.  Vishnevskiy, (2015), Regulating Shadow banking in Russia: Brief Overview, International Journal for Financial Services. Nr. 3, pp. 26–32. His analysis includes broker and dealer activities, activities of special purpose vehicles, micro-finance companies, investment funds and non-state pension funds as well pawnshops; A.  Ponomarenko, (2016), A Note on Money Creation in Emerging Market Economies, Bank of Russia Working Paper Nr. 10, May.

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unchanged in relation to the size of the banking system. Hence, OFI has largely grown at the same rate as the banking sector over that period.253 In relation to GDP and the overall banking sector the OFI segment is smaller than the global average. And for Sweden not the entire OFI segment qualifies as shadow banking as a significant part is regulated and supervised by Finansinspektionen and the entities are subject to the UCITS and AIFM Directives aligned regulation in the country. Within the OFI segment, equity funds, investment firms, hedge funds and ETFs make up the largest portions.254 None of these firms engage in maturity, liquidity or credit transformation. Excluding them would halve the shadow banking sector in Sweden. Securitization is limited is limited as mortgages stay on the balance sheet of the originators and are mainly funded with covered bonds.255 That contributes materially to financial stability while providing the benefit of lower funding costs for the originating banks.256 There are two ways of structuring covered bonds. In one approach the bank originates the loans and ring fences the loans on its balance sheet to back the securities it issues. In a bankruptcy the bondholders would have first claim on the proceeds from sale of the ring-fenced loans as well as having a claim on the rest of the assets of the bank. Alternatively the bank can set up an SPV which holds the loans and issues the bonds. But the economics of the transaction is very similar. The bondholders in this structure also have recourse to the issuing bank as well as first claim on the pool. There is a covered bond trustee which supervises the management of the covered bond pool. Covered bonds are more like secured funding than shadow banking. Banks originate the assets and the bondholders have recourse to the bank and the pool.257 Repos and securities lending are available but limited in use. The securities lending is in Sweden, as is the case EU-wide much smaller than the repo market.258 The shadow banking sector (both the Swedish and the overseas one) has exposures to the Swedish banking sector but in modest amounts.259  D.  Hansson et  al., (2014), Shadow Banking from a Swedish Perspective, Sveriges Riksbank Economic Review, Issue 3, Stockholm, p. 34. 254  D. Hansson et al., (2014), ibid., p. 37. 255  D. Hansson et al., (2014), ibid., p. 38. Also more recent: R. Portes, (2018), Interconnectedness; Mapping the Shadow Banking Sector, Ademu Working Paper Nr. 117, April, via ademu-project.eu, p. 4; J. Abad, (2018), Mapping the Interconnectedness between EU Banks and Shadow Banking Entities, Ademu Working Paper Nr. 114, April, via ademu-project.eu. 256  M.  Sandström, (2013), The Swedish Covered Bond Market and Links to Financial Stability, Sveriges Riksbank Economic Review, Issue 2, Sveriges Riksbank, Stockholm, pp. 22–49. Covered bonds are characterized by increased safety for the investor by a claim both on the issuer and on an underlying cover pool. 257  P. Jackson, (2013), Shadow Banking and New Lending Channels—Past and Future, in 50 Years of Money and Finance: Lessons and Challenges, M. Balling and E. Gnan (eds.), SUERF/Larcier, Vienna, p. 391. 258  J.  Keller, et  al., (2014), Securities Financing Transactions and the (Re)use of Collateral in Europe – An analysis of the first data collection conducted by the ESRB from a sample of European banks and agent lenders, ESRB Occasional Paper Series, Nr. 6 (September), European Systemic Risk Board; D. Hansson et al., (2014), ibid., pp. 39–43. 259  D. Hansson et al., (2014), ibid., p. 48. Also: B. Wilhelm, (2018), Shadow Banking, in J. TaeHee and L.  Chester, C.  D’Ippoliti (eds.) The Routledge Handbook of Heterodox Economics. Theorizing, Analyzing, and Transforming Capitalism, London: Routledge, pp. 264–275. 253

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France  Very few specific features are noteworthy except the fact that its shadow banking markets is valued (2014) at around EUR 2 trillion (same more or less as Germany’s260). As decent size (more than half of the total SB segment) of that is MMFs and non-MMFs and the OFI sector is fairly modest.261 Despite that, overall concern persists regarding the systemic risk the shadow banking model poses.262 The overall SB market (MMF) seems to grow beyond average in recent years.263 Luxembourg  It has by far the largest shadow banking segment amounting more than EUR 7 trillion.264 A large chunk of that are MMFs and non-MMFs as well as residual OFIs.265 It reflects the preference of Luxembourg as a fund location. UK  The Bank of England Act 1998 as amended by the Financial Services Act 2012 (the Act) gives the Financial Policy Committee (FPC) responsibility to identify, assess, monitor and take action in relation to financial stability risk across the whole financial system, including risks arising in the nonbank financial system (including institutions and markets). In support of this, the Act gives the FPC the power to make recommendations to HM Treasury (HMT) on regulated activities, as well as more general powers in respect of information gathering. Their monitoring framework encompasses two levels: (1) at the

 Germany sees no rise in systemic risk coming from their shadow banking sector. The weight of the German shadow banking industry has grown in recent years relative to the rest of Germany‘s financial system. Germany‘s shadow banking actors are generally regulated entities such as mutual funds. Maturity and liquidity transformation stable and leverage on the decline in the system; see: Deutsche Bundesbank, (2015), Financial Stability Review, November 25, p.  10. The German shadow banking system is considered small but globally connected: Deutsche Bundesbank, (2012), Financial Stability Review 2012, pp. 67–78. More broadly: Deutsche Bundesbank, (2014), The Shadow Banking System in the Euro Area: Overview and Monetary Policy Implications, Monthly Report, March, pp. 15–34; O. Kessler and B. Wilhelm, (2017), Shadow Banking and the Question of Political Order, in: Anastasia Nesvetailova (ed.) Shadow Banking. Scope, Origins and Theories. Abingdon: Routledge, pp. 54–71. In 2018 about a third of the over 1 trillion in managed assets, about one-third were SB denominated assets. See: DBD, (2018), Deutsche Bundesbank Financial Stability Report 2018, pp. 100–102. 261  See for details: ECB, (2015), Financial Stability Review 2014, Frankfurt, pp.  88, 91, 98, passim. 262  M. Charrell, (2013), La finance del’ombre représente toujours un énorme risqué systémique, Le Monde, September 15–16; L. Scialom and Y. Tadjeddine, (2014), Banque hybride et réglementation des banques de l’ombre, Working Paper, November 14; E. Jeffers and D. Phihon, (2014), Le shadow banking system et la crise financière, Cahiers français Nr. 375, pp.  50–57, Paris, La Documentation française; D. Plihon, (2010), La réforme de la régulation financière, Cahiers français Nr. 359, novembre-décembre. 263  FSB, (2019), Global Monitoring Report on Non-nank Financial Intermediation 2018, pp. 13, 19. 264  ECB, (2015), ibid., p.  98. Also: C.  Duclos and R.  Morhs, (2017), Analysis on the Shadow Banking Context of Captive Financial Companies in Luxembourg, Working Document, Comité du Risque Systémique, April. 265  This remains their largest market; FSB, (2019), ibid., p. 14. 260

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level of the entity (and whether it is regulated or not) and (2) the level of the activity (and whether it is regulated or not). Three key channels are observed through which financial stability risk might occur: (1) the provision of critical services, (2) risk to systemically counterparties and (3) the disruption to systemically important financial markets. Each of these risk channels are likely to be made more acute when they are combined with sources of fragility, such as leverage and/or liquidity or maturity mismatch between assets and liabilities.266 The UK, given its sizable banking sector and node in the global financial sector, pays more than average attention to investment funds, including hedge funds and securities financing transactions.267 It was in 2014 that the Bank of England turned around its position and reframed its shadow banking efforts to building a sustainable market-based infrastructure.268 In fact, as of the late 2015 financial stability review no reference is any longer made to ‘shadow banking’ but only to ‘market-based finance’. This could be part of a broader dynamic late 2015 of the Bank of England to end the bank bashing that had been in force since the 2008 crisis.269 Nevertheless, despite the semantics the nonbank financial intermediary accounts for almost half of the UK financial system’s total assets. They use the broader definition to include broker-dealers, insurance companies and pension funds, investment funds, structured finance vehicles and so on. The Bank of England evaluates the system to be balanced and stable especially now that CCPs (and using standardized contracts) are overseen and the leverage ratio of this group is improving. The securities lending and repo as the dealers’ level is reason for ongoing monitoring and this despite the reduced level of repo activity in the recent years which now approaches USD 2 trillion.270 Nonbank leverage is a concern in recent years concluding that nonbank leverage can support financial market functioning, but it can also expose nonbanks to greater losses and sudden demands for high-quality collateral, which could result in forced sales of potentially illiquid assets.271

3.15.3 Shadow Banking in Switzerland In the Swiss financial environment, large importance goes to the OFI segment. The assets held by the OFI segment is often used as a proxy for the size of the entire shadow banking industry. Measured in terms of the Swiss GDP (2013) the Swiss OFI sector is the third largest in the world with about CHF 1500 billion in financial assets (FSB 2014 report) or

 See in detail: Bank of England, (2014), Financial Stability Review, June Nr. 35, pp. 73–76.  Bank of England, (2015), Financial Stability Review, July Nr. 37, pp. 46–47. 268  Bank of England, (2014), Financial Stability Review, December Nr. 36, pp. 40–42. 269  C. Giles, C. Binham and M. Arnold, (2015), Bank of England Draws Line Under Bank-Bashing, Financial Times, December 1. 270  Bank of England, (2015), Financial Stability Review, December, Nr. 38, pp. 51–54. 271  Bank of England, (2018), Financial Stability Review, November, Nr. 44, pp. 51–57. 266 267

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CHF 1339 billion when using the FSB’s narrow methodology. However, part of that ­narrowed down shadow banking market exposes actual ‘bank-like systemic risk’. When focusing only on that part of the narrowed down shadow banking market displaying those risks a recent study narrows the Swiss shadow banking market down to only CHF 500 billion272 and the entities involved exhibit only a low to moderate bank-like systemic risk profile. This conclusion would materially narrow down the exposure of the Swiss banking sector compared to other methodologies used. This is somewhat in contrast to other reports on the matter.273

3.15.4 The Shadow Banking Market in the Netherlands 3.15.4.1  Introduction Relative to its GDP,274 the Netherlands traditionally had a large shadow banking. It is intrinsically linked to its role and function as a holding company location and extensive ruling and Advance Pricing Agreement (APA) facilities available to internationally operating groups and conglomerates. Of all the subsegments analyzed by the FSB, a significant portion ends up being allocated to the OFI group (other financial intermediaries). This sector includes all financial institutions with the exception of banks, insurers and pension funds. For the Netherlands that OFI to a large degree is made up of special financial institutions (SFIs). While the Netherlands’ shadow banking market in 2011 accounted for 6% of the global shadow banking market that has materially risen in the last few years. Partly that has to do with better and more granular data aggregation. The FSB in this respect indicates: ‘the Netherlands made substantial revisions and reclassification of the OFI sector assets due to a revision of national accounts data which led to a significant upward revision of the OFI sector assets for the period 2002–2012 compared to the previous year’s report.’275 The FSB, when focusing on the OFI group report ‘[t]he relative size of the OFI sector varies widely among individual jurisdictions and is closely linked to the degree of disintermediation and financial deepening of jurisdictions’. In terms of share of GDP, OFIs in the Netherlands stood at 760% of GDP and detailing that ‘Special Financial Institutions (SFIs) comprise about two-­thirds of the OFIs sector and thereby explain most of the size of the shadow banking sector. There are about

 Study conducted as a cooperation between the Financial Stability Board and the Swiss National Bank in collaboration with the SNB’s Statistics and International Monetary Relations units, as well as the Federal Department of Finance and the Swiss Financial Market Supervisory Authority, FINMA. 273  T.K. Birrer et al., (2019), Unternehmensfinanzierung mit Private Debt in der Schweiz, Lucern University Report. Also see SNB, (2018), Financial Stability Report, pp. pp.  22–23. Also infra special report on Switzerland under 13.15.4 274  About 760% of GDP compared to 348% (UK) and 261% (Switzerland); FSB, (2014), Global Shadow Banking Monitoring Report, Basel, p. 11. 275  FSB, (2014), Global Shadow Banking Monitoring Report 2014, p. 7. 272

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14 thousand SFIs, which are typically owned by foreign multinationals who use these entities to attract external funding and facilitate intra-group transactions.’276 But that is not where it ends: also credit risk for banks was and is sharply on the rise. Banks’ assets to OFIs typically range between 1% and 5% of bank assets in most jurisdictions. The Netherlands has broken out of that bandwidth and is now hovering around the upper end of the 5–10% bandwidth.277 The overall picture is as such that the share of total financial assets by jurisdiction for the Netherlands displays that close to 60% is held by OFIs, which is unique even on a global scale. The US has a thriving OFI market but that accounts for slightly above 30% of total financial assets and is on par somewhat with the traditional banking ­sector, whereas in the Netherlands that share accounts for around 23%. In short, the Netherlands is a major contributor to the European OFI sector (together with the UK and Switzerland). In case one would analyze the Dutch shadow banking sector from the narrow definition approach the SFIs are excluded as they are not part of a financial enterprise. They also don’t have a lot of credit intermediation business going on, a major criterion for the FSB, in terms of systemic and contagion risk. In a Dutch context the credit intermediation risk sits with Financial BFIs (BIjzondere Financiële instellingen),278 special purpose vehicles, money market funds, finance companies and the dedicated hedge funds. Part of those special purpose vehicles are the securitization SPVs in the Netherlands. They ‘provide maturity and liquidity transformation within the credit chain, whilst reducing the solvency requirements for the lender by transferring risk to other parties’.279 Most of the Dutch securitized SPV are securitized residential mortgages and of which the majority is owned and operated by banks.280 The other components that are relevant from a credit intermediation perspective are MMFs, finance companies and hedge funds. Out of those three categories, from a Dutch perspective, the finance companies (consumer credit, mortgages, factoring, lease, etc.) are material and the credit-oriented funds of funds as well somewhat, although the last category can be considered small for the Netherlands. The same holds true for credit-­oriented private equity firms; collective investment schemes and investment firms (securities

 FSB, (2014), Global Shadow Banking Monitoring Report 2014, p.  11. Elsewhere the FSB reports; ‘In the case of the Netherlands, Special Financial Institutions (SFIs) dominate the OFI sector (they accounted for 68% of the OFI assets in 2013). About 80% of the Dutch SFIs are part of non-financial groups which are not involved in credit intermediation outside of the group. These non-financial SFIs therefore do not fall within the FSB’s shadow banking definition and were excluded in the narrow measure of shadow banking’ (pp. 21–22). 277  FSB, (2014), Global Shadow Banking Monitoring Report 2014, p. 26. 278  More recently the growth of BFIs is on the decline (in capital terms): DNB, (2014), Groei BFI’s neemt af in 2013, Statistisch Nieuwsbericht, 29 December 2014, www.dnb.nl. One-third of them are linked to US MNCs and increasingly linked to emerging market MNCs. 279  DNB (M. Broos et al.), (2012), Shadow Banking: An Exploratory Study for the Netherlands, DNB Occasional Studies, Vol. 10 Nr. 5, p.  24; see also D.  Bezemer and J.  Muyskens, (2015), Dutch Financial Fragilities, WRR Working Paper Nr. 13, November. 280  De Nederlandsche Bank (DNB), (2012), Nederlandse banken en buitenland grootste bezitters van Nederlandse securitisaties, Statistisch Nieuwsbericht, 24 April 2012, www.dnb.nl 276

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brokers and asset managers) are shaped in line with the rest of the financial sector in the Netherlands. Most of these entities don’t engage in credit, liquidity or maturity transformation. The narrow FSB definition makes the shadow banking size for the Netherlands drop by about two-thirds and would account for about 15% of the Dutch financial sector. When using the wide FSB definition that would increase to 46–50% of the Dutch financial sector using the size of their balance sheet as a measurement criterion.281

3.15.4.2  Special Financial Institutions The aforementioned SFIs are often ‘owned by foreign multinationals, which use them to channel financial flows between group entities via the Netherlands’.282 They have been around since the early 1980s283 and can be considered as a special purpose entity for OECD purposes.284 Most of these SFIs are classified as holding companies or group finance companies and do not require a banking license from the Dutch regulator to raise money from the public. That is to say, they need to meet certain conditions: ‘a group finance company must raise money by issuing securities, must have a guarantee issued by its parent company (which must have positive equity) and must invest at least 95% of the funds raised within the group to which it belongs.’285 As indicated, the key motives for having an SFI in the Netherlands is tax arbitrage, thereby using not only there extensive tax-treaty network but also their equally extensive APA infrastructure providing upfront certainty about the tax treatment of transactions and structures. Other arguments provided as a quality financial services industry and a participation exemption are not unique or fading in an increasingly competitive landscape. The SFIs can be either a holding company or a group company. As a holding company they organize capital flows between group entities. As a finance company, their main concern is raising capital for the parent group. That is the part that interests us most from a shadow banking point of view. SFIs can be seen as a finance company in case they raise more than 10% of their funds from outside the group. The difference is their direct interface with the capital markets and therefore investors. Some nonfinancial SFIs act as a

 See the study of Den Boer who explored the Dutch National Accounts in search for some answers regarding the size and nature of the Dutch shadow banking market, P. den Boer, (2016), Shadow Banking in the Dutch National Accounts, Paper prepared for the 34th IARIW General Conference, via iariw.org 282  DNB, (2012), ibid., p. 27. 283  De Nederlandsche Bank (DNB), 2008, Nederland nog steeds aantrekkelijk voor BFI’s, Statistisch Bulletin, September pp. 21–24, www.dnb.nl. See for a historical write-up: De Nederlandsche Bank (DNB), 2000, Bijzondere financiële instellingen in Nederland, Statistisch Bulletin, March, pp. 19–27, www.dnb.nl 284  OECD, (2013): ‘[in] general terms SPEs are entities with no or few employees, little or no physical presence in the host economy, whose assets and liabilities represent investments in or from other countries, and whose core business consists of group financing or holding activities.’ 285  DNB, (2012), ibid., p. 28. 281

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royalty and licensing company that manages intellectual property, leasing and factoring arrangements. Most of these SFI, although having a physical presence in the Netherlands, are managed from abroad, and are therefore disconnected from the Dutch domestic economy. Most of them are part of a nonfinancial group and only a quarter are linked to a financial conglomerate.286 Only the latter subgroup is relevant from a shadow banking perspective (i.e. only 25% of the SFI group).287 To that effect it can be noted that ‘the financing of SFIs is more concentrated than their exposures: on average, their assets are spread over far more countries than their liabilities. This is because SFIs often have global activities as holders of operating companies (assets), whereas the financing is linked to the parent company (liabilities). In the case of SFI finance companies, financing appears to be concentrated in the principal global capital markets.’288 The Dutch SFIs can therefore be seen as a wider financing chain for multinational corporations (MNCs) that often link offshore and onshore entities and locations together. These finance SFI have, from a balance sheet point of view, bank-like characteristics. That includes more external funding, higher levels of leverage and a large part of both their exposures and obligations consists of loans.289 Often ‘the degree of external finance is either almost zero or almost 100%, in line with the distinction between finance and holding companies. The equity position also varies widely: more than half of the financial SFIs hold virtually no equity.’290 Some SFIs are sizable and the use is concentrated at the top end of the MNC market. The overall conclusion is therefore that although the SFI market is sizeable, it poses limited shadow banking risk. Only the SFIs that are financial conglomerate-related are relevant. They often play a role that deviates from the main distinction between holding and finance companies within the SFI group and are often designed as ‘bankruptcy remote’, that is, standalone from other SFIs or group companies and often ‘engage in the securitization of foreign assets administered by foreign parties. A high proportion of them consist of collateralized debt obligations (CDOs), which are used to create structured credit products’.291 These financial SFIs, although performing a similar function as holding companies or nonfinancial SFIs, ‘form part of the financial intermediation process, with the channeling of funds via the Netherlands clearly being a construction that falls outside the regular banking system’.292 SFIs have traditionally been linked to offshore contractions, tax planning and tax avoidance schemes. Lejour et al. used the financial statements of special purpose entities (SPEs) for explaining the origin and destination of dividend, interest and royalty flows passing through The Netherlands. They find that Bermuda is the most important destination

 DNB, (2012), ibid., p. 30.  The other part is not involved in (credit, liquidity or maturity) transformation. 288  DNB, (2012), ibid., p. 31. 289  DNB, (2012), ibid., p. 33. 290  DNB, (2012), ibid., p. 33. 291  DNB, (2012), ibid., p. 34. 292  See also: R. Fernandez and E. Engelen, (2014), Shadow Banking and Offshore Finance: The Role of the Netherlands, Working Paper, pp.  9–20; E.  Engelen, (2017), Shadow Banking After the Crisis: The Dutch Case, Theory, Culture and Society, Vol. 34, Issue 5–6, pp. 53–75. 286 287

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for royalty flows. These flows come from Ireland, Singapore and the US. For dividend and interest payments the geographical pattern is more widespread. They also observed a substantial tax reduction for royalties by using Dutch SPEs compared to a direct flow between the origin and destination country. However, they cannot find such tax savings for dividends and interest with an approximation based on statutory tax rates.293 It has led some authors to conclude that the structure of the financial sector in the Netherlands is crowding out the real sector and leads to structural imbalances.294 From a systemic risk point of view, it was already concluded earlier that the shadow banking sector in the Netherlands might be sizeable but less substantial than initially perceived since ‘only “financial SFIs”, i.e. parts of financial institutions, count as shadow banks because they facilitate the financial intermediation process’.295

3.15.5 The Shadow Banking System in Switzerland296 According to the annual FSB reports the Swiss shadow banking sector consists of six subsegments297: (1) money market funds with variable net asset value (MMFs VNAV), (2) bond funds, (3) equity funds, (4) other investment funds, (5) central mortgage bond institutions and (6) a large residual subsector labeled ‘Others’. In line with the narrowed down methodology of the FSB, assets held by equity funds (CHF 163 billion) are filtered out. That leads to the CHF 1339 billion (2013). The next step is then to refine the FSB narrow definition. That pushes the actual size of the Swiss shadow banking market down to CHF 481 billion. From the five abovementioned items constituting the Swiss shadow banking market the MMF (with VNAV) and central mortgage bond institutions are excluded as they are assumed carrying no banklike systemic risks. The reasons for filtering out the MMF VNAV are the following: (1) they are not involved in considerable maturity transformation; (2) regulatory restrictions mean that they can only invest in highly liquid assets; and (3) they do not promise fixed returns like MMFs with CNAV. CNAV MMFs are not allowed under Swiss law. Equally so there are two reasons for filtering out ‘central mortgage institutions’: (1) do not entail any material risk transfer or maturity transformation and (2) they are prudentially supervised by the Swiss Supervisory Authority (FINMA), in the ame way as banks are supervised. The last sector under review is the category ‘other OFIs’. In Switzerland these other OFIs account for nearly two-thirds of all OFI assets. According to the FSB 2014 study and the underlying Swiss statistics, the Swiss other OFIs sector consists of five subgroups: these

 See for analysis and detail: A. Lejour et al., (2019), Dutch Shell Companies and International Tax Planning, CPB Discussion Paper, June 26 via cpb.nl. See also their policy brief on the matter earlier in the year: A. Lejour et al., (2019), Doorsluisland NL doorgelicht, CPB Policy Brief, January. 294  D. Bezemer and J. Muysken, (2015), Dutch Financial Fragilities, Working Paper, April 15. 295  DNBulletin, (2012), Dutch Shadow Banking Sector Smaller Than It Seems at First Sight, De Nederlandsche Bank, 29 November. See for recent data FSB, (2019), ibid., pp. 14, 18–20, 25. 296  In contrast to section 3.15.3 this section deals exclusively with the Swis SB position in the context of the FSB analysis in their global annual write-up. 297  See FSB, (2014), Global Shadow Banking Monitoring Report, Exhibit A2–1, p. 31. 293

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are: ‘finance companies’, holding companies, consumer credit to households, loans to cantons and municipalities, and a residual item. The financial assets held by these ‘five types of OFIs are divided into and assessed based on eight balance sheet items: currency and deposits, debt securities, domestic credit, cross-border credit, cross-border intragroup credit, shares and other equity, units in collective investment vehicles (CIVs), and structured products’.298 These eight balance sheet items are, as indicated, assessed for the extent to which they represent credit intermediation and carry bank-like systemic risks and, therefore, represent the shadow banking market. Within those eight categories the following balance sheet items are not considered to be representing shadow banking activities. They include: cross-border intragroup credit (of holding companies), shares and other equity, currency and deposits, debt securities, units in CIVs, and structured products. The reason for that is cross-border intragroup financing, which occurs in pretty much every large multinational corporate structure, which embodies no credit intermediation. In a similar way do ‘currency and deposits as well as shares and other equity’ not represent credit intermediation. What is left behind in terms of categories are the debt securities, units in CIVs (collective investment vehicles) and structured products. They all tend to embody credit intermediation of some sort in case the entity conducting these activities is part of a credit intermediation chain. All of these categories are only observed for their ‘residual’ item only. The residual item includes various entities ‘such as non-mandatory pension plans, vested benefits foundations, and the remaining balance sheet items of “finance companies” and holding companies. These exhibit hardly any risk associated with shadow banking, such as maturity and liquidity transformation, and/or leverage.’299 What is left as being considered part of the shadow banking market and therefore identified as potentially carrying bank-like systemic risks are ‘domestic credit and crossborder credit’ activities. That activity amounts to CHF 192 billion (2013). The overall conclusion is that the narrowed down methodology focusing on bank-like systemic risks narrows the Swiss banking sector down to about CHF 481 billion or 81% of GDP (2013). The Swiss report also engages in an alternative approach which is described as an activity-­based300 measure and which calculates the relevant Swiss shadow banking market at CHF 315 billion or 53% of GDP (2013).

 See FSB, (2014), Global Shadow Banking Monitoring Report, pp. 32–33.  See FSB, (2014), Global Shadow Banking Monitoring Report, pp. 33–34. 300  These five activities, as already discussed, are (1) management of collective investment vehicles, (2) loan provision that is dependent on short-term funding, (3) intermediation of market activities that is dependent on short-term funding or on secured funding of client assets, (4) facilitation of credit creation and (5) securitization and securitization-based credit intermediation and funding of financial activities. That categorization is based on the criteria as set out by the FSB; see in detail: FSB, (2013), Policy Framework for Strengthening Oversight and Regulation of Shadow Banking Entities, pp. 6–11. 298 299

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3.16 European Shadow Banking in Recent Times 3.16.1 Introduction The risk matrix for shadow banking can be broken down along the lines of the different transformation and intermediation elements applied in the analysis.301 Maturity transformation

Liquidity transformation

Leverage Credit intermediation Interconnectedness302 with the regular banking system

Short-term assets/total assets Long-term assets/total assets Short-term liabilities/short-term assets Long-term assets/short-term liabilities Nonliquid assets (i.e. total assets less liquid assets)/total assets Short-term liabilities/liquid assets Short-term assets/short-term liabilities (current ratio) Liquidity mismatch: Liquid liabilities less liquid assets, as share of total assets Leverage = Debt/total assets Leverage multiplier = Total assets/equity Loans/total assets ‘Credit assets’ (loans and debt securities)/total assets Assets with credit institution counterparty/total assets Liabilities with credit institution counterparty/total assets

Starting 2016 the ESRB produces an annual EU Shadow Banking Monitor providing detailed analysis regarding the European shadow banking market(s) using the dual approach method (activity- and entity-based approach).303

 See in detail: L. Grillet-Aubert et al., (2016), Assessing Shadow Banking—Non-Bank Financial Intermediation in Europe, ESBR Report Nr. 10, July, Table 2, pp. 6 ff and Annex 2 (p. 50). It should be noted, however, that although standardization is attempted across supervisors and regulators, each body uses their own set of criteria which might or might not look (relatively) similar to this one. 302  See in detail: C. Girón and A. Matas, (2017), Interconnectedness of Shadow Banks in the Euro Area, IFC-National Bank of Belgium Workshop on ‘Data Needs and Statistics Compilation for Macroprudential Analysis’, 18–19 May 2017. They use the already discussed network centrality concept, eigenvector centrality, to provide a euro area cross-country comparison of interconnectedness of shadow banks with the rest of the economy. By using eigenvector centrality they capture direct and indirect financial connection paths between sectors (p. 21). 303  See: ESBR, (2016), EU Shadow Banking Monitor, Nr. 1, July; ESBR, (2017), EU Shadow Banking Monitor, Nr. 2, May. For assessment year 2016 (report 2017) it was highlighted that ‘[t]he increasing size of the EU investment fund sector as a proportion of the financial system, coupled with the liquidity transformation and leverage present in some investment funds’ business models, can amplify financial stability risks’. Honesty forces me to acknowledge that the ‘can amplify financial stability risks’ argument is used for the levels of leverage measured, the buildup of synthetic leverage, parts of the SB space that fall outside the currently applied perimeters and certain types of interconnectedness identified. Passe-partout statement, however, reduces the usefulness of the analysis (p. 2); ESBR, (2018), EU Shadow Banking Monitor, Nr. 3, September 10, Frankfurt am Main. 301

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3.16.2 T  he Growth of the EU Shadow Banking Sector and Financial Stability Risk In recent years a continued concern was echoed regarding the prospective stress in the investment fund sector combined and amplified by liquidity risks and spillovers to the broader financial system.304 Possible spillover scenarios include the spillovers from the nonbank financial sector to the euro area banking and insurance sectors via the funding channel and lower asset valuations. Each shadow banking model is the result of its own regulatory, cultural, macroprudential and business environment. That is also the case for the EU. Post-crisis it was often seen as merely a by-product of the American SB system but it has rather unique roots that have led to a distinct SB model. The European SB model occurs partly within the banks themselves. In fact, the European SB model exists within a framework of a different variety of capitalism than that of the US.305 Both an entity-based approach and an activity-­based approach are necessary in order to cast the net wide when mapping shadow banking in the EU. This dual approach to mapping shadow banking allows a more complete analysis of the structural vulnerabilities of the shadow banking system by considering both on- and off-balance sheet activities. From that dual perspective the following EU-related conclusions can be drawn.306 From an entities perspective, it is evident that there is significant heterogeneity in the shadow banking activities of investment funds and OFIs in Europe. The analysis finds that a large part of the other OFI sector appears to have limited engagement in shadow banking activities, although more granular data are required. The activitybased mapping approach complements the entity-based mapping approach by allowing a broader analysis of shadow banking which may not be fully captured by the balance sheet risk metrics. Over half of the broadly defined EU shadow banking system consists of entities for which granular data are currently not available.307

The size of the EU shadow banking system was little changed in 2017, with total assets of just over EUR 42 trillion. European banks remain highly interconnected with the shadow banking system by providing funding to entities engaged in shadow banking activities. Interconnectedness, in the form of wholesale funding provided to euro area banks by entities included in the shadow banking measure, has increased, following a period of contraction. EU bond funds, for example, have increased their liquidity transformation, credit and interest rate risk-taking activities in recent years. See for a review of the different shadow banking components in Europe: L. Grillet-Aubert et al., (2016), Assessing Shadow Banking—Non-Bank Financial Intermediation in Europe, ESBR Report Nr. 10, July. They use both an entity- and activity-based approach (dual approach), due to the fact that it yields a more comprehensive overview (both off- and on-balance sheet analysis) and a deeper understanding of the structural vulnerabilities of any shadow banking system. 304  ECB, (2016), Financial Stability Review, May, pp. 12, 91 ff. 305  See E.  Jeffers and D.  Plihon, (2016), What Is So Special European Shadow Banking, FEPS Studies, August. 306  See for extensive coverage: L. Grillet-Aubert et al., (2016), Assessing Shadow Banking—NonBank Financial Intermediation in Europe, ESBR Working Paper Nr. 10, July. 307  Ibid., pp. 40–41.

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Just like the FSB in its recent report (February 2019), the ECB reported recently that the shadow banking market is on a tear and growing clearly above-trend levels, on both a European and a global scale. That makes sense, I guess, given the discussed implications of enhanced capital requirements. It was documented that euro area nonbank financial institutions have increased their share of credit provided to the real economy over the last six months (Q 1–2, 2019). The size of the nonbank financial sector—which includes investment funds (IFs), MMFs, financial vehicle corporations, insurance corporations, pension funds and remaining OFIs—increased only slightly in 2018 (but materially in 2017), due to low inflows and valuation effects. At the same time, nonbanks continued to provide significant financing to households, nonfinancial corporations (NFCs) and governments in 2018, both within and outside the euro area.308 Further areas of concern include high indebtedness and deteriorating credit quality, outflows out of bond and equity funds, and weak investment income for insurers and consequently the exposure to risky assets. Also the ECB repeatedly has pointed at the fact that despite the fact that from a regulatory and oversight point of view much has happened, vigilance is needed regarding new and unexpected risks, including new forms of (legal or balance sheet) interconnectedness and cross-sectoral ownership.309 The ECB’s focus thereby is, in my line of thinking, too much focused on completing the CMU project, whereas it should be on evolving from transaction-­based to holistic-based systematic legislation and its alignment with macroeconomic policies. Over a long-term period further issues include hampered bank intermediation capacity, and expected liquidity strains310 in the fund sector, including those funds that enable sovereign financing and disorderly unwinding or repricing of the global risk premia and public and private debt sustainability.311 The increasing size of the nonbank financial sector has also been accompanied by greater interconnectedness within this sector. Euro area nonbank financial institutions are also exposed to vulnerabilities in the real estate market, which are high in some countries. The repo market312 is still working through all the recent regulatory changes and haircuts. We know that repo markets play a key role in facilitating the flow of cash and securities around the financial system and are crucial for the implementation of monetary policy. However, the excessive use of repos in the creation of leverage and in financing long-term assets with short-term funding was one factor that contributed to

 ECB, (2019), Financial Stability Review, May, p. 97.  See ECB, (2019), Financial Stability Review, May, pp. 97–110, for details and number support. 310  R. Heuver and R. Triepels, (2019), Liquidity Stress Detection in the European Banking Sector, DNB Working Paper Nr. 642, June 28. The focus on the aspect of machine learning is helping the central banks to conduct (liquidity) stress tests, by using certain classifiers. 311  ECB, (2018), Financial Stability Review, November, pp. 31–32, passim; ECB, (2018), Financial Stability Review, May, pp. 113–129. 312  CGFS, (2017), Repo Market Functioning, CGFS Papers Nr. 59, Committee on the Global Financial System, Bank for International Settlements, April, via bis.org 308 309

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the Great Financial Crisis (GFC). Regulatory measures have been introduced in the aftermath of the GFC to address excessive leverage and the use of unstable funding structures. The repo market has gained in importance, while the turnover in the unsecured market has declined strongly, making the repo market the main interbank market segment in the euro area. Liquidity requirements affect banks’ incentives to enter into repo transactions in different ways and change the incentives for banks to enter into repo transactions. At the same time, attempts are made to revive the European securitization markets, while working through the undigested high levels of non-­performing loans on European bank balance sheets.313 NPLs are and will be a structural problem in the European (non- and traditional) banking scene, to such extent that the EBA released a consultation document regarding loan origination and monitoring. Learning from the elevated levels of non-performing exposures (NPEs) across the EU in recent years, the draft guidelines aim to ensure that institutions have robust and prudent standards for credit risk taking, management and monitoring, and that newly originated loans are of high credit quality.314 The ESRB, which publishes since 2016 an EU shadow banking monitor, also listed its concerns of the EU shadow banking system, which now accounts for 40+% of EU financial system. The concerns center around the following: (1) liquidity risk and risks associated with leverage among some types of investment funds; (2) interconnectedness and the risk of contagion across sectors and within the shadow banking system, including domestic and cross-­border linkages; and (3) procyclicality, leverage and liquidity risk created through the use of derivatives and securities financing transactions. There is also the overall concern that data gaps and limited understanding of risk of some parts of the EU shadow banking segment might embody a comprehensive risk assessment and potentially systemic risk.315 A bit of a detail, but an increased level of CDS was observed in UCITS funds (in particular in those with alternative fixed-income strategies). UCITS is a standard mutual fund model in the EU and is characterized by diversification of risk and stability. CDS can enhance liquidity in some situations however.316

 ECB, (2017), Financial Stability Review, May, pp. 158–174; ECB, (2016), Financial Stability Review, November, pp. 134–146. 314  EBA, (2019), Draft Guidelines on Loan Originating and Monitoring, Consultation Paper, EBA/CP/2019/04, June 19, via eba.europe.eu. The draft Guidelines specify the internal governance arrangements for granting and monitoring of credit facilities throughout their lifecycle. They introduce requirements for borrowers’ creditworthiness assessment and bring together the EBA’s prudential and consumer protection objectives. The EBA has developed these Guidelines building on the existing national experiences, addressing shortcomings in the institutions’ credit granting policies and practices highlighted by the recent financial crisis. At the same time, these Guidelines reflect recent supervisory priorities and policy developments related to credit granting. 315  ESRB, (2018), EU Shadow Banking Monitor Nr. 3, September, via esrb.europa.eu 316  C. Guagliano et al., (2019), Use of Credit Default Swaps by UCITS Funds: Evidence from EU Regulatory Data, ESRB Working Paper 95, June 17. 313

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3.17 Safe Asset Creation (in the EU)317 3.17.1 Introduction: Manufacturing Safe Assets The need for safe assets318 was already discussed before and its constituent foundation as an element of the shadow banking system was made clear.319 Historically, institutional cash pools were in need for safe assets beyond what the traditional AAA-treasury market could supply. In recent years that has changed, and now the technocracy suggested to create safe assets. It was also argued that the rising demand for money-like claims was the main driver behind the rise of the shadow banking segment pre-crisis. In the EU, the ESRB proposed to create ‘safe assets’ for the eurozone based on the repackaging of the risks of sovereign bonds. The reason why they propose to do so is clear. The European sovereign bond market is inherently unstable due to large discrepancies in ratings given to the individual instruments but also due to the ongoing convergence of the underlying EU economies. The ESRB hopes that this type of financial engineering will help to stabilize an inherently unstable system. The ESRB proposal creates the illusion that the sovereign bond markets in the eurozone can

 See for the issue(s) in general: V. Acharya, et al. (2016), ‘Lender of Last Resort Versus Buyer of Last Resort – The Impact of the European Central Bank Actions on the Bank-Sovereign Nexus’, ZEW Discussion Paper, Nr. 19; C.  Altavilla, et  al., (2016), Bank Exposures and  Sovereign Stress Transmission, ESRB Working Paper, Nr. 11, May; R.J. Barro, and A. Mollerus, (2014), Safe Assets, NBER Working Paper, Nr. 20652, October; R.  Beck, et  al., (2016), Determinants of  Subsovereign Bond Yield Spreads: The  Role of Fiscal Fundamentals and Federal Bailout Expectations, ECB Working Paper, Nr. 1987, December; M. Brunnermeyer et al., (2016), The Sovereign-Bank Diabolic Loop and ESBies, American Economic Review: Papers and Proceedings, Vol. 106, Nr. 5, pp. 508–512; R.J. Caballero et al., (2016), Safe Asset Scarcity and Aggregate Demand, American Economic Review: Papers and Proceedings, Vol. 106, Nr. 5, pp.  513–518; Deutsche Bundesbank (2016), Approaches to  Resolving Sovereign Debt Crises in the Euro Area, Monthly Report, July, pp. 41–62; A. Gelpern and E.F. Gerding, (2016), Rethinking the  Law in  ‘Safe Assets’, Chapter 9 in  R.P.  Buckley, E.  Avgouleas and  D.W.  Arner (eds.), Reconceptualising Global Finance and  Its Regulation, Cambridge University Press, New  York, pp.  159–189; G.B.  Gorton, (2016), The  History and  Economics of  Safe Assets, NBER Working Paper, Nr. 22210, April; P.-O.  Gourinchas, and  H.  Rey, (2016), Real Interest Rates, Imbalances and the Curse of Regional Safe Asset Providers at the Zero Lower Bound, NBER Working Paper Nr. 22618, September; R.J.  Caballero, (2016), Safe Asset Scarcity and  Aggregate Demand, American Economic Review, Vol. 106, Issue 5, pp. 513–518. 318  See regarding the nature of safe assets: A. van Riet, (2017), Addressing the Safety Trilemma: A Safe Sovereign Asset For the Eurozone, ESRB Working Paper Series, Nr. 35, pp. 6–12; Z. He et al., (2016), What Makes US Government Bonds Safe Assets?, American Economic Review: Papers and Proceedings 2016, Vol. 106, Nr. 5, pp.  519–523; Z.  He, et  al., (2016), A Model of Safe Asset Determination, NBER Working Paper, Nr. 22272, May; A. Gelpern and E.F. Gerding, (2016), Inside Safe Assets, Yale Journal on Regulation, Vol. 3, Issue 2, pp. 363–421; also as Georgetown University Law Center Working Paper, September 26, pp. 10–24. 319  The rising demand for money-like claims is considered the main driver behind the growth of the shadow banking segment pre-crisis. The supply of T-bonds and T-bills was not only no longer sufficient, there is also a benefit for the financial intermediaries through the money premium when 317

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be stabilized without the need to share the risk among sovereigns.320 That sounds like a no-go, unless a budgetary and political union would be underlying. De Grauwe and Ji correctly pointed out years ago that the market is intrinsically unstable and cannot be credited with being consistently disciplined with price discovery and risk identification. History tells us over and over again. Besides a brutal amount of austerity the EU now is considering imposing the right amount of discipline in the eurozone. Suggestions include sovereign bankruptcy procedures and mechanisms that contain triggers of a risklayered issuance of sovereign debt. All with a view to undergoing to the discipline of a market-based financial system.321 The ESRB created its own proposal.322 Before 2008, the European Central Bank used shadow banking to create a single safe asset that was termed shadow money, and in doing so also erased borders between euro area government bond markets. Lacking appropriate ECB support, shadow euros could not withstand the pressures of the global financial crisis and brought down several periphery euro government bonds with them.323 The CMU project combined with the project on STS securitizations seems to turn once again the EU toward the creation of shadow banking products (private or public-private safe assets) and systems to patch up an unstable and limping European financial bond infrastructure. The market mechanism of forcing national member states to compete for investors, within ECB coverage of the issuances, leads to the structural risk, besides the questioning ability to issue debt in liquid

they issue certain types of low-risk, short-term debt, such as asset-backed commercial paper or repo. An interesting question in this context is, given the demand for safe assets as a fixed element, how central banks can improve financial stability and manage maturity transformation by the private sector through their ability to affect the public supply of short-term safe instruments (STSI). Carlson et al. provide some insights into this and conclude that ‘increasing the supply of public STSI reduces the attractiveness of private STSI, and thus potentially helps improve the stability of the financial system’ (p. 15). Private and public STSI are substitutes, ‘so that greater provision of STSI by a central bank, for example, through reverse repurchase agreements, could meet the demand for STSI and help crowd out creation of private STSI’. The precise extent to which an increase in public STSI would crowd out private STSI remains uncertain until now. See in detail: M. Carlson et al., (2014), The Demand for Short-Term, Safe Assets and Financial Stability: Some Evidence and Implications for Central Bank Policies, Finance and Economics Discussion Series (Nr. 102), Divisions of Research & Statistics and Monetary Affairs Federal Reserve Board, Washington, DC, November 25. 320  P. de Grauwe and Y. Ji, (2018), How Safe Is a Safe Asset, CEPS Policy Insight, Nr. 2018–08, February (via ceps.eu), and P. de Grauwe and Y. Ji, (2018), Financial Engineering Will Not Stabilize an Unstable Euro Area, March 19 (via voxeu.org). 321  A.  Bénassy-Quéré, et  al., (2018), Reconciling Risk Sharing with Market Discipline: A Constructive Approach to Euro Area Reform, CEPR Policy Insight, Nr. 91, January. 322  European Systemic Risk Board (ESRB), (2018), Sovereign Bond-Backed Securities: A Feasibility Study, ESRB High-Level Task Force on Safe Assets, January, Vol. I and II. It actually all started with a speech given by B. Coeuré in 2016: B. Coeuré, (2016), Sovereign Debt in the Euro Area: Too Safe or Too Risky? Keynote Address Harvard University’s Minda de Gunzburg Center for European Studies in Cambridge, MA, November 3. 323  See in detail D. Gabor and J. Vestergaard, (2018), Chasing Unicorns: The European Single Safe Asset Project, Competition and Change, Vol. 22, Issue 2 pp. 140–164. Also abbreviated on the topic: D. Gabor, (2018), The Single Safe Asset: A Progressive View for a ‘First Best EMU’, FEPS Policy Brief, May.

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markets, that market-based engineering of single safe assets runs the danger of repeatedly destabilizing national bond markets.324 It was demonstrated before that sovereign bond markets in a monetary union are inherently unstable.325 That process starts when governments in the eurozone issue debt in a currency that is not their own, and therefore lack essential control also over repayment at maturity date.326 That inherent feature creates a natural level of distrust, creating temporary sell-offs, yield risers and complicating any rollover of debt leading to liquidity issues.327 Arbitrage will take place and investors will seek out the least risky eurozone bonds, leading to shifts in capital flows potentially destabilizing the monetary system of the union. An additional complication is the fact that banks in the eurozone hold a significant amount of sovereign paper, so when banks get into trouble, the sovereign will be too and will not be in a position to provide the liquidity needed to support the fractional banking model. It also works the other way around: banks get into trouble when the sovereign gets into trouble and faces issues rolling over the debt. The ESRB proposal of early 2018 tries to eliminate the instability inherent to the model of national bond issuances in non-­domestic currencies.328 The creation of a safe asset occurs by facilitating financial institutions to buy a portfolio of sovereign debt from different eurozone countries and use that portfolio to back the issuance of their own bonds known as ‘sovereign bond-backed securities’ (SBBS). Just like in any securitized model, the junior tranche329 absorbs the losses in case they occur. All following tranches are increasingly more senior and so less risky as they do not absorb losses occurring in the underlying portfolio. In this model the junior tranches would be expected to be typically no larger than 30% and so 70% of the securitized product would be considered risk free. The aim of this is to enlarge

 D. Gabor and J. Vestergaard, (2018), ibid.  P. De Grauwe and Y. Ji, (2013), Self-fulfilling Crises in the Eurozone: An Empirical Test, Journal of International Money and Finance, Vol. 34, April, pp. 15–36. 326  When issued in their own currency they also have their own national bank that can step in and provide liquidity to repay investors at maturity date. See about the safe haven of currencies: K.-S.  Lee, (2017), Safe-Haven Currency, Review of International Economics, Vol. 25, Issue 4, pp. 924–947. He concludes that only the Swiss franc and the Japanese yen qualify as safe. The others are ‘equity-like’ or risky positive related to risky assets and even more so in times of crisis. 327  Often during recessions. See also M. Bichuch and P. Guasoni, (2018), Investing with Liquid and Illiquid Assets, Mathematical Finance, Vol. 28, Issue 1, pp. 119–152. Hartmann studies different dimensions of (international) liquidity. He concludes that financial regulation in this matter needs to be designed in a way that preserves incentives for market making in major international assets. See Ph. Hartmann, (2018), International Liquidity, CEPR Discussion Paper Nr. DP12337, October. Also see R.  Lagos et  al., (2017), Liquidity: A New Monetarist Perspective, Journal of Economic Literature, Vol. 55, Issue 2, pp. 371–440. 328  This model needs to be seen as distinct to the model earlier suggested where Eurobonds would be created. In that model the participating governments are jointly liable for servicing the (national) debt issued. In the ESRB model there is no ‘joint liability element’, and so no pooling of risk. The only thing that happens is the repackaging of a set of diverse (i.e. issued by different countries) Eurobonds that are bundled and offered to the market. 329  Often separated in two classes: the junior tranche (mot risky) and the mezzanine tranche (less but still risky). 324 325

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the pool of ‘safe assets’ in the eurozone.330 Destabilizing capital flows would be halted as capital would flow into the safe asset (senior tranches) away from the risky tranches. The attentive reader will likely see more of an opportunity to diversify (normalized) risk in this model than the creation of safe assets, at least under normal market conditions. But under stress, that idea fades easily. Arguments331 to support that view could be that: • The creation of safe assets this way does not eliminate the sovereign bond markets as they exit. Even more, the ESRB requires the existence of national bond markets for ‘price formation’ and thus assuming abundant liquidity at all times in these markets. That by the way implies that only a limited amount of national debt issued would be eligible for SBBS treatment.332 • Given the aforementioned continuance of national bond markets it implies that destabilizing capital flows333 within those markets will not seize to exist. In fact, the SBBS model could potentially make things worse as now the size of those national markets has shrunk and thus yields will behave more volatile during stress periods. Yields under stress become polarized and highly correlated on both ends of the spectrum. That raises the question whether, during times of stress in the market, the (safe) credit tranche of an SBBS can maintain its safe status. Investors will still try to distinguish based on quality in the portfolio and the income-generating capacity of the underlying domestic bonds. The credit tranche will never be seen as a true safe asset as would be the case as buying a safe haven AAA-bond from a particular eurozone country. Investors will then move from the riskfree credit tranche of the SBBS to individual safe haven bonds, creating a­ dditional turmoil. It was already discussed how in times of stress, the information-­insensitive debt markets become information-sensitive triggering severe and sudden dislocations of capital across debt markets.334 That principle also plays a role here.335

 For example, larger than in case each country individually issues national debt in euro-terms. The ESRB believes it could actually double the volumes of safe eurozone assets. 331  Also see P. de Grauwe and Y.  Ji, (2018), How Safe is a Safe Asset, CEPS Policy Insight, Nr. 2018–08, February, pp. 2–4 (via ceps.eu). 332  European Systemic Risk Board (ESRB), (2018), Sovereign Bond-Backed Securities: A Feasibility Study, January, p.  33. The ESRB assumed one-third of total bond stock would be eligible for SBBS. Also see M. Brunnermeier, et al., (2016), ESBies: Safety in the tranches, ESRB Working Paper Series, Nr. 21. 333  Brunnermeier and Huang have taken it a notch up and have examined international capital flows induced by flight-to-safety. They suggest a new global safe asset. In a variety of scenarios they demonstrate that it can reduce the severity of a crisis and alternatively capital flows are re-channeled from international cross-border flows to flows across two emerging market economy asset classes. See in detail: M. K. Brunnermeier and L. Huang, (2018), A Global Safe Asset for and from Emerging market Economies, NBER Working Paper Nr. 25373, December. Le Grand and Ragot are thinking along the same line, and recommend that a world fund issuing a safe asset increases aggregate welfare. Those assets can be related with the existing International Monetary Fund (IMF) American Depository Receipts (ADRs). See in detail F. Le Grand and X. Ragot, (2018), Sovereign Default and Liquidity: The Case for a World Safe Asset, Working Paper, September 7, mimeo. 334  See the already discussed: B.  Holmström, (2015), Understanding the Role of Debt in the Financial System, BIS Working Paper, Nr. 479, January. 335  It is a much stronger force of nature than a stylized model that demonstrates that a unionwide safe asset without joint liability would resolve capital flight dislocations and marketplace 330

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• There are collateral issues.336 These SBBS will be used to price derivatives and repos in the eurozone market. Parts of the market beyond the sovereign debt market will therefore be considered liquid and/or safe by proxy of these SBBS instruments and in particular the credit tranche. In case of distress liquidity and the perceived risk-free dynamics will vanish now contaminating a larger part of the bond market in the eurozone. It seems to be that the ESRB proposal is nothing more than the academic underpinning of a political construct that tries to avoid true Eurobond issuances. In any case, the dynamics of securitization here at least are ill-understood. It was discussed at length before, that even when securitized products are meeting the simple transparent and standardized label they fail to nullify uncertainty. The uncertainty mainly is a problem in senior tranches. Put differently, the senior tranches are never as risk-free as intended. Besides the fact that they cannot take away any possible contagion effect, the securitization leads to a concentration of already difficult to quantify and varying natures of uncertainty. This will show in the mezzanine as well as credit tranche of the product.337 It is strange to observe that the ESRB didn’t learn a lot observing the CDO markets under stress, which also were created to better spread risk. The underlying dynamic cannot be fought, not even by the best financial models or product contractualizations.338 The debt market under stress goes from being information-insensitive to information-sensitive overnight.339 The firm idea that SBBS products (or ESBies as they became coined in literature) eliminate cross-border flight-to-safety capital flows because they pool the sovereign bonds of all euro area member states and weaken the diabolic loop by providing banks with a safe and liquid store of value seems butch against a history of evidence that points in a different direction in periods of distress. But then again, it is exactly for periods of market stress that

instability as well as the fact that diversification and seniority can weaken the loop between sovereign and bank risk; see: M. K. Brunnermeier, et al., (2017). ESBies: Safety in the Tranches. Economic Policy, Vol. 32, Issue 90, pp. 175–219; C. Buch, (2016), Banks and Sovereign Risk: A Granular View, Journal of Financial Stability, Vol. 25, pp.  1–15; E.  Farhi and J.  Tirole, (2016), Deadly Embrace: Sovereign and Financial Balance Sheets Doom Loops, NBER Working Paper Nr. 21843. 336  See J.C.  Lopez et  al., (2013), The Market for Collateral: The Potential Impact of Financial Regulation, Financial Stability Review, June, pp. 45–53. M. Carlson et al., (2016), The Demand for Short-Term, Safe Assets and Financial Stability: Some Evidence and Implications for Central Bank Policies, International Journal of Central Banking, Vol. 12, Issue 4, pp.  307–333; R.  Greenwood et  al., (2016), The Federal Reserve’s Balance Sheet as a Financial Stability Tool, Harvard Business School Paper, September, mimeo. 337  See in detail the already discussed: A.  Antoniadis and N.  Tarashev, (2014), Securitizations: Tranching Concentrates Uncertainty, BIS Quarterly Review, December, pp.  37–53; A.  Persaud, (2015), The Assets Made Combustible When Regulators Call Them ‘Safe’, Financial Times, June 2. 338  Correlation can only be assumed to be fixed; in case they go random which they do under stress, the model goes idle; see also M. Brunnermeier, et al. (2017), ESBies: Safety in the tranches, Economic Policy, Vol. 32, Issue 90, pp. 175–219 (also in ESRB Working Paper Series 2016, Nr. 21). 339  That information-sensitivity will look deeply problematic in the face of all the issues still surrounding the rating of an SBBS product. See M.  Kraemer, (2017), How S&P Global Ratings Would Assess European ‘Safe’ Bonds (ESBies), S&P Global Ratings, April 25.

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a solution needs to be found. For period of normal market activity there is no liquidity or issue otherwise.340 And so the question is what the likely losses are that the different kind of holders would suffer under (simulated) default scenarios. De Sola Perea et al.341 examine how ex ante exposures will behave under various securitization structures. They find that ‘the senior SBBS has extremely low ex ante tail risk342 and that, like the lowest-risk single-named sovereigns, it acts as a hedge against extreme adverse movements in the yields on more junior tranches. The mezzanine SBBS has tail risk exposure similar to that of Italian and Spanish bonds.’ They understood my real concern—that is, when expected losses on mezzanine or junior bonds are at very high levels, the senior SBBS may suffer much larger mark-to-market valuation risks than existing safe assets and that there would be no interest in junior tranches given its yield relative to the yield when holding individual sovereign assets. • The only meaningful conclusion is that Eurobonds343 are needed to arrive at a safer and stable monetary union in the eurozone. An ex ante joint-stop mechanism is a necessity to arrive at a long-term stable market. Spreading technocratic fairy dust about the perceived risk-free nature of securitized products does not only violate past

 The impression is that the process is organized backward. There is a large unmet need for safe assets in the eurozone. That need becomes pressing in times of market stress. With political reality in mind, an artefact is constructed obeying that political reality, but which ignores market characterizations in times of distress. A combination of pooling and tranching provides better results than either of these two separately, but that was not the question; in fact it never has been the question. The junior tranche would have risk characteristics and embedded leverage that would be attractive to high-yield investors (M. Brunnermeier, et al. [2017], ibid., p. 36) points exactly at the problem. The attractiveness of high-yield investor wanes overnight in times of distress, aggravating the dislocation caused by capital flight. ESBies would then insulate senior bondholders from actual default risk; the dislocation and contamination would then come from the junior or mezzanine tranches. But spillover effects seem to fall in general during market stress; see D. Cronin and P.G. Dunne, (2018), How Effective are Sovereign Bond-Backed Securities as a Spillover Prevention Device?, ESBR Working Paper Series Nr. 66, January. See regarding the constituent elements of the bid-ask spread: B. Hagströmer et al., (2016), Components of the Bid–Ask Spread and Variance: A Unified Approach, Journal of Futures Markets, Vol. 36, Issue 6, pp. 545–563. 341  M. de Sola Perea et al., (2018), Sovereign Bond-Backed Securities: A VAR-for-VaR and Marginal Expected Shortfall Assessment, ESRB Working Paper Series Nr. 65, January. They use a combination of VAR-for-VaR and MES models to arrive at their conclusions. Earlier models were based on simulated default outcomes—based on a variety of assumed probabilities of defaults, default correlations and expected losses given defaults—rather than on the losses that arise from fluctuations in the market valuation of the securities. The VAR-for-VaR reveals how the likelihood of extreme outcomes in one asset relates to another given some causal ordering. The MES, in contrast, reveals how one asset is expected to fare in terms of expected return when another asset is likely to be experiencing a tail event. MES can therefore capture flight-to-safety dynamics (i.e. a positive outcome when a riskier asset is expected to be experiencing an extremely negative outcome) (pp. 1–2). P. Gao, et al., (2017), Liquidity in a Market for Unique Assets: Specified Pool and To-Be-Announced Trading in the Mortgage-Backed Securities Market, The Journal of Finance, Vol. 72, Issue 3, pp. 1119–1170. 342  See regarding tail risk (in the eurozone): A. Lucas, et al., (2017), Modelling Financial Sector Tail Risk in the Euro Area, Journal of Applied Econometrics Vol. 32, pp. 171–191. 343  Which, at least politically, requires full fiscal consolidation. 340

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experiences and research but also hides the political incompetence to guarantee the objective of a stable public financial market. It could be seen, if you want, as a European supranational structure trying to reign beyond its institutional capacity by forcing the market on something it cannot politically master.344 Ultimately we can only conclude with Milne345: ‘[r]isky assets do not cause crises. It is those perceived as being safe that do.’ Although prioritization of objectives is always in the eyes of the beholder, liquidity benefits to the extent guaranteed or likely as a positive spillover of SBBS products, the question remains whether those positive spillovers are likely beyond the context of normal market conditions, an answer that most literature stays pretty silent about.346 • An alternative to the ESRB proposal was to establish a credible multipolar system of safe national sovereign assets. For this purpose, they could all issue both senior and junior tranches of each national government bond in a proportion such that the expected safety of the senior tranche is the same across countries while the junior tranche would absorb any sovereign default risk. Additional issuance of national GDP-linked bonds could insure governments against a deep recession that might lead to a self-­fulfilling default and thereby help to make the junior tranche less risky.347 • Strangely enough technocrats did observe the potential of ‘moral hazards’ at the level of the individual member states issuing bonds in terms of their (perceived) loosened constraints at a budgetary level for which solutions were suggested in the technicalities of the tranching sphere.348 Besides the abovementioned models to create safe assets, a number of other techniques might be helpful. Four approaches so far have been identified: (1) a diversified portfolio of senior tranches of sovereign debt (‘national tranching’); (2) a senior security backed by a diversified pool of national sovereign debt (‘ESBies’); (3) debt issued by a senior financial intermediary, backed by a diversified pool of national debt (‘E-bonds’); and (4) debt

 See in extenso: B. Braun et al., (2018), Governing Through Financial Markets: Towards a Critical Economy of Capital Markets Union, Competition and Change, Vol. 22, Issue 2, pp. 101–116; L.  Quaglia, (2016), The Political Economy of European Capital Markets Union, Journal of Common Market Studies, Vol. 54, S1, pp. 185–203. See also in detail regarding the use of financial instruments to reach beyond EU budgets: J.N. Ferrer et al., (2018), Expanding the Reach of the EU Budget Via Financial Instruments, CEPS Commentary, February 26. 345  R.  Milne, (2011), Beware of Perceived Safe Havens: Favouring Triple A Government Debt Increases Systemic Risks, Financial Times, July 28. 346  P.G. Dunne, (2018), Positive Liquidity Spillovers from Sovereign Bond-Backed Securities, ESRB Working Paper Series Nr. 67, January; Y. Baranova, et al., (2017), Dealer Intermediation, Market Liquidity and the Impact of Regulatory Reform, Bank of England Staff Working Paper Nr. 665. 347  See A. van Riet, (2017), Addressing the Safety Trilemma: A Safe Sovereign Asset for the Eurozone, ESRB Working Paper Series, Nr. 35, pp.  35–38. Also van Riet prefers the synthetic model: pp. 38–47. See for a risk-safety model of the different options around: pp. 45, figure 5. See also S. Tober, (2016), The ECB’s Monetary Policy: Stability Without ‘Safe’ Assets, Han Böckler Stiftung, IMK Working Paper Series Nr. 9, May, pp. 1–13. 348  Asymmetric attention for perceived issues is common in literature, and resembles in this case political rhetoric. A. van Riet, (2017), ibid., pp. 46–48. 344

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issued by a euro area budget or a leveraged wealth fund, based on member state contributions or dedicated direct revenue sources. None of these approaches rely on explicit guarantees of Member States (in the EU).349 Simultaneously, there are also calls for Central Fiscal Stabilization Capacity for the Euro Area to smooth country-specific and common shocks.350

3.17.2 Safe Assets as a Distinct Asset Segment After the 2007–2009 financial crisis not only regulators and supervisors351 were extremely busy trying to figure out what happened. Also academia got involved. But it was only five years after the crisis that the concept of (synthetic) safe assets emerged in literature as a distinct element in the puzzle trying to explain the shadow banking industry. The initial line of thinking was this. The market only produces something for which there is demand and preferably solid demand. So there must be demand for what the shadow banking industry produces. But what exactly was that? What lies at the nexus of liquidity risk, maturity transformation risk, imperfect credit transformation risk, leverage and so on. Many answers (or attempts thereof) emerged. But it took time before ‘demand for safe assets’352 came to the forefront. Institutional cash pools that operate internationally grew bigger before but also after the financial crisis. Demographics in the West play a role but also the overall financialization of  See in detail: A. Leandro and J. Zettelmeyer, (2019), The Search for a Euro Area Safe Asset, CEPR Discussion Paper Nr. DP12793, February, revised edition; also see ‘Europe’s Search for a Safe Asset’ aligned presentation 2018, March 23, for the Peterson Institute for International Economics. They highlight the following differences across a number of different important dimensions: ‘[a] euro area budget or wealth fund could create the largest volume of safe assets, followed by ESBies, E-bonds, and national tranching. A euro area budget or wealth fund is also likely to have the lowest impact on the structure and liquidity of national bond markets, while national tranching would have the largest impact. ESBies and E-bonds occupy an intermediate position. ESBies and potentially bonds issued by a euro area budget would offer their holders greater protection from deep national defaults than the other two proposals. Both ESBies and national tranching would avoid cross-country redistribution by construction, whereas E-bonds and a euro area budget could have significant distributional consequences, depending on their design. E-bonds are unique in that they would raise the marginal cost of sovereign debt issuance at higher levels of debt, thereby exerting fiscal discipline, without necessarily raising average debt costs for lower-rated borrowers.’ Creating safe assets by contract, that is, European bond-backed security (ESSBs), are just a CDO. Constructed safe assets are interesting only if they require neither mutual guarantees nor tranching. 350  In essence it is a macroeconomic stabilization fund financed by annual contributions from countries used to build up assets in good times and make transfers to countries in bad times, as well as a borrowing capacity in case large or persistent shocks exhaust the fund’s assets. See in detail: N.G. Arnold et al., (2018), A Central Fiscal Stabilization Capacity for the Euro Area, IMF Staff Discussion Notes, Nr. SDN/18/03, March. 351  See about the still problematic relationship between the EU and national supervisors, ten years after the crisis: W.P. De Groen and K. Zielińska, (2018), European Supervisory Authorities Still Playing Second Fiddle to National Financial Regulators, CEPS Commentary, March 14. 352  Maybe it wasn’t the demand for safe assets that went unnoticed, but the fact that the demand for safe assets has grown beyond its natural transactional and liquidity role. See in detail: T. Ahnert and E. Perotti, (2018), Seeking Safety, Bank of Canada Working Paper Nr. 41, August. 349

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society. Those cash pools often have a limited risk appetite given their investment objectives.353 And so the first of arguments was that shadow banking serves the purpose of producing ‘safe assets’ beyond what the market naturally produces in terms of investment-grade bonds, simply because there was demand. And so over time, the idea emerged that ‘demand for safe assets’ existed distinct from liquidity and classic money demand. And so shadow banking became coined as the system that privately produced (quasi) safe assets over and beyond what the sovereigns produced in terms of high-quality, safe, risk-free assets. The system was and is managed by private intermediaries shedding light on questions as market stability, credit cycles354 and prudential policy.355 But so, we are in the early stages of exploring the concept of ‘safe assets’. And so many more questions than answers exist. New macromodels study the dynamics of economic propagation of financial shocks under financial constraints. Financial research looks at how risk incentives shape the distribution of shocks and how contracts redistribute their impact.356 And obviously, the dominant question was to what extent there was ‘excess risk creation’ over the financial cycle stemming from this type of private financial activity. Needless to say that the answers to these questions could and will lead to a major theoretical reassessment of financial and macroprudential theory. If there is demand for private safe asset creation and products, the question that follows is how then does the pricing work, what exactly is that demand for safety and how does it impact the traditional model of financial intermediation and what does it mean to have a higher level credit available in the market than managed by the public central bank. And obviously, there is the question if the demand for safety and safe assets adds to aggregate risk. The answer is clearly positive as the demand for absolute safety (which one could see as not natural) leads to risk intolerance and extreme levels of sensitivity of funding flows to even minimal levels of risk. The contractualization of an almost unrealistic level of risk intolerance leads to the creation and propagation of fragility. In what follows in this section I will try to provide an insight into the state of affairs in terms of ‘understanding the market for safe assets’ as well as demonstrate the key points, all in the understanding that all these issues, questions as well as answers are still in flux.357  See how demographics and cash hoarding with a view toward building up retirement savings come with a full list of complications and the need to revise the legal settings for retirement schemes in: D. Amaglobeli et al., (2019), The Future of Saving: The Role of Pension System Design in an Aging World, IMF Staff Discussion Note, SDN/19/01, January. 354  See in detail C. Azariadis et al., (2015), Self-Fulfilling Credit Cycles, The Review of Economic Studies, Vol. 83, Issue 4, pp. 1364–1405. 355  Ahnert and Perotti describe the private industry of safe assets as ‘[t]he private provision of safety relies on carving safe claims out of risky investment’. See T.  Ahnert and E.  Perotti, (2017), Intermediaries as Safety Providers, Working Paper, May 8, mimeo. They conclude further: ‘higher safety needs do not simply reallocate risk bearing, as they can be satisfied only at the cost of increased fragility.’ Safe assets are priced above their implied risk-return trade-off, especially when the supply of public debt is low (p. 1). Also see J.R. Roderick et al., (2016), Warehouse Banking, Working Paper, March 30, mimeo. 356  P. Golec and E. Perotti, (2017), Safe Assets: A Review, ECB Working Paper Series Nr. 2035, March, p. 2. 357  See for a valuable and in-depth, but already a bit outdated, overview: P. Golec and E. Perotti, (2017), ibid. 353

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Let’s start with the demand for safe assets. It was as early as 2012 that the first evidence emerged that a ‘safety premium’ existed separate from the liquidity premium.358 The safety premium distinct from its liquidity premium covers the value of absolute guarantee of being repaid. And so the safety premium is high when the prime source of safe assets (the highquality sovereign bond market) is drying up and assets are scarce.359 Periods of low government debt will therefore lead to the creation of private safe assets in the form of short-­term liabilities issued by the financial sector.360 These assets are in demand worldwide but definitely in emerging economies as the local supply of safe assets is limited.361 Secondly, there is the question of what constitutes a safe asset.362 Safe assets are unconditional promises that repayment (of principal and interest) is guaranteed (and so there is no credit risk). This almost implies a government, with its own central bank, stable currency, low debt levels and a meaningful rule of law. It also assumes low inflation risk. Privately issued safe assets can never be absolute, in the sense that they can only be quasisafe, and most likely not so safe in times of financial market distress.363 The idea is that safe assets operate as a ‘store of value’ but that also easily be converted back into cash. The focus is thus on wealth preservation rather than means of payment. Liquidity and safety are, however, distinct features.364 Third, demand and supply for safe assets can be measured through the safety and liquidity premia for safe assets.365 The fact that there is a safety premium contradicts classical portfolio theory which assumes that asset prices are determined through their dis-

 In fact it was as early as 2005, during the credit boom from 2002 to 2007, that led to the Great Recession. See in detail S.  Nagel, (2016), The Liquidity Premium of Near-Money Assets, The Quarterly Journal of Economics, Vol. 131, Issue 4, pp. 1927–1971; A. Sunderam, (2015), Money Creation and the Shadow Banking System, Review of Financial Studies, Vol. 28, pp.  939–977; C. Pérignon et al., (2017), Wholesale Funding Dry-Ups, ESRB Working Paper Series Nr. 49, July. 359  A. Krishnamurthy and A. Vissing-Jorgensen, (2012), The Aggregate Demand for Treasury Debt, Journal of Political Economy, Vol. 120, Issue 2, pp. 233–267; G. Gorton, et al., (2012), The SafeAsset Share, American Economic Review, Vol. 102, Issue 3, pp. 101–106. 360  Through, for example, repos and commercial paper: A. Krishnamurthy and A. Vissing-Jorgensen, (2015), The Impact of Treasury Supply on Financial Sector Lending and Stability, Journal of Financial Economics, Elsevier, Vol. 118, Issue 3, pp. 571–600. This obviously leads to credit creation and an increase of net long-term investment with associated maturity transformation at the level of the intermediary. 361  See for an overview of literature on this matter: P. Golec and E. Perotti, (2017), Safe Assets: A Review, ECB Working Paper Series Nr. 2035, March, pp. 3–4. 362  See in detail: P. Golec and E. Perotti, (2017), ibid., pp. 5–8; A. van Riet, (2017), Addressing the Safety Trilemma: A Safe Sovereign Asset for the Eurozone, ESRB Working Paper Series Nr. 35, February, pp. 6–12. 363  See for an analysis of ‘crash risk’ in safe assets: A. Ben Nasr et al., (2018), Investor Sentiment and Crash Risk in Safe Havens, Working Paper, February 1, mimeo. 364  That idea has long been ignored, most likely as safe assets tend to have liquid secondary markets. But safe assets can be illiquid and risky assets can be more liquid than safe assets under market stress. See for an overview of the classification of different assets in the liquidity-safety matrix and aligned literature: P. Golec and E. Perotti, (2017), ibid. Figure 1, pp. 7–8. The major distinction is that absolute safe assets are government backed and issued and that private issued safe assets are safe and liquid outside of a crisis but no longer during a crisis. 365  See in detail: P. Golec and E. Perotti, (2017), ibid., pp. 8–13. 358

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count factor and not their supply levels. So the liquidity premium is driven and correlated with the federal fund rates; the safety premium is driven by demand and supply of safe assets. Supply of private safe assets increases as government safe assets are scarce. Interesting is that private intermediaries tend to engage in short-term lending for long-term commitments increasing the maturity mismatch.366 Treasury supply is crowded out by short-term private sector debt in case of low business cyclicality. In high cyclicality treasury supply crowds out private sector debt. Fourth, where does the demand for safe assets come from? As it operates as a store for value it can be argued in terms of liquidity and transaction costs and the utility function of money. But more recently, it has been considered that a structural demand for safe assets is triggered by the understanding that economic agents need to attain a minimum level of wealth before they are willing to absorb losses in utility. From that perspective a safe asset is needed before economic agents are willing to absorb risk elsewhere in their portfolio. That minimum level of wealth is subjective but it does explain the concept of absolute risk tolerance.367 An interesting add-on is the question whether the demand for safe assets is triggered or increased by liquidity demand. When intrinsic or fundamental risk is low, a safe asset does not face illiquidity.368 When fundamental risk increases, the information-sensitivity engine starts automatically creating the possibility that safe assets might become illiquid.369 Last but not least, and ignoring the policy implications for a moment,370 the question that deserves attention is the private creation dynamics of safe assets and the implicit instability of the product group. The private creation of quasi-safe money can thus be explained, but what does it capture? Private safe money creation captures the safety premium the market is willing to pay. The technique that produces those quasi-safe assets is risk distribution and sharing also known as securitization. We now know that the redistribution of risk (e.g. of real estate in the case of mortgages) also leads to a correlation of returns both on the upside as well as on the downside. It creates the systemic nature of

 R.  Greenwood and D.  Vayanos, (2014), Bond Supply and Excess Bond Returns, Review of Financial Studies, Vol. 27, Issue 3, pp. 663–713; A. Sunderam, (2015), Money Creation and the Shadow Banking System, Review of Financial Studies, Vol. 28, Issue 4, April, pp. 939–977. 367  T. Ahnert and E. Perotti, (2015), Cheap but Flighty: How Global Imbalances Create Financial Fragility, Tinbergen Institute Discussion Papers 15–036/IV/DSF89, Tinbergen Institute; N. Gennaioli, et al.,(2013), A Model of Shadow Banking, The Journal of Finance, Vol. 68, Issue 4, pp. 1331–1363. Also see P. Golec and E. Perotti, (2017), ibid., pp. 13–16. 368  Banks create liquidity by issuing ‘safe assets’. They can be generated by either ‘holding asset to maturity and issuing risk-absorbing equity claims, or by fire-selling risky assets in downturns’. One could state that fire sales are always excessive, but that liquidity creation is not necessarily too high but can also be inefficiently low. The latter might be the result because ‘fire sales increase liquidity creation only if the equilibrium fire-sale price is sufficiently high, but start to destroy liquidity once the fire sale price is too low’. See: S. Luck and P. Schempp, (2018), Inefficient Liquidity Creation, Working Paper, March 21, mimeo; G.  Gorton and E.W.  Tallman, (2016) How Did Pre-Fed Banking Panics End? NBER Working Papers Nr. 22036. 369  E.  Farhi and J.  Tirole, (2015), Liquid Bundles, Journal of Economic Theory, Vol. 158, pp. 634–655; G. Gorton and G. Ordonez, (2014), Collateral Crises, American Economic Review, Vol. 104, Issue 2, pp. 343–378. 370  See for that in extenso: P. Golec and E. Perotti, (2017), ibid., pp. 20–23. 366

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runs in the marketplace. Safe assets are systemic because they are the medium of exchange for risky assets. Like commodity money, they are costly to produce and have some intrinsic value. Eden and Kay conclude that it leads to non-neutrality and overproduction of those assets.371 The conditions for private agents to create safe assets are: (1) decent enforcement of property rights, (2) the ability to create an unconditional debt claim (which is the security least sensitive to value fluctuations), possible reinforced by contractual dynamics such as collateralization (enhanced security), maturity (timing element) and seniority (contractual priority at maturity or at default).372 In most cases the privately created safe asset emerges as short-term debt. The reasons why the product emerges that way is linked to the (1) transaction dynamics of money, (2) the required liquidity, (3) short-term debt is inherently less risky as asset risk is less likely to materialize,373 (4) it best reflects the deposit insurance dynamics in this case through an option to exit fairly early on, (5) fact that short-term debt is repaid earlier on in the cash flow waterfall and often enjoy special creditor protection.374 Asset liquidity risk, which is higher in case of short-term debt, which emerges in case of a run in the market, is a kind of non-fundamental price risk due to distorted demand-supply for cash or cash equivalents in the market. The implication is that during a run in the market, the repricing issue is due to the earlier liquidation value of assets rather than fundamental concerns. Asset illiquidity affects that way run beliefs, aggravated by a market stay, like we know it in bankruptcy proceedings.375 The call option embedded in short-term debt relative to longer-­maturity instruments operates as an insurance contract when it can be lifted even when default risk is minimal or non-existent.

 M. Eden and B. Kay, (2015), Safe Assets as Commodity Money, OFR Working Paper Nr. 15-23, November 25. 372  P. Golec and E. Perotti, (2017), ibid., p. 16. 373  Although even short-term private safe assets are sensitive to changes in the information environment and should not be treated as equally safe at all times. See M. Kacperczyk et al., (2017), The Private Production of Safe Assets, Working Paper, June 9, mimeo. The latter demonstrate that privately issued securities can benefit from a safety premium if their maturity is very short. 374  Short-term creditors can adjust their claim faster and more frequent than others based on information coming to the market, demand-supply dynamic in the market. The repricing, as a result, gives them an advantage over long-term creditors. You could say that short-term creditors are ‘de facto’ more senior due to their position in the cash flow repayment schedule. Risk intolerance then causes short-term spirals of debt issuance. More short-term debt also means more rollover risk. In extremis this might lead to coordination issues in the market even when the underlying fundamentals are economically sound. Also see S.G. Hanson, et al., (2015), Banks as Patient Fixed-Income Investors, Journal of Financial Economics, Vol. 117, pp. 449–469. What happens is that the shortterm nature and the volume of rollover requirements do not allow for sufficient time to ‘reprice risk’ required to roll over debt. No rollover means assets need to be liquidated, thereby reducing asset value for remaining investors (those that approved debt rollover). See for that: R.  Matta and E. Perotti, (2015), Secured vs. Unsecured, SRC Discussion Paper Nr. 41, July. See in detail regarding liquidity risk and bank runs under minimal fundamental risk: R. Matta and E. Perotti, (2017), Insecure Debt and Liquidity Runs, Working Paper, June 22, mimeo. 375  The market stay ‘contributes to a surprising concave effect of liquidity risk on run frequency, quite unlike fundamental risk. In general, abundant liquidity encourages rollover as it supports 371

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A similar reasoning can be followed when it comes to the use of secured debt and/or collateral in producing safe assets. Shadow banks replicated the safety and liquidity of their banking counterparts by using collateralized credit.376 The collateral or pledge eliminates credit and counterparty risk in, for example, repos.377 Collateral use is the consequence of contractual asymmetry between market agents. The contractual asymmetry is the consequence of the limits of verification regarding a variety of aspects regarding the counterparty, moral hazard or the asymmetric availability of information.378 One would think that the use of secured debt would reduce aggregate risk. Ultimately, it eliminates runs driven by the idea that selling or withdrawing first gives you an edge over others in the market. However, there are indirect issues related to collateral. That collateral provides safety. But in case the collateral is lifted, it often, so tells us history, is immediately resold

confidence that the bank can repay withdrawals. As some default risk arises, the appeal of running increases as asset liquidity falls, since runners are paid out of an increasingly scarce asset class. However, as liquid assets become extremely scarce the rollover payoff increases relative to the run payoff, as more assets will be left in the estate. Thus, in equilibrium there is a concave, inverted U-shaped relation between asset liquidity and run frequency’: R.  Matta and E.  Perotti, (2017), ibid., p. 3. Some compare it to a ‘Knightian uncertainty emerging’: R.J. Caballero, and E. Farhi, (2017), The Safety Trap, The Review of Economic Studies, Vol. 85, Issue 1, pp. 223–274. 376  Even more: the creation of private safe assets by shadow banks can crowd out traditional banks’ supply of safe assets. Narajabad and Gissler highlighted that ‘the 2014–2016 money market fund reform created a large demand shock for government- or government-like safe assets. Shadow banks responded, and in particular, Federal Home Loan Banks (FHLBs) increased their issuance of shortterm safe debt as well as their lending to banks. To manage their interest rate risk, FHLBs changed the terms of their lending; the new loans had a shorter maturity and reset the interest rate at a high frequency.’ They study, through differences in interest rate management, the banks responses. The differential on borrowing by banks following the MMF reforms were studied as well as the effect of increased supply of safe assets by FHLB on banks’ balance sheets. They observe that ‘banks use FHLB borrowing as a perfect substitute for deposit financing. The substitution of safe debt with FHLB borrowing does not go along with an overall increase in the balance sheet and therefore has no lending effect.’ ‘If shadow banks create safe assets at the expense of traditional banks’ deposits, then there will be a minimal effect on the total funding available for households and firms from banks and shadow banks.’ See B. Narajabad and S. Gissler, (2018), Supply of Private Safe Assets: Interplay of Shadow and Traditional Banks, Working Paper, June 13, draft, mimeo. 377  Repos were considered safe and that understanding is built on the neoclassical premise that markets are reliable sources of liquidity. Reality disproved that thesis by generating collateral calls, collateral sales, liquidity events and liquidity-driven losses for repo-borrowing funds and their end investors. Repo-lending now dominates money markets and thus protect borrowers themselves through safe asset collateral. It is claimed that the potential is there for that situation can distort financial markets and disrupt private investment and economic performance. Sissoko analyzed and contrasted the liquidity-supporting role of the traditional banking system with the liquiditydemanding, repo-based financial system and concludes that the contractual structure determines the balance in the private loan sector and that, although private debt never is really free, the balance of safety has shifted, because of this trend, toward lenders. See C.  Sissoko, (2017), Repurchase Agreements and the De(con)struction of Financial Markets, Working Paper, July 12. One can say it is a(n) (un)intended consequence of market-based finance. 378  In extenso: G. Coco, (2000), On the Use of Collateral, Journal of Economic Surveys, Vol. 14, Issue 2, pp. 191–214. For example, repos are not only exempted from automatic stay, but due to their shortterm nature, haircuts can be adjusted on a frequent basis making them virtually risk-free.

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by holders.379 That leads to asset value declines and runs. Other non-involved parties see this happening and are inclined to sell as well, not because of fundamental risks in their transaction but simply due to the wish to avoid dilution. Now those creditors that seek collateral will seek liquid collateral.380 By doing so they capture the safety premium. That is fine as the debt now is secured. But it comes at a cost because debt not covered by the collateral now becomes relatively less safe, as they bear the immanent threat of increasing risk now that assets are pledged elsewhere. Collateralized debt makes other debt less secure and therefore more prone to runs. That leaves a conundrum: the market will require high rollover rents for the less secure debt whereas the borrower will look to minimize funding costs. Contractual asymmetry and collateral therefore reach no market equilibrium but are at risk of inefficient runs and increase default risk. There is a strong policy implication derived from this as in a lot of incoming regulation in recent years, margins were increased or collateral requirements enhanced. In most cases, research focuses on repos when considering these issues, and the use of derivatives in creating safe assets in private markets stays largely under-highlighted. Collaterals pledged on derivatives enjoy, however, the same exemption from automatic stay and it was demonstrated that this privilege induces the same risk shifting at the cost of unsecured lenders and contributes to a higher cost funding and the inherent risk of runs and increased levels of defaults.381 If you would consider these elements one would conclude that the aggregate level of risk in the market cannot be altered at the level of a security, unless it is at the cost of someone else. Tampering with the ‘safe’ denomination or predicate is then in summary misleading or at least incorrect.382 In fact, existing theories do not explain where safe assets get their safety. Galpern and Gerding put it bluntly and correct: ‘[p]recisely because

 See for that: M. Oehmke, (2014), Liquidating Illiquid Collateral, Journal of Economic Theory, Vol. 149, pp. 183–210. 380  The market for collateral also plays a role in the financial system and in particular with respect to financial stability and the conduct of monetary policy. Collateral is neither a sufficient nor a necessary condition for financial stability. To ensure the stability of collateralized markets a mix of microand macroprudential regulation, as well as a sufficient supply of safe public assets that can be used as collateral, is needed, conclude Corradin et  al. See S.  Corradin et  al., (2017), On Collateral: Implications for Financial Stability and Monetary Policy, ECB Working Paper Nr. 2017, November. 381  P.  Bolton, and M.  Oehmke, (2014), Should Derivatives Be Privileged in Bankruptcy? The Journal of Finance, Vol. 70, Issue 6, pp.  2353–2394. See for a general review of the issue: F.R. Edwards and E.R. Morrison, (2005), Derivatives and the Bankruptcy Code: Why the Special Treatment, Yale Journal on Regulation, Vol. 22, pp. 101–133. This position continued under the new regulation in recent years: S.  Adams, (2013), Derivatives Safe Harbors in Bankruptcy and Dodd-Frank: A Structural Analysis, Harvard University Working Paper, April 30, mimeo. 382  See for a variety of studies on the matter: A.B.  Abel, (2017), Crowding Out in Ricardian Economies, Journal of Monetary Economics, Vol. 87, pp. 52–66; R.J. Barro, and T. Jin, (2016), Rare Events and Long-Run Risks, NBER Discussion Paper Nr. 115371; R.J. Barro et al.,(2017), Safe Assets, CEPR Discussion Paper Nr. DP12043; S.T. Rachev and F.J. Fabozzi, (2016), Financial Market with No Riskless (Safe) Asset, Working Paper, December 5; M. Lenel, (2017), Safe Assets, Collateralized Lending and Monetary Policy, Stanford University Working Paper, January 1, mimeo; P.-O. Gourinchas and O. Jeanne, (2012), Global Safe Assets, Paper presented at the XI BIS Annual Conference held in Lucerne, 20–21 June 2012, mimeo; IMF, (2012), Safe Assets: Financial System Cornerstone, Global Financial Stability Report, Chapter 3, pp. 81–122. 379

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there are no risk-free contracts, state intervention supplies the essential infrastructure to let people act as if some contracts were risk-free. The law constructs and maintains safe asset fictions, and it places them at the foundation of institutions and markets. This project is unavoidably distributive and fraught with distortions.’383 Galpern and Gerding contribute in a very interesting way to the discussion regarding the nature and creation of ‘safe assets’384 as well as what can go wrong during and after the process produced safe assets.385 What I particularly like about the report, and which appeals to my lawyer’s mind and way of thinking, is that there are no assets to be found which are ‘safe’ in their natural state.386 Thus assets that we consider safe are so because they were ‘made’ safe, ‘labeled’ safe or ‘guaranteed’ safe, the latter which implies that someone else picks up the risk through guarantees, backstops or collateral.387 In all honesty, that is a clearer, more s­ traightforward and more helpful way of characterizing the state and nature of safe assets than any economic review has done so before. It must be clear that a manufactured industry of safe assets is prone to misuse, erroneous labeling, contagion and misalignment and has produced a system that is inherently unstable. The distribution of safe assets has a political dimension to it. The intervention in the creation and distribution of safe assets distributes resources and power and allows to prioritize policy objectives. It allows market participants to attract capital, lower the cost of funding and gain access to certain public infrastructure. The labeling of assets to be safe in fact is a way to route capital in the marketplace. But also forces market participants to absorb or internalize risk—risk that might or might not be able to tolerate when heaving to bear on their own. Now the distribution of safe assets might not be so problematic, the technocratic packaging of these distributional choices is problematic in nature. A good example, provided by Galpern and Gerding, is the row of incremental regulatory interpretations which turned leveraged derivatives contracts into permitted products for banks and pretty much on par with plain

 A. Gelpern and E.F. Gerding, (2016), Inside Safe Assets, Georgetown University Law Center Working Paper, September 26 (also as A. Gelpern and E.F. Gerding, (2016), Rethinking the Law in Safe Assets, Reconceptualising Global Finance and Its Regulation, (eds.) R.  P. Buckley, E. Avgouleas, and D. W. Arner, Cambridge University Press, Cambridge). See for their earlier work in this field: A.  Gelpern and E.F.  Gerding, (2015), Private and Public Ordering in Safe Asset Markets, Brooklyn Journal of Corporate, Financial & Commercial Law Vol. 10, pp. 1–31. 384  See for the legal architecture of safe assets: A. Gelpern and E.F. Gerding, (2016), ibid., pp. 25–43. 385  A. Gelpern and E.F. Gerding, (2016), ibid., pp. 45–52. 386  Let’s be fair: even in case an AAA-rated sovereign issues bonds, they are only considered AAA not only because of the underlying fundamentals of its economic, trade balance and so on but particularly because the central bank in that country can at any time print additional debt to roll over any existing liability in its own currency the sovereign might have. That sounds like a free lunch was it not for the fact that monetary expansion creates a natural inflationary uptick and so the cost of that transaction is spread across society. 387  See for the proposed remedies which include: (1) cataloguing safe assets, who uses them and for what reason. The monitoring should allow timely review and realignment of assets, although that process is as burdensome as general macroprudential tools; (2) fixing wrongful labeling. Public labels are better than private labels only if they effectively can correct market failures. Label-as-price has minimal information value of its own, even as it tries to block market price signals, and its use should therefore be minimized. Those who now benefit will do whatever it takes to see labeling go away. See in detail A. Gelpern and E.F. Gerding, (2016), ibid., pp. 52–58. 383

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vanilla corporate loans.388 The only way to get rid of this is to get rid of the regulatory rhetoric of ‘safe’ and ‘risky’.389 Alignment and safety should be the objective.390 Therefore, they ‘favor an oversight regime that focuses on matching the risk attributes of a contract to the way in which it is being used. Gaps between asset uses and attributes can harbor systemic risk.’391 So not the creation but the wrongful attribution seems the battle to take on.

3.17.3 Are Safe Assets a Problem? Safe assets, as we discussed the asset group, is a store of value. Economic agents, ranging from households, corporations, banks to central banks and sovereign wealth funds need stores of value for a variety of purposes. But not all stores of value are created equal. Because of that, their degree of liquidity differs and therefore also sensitivity to various risk factors. And so safety differs across a gliding scale within the ‘safe asset’ group, where nothing is ever absolutely and across all possible conditions safe. In the end, there is no asset that is expected to preserve its value across a group of systemic risk events that we haven’t even fully defined or catalogued.392 We discussed earlier how debt markets go from being information-insensitive to information-sensitive in times of distress and all bets are off during such periods.393 So safe assets are a matter of belief, formed by reputation and history, and so safe is when others believe it to be safe.394 Gorton reiterates:

 A. Gelpern and E.F. Gerding, (2016), ibid., pp. 49–52. See in particular S.T. Omarova, (2013), The Merchant of Wall Street: Banking, Commerce and Commodities, Minnesota Law Review, Vol. 98, pp. 295–355; S.T. Omarova, (2009), The Quiet Metamorphosis: How Derivatives Changed the Business of Banking, University of Miami Law Review, Vol. 63, pp. 1041–1109. See for the moral hazard in this: S.L. Schwarcz, (2015), Derivatives and Collateral: Balancing Remedies and Systemic Risk, University of Illinois Law Review, Nr. 2, pp. 699–719. 389  See also S. Luck and P. Schempp, (2016), Regulatory Arbitrage and Systemic Liquidity Crises, Working Paper, mimeo; A. Moreira and A. Savov, (2017), The Macroeconomics of Shadow banking, The Journal of Finance, Vol. 72, Issue 6, pp. 2381–2432; G. Ordoñez, (2018), Sustainable Shadow Banking, American Economic Journal, Vol. 10, Nr. 1, January, pp. 33–56; P. Benigno and S. Nisticò, (2017), Safe Assets, Liquidity, and Monetary Policy, American Economic Journal, Vol. 9, Nr. 2, April, pp. 182–227. 390  Weymuller argues that banks hold so many government bonds, because their role is to multiply safety, and their Treasury holdings help them achieve exactly that. Private safety creation requires banks to hold on their balance sheets government bonds, whose returns are negatively correlated with macroeconomic shocks. The European debt crisis of a few years ago is therefore nothing less than a shortage of safe public assets. The spread between public debt yield and private debt yield reveals bank leverage. See in detail C.-H. Weymuller, (2015), Banks as Safety Multipliers: A Theory of Safe Asset Creation, Working Paper, May, mimeo. 391  A. Gelpern and E.F. Gerding, (2016), ibid., p. 55. 392  R. Caballero et al., (2017), Rents, Technical Change, and Risk Premia Accounting for Secular Trends in Interest Rates, Returns on Capital, Earning Yields, and Factor Shares, American Economic Review, Vol. 107, Issue 5, pp. 614–620. 393  T.V. Dang et al., (2015), Ignorance, Debt, and Financial Crises, Columbia Working Paper, April, mimeo; G.B. Gorton et al., (2016), The Safe-Asset Share, NBER Working Paper Nr. 22210. 394  E.  Fahri and M.  Maggiori, (2016), A Model of the International Monetary System, NBER Working Paper Nr. 22295; Z. He et al., (2016), What Makes US Government Bonds Safe Assets?, NBER Working Paper Nr. 22017. 388

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‘[f ]inancial crises are runs on short-­term debt. Whatever its form, short-term debt is an inherent feature of a market economy. A run is an information event in which holders of short-­term debt no longer want to lend to banks because they receive information leading them to suspect the value of the backing for the debt, so they run.’395 The financial sector and the government have been the main manufacturers of financial (safe) assets. Except for some minor episodes, the supply of safe assets has not kept up with demand during the last couple of decades.396 The capacity of a country to produce safe assets is determined by ‘constraints in the financial sector, the level of financial (under-)development, the fiscal capacity of the sovereign, and the track record of the central bank for exchange rate and price stability’.397 The world growth rate has advanced faster than the supply combined with the fact that the savings rate in emerging economies has accelerated, and it is those countries that fail to produce ‘safe assets’.398 The structural excess of demand over supply has helped interest rates to come down, has led to large account surpluses in many emerging economies and has triggered the discussed ‘private label’ production of safe assets. That created already a material distortion in and of the financial system. Since the financial crisis of 2007–2009 and the sovereign debt crisis in Europe, the interest rates have reached their ‘effective lower bound’ which refers to the rate at which it becomes more interesting than financial assets.399 The question now is if that is going to be a problem over time. Since 2017 interest rates are on the rebound, potentially ending a decades-long debt bull market, but things are moving at a very slow pace. Are there macroeconomic consequences to all this? The answer must include the concern that with constrained supply, the global economy is pushed below its potential. Decline in global output likely leads to a decline in the demand for safe assets. The Great Recession was a prime example of that happening. But so overall, the conclusion could be that a structural shortage is a source of fragility for the economy. But the financial system is like a living organism: if something doesn’t work it will have effects elsewhere or the system will look for escape valves. Caballero et al. examine four of these possible escape valves and elaborate on their macroeconomic and finan-

 G. Gorton, (2018), Financial Crisis, Annual Review of Financial Economics, Vol. 10, pp. 43–58.  See for the historical dimension in detail: G. Gorton, (2017), The History and Economics of Safe Assets in Detail, Vol. 9, pp. 547–586; Ŏ. Jordà et al., (2017), The Rate of Return on Everything, 1870–2015, Federal Reserve Bank of an Francisco Working Paper Series Nr. 2017-25, December. 397  R.J.  Caballero et  al., (2017), The Safe Assets Shortage Conundrum, Journal of Economic Perspectives, Vol. 31, Nr. 3, pp. 30. 398  R.  Ahrend et  al., (2017), The Demand for Safe Assets in Emerging Economies and Global Imbalances: New Empirical Evidence, Vol. 41, Issue 2, pp. 573–603; D. Bleich and A. Dombret, (2014), Financial System Leverage and the Shortage of Safe Assets: Exploring the Policy Options, German Economic Review, Vol. 16, Issue 2, pp. 161–180. 399  Government financial assets are increasingly recognized as playing an important role in assessing fiscal sustainability. See M. Ruzzante, (2018), Financial Crises, Macroeconomic Shocks, and the Government Balance Sheet: A Panel Analysis, IMF Working Paper Nr. WP/18/93, April. Also see A.  Afonse et  al., (2017), Fiscal Developments and Financial Stress: A Threshold VAR Analysis, Empirical Economics, pp. 1–29; E. Bova et al., (2016), The Fiscal Costs of Contingent Liabilities. IMF Working Paper Nr. WP/16/14. 395 396

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cial trade-offs. They see possible escape valves through: (1) a valuation rise through the exchange rate appreciation of safe asset producer economies, and the US dollar in particular; (2) the issuance of public debt; (3) the production of private safe assets and (4) changes in regulatory frameworks, global risk sharing, as well as re-profiling of central bank asset purchase practices to reduce the demand for safe assets.400 From a shadow banking perspective, the production of private safe assets interests us the most. In case the public sector cannot produce sufficient safe assets given the demand, the private sector can or will step in. In fact, and maybe in contrast to what one would expect, evidence produced demonstrates that an increase in the demand for safe assets induces the private sector to create more money-like claims. Infante demonstrates that an increase in the demand for safe assets leads to a decrease in the issuance of Treasury repos.401 The private sector’s ability to satisfy the demand for safe assets depends on the type of liabilities it creates. He concludes that ‘if the underlying collateral which backs privately produced safe assets is a public safe asset, then the demand for safe assets can be satisfied by reducing private safe asset creation’.402 Additionally, one can wonder if the private sector will step in only in case the public sector cannot produce sufficient assets or whether they will also step in under the umbrella of private rent-seeking, in case there is sufficient supply, but privately engineered assets can yield higher return given the same level of perceived risk-freeness. Because ultimately, and that has been well documented, has there been a structural transformation in the way that the private sector produces ‘safe assets’.403 Given the experiences in the period 2007–2009, the idea is now that it is possible to create private safe assets as long as there is a situation of ‘overcollateralization’.404 But this qualifies as a suboptimal and deficient solution. Besides the effects in the collateral markets and the valuation used that could cause additional contagion in case of ­distress, there is also the demand-supply issue in case regulation asks for enhanced levels of collateral for all sorts of transactions. But more importantly, the private sector is unable, in an absolute way, to insure against truly systemic events. That has quite some implications. Keeping in mind the above discussion  R.J.  Caballero et  al., (2017), The Safe Assets Shortage Conundrum, Journal of Economic Perspectives, Vol. 31, Nr. 3, pp. 32–42. See about the role of central banks in affecting the quantity and mix of short-term liquid assets available to the market: M. Carlson et al., (2016), The Demand for Short-Term, Safe Assets and Financial Stability: Some Evidence and Implications for Central Bank Policies, IJCB, Vol. 12, Nr. 4, pp. 307–333. 401  S.  Infante, (2017), Private Money Creation with Safe Assets and Term Premia, Finance and Economics Discussion Series Nr. 2017-041, via federalreserv.gov. 402  S. Infante, (2017), ibid., p. 27. He also concludes that the creation of private safe assets with long-term public safe assets is beneficial because it shifts risk to agents which have a higher tolerance for it. Banks can satisfy demand for safe assets according to Infante by assuming the risk of government debt and issuing short-term claims, although the latter does not create but only transform them. Private safe asset creation occurs when the assets backing them do not already have a safe asset premium. 403  See for a historical review: G.B. Gorton et al., (2016), The Safe-Asset Share, NBER Working Paper Nr. 22210. 404  R.E. Hall, (2016), The Role of the Growth of Risk-Averse Wealth in the Decline of the Safe Real Interest Rate, Stanford Working Paper, mimeo. 400

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about extracting safe assets from a pool of ‘on aggregate’ non-safe assets is a fragile endeavor. But there is more. It wasn’t just the engineering that was a problem, even the ‘most senior and seemingly safe tranches on private assets may contain some irreducible tail-risk, making these assets unsafe when faced with truly systemic events’.405 Without a public backstop or insurance overlay this will become an environment known for its ability to create instability.406 The big distinction lies in the fact that private sector engineering creates ‘micro-AAA assets’ rather than the public ‘macro-AAA assets’.407 Solutions for this problem have been suggested but were all found to be flawed or of no ultimate remedy. These solutions included allowing the Treasury to flood the market with short-term debt or the creation of all sorts of private-public partnerships. While the former might resolve the issue temporarily, there is a fiscal-political capacity constraint building over time.408 The public-private partnerships could absorb the severe tail risks in privately engineered assets while observing moral hazard, or force financial i­ ntermediaries to buy tail-risk insurance from the government. Both409 sound like shooting the breeze and highly unstable or outright unrealistic.410 Public debt would become an instrument for creating private liquidity as issuing more debt eases the underlying financial friction discussed. As said, it improves welfare but tightens and ultimately constrains government

 J.  Caballero et  al., (2017), The Safe Assets Shortage Conundrum, Journal of Economic Perspectives, Vol. 31, Nr. 3, p. 40. G. Calvo, (2017), Liquidity Deflation and Safe Asset Shortage, Columbia Working Paper, mimeo. 406  See also W. Nelson, (2017), Recognizing the Value of the Central Bank as a Liquidity Backstop, The Clearing House Staff Working Paper Nr. 2017-1, January. Daniel Schwarcz leaves no room for doubt when claiming, ‘many of the assumptions on which state insurance regulation is premised are outdated or simply wrong’ and therefore ‘much of the current system of insurance regulation in the United States is obsolete, ineffective, and inefficient’. See D. Schwarcz, (2017), The Failures of State Insurance Regulation, ALI Early Career Scholars Medal address delivered at the American Law Institute’s 94th annual meeting in Washington, DC, on 24 May 2017. In fact, he goes further when indicating that ‘to protect the stability of the financial system, regulators and policy makers have been extending bankruptcy-resolution techniques beyond their normal boundaries’. The insufficiency lies in the fact that bankruptcy regulation has microprudential goals whereas financial stability is a macroprudential goal. See S.L.  Schwarcz, (2019), Beyond Bankruptcy: Resolution as a Macroprudential Regulatory Tool, Duke Law School Public Law & Legal Theory Series Nr. 201753 (also in Notre Dame Law Review, Vol. 94, Issue 2, pp. 709–750). 407  R. J. Caballero et al., (2017), ibid., p. 40. 408  In fact Schulknecht argues that from a certain point more public debt will not ‘buy’ more safety: countries face a kind of ‘safe-assets Laffer curve’ with a maximum amount of safe assets at some level of indebtedness. See L. Schulknecht, (2016), The Supply of ‘Safe’ Assets and Fiscal Policy, CFS Working Paper Series Nr. 532. 409  See in detail J.C. Stein, (2012), Monetary Policy as Financial Stability Regulation, Quarterly Journal of Economics, Vol. 127, Issue 1, pp. 57–95; E. Farhi and M. Maggiori, (2016), A Model of the International Monetary System, NBER Working Paper Nr. 22295. 410  How much tail risk can the government absorb without ripping apart the public budget? Wouldn’t it then be better to issue the instruments themselves? What is the premium for tail risk we have a problem defining? Limiting tail risk to what we know creates open exposures. So this would become carte blanche and an absolute backstop by the government for a marginal insurance fee to allow unlimited rent extraction. 405

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budgets, if not by pushing up the natural interest rate on public debt. Liquidity management and debt policy become intertwined.411 For the time being it is very likely that the world will continue to experience a structural safety trap. Let’ put some elements into perspective: the percentage of safe assets to total assets has been relatively stable over longer periods of time. That implies that scarcity of safe assets412 is mainly a ­demand-­related phenomenon.413 It has driven down safe asset interest rates to the lower bound and cannot fall materially any further. That constraint will lead to a fall in wealth capacity and growth output globally.414 And let’s not forget: an equilibrating mechanism that accounts for the fact that interest rates cannot go below the

 See for the analysis of the Ramsey model, the quest for a long-run optimal quantity of public debt and the possible policy responses to shocks: G.-M. Angeletos et al., (2016), Public Debt as Private Liquidity: Optimal Policy, Working Paper, October 28, mimeo; K. Aoki et al., (2014), Safe asset shortages and asset price bubbles, Journal of Mathematical Economics, Vol. 53 (C), pp. 164–174; Ph. Bacchetta et al., (2016), Money and Capital in a Persistent Liquidity Trap, CEPR Discussion Papers Nr. 11369, July. 412  The intrinsic characteristics and supply of the assets determine their liquidity properties and degree of safeness. With safe assets, we basically mean ‘information-insensitive’ assets. Only a sufficiently broad expansion of a particular class of safe information-insensitive assets can achieve the first-best allocation (safety as an equilibrium outcome), while a marginal increase in their supply can be ineffective. An asset is safe as long as there is no incentive to produce private information about its quality. Information can create volatility and makes it not suitable for facilitating transactions. Opacity trumps transparency (C. Monnet and E. Quintin, [2017], Rational Opacity, The Review of Financial Studies, Vol. 30, Issue 12, pp. 4317–4348.). A liquidity trap then means that only when a sufficient supply of safe assets is warranted the market can function at its optimal level, if not it is trapped. Safe asset scarcity therefore is a policy issue and producing private information (from information-insensitive to information-sensitive) implies an uncertainty about the outcome of a transaction. See in detail M.  Lomberto, (2019), Safety Traps, Liquidity and InformationSensitive Assets, Bank of Italy Working Papers Nr. 1216, April. The bottom line here is ‘[t]aking the safety of an asset as a primitive can provide wrong insights about the implications of a shortage of safe assets’ (p. 25). See broader for the constituents of safe assets: S. Nagel, (2015), What Is a Safe Asset, University of Michigan Presentation, June. Elements included are: (1) riskless payoff in real and nominal terms, (2) information-insensitive assets, (3) assets that satisfy regulatory constraints, (4) risky asset that pays promised stochastic payoff for sure and (5) negative beta assets. Loberto takes a different approach. In his model the degree of safeness of an asset is not an intrinsic characteristic. An asset is safe when it circulates in the economy and is accepted as a payment or collateral instrument without the incentive to check its quality every time. In detail: M. Loberto, (2019), Safety Traps, Liquidity and Information-Sensitive Assets, Bank of Italy Working Paper Nr. 1216, April 29. 413  Driven by regulation, reserve accumulation in the public and private sphere and most importantly demographics. See regarding the latter in specific: J.  Callum, (2018), Aging, Secular Stagnation and the Business Cycle, IMF Working Paper Series Nr. WP/18/67, March 23. 414  In fact the story goes further: the costs and benefits of increasing government debt in a low interest rate environment are material. Higher risk increases the demand for safe assets, lowering the natural rate of interest below zero, constraining monetary policy at the zero lower bound, and raising unemployment. Higher government debt satiates the demand for safe assets without requiring negative interest rates, raising the natural rate and restoring full employment. This permanently lowers investments as discussed, but a commitment to low inflation leaves policy-wise no other options. See in detail: S. Acharya and K. Dogra, (2018), The Side Effects of Safe Asset Creation, 411

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effective lower bound415 and the effect on wealth and output, is generated through a recession which is exactly what was experienced in the period 2007–2009. The high demand for safe assets implies that only a small fraction of economic investment to generate growth needed will be funded by society. Given the discrepancy between safe assets interest levels and riskier investments is large as risky investment interest rates are still elevated, pointing at the fact that banks cannot properly manage the transmutation of interest yields between the different asset classes, the investment in physical economic assets will continue to drop.416 The aforementioned Acharya and Dogra hinted as well at the fact that in a risky economy negative interest rates are required to sustain high investments. A question they add on is whether low safe rates indicate a shortage of safe assets (a situation in which issuing more safe assets increases welfare).417 Whether low rates indicate a shortage depends on whether negative interest rates are implementable.418 They are not the first to study the interaction of public debt and the zero lower bound419 in economies with capital. But in

Federal Reserve Bank of New York Staff Reports, Nr. 842, August. In contrast higher inflation targets permit both full employment and high investment, but allow for harmful bubbles which need to be tamed through aggressive fiscal policies. The fundamental problem is that the optimal natural allocation in a risky economy requires negative real rates to sustain high investment. See A. Martin and J.  Ventura, (2018), The Macro-Economics of Rational Bubbles: A User’s Guide, NBER Working Paper Series Nr. 24234, January. Also see N.  Caramp, (2016), Sowing the Seeds of Financial Crises: Endogenous Asset Creation and Adverse Selection, MIT Working Paper, mimeo. 415  M.K.  Brunnermeyer and Y.  Koby, (2016), The Reversal Interest Rate: The Effective Lower Bound of Monetary Policy, Working Paper Princeton University, mimeo; M.  Del Negro et  al., (2017), Safety, Liquidity, and the Natural Rate of Interest. Brookings Papers on Economic Activity, Nr. 1, pp. 235–316; R.J. Caballero and E. Farhi, (2018), The Safety Trap, Review of Economic Studies Vol. 85, Issue 1, pp. 223–274. 416  Investing in infrastructure might prove to be a good solution: lower bound risk combined with a boosting of potential growth and so optimizing the relation between invested capital and volume of safe assets generated. 417  As was argued by the discussed: J. Caballero et al., (2017), The Safe Assets Shortage Conundrum, Journal of Economic Perspectives, Vol. 31, Nr. 3, pp. 29–46; P.-O. Gourinchas and H. Rey, (2016), Real Interest Rates, Imbalances and the Curse of Regional Safe Asset Providers at the Zero Lower Bound, NBER Working Paper Nr. 22618, September. 418  See F.  Dong and Y.  Wen, (2017), Optimal Monetary Policy Under Negative Interest Rates, Federal Reserve Bank of St. Louis Working Paper Nr. 19A, St. Louis. 419  Zero lower bound (ZLB) in this context can be described as a situation where the short-term nominal interest rate is at or near zero, causing a liquidity trap and limiting the capacity (or the options) of the central bank to engage in actions to stimulate economic growth. See on the ZLB (and the impact on the economic environment and asset classes) in detail: S.D. Williamson, (2017), Low Real Interest rates and the Zero Lower Bound, Federal Reserve Bank of St. Louis, Working Paper Series Nr. 2017-010A, April; C.J.  Gust et  al., (2015), Monetary Policy, Incomplete Information and the Zero Lower Bound, Finance and Economics Discussion Series Nr. 2015-099, Washington: Board of Governors of the Federal Reserve System, November 3; R.  Agarwal and M. Kimball, (2015), Breaking Through the Zero Lower Bound, IMF Working Paper Series Nr. WP/15/224, October; S. Schmidt, (2015), Lack of Confidence, the zero Lower Bound, and the Virtue of Fiscal Rules, ECB Working Paper Series Nr. 1795, May; H.  Kick, (2017), Pricing of Bonds and Equity When the Zero Lower Bound Is Relevant, ECB Working paper Series Nr. 1992,

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their model the natural interest rate is affected both by idiosyncratic risk and by fiscal policy. They conclude: ‘[b]y increasing the supply of safe assets, policy makers can prevent an increase in risk from driving the natural rate below zero, allowing monetary policy to operate effectively rather than being constrained by the ZLB. However, negative natural rates do not necessarily indicate a shortage of safe assets. While fiscal policy can keep the natural rate positive, the optimal natural allocation allows risk to drive the natural rate below zero, because increasing debt crowds out investment.’ So there is a permanent cost, that is, a permanent decline in investments.420 A possible return to full employment under those circumstances disguises the fact that the economy can operate at potential with negative interest rates leading to sluggish investment rates and labor productivity. Those negative interest rates are also a source of welfare reducing bubbles421 and might lead to a ‘bubbly pecuniary externality’ which could push the economy into a secular stagnation equilibrium. This could trigger a persistent and efficient recession because the zero lower bound and nominal wage rigidity constraint bind.422 January; M.  Amador et  al., (2017), Exchange rate Policies at the Zero Lower Bound, Federal Reserve Bank of Minneapolis Working paper Nr. 740, Revised October 2017; G.  Bäurle et  al., (2016), Changing Dynamics at the Zero Lower Bound, Swiss National Bank Working papers Nr. 16/2016, November; B.  Feunou et  al., (2017), Tractable Term-Structure Models and the Zero Lower Bound, Bank of Canada Working Paper Series Nr. 2015–46, December; D. Datta et al., (2017), Oil, Equities and the Zero Lower Bound, BIS Working Paper Nr. 617, March; D. Debortoli et  al., (2018), On the Empirical (Ir)Relevance of the Zero Lower Bound Constraint, Working Paper, January, mimeo; M. Cacciatore and R. Duval, (2017), Market Reforms at the Zero Lower Bound, Working Paper, August, mimeo. 420  Kahn takes it the other way and describes how government borrowing can increase corporate investments. He explains: ‘corporations make endogenous corporate financing and investment decisions. The government affects these decisions through its issuance of safe debt. In the model, firms use safe assets to retain their earnings and avoid future financing costs. When the corporate sector is limited in its ability to create safe assets by the pledgeability of their capital, safe assets are scarce: a liquidity premium emerges, and the return on safe assets falls below the return on the firm in equilibrium. When safe assets are scarce, low interest rates on safe assets mean firms rely more on costly financing, resulting in lower investment. In this setting, in contrast to the common crowding-out story, increasing government borrowing raises the return on safe assets, making safe assets more available to firms and allowing them to better retain earnings in order to invest in the future.’ Kahn finds that a 1% increase in government borrowing increases the return on safe assets by 60 basis points and increases aggregate investment by 13 basis points. See in detail: R.J. Kahn, (2018), Corporate Demand for Safe Assets and Government Crowding-in, Working Paper, November 16, mimeo. Also interesting is the literature list pp. 45–47. 421  The authors conclude that although empirical evidence of the model is still out there the findings of the mode are ‘in some respects disturbingly similar to the experience of the U.S. and other advanced economies during the recovery from the Great Recession. These economies experienced a large increase in publicly issued safe assets (government debt held by the public and central bank reserves). Even after returning to full employment, output, investment, labor productivity, and capacity utilization have remained persistently below their pre-crisis trends.’ These outcomes they conclude are the unavoidable consequence of an increase in safe asset creation (pp. 30–31). See also F.  Allen et  al., (2017), On Interest Rate Policy and Asset Bubbles, Working Paper Series Nr. WP-2017-16, Federal Reserve Bank of Chicago. 422  See in detail: S.  Biswas et  al., (2018), Bubbly Recession, Federal Reserve Bank of Richmond Working Paper Series Nr. WP18-05, February; M. Boullot, (2016), Secular Stagnation, Liquidity

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Solutions to reducing demand for safe assets are fragile, incomplete and untested.423 Central banks require safe assets for a variety of reasons (intervening in the currency market or to effectuate quantitative easing policies) and so reducing demand is difficult to achieve and requires complex and alternative pools globally of macro-risks or reduce the safe asset holdings to achieve levels actually needed to execute and anticipate monetary policies. Other areas where demand for safe assets is on the rise is all places where collateral requirements have increased due to regulatory interventions (Basel III, haircuts, margin requirements, etc.). For now also in this area ensuring stability without increasing the demand for safe assets is unlikely.424 Over time, different exchange rate relations might create additional safe asset capacity as well as the fact that emerging economies like China will build up the institutional capacity to issue safe assets of their own. These are all long-term trends and so for now the out-of-shape equilibrium for safe assets will yield continued low interest rates on safe assets, as well as bubbly dynamics in the segments that seem safe or are labeled safe, more than modest currency repositioning425 and recessionary dynamics all pointing at the same underlying problematic nature between the demand and supply side for safe assets.426 In

Trap and Rational Asset Price Bubbles, Working Papers, mimeo; M. del Negro et al., (2017), Safety, liquidity, and the natural rate of interest, Staff Reports Nr. 812, Federal Reserve Bank of New York May; A. Martin and J. Ventura, (2018), The Macroeconomics of Rational Bubbles: A User’s Guide, NBER Working Paper Nr. 24234, January; F. Dong et al., (2018), Asset Bubbles and Monetary Policy, Working Paper, January, mimeo; T.  Hirano and N.  Yanagawa, (2017), Asset Bubbles, Endogenous Growth, and Financial Frictions, Review of Economic Studies, Vol. 84, pp. 406–443; D.  Ikeda, (2017), Monetary Policy, Inflation and Rational Asset Price Bubbles, Working Paper, February, mimeo; J. Miao and P. Wang, (2017), Asset Bubbles and Credit Constraints, Working Paper, July 3, mimeo. 423  See in detail: J.  Caballero et  al., (2017), The Safe Assets Shortage Conundrum, Journal of Economic Perspectives, Vol. 31, Nr. 3, pp. 41–42; M. Azzimonti and P. Yared, (2019), The Optimal Public and Private Provision of Safe Assets, Journal of Monetary Economics, Vol. 102, pp. 126–144. 424  Global demand for safe assets will either remain dangerously unsatisfied, or force excessive US fiscal debt. This story posits implausibly inflexible demand for and supply of safe assets. See M.D. Bordo and R.N. McCauley, (2018), Triffin: Dilemma or Myth, NBER Working Paper Nr. 24195, January. 425  See about the impact of safe asset demand on exchange rates: Z. Jiang et al., (2018), Foreign Safe Asset Demand and the Dollar Exchange Rate, Working Paper, March 15, mimeo. And for their relationship with equity markets, see: R.N. McCauley, (2017), Risk-On/Risk-Off, Capital Flows, Leverage and Safe Assets, Journal of Financial Perspectives, Vol. 1, Nr. 2, pp.  1–10. McCauley describes the mutation from calm to volatile equity markets and the role of safe assets: ‘[t]hus, calm periods, marked by leveraged investing in emerging markets, lead to an asymmetric asset swap (risky emerging market assets against safe reserve currency assets) and leveraging up by emerging market central banks. In declining and volatile global equity markets, these flows reverse, and, contrary to some claims, emerging market central banks draw down reserves substantially.’ … ‘the international flow of funds produces not an exchange of risky assets, but an acquisition of risky assets on one side and acquisition of safe assets on the other.’ 426  See also: R.J.  Caballero et  al. (2016), Safe Asset Scarcity and Aggregate Demand, American Economic Review Vol. 106, Issue 5, pp. 513–518; R.J. Caballero et al., (2017), Rents, Technical Change, and Risk Premia Accounting for Secular Trends in Interest Rates, Returns on Capital, Earning Yields, and Factor Shares, American Economic Review, Vol. 107, Issue 5, pp. 614–620;

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the meantime, the system will have to take care of its (un)intended side effects. The rise of shadow banking undermines market discipline on traditional banks. Traditional banks typically commit to a safe strategy to prevent preemptive withdrawals in times of distress. Shadow banking emerges as an alternative banking strategy that combines high risk taking with early liquidation in times of crisis.427

3.17.4 The Sovereign Bond-Backed Securities Proposal In May 2018 the EC presented their SBBS proposal which should enable a market for sovereign-backed bonds. According to their own understanding the proposal ‘aims to level the playing field by removing unjustified regulatory impediments and granting SBBS the same regulatory treatment as national euro-area sovereign bonds (in terms, for example, of capital requirements, eligibility for liquidity coverage and collateral, etc.)’. They continue: ‘[t]his should pave the way to the market-led development of SBBS, boosting the flow of euro-denominated low-risk liquid assets in the system. Banks and other financial operators that invest in these assets will achieve greater diversification and less risk for their sovereign bond portfolios, with a positive impact on the stability of the financial system as a whole.’428The idea is to encourage banks and investors to diversify their holdings of eurozone bonds. SBBS would reduce investors’ bias toward their own countries and increase the financial stability of the eurozone.429 Following the financial

D. Andolfato and S. Williamson, (2015), Scarcity of Safe Assets, Inflation and the Policy Trap, Federal Reserve Bank of St. Louis, Working Paper Series, Nr. 2015-002A, January. 427  The sequence then is built up of assets in the shadow banking sphere during calm times to meet safe asset demand. When volatility kicks in, funding dries up and liquidation of assets is inevitable. By doing that the shadow banking segment exposes traditional banks to liquidity risk. See in detail: A. Ari et al., (2017), Shadow Banking and Market Discipline on Traditional Banks, IMF Working Paper Series Nr. WP/17/285, December. They correctly point out at the fact this has adverse implications. Traditional banks pursue risky portfolios that may leave them in default. But even more: trying to resolve the situation aimed at making traditional banks safer such as liquidity support, bank regulation and deposit insurance fuels further expansion of shadow banking but has luckily a net positive impact on financial stability. A shadow banking tax is also suggested to achieve financial stability (as an alternative). 428  Proposal for a REGULATION OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL on sovereign bond-backed securities, COM(2018) 339 final of 24 May 2018. At the time of the closing of the manuscript the proposal was only in its first reading at the level of the European Parliament and the Council. The outlook for the proposal is grim as objections persist. Politically it seems little realistic and the EU faces post May-2019 elections many more important and more urgent matters. However, just before the EP May 2019 elections, the ECB reiterated their interest and support for the SBBS product and philosophy. According to some members of the ECB Board the introduction would help shield the region’s financial markets from future crises. Politically, however, the idea still seems stillborn. See C. Look, (2019), ECB Call to Discuss Safe Assets Signals Renewed Push for Action, May 16, via bloomberg.com 429  The Dutch CPB carefully and prudently conclude that ESBies might increase financial stability in the euro area. ESBies can achieve the goals of increasing the supply of safe assets and weakening the sovereign-bank nexus. ESBies may, however, suffer great losses in a systemic crisis, and the

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crisis and the euro crisis that followed a few years later it became clear that cross-border trust in the sovereign paper of other EU nations was limited and that a protracted process could impair financial stability. Solving that problem makes perfect sense. The question that keeps resurfacing is how exactly that should be done. It was discussed before in this chapter how problematic it is to create safe assets out of a pool of assets that are not considered all 100% safe. It is therefore no surprise that the initial SBBS proposal was lukewarm received. Most financial parties involved poured cold water on the proposal and stated that a number of essential criteria to successfully develop a market for SBBS have not yet been met. As a risk reduction rule it is idle as financial players can already pool sovereign debt and issue securities. In order to generate demand the proposal included a zero-risk weight to the new product including the beneficial capital requirements as is the case for AAA-rated sovereign debt. Risk distribution can also be done better by markets with existing product than under the proposal using a single security where investors would hold tranches made of a fixed blend of national bonds. That is a couple of notches down from the level of sophistication global investors have been dealing with sovereign risk in recent times, whereby not so much economic fundamentals matter but rather the designation of a country.430 Also the link between the banking sector and the sovereign differ materially in Europe. Traditionally, four indicators are used to measure sovereign

implicit guarantees by euro area states cannot be completely ruled out. See in detail: K. Ji, (2018), A Review on ESBies. The Senior Tranche of Sovereign Bond-Backed Securities, CPB Background Document, June. Also: M.K. Brunnermeier, et al. (2016), The Sovereign-Bank Diabolic Loop and ESBies, American Economic Review Papers and Proceedings Vol. 106, pp. 508–512. R.J. Caballero, et al. (2016), Safe Asset Scarcity and Aggregate Demand, American Economic Review Vol. 106, Nr. 5, pp. 513–518. 430  M. Amstad et al., (2016), How Do Global Investors Differentiate Between Sovereign Risks? The New Normal Versus the Old, BIS Working Paper Nr. 541, January. They observe sovereign risk through CDS spreads. While the movements in global risk factors determine whether CDS spreads rise or fall over time, the extent to which these spreads rise or fall depends on the country. They conclude that ‘CDS returns in the new normal move over time largely to reflect the movements of a single global risk factor, with the variation across sovereigns for the most part reflecting the designation of “emerging market”.’ Designation as an emerging or mature market, however, lacks the granularity that one would have expected for a fundamental on which investors’ risk assessments are based. Also interesting in this context is the fact that the historic understanding that sovereign debt in local currency is safer than debt in foreign currency is no longer carved in stone as it used to be. The traditional line of thinking was that sovereign always has control over the money supply in the local currency, something it lacks in foreign currency terms. Recent research, however, demonstrates that the gap still exists but has become much smaller than traditionally measured. A slow and steady convergence of sovereign risk in local and foreign currency over the past 20 years has been occurring. Amstad et  al. observe that differences in inflation do not explain the assessed gaps between local and foreign currency credit risk (based on the credit rating of the three credit ratings provided by the global rating agencies). They find limited evidence of sovereigns’ willingness to inflate away their local debt in our measures of credit risk. The banking sector’s vulnerability to sovereign debt problems is a significant determinant of the spread, but does not account for its decline over time. Instead, the surge in global foreign exchange (FX) reserves, and to lesser extent the reduced reliance on overseas foreign currency borrowing (i.e. the decline of original sin), as well as lower global volatility, appear to have lessened the gap. See in detail: M. Amstad et al., (2018),

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risk and thus differences between countries. They include the long-term (ten-year) government bond yield spread, the CDS spread, the overall country risk score and the sovereign credit rating.431 Also the design of the tranches caused concern, as the high risk of contagion between European economies in turbulent times would further decrease the appetite for blended national debt. The EU tries to avoid a mutualization of losses as that is politically not achievable.432 When eurozone member states get into budgetary or overall financial trouble, the spreads between the member states bonds increase and, as was the case for Greece some years ago, ultimately stopped them from getting access to capital markets. That forced the EC and other member states to step in and bail out Greece. A repeat of that scenario is unwanted but issuing Eurobonds as well (whereby budget risks and political as well as fiscal risks are shared among member states).

Does Sovereign Risk in Local and Foreign Currency Differ, BIS Working Paper Nr. 709, March. Also observe the interesting literature list (pp. 21 ff.) regarding historic and contemporary research in the field related to the five ‘hypotheses’ to explain the traditional gap. In short the five arguments to explain the gap were: (1) the inflation hypothesis, that is, higher inflation lowers sovereign creditworthiness but less so for domestic currency debt—thus increasing the gap; (2) the reserves hypothesis, that is, high FX reserves (over GDP) increases creditworthiness, but more so for foreign currency obligations—thus diminishing the gap; (3) the original sin hypothesis, that is, lower original sin (greater international debt financing in local currency) raises sovereign creditworthiness and more so for foreign currency obligations—thus diminishing the gap; (4) the banking sector exposure hypothesis, that is, greater exposure of the banking sector to government bonds decreases sovereign creditworthiness, because of the mutual reinforcement of sovereign and financial system risk (the ‘doom loop’). Since this influence is expected to affect local currency obligations more strongly, banking sector exposure to sovereign risk will decrease the gap; and (5) the global volatility hypothesis, that is, high global volatility (as measured by VIX) lowers sovereign creditworthiness and more so for foreign currency obligations—thus increasing the gap. 431  J.  Bruha and E.  Kočenda, (2017), Financial Stability in Europe and Sovereign Risk, CESifo Working Paper Nr. 6453, Center for Economic Studies and Ifo Institute (CESifo) Munich, April. Their findings are mixed. In general, the stability and size of the banking industry are linked to lower sovereign risk in general. Foreign bank penetration and competition (a more diversified structure of the industry) are linked to lower sovereign risk. Bank efficiency (measured by lower NPLs) is correlated with lower sovereign risk. See also: C. Buch, et al. (2016), Banks and Sovereign Risk: A Granular View, Journal of Financial Stability, Vol. 25, pp.  1–15 R.  Kallestrup et  al., (2016), Financial Sector Linkages and the Dynamics of Bank and Sovereign Credit Spreads, Journal of Empirical Finance, Vol. 38, pp.  374–393; T.  Klinger and P.  Teplý, (2016), The Nexus Between Systemic Risk and Sovereign Crises. Czech Journal of Economics and Finance, Vol. 66, Issue 1, pp. 50–69; M.S. Pagano and J. Sedunov, (2016), A Comprehensive Approach to Measuring the Relation between Systemic Risk Exposure and Sovereign Debt, Journal of Financial Stability, Vol. 23, pp. 62–78; S. Yu, (2017), Sovereign and Bank Interdependencies—Evidence from the CDS Market, Research in International Business and Finance, Vol. 39, pp. 68–84. 432  See, for example, in detail K.  Best, (2018), Shared Scepticism, Different Motives: FrancoGerman Perceptions of a Common European Asset, Jacques Delors Institute Berlin, Center for European Affairs at the Hertie School of Governance, Working Paper, October 28. Although Germany and France both rejected the SBBS proposal as ‘a deeper investigation into the safe asset debate in both countries reveals considerable differences in how policy makers engage with safe asset proposals, assess the costs and benefits, and set conditions for its acceptability. These are rooted in more fundamental differences between the two countries in beliefs, values, and interests linked to

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Or, put differently, the term ‘sovereign-bank nexus’ is used to describe the link between the creditworthiness of a country’s government and that of its banks. The deterioration of sovereign creditworthiness in Greece, Ireland, Italy, Portugal and Spain during the sovereign debt crisis reduced the market value of their domestic banks’ holdings of domestic sovereign debt. The drop in value in turn reduced the perceived solvency of domestic banks and curtailed their lending activity.433 The initial group of economists that advocated the European Safe Bonds did so because they believed that the euro crisis was fueled by the aforementioned ‘diabolic loop’ between sovereign and bank risk, coupled with cross-border ‘flight-to-safety’ capital flows, and that the ESBies would help to resolve these problems. It comes as demonstrated with many complications and the EC has a perpetual inclination to blind-eye risk dynamics that come with tranching and securitizing loans books regardless whether they are mortgages or sovereign bonds. Beyond the little appreciation of the idea received from the political scene, it became clear throughout the legislative process that if this will ever become realistic it will only be after many more analyses and consultation with stakeholders, also in the private sector. Ultimately, somebody has to buy these things.434 And it is far from sure that the SBBS model, as it is suggested at this stage, will have a buying audience, in particular when it comes to the junior tranches an SBBS model would produce. No wonder responses varied from ‘the existence of an investor class willing and able to hold the subsequent large size of the junior tranche has yet to be demonstrated’ to ‘it is unclear whether there would be sufficient market capacity to absorb” a 10%-thick junior tranche.’435 Also researchers have been casting doubt and indicated436 that ‘if the market for the junior tranche broke down, the whole concept would collapse’ and ‘the prospective holders of junior SBBS would require a high return such that the yield on senior SBBS would be negative in the current interest rate environment’. They continue: ‘the attractiveness of junior SBBS depends on clear com-

economic policy. Broadly, while the French debate is heterogenous, technical, and focused on assessing the present effectiveness of a safe asset in improving Euro area financial stability, the approach in Germany is more uniform, straightforward, and focused on avoiding moral hazard and other long-term risks,’ Best concludes. 433  A. Delivorias and J. Ulic, (2018), Sovereign Bond-Backed Securities, Risk Diversification and Reduction, Briefing EP, September 13; K.  Brunnermeier et  al., (2016), The Sovereign-Bank Diabolic Loop and Esbies, NBER Working Paper Nr. 21993, National Bureau of Economic Research, Cambridge, USA, February. Also N.  Gennaioli, et  al., (2018), Banks, Government Bonds, and Default: What Do the Data Say?, Journal of Monetary Economics, Vol. 98, pp. 98–113. 434  In the run-up to the European Parliamentary Elections of May 2019, the legislative process on this matter slowed significantly, and the Parliament or Council have not yet issued any draft position on the subject. It is for the new Parliament that comes in July 2019 to revive the whole thing. At this stage it is anticipated that it will take years for the idea to become reality and the risk still is that the idea will be stillborn. See for an analysis of the position pre-elections: J. Deslandes et al., (2018), Are Sovereign Bond-Backed Securities (‘SBBS’) a ‘Self-Standing’ Proposal to Address the Sovereign Bank Nexus, EP Briefing, September, via europarl.europe.eu 435  See for an overview: J. Deslandes et al., (2018), ibid., pp. 10–12. 436  M.  Demary and J.  Matthes, (2017), An Evaluation of Sovereign-Backed Securities (SBSs), Potentials, Risks and Political Relevance for EMU Reform, Cologne Institute for Economic Research, IW Paper Policy Paper Nr. 12/2017.

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munication to investors that the euro area policy stance on fiscal discipline will not weaken as a result of SBBS issuance.’ There is even doubt if the senior tranche of an SBBS would be attractive to typical fixed-income investors: ‘[German] banks might tend to favor German bunds as safe assets over a new and untested asset class.’ Sovereign bond investors tend to be very risk-averse investors. I have displayed sufficiently in this chapter and the chapter on securitization what the ‘known and unknown unknowns’ are of using a securitized model. Politico437 summarizes them in three categories of issues: 1. Concentration risk: A portfolio of sovereign bonds will consist (in the euro area) of only 19 sovereign packages. In case of a corporate bond portfolio it typically is a multiple of that volume and is the portfolio diversified in terms of industries and geographies. The effectiveness would be reduced, while the SBBS would overall reduce the amount of AAA-rated assets available in the marketplace.438 2. Correlation: There will be much higher correlation between the eurozone sovereign bonds. Concentration and high correlation indicate a less effective securitization instrument, and less powerful in terms of supporting both the senior and the junior tranches. 3. External liquidity support: In case a default would occur in an SBBS, one needs an external liquidity backstop while operating recovery frameworks in order to pay coupons. That is far from the reality the 14 economists had in mind that put the whole SBBS idea into the limelight.439 A fourth concern can be added as AFME440 indicates: ‘[a]sset-backed securities have traditionally been less liquid than government bonds. Therefore it is unclear to us whether a sufficiently large pool of investors would be attracted to SBBS as investors can already build portfolios replicating what would be the underlying portfolios of SBBS, with the ability to shift risk more easily than if they were holding tranches of SBBS.’ If the market tries up for the junior tranches, a default will cut not only fully through the SBBS (into the senior tranches), but it will also lead to a risk of full and unconditional debt mutualization through a bail-in. You can block any financial guarantee for that purpose (for the senior tranches) like the ESRB Task Force/European Debt Agency suggests, but it will not make the problem go away. And what will happen in distressed scenarios? Well, the first exclusion is already included in the EC’s proposal which indicates that ‘sovereign bonds of a particular  B. Smith-Meyer, (2018), No AAA for ESBies, May 30, via politico.eu.  ‘Since some “AAA” rated sovereign bonds are likely to be repackaged into lower-rated ESBies’ according to a study done by the S&P in 2016: M. Kraemer, (2016), How S&P Global Ratings Would Assess European ‘Safe’ Bonds (ESBies), via politico.eu. S&P also indicates, in the same study, that given the lack of diversification of the sovereign bond portfolio underlying ESBies, and the high correlation of eurozone sovereign default risk, we would likely rate ESBies in the lower half of the investment-grade category. Credit ratings of SBBS would mainly depend on whether this financial instrument brings about the required level of diversification and low correlation. 439  A. Bénassy-Quéré et al., (2018), Reconciling Risk Sharing with Market Discipline: A Constructive Approach to Euro Area Reform, CEPS Policy Insight Nr. 91, January. 440  AFME, (2018), European Commission Inception Impact Assessment  – Enabling regulatory framework for the development of sovereign bond-backed securities, Consultation response, February 20, via afme.eu. 437 438

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Member State may be excluded from the underlying portfolio when and until the issuance of sovereign bonds by a Member State is significantly limited due to a reduced need for public debt or impaired market access’. On top of all that Claeys indicates that ‘for other countries, finding buyers for junior SBBS in bad times would become crucial as this would limit the possibility of issuing any SBBS at all during stress periods’.441 Distressed scenarios in the market tend to lead to a flight to ‘safety’ and ‘simplicity’. Structured products also perform worse under distress. That, combined with the initially expected low liquidity levels in the market when demand for the SBBS product builds up, probably leads the initial group of advocates for the SBBS products to envisage some sort of ‘centralized swap mechanism’ whereby banks could swap a portfolio of sovereign bonds for senior and junior SBBS. The economic and financial subcommittee within the Committee on Sovereign Debt Markets summarizes the pain that seems to come from all angles and dimensions when it comes to the SBBS product when indicating that ‘from a broader and more fundamental point of view, assessing the risk and payoff of such a complex financial product as SBBS implies necessarily assessing the probability of a partial or generalized sovereign default event in the Eurozone’, which implies ‘initiating debates on very complex and politically sensitive issues’.442 Claeys gets, in my understanding, very close to the truth when lambasting that ‘SBBS do not fully fulfil their original promises. If introduced on a massive scale, they might increase the supply of safe assets in good times and loosen the link between sovereigns and banks. But they will not give governments a means to maintain market access during crises, they might change incentives for governments to default, and they could pose a problem to individual bonds not included in SBBS if, in the end, they are put at a regulatory advantage vis-à-vis individual bonds.’443 But who will tell, it might be that the SBBS idea will be buried and replaced by the ‘Sovereign Concentration Charges’.444 The idea is to create a Sovereign Concentration Charges Regulation (SCCR). But what entails the SCCR?445 The SCCR would add sovereign exposures above a certain threshold (defined as a ratio to Tier 1 capital), weighted by a coefficient (sovereign concentration charge) that increases with the exposure ratio, to risk-weighted assets in the capital ratio’s denominator.446 The charges for concentrated sovereign exposures to different euro-area countries would add up. The proposed calibration for the SCCR errs on the side of leniency, to avert any risk of disturbance in sovereign debt markets. Sovereign

 G. Claeys, (2018), Are SBBS Really the Safe Asset the Euro Area are looking for, via bruegel.org, May 28. 442  Economic and Financial Committee letter of 23 June 2017 to the DG Economic and Financial Affairs, via europe.eu. 443  G. Claeys, (2018), ibid. 444  N.  Véron, (2017), Sovereign Concentration Charges: A New Regime for Banks’ Sovereign Exposure, Working Paper, via Bruegel.org, November. 445  See N. Véron, (2017), ibid., p. 5. 446  G. Cappelletti et al., (2019), Impact of Higher Capital Buffers on Banks’ Lending and RiskTaking: Evidence from the Euro Area Experiments, ECB Working Paper Nr. 2292, June. Banks identified as systemically important institutions reduced, in the short-term and when faced with capital surcharges given their systemic nature, their credit supply to households and financial sectors and shifted their lending to less risky counterparts within the nonfinancial corporation sector. 441

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exposures under 33% of Tier 1 capital would be entirely exempted. The marginal capital charges on concentrated exposures would be mild for exposures up to 100% of Tier 1 capital, and rise more steeply above that level. Should this calibration turn out to have an insufficient impact, it could be strengthened at a later stage. The proposed transitional arrangements are also designed to ensure a smooth path toward the new regime even if market conditions become less favorable than currently. The transitional arrangements include extensive consultation with market participants, a gradual phase-in over a long period and grandfathering (i.e. exemption from the concentration charges) of all debt issued before the SCCR’s entry into force. The SCCR does not require any consideration of a euro area ‘safe asset’, but can easily accommodate a safe asset if it is introduced and incentivize its use if deemed appropriate. It is expected that most banks will respond to the introduction of the SCCR by diversifying their sovereign exposures away from their current home bias, but leaving them largely unchanged in euro area aggregate. In case the model delivers in reality the SCCR would significantly reduce bank-sovereign linkages and thus strengthen the banking union, foster greater EU financial integration and increase financial stability for each member state and for the European Union as a whole.

3.17.5 Alternatives to the SBBS Model Maybe, the whole safe asset discussion is idle without even knowing. Gros447 indicates that the banking system of the euro area can be stabilized even without creating a new ‘safe’ asset. The real problem is the concentration of risk on bank’s balance sheets in the form of large holdings of bonds of the home sovereign. Diversification should be the first priority. But the current regulatory framework hinders diversification of sovereign risk because existing investment funds of euro area government bonds are treated as if they were much less safe and liquid than the individual government bonds themselves. Enabling SBBS is useful, but it requires a new framework for the tranching involved, with no track record in markets. It is thus highly uncertain whether SBBS will be widely adopted. The model proposed by Gros relies on an existing globally recognized framework (e.g. the Luxembourg or Irish UCITS or electronic-traded funds), widely used by market participants today. In operational terms the model suggested by Gros would imply that regulators should treat regulated funds based on the assumption that they invest only in euro area government securities in the same way they treat the underlying government bonds (the ‘look-­through approach’). This applies in particular to two key issues: capital and liquidity requirements. As long as government bonds have a zero-risk weight (under the standard Basel approach), euro area banks should not have to hold any

In the medium term, the impact on credit supply is attenuated, and banks continue to shift their lending to less risky counterparts within the financial and household sectors. 447  D. Gros, (2018), Does the Euro Area Need a Safe or a Diversified Asset, CEPS Policy Brief, Nr. 3, Brussels, May 24. See in contrast the arguments of the EU in favor of an SBBS model: EC, (2018), Frequently asked questions: Enabling framework for sovereign bond-backed securities, Factsheet, Memo/18/3726, May 24.

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additional capital on funds based only on euro area government securities. The same treatment should apply to the LCR, which obliges banks to hold a buffer of cash or liquid high-quality securities. Investment funds (or ETF) of euro area government bonds should be put into the same liquidity category as government bonds themselves. Diversified funds of the debt of many countries have a more stable market value than even the safest ­individual country bond. They should thus become the preferred instrument to satisfy liquidity needs. Funds that contain euro area government bonds in proportion to the capital key in the ECB should be recognized as ‘diversified’ and therefore exempted from the large exposure limits, Gros explains. It is an interesting idea, with known instruments and concepts.448 Another alternative suggested was brought to the table by Tonveronachi.449 He proposes the alternative in line with the three issues he identified in the SBBS model. The three issues he saw were450: • The lack of a truly common yield curve for the common currency area, which renders its financial markets fragmented. • The excess of public debt beyond the Maastricht ceiling, which is taken as an indicator of unsustainable debt and requires strong fiscal convergence conditions. • The vicious spiral between bank and sovereign crises, with the new bank resolution regime intended to impede bank crises from impinging on public debt and the possession of safe European debt securities by banks shielding them from sovereign crises. The corresponding alternative embodies451: • The solution is based on the ECB absorbing a share of national debts according to the ECB capital keys and issuing its own safe assets along the maturity spectrum needed to produce a euro area yield curve (solution to problem 1). The ECB would render stable the sovereign debt acquisition made with the ongoing Asset Purchase Program (APP) and transform the liquidity thus created into its own debt certificates (DCs), which by statute it can issue without limits on volume and maturities. Those DCs would entirely replace national sovereign bonds as collateral for the operations of financial institutions with the ECB.  See his memo for the technical workout, in particular pp. 3 ff.  M. Tonveronachi, (2018), European Sovereign Bond-Backed Securities: An Assessment and an Alternative Proposal, Levy Economics Institute of Baird College, Public Policy Brief Nr. 145. Tonveronachi already published earlier draft of his model; see: M. Tonveronachi, (2014), The ECB and the Single European Financial Market: A Proposal to Repair Half of a Flawed Design. Public Policy Brief Nr. 137. Annandale-on-Hudson, NY: Levy Economics Institute of Bard College. September. M. Tonveronachi, (2015), Revising ECB Operations and the European Fiscal Rules to Support Growth and Employment. Journal of Post Keynesian Economics, Issue 38, pp. 495–508. M. Tonveronachi, (2016), Three Proposals for Revitalizing the European Union. PSL Quarterly Review Vol. 69, Issue 279, pp. 301–336. 450  M. Tonveronachi, (2018), ibid., p. 4. 451  M. Tonveronachi, (2018), ibid., pp. 9–10. 448 449

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• The liabilities of the ECB would be the safest assets available. A new form of seigniorage would be created ‘due to the difference between the yield of the national debt the ECB holds and the yield of the corresponding DCs it issues’. The seigniorage earned by the ECB would be paid back to national governments according to this difference in yields—thus without entailing transfer of resources between countries. All Euro area governments would pay the same safe interest rate on the share of their debt held by the ECB. Debt sustainability would be measured by the volume of sovereign debt of member states by the market, thereby triggering lower returns and minimal spreads across themselves. Taking a share of sovereign bonds out of the market increases the sustainability of sovereign debt (solution to problem 2). • The current excess liquidity created by the APP would migrate into DCs of different maturities. Sovereign bonds retained by banks would be subject to regulatory requirements according to their merit of credit and with concentration limits. Compared to current practice, this more unfavorable treatment—which is strongly opposed by several member countries—would end banks’ current excessive exposure to national debt (solution to problem 3). The end result would be that common risk-free assets along the maturity spectrum of the yield curve would end the structural fragmentation of the EU banking system and contribute to a unified banking model. Every debtor would play on a level playing field. The ECB would issue new DCs and consequently buy new sovereign bonds of the secondary market only to the extent matched by demand for liquidity coming from the market. As indicated before, national indebtedness toward the market would decrease and debt sustainability would improve. Guiding new fiscal rules would be required to control and enforce debt ceilings. It could be organized in such a way that it triggers strong incentives for governments to comply. Countries out of compliance would be expelled from the scheme, obliged to pay for the difference between the purchasing and selling price of the debt held by the ECB, and returned to the current arrangement. That way, the indirect risk of sovereign debt mutualization is neutralized.452 Noncompliance with the framework would then become (highly) unlikely due to the fact that ‘the initial debt acquisition by the ECB, its effect on cutting the present value of debt by reducing interest payments, its dynamic impact on growth and debt, and the strong incentive to comply with the rules would send clear signals of debt sustainability to the markets, thus progressively reducing interest payments on the entire stock of debt—a virtuous dynamic path’.453 This contrasts deeply with the asset purchasing model currently engaged by the ECB that indirectly creates debt mutualization for the volumes held by the ECB.

 See for criticism on the model: A. van Reit, (2017), Addressing the Safety Trilemma: A Safe Sovereign Asset for the Eurozone. ESRB Working Paper Nr. 35. Frankfurt am Main: European Systemic Risk Board. February 453  M. Tonveronachi, (2018), ibid., p. 10. 452

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3.17.6 A  re There Downsides to (Private) Safe Asset Creation? We have already elaborated in this and other chapters on the issue of private money creation and why there is demand for safe assets. The conclusions were that, besides the fact that demand isn’t going to go away any time soon, private safe asset creation has implications for the role of the state/central bank in terms of being the ultimate backstop. Private money creation and public money creation have different functionalities and the market responds different to them. They have in common that they are both information-insensitive instruments but that once contagion and systemic risks occur the market responds in an asymmetric way to private securities, despite their qualification as ‘safe’. Also the question arose if the central bank should then engage in producing as much safe assets as the market is looking for (and increasing government debt in a low interest rate environment), assuming there is a limit to that demand. As long as some kind of return is warranted on what essentially is a safe asset, there will be actual or at least artificial demand. Return without some sort of risk is ultimately an anomaly. That somebody else picks us that risk (the sovereign) is also an anomaly as it doesn’t change the qualification as a risk-free issuer of public money. That risk then simply goes away? We’re getting into a deadlock here without a lot of answers. Maybe there are no answers to anomalies of this nature. What we do know, however, is that there definitely are side effects to the creation of ‘safe assets’. We concluded before that ‘higher risk increases the demand for safe assets, lowering the natural rate of interest below zero,454 constraining monetary policy at the zero lower bound, and raising unemployment. Higher government debt455 satiates the demand for safe assets, raising the natural rate and restoring full employment. While this permanently lowers investment, a policy maker committed to low inflation has no alternative. Higher inflation targets, instead, permit both full employment and high investment, but allow for harmful bubbles.’ Acharya and Dogra conclude in the same direction.456 In

 Liquidity and safety premia are the main drivers in the decline of the natural interest rate. See in detail: M.  Del Negro et  al., (2017), ‘Safety, Liquidity, and the Natural Rate of Interest’, Staff Reports Nr. 812, Federal Reserve Bank of New York, May. 455  Traditionally treated as the only ‘real safe asset’. 456  S. Acharya and K. Dogra, (2018), The Side Effects of safe Asset Creation, Federal Reserve Bank of New York Staff Reports, Mr. 842, August. They treat government debt as a ‘safe asset’ in the literal sense that ‘its return does not co-vary with a household’s marginal utility, unlike the return on capital, the other asset in our economy’ (p. 3). Other definitions focus on liquidity, default risk and so on—see footnote 9 for literature references. Also: R. Caballero et al., (2017), The Safe Asset Shortage Conundrum, Journal of Economic Perspectives, Vol. 31, Issue 3, pp. 29–46. Regarding the shortage of safe assets during periods of market stress, see R. Aggarwal et al., (2017), Safe Asset Shortages, Working Paper, December 15, mimeo. They first identify the unique role of the government bond lending market in accessing safe assets during periods of market stress. It gets interesting when they conclude that market participants are able to obtain safe assets using relatively lowquality non-cash collateral, allowing for collateral transformation. These attributes are important since they increase the velocity of safe assets and hence alleviate the pressure of safe asset shortages. 454

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a geriatric economy with surplus liquidity, there is a higher demand for safe assets, driving the natural interest rate down. But there is another downside: the demand for safe assets drives down or better crowds out investments.457 Producing safe assets (in line with demand) in itself is good as it avoids a liquidity trap, but the unlimited creation of safe assets by a government has a material downside and may be restricted because issuing safe assets exposes a sovereign to self-fulfilling confidence crises or real appreciations. Despite being a theoretical risk for the moment, there is another downside: issuing safe assets prevents liquidity traps; it crowds out investment, reducing the full-­employment level of GDP.458 The analysis of Acharya and Dogra can be positioned within the understanding that public debt relaxes private constraints. They demonstrate and conclude that the natural rate of interest is affected both by idiosyncratic risk and by fiscal policy. By increasing the supply of safe assets, they can prevent an increase in risk from driving the natural rate below zero. Negative interest rates, however, do not mean there is a shortage of safe assets. ‘While fiscal policy can keep the natural rate positive, the optimal natural allocation allows risk to drive the natural rate below zero, because ­increasing debt crowds out investment.’459Public policy that I committed to low inflation and full employment might be faced with the necessity to step away from an optimal natural allocation,460 and produce safe assets to raise the natural rate and prevent an economic downturn. It, however, crowds out investments further. Acharya and Dogra recommend as an alternative to increasing government debt, to engineer negative real interest rates through, for example, higher inflation targets as that would sustain investments, thereby acknowledging that negative real rate is often the root cause of bubbles which can often be fought with aggressive fiscal policy. Bubbles in itself can in their turn depress investments. Their model can explain a lot of what we are witnessing in reality. Government debt has risen in many Western countries and reaching new full employment, output, investments, labor productivity and capacity utilization remains persistently below pre-crisis levels.461 Whatever way we want to take the discussion on safe assets, McCauley462 conveys the message that we need not worry about a shortage of safe assets. He analyzes whether demand for dollar safe assets will grow as rapidly as emerging market economies (EMEs). Second, it turns on whether the supply of dollar safe assets only grows with US fiscal deficits. Neither holds. The US Treasury does not have a monopoly in the production of safe

 Most recently: E.  Farhi, and M.  Maggiori, (2018), A Model of the International Monetary System, Quarterly Journal of Economics, pp. 295–355. 458  S. Acharya and K. Dogra, (2018), ibid., p. 4. 459  S. Acharya and K. Dogra, (2018), ibid., p. 30. 460  Also: M. Magill et al., (2019), The Safe Asset, Banking Equilibrium, and Optimal Central Bank Monetary, Prudential and Balance Sheet Policies, Journal of Monetary Economics, available online, sciencedirect.com, February 19. 461  S. Acharya and K. Dogra, (2018), ibid., p. 31. 462  R.  N. McCauley, (2019), Safe Assets: Made, Not Just Born, BIS Working Paper Nr. 769, February. 457

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US dollar assets, at least insofar as such assets are measured by the holdings of official reserve managers. The risk of an excess of US Treasury securities seems more clear and present than any shortage. But then again safe assets are systemic because they are the medium of exchange in risky assets. Because safe assets have intrinsic value, changes in their supply lead to changes in market efficiency. Additionally, because safe assets are costly to produce, there is overproduction of safe assets relative to the social optimum.463 But what makes an asset safe? Is it a relative or an absolute concept, and this despite the technical criteria you can use to judge that question? He et  al.464 studied a model where two countries each issues sovereign bonds to satisfy investors’ safe asset demands. The countries differ in the float of their bonds and the fundamental resources available to roll over debts. A sovereign’s debt is safer if its fundamentals are strong relative to other possible safe assets, not merely strong on an absolute basis. If demand for safe assets is high, a large float enhances safety through a market depth benefit. If demand for safe assets is low, then large debt size is a negative as rollover risk looms large. So it’s a relative game, not an absolute game. That implies that investor psychology is a more central theme in systemic risk and financial fragility terms that absolute safety, if that is a concept that effectively exists. A rethink of the nature of economic risk is required.465

 M. Eden and B.S. Kay, (2018), Safe Assets as Commodity Money, Journal of Money, Credit and banking, available online through Wiley online library, October 8. 464  Z. He et al. (2019), A Model for Safe Asset Determination, American Economic Review, Vol. 109, Nr. 4, April, pp. 1230–1262. 465  See extensively: N. Gennaioli and A. Schleifer, (2018), A Crisis of Beliefs. Investor Psychology and Financial Fragility, Princeton University Press, NJ. 463

4 Shadow Banking in the Americas

4.1 Introduction The Financial Stability Board (FSB),1 starting December 2012, has been conducting regional studies2 regarding the shadow banking (SB) sector complementing the global studies it conducts for quite some years now. The idea is to achieve a better understanding of the shadow banking market in these jurisdictions and identify specific characteristics of the shadow banking sector, in this case in the Americas. That includes in this case the ambition to capture offshore shadow banking activities in international financial centers (IFCs) and their relationship with the onshore financial system. As already highlighted before, IFC typically engages in material levels of credit intermediation (large volumes of bank and nonbank credit intermediation), but up till now the availability of data has been dismal or at least incomplete. The specific reporting by region by the FSB allows to cater more specifically the financial sector in that region. That includes the role of development banks and the assessment of the share of public sector ownership in commercial banks. Also the investment funds subset was split into money market mutual funds, private investment funds and public investment funds compared to the global data set. The global set indeed divides investment funds into money market, hedge funds and other funds c­ ategories. The changes were made in the understanding that ‘the private funds category reflected the characteristics of hedge funds while capturing other funds with very similar characteristics that are not labelled as “hedge funds” in participating jurisdictions’.3 A third item that was included specifically for the Americas was the assessment of the assets of nonbank credit card companies. All that falls somewhat outside the typical shadow banking market, but  To be precise, the FSB Regional Consultative Group for the Americas (RCGA) within the FSB.  See in detail: FSB, (2014), FSB Regional Consultative Group for the Americas. Report on Shadow Banking in the Americas; also, infra in this chapter. 3  FSB, (2014), Global Shadow Banking Monitoring Report, p. 41. 1 2

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an understanding of its size, functioning and how they relate to the ‘real’ shadow banking SB market, provices useful insights about the shadow banking market itself. With respect to the IFCs, the assessment methodology splits the pool of financial assets into those that are held by local and those by offshore institutions. In defining offshore institutions, they have used a ‘de jure’ basis as ‘those that by regulation are precluded from participating in  local financial markets or are restricted from offering financial services to domestic residents’.4 That categorization has some drawbacks. For example, and even in the absence of regulatory prohibitions, many IFC institutions often in reality focus on providing services to nonresidents only.

4.2 F indings Regarding Shadow Banking in the Americas Banks dominate financial activities in the Americas, as they hold close to 40% of financial assets. That share however has been declining during the decade due to the growth of the other financial intermediaries (OFI) sector. The largest economies of the region such as the US, Canada, Brazil and Mexico also have the largest OFI sector.5 That group is followed by the Cayman Islands with domestic assets totaling USD 127 billion. When adding offshore assets that total increases to USD 1963 billion. The average composition of the OFI sector in the Americas is pretty similar to that in other parts of the world with a somewhat higher share for the ‘broker-dealers’ in some American jurisdictions. What was also remarkable in the findings was the fact that in some jurisdictions the link between the shadow banking and the banking sector is very tight. For example, in Canada the exposure to OFI by banks is close to 10% of banks assets. As a remainder, globally that is somewhere between 1% and 5%. In other American jurisdictions (Brazil, Chile, etc.), banks rely on funding by OFI. That occurs often through investment funds and not through balance sheet interconnectivity. For the IFCs in the Americas, the reporting offshore assets are held by banks that operate under specific banking licenses, captive insurance companies and catastrophe bonds (fixed duration bonds that repay investors if the stated peril does not occur during the duration of the bond). In terms of data sets for those IFCs, the offshore assets (2013) of the Cayman Islands amount to USD 3.3 trillion (1600% of gross domestic product or GDP). For Panama, this amounts to USD 16.6 billion or 45% of GDP. Almost 56% of the offshore assets are held by investment funds with the remaining 44% held by special license banks.

 FSB, (2014), Global Shadow Banking Monitoring Report, p. 42.  FSB, (2014), Global Shadow Banking Monitoring Report, Exhibit A5–1, p. 43.

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4.3 T  he Real Shadow Banking Exposure in the Americas The areas6 identified as being of material interest in terms of posing a potential risk to financial stability due to its connections to the banking sector in the region or its role in the markets relative to banking sector funding or liquid assets can be categorized in four distinct categories: 1. Open-ended investment funds: They make up a larger portion of the OFI sector than in other countries or regions in the world, particularly in Brazil, Chile and the US, where their role in bank funding is material. In particular, money market funds (MMFs) provide a large part of funding to the banking sector especially in the US and Chile. Large changes in the portfolio construction of these funds have the potential to affect the valuation and liquidity of those assets materially, which then can translate into a systemic effect which contagion exposure to the banking sector. 2. Broker-dealers: In some of the American jurisdictions, the broker-dealers are sizeable and highly levered and engage in maturity transformation. That often happens through offering short repo products to households and firms to finance the purchase of long-term public debt. More in general, the risk arises from the material presence of lightly regulated broker-­dealers ‘in retail public debt markets the imperfect legal protection of the collateral in the secured financing operations and the lack of awareness of the risks by retail clients’.7 3. Nonbank deposit-taking institutions: These institutions provide similar roles than the banking sector by intermediating credit and therefore p ­ roviding maturity transformation. In most jurisdictions, they have, like banks, access to deposit guarantee systems, central banking liquidity facilities so that the typical ‘moral hazard’ of the banking sector is also applicable in this subsegment. They are regulated and supervised like banks, but the intensity varies materially in the Americas. As Basel III is gradually implemented, the gap between regulation and supervision of these institutions and the banking sector will be widening in the areas of capital adequacy standards, liquidity and leverage rules, and this will leave the door open for regulatory arbitrage. 4. Finance companies: Finance companies including nonbank credit card issuers are also a potential concern, in particular Chile, Mexico and Uruguay. The sources of vulnerability vary from ‘potential risk that households may leverage up through credit from these entities, or that they become significant in banks loan portfolios’ (Mexico, Chile). The latter would be caused by increased competition coming in from the banking sector which forced those entities into riskier credit segments. That in itself is problematic, in particular when regulation and supervision is very heterogeneous.

6 7

 FSB, (2014), Global Shadow Banking Monitoring Report, pp. 44–45.  FSB, (2014), Global Shadow Banking Monitoring Report, p. 44.

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4.4 A  Closer Look at the Shadow Banking Industry in the Region 4.4.1 Introduction What will follow is a detailed review, within limits, of the shadow banking market on the American continent. Two preliminary points of attention deserve further detailing. In contrast to other surveys and reports conducted and issued by the FSB, the survey regarding the Americas sets itself apart in two distinct ways: (1) the template with respect to vulnerabilities was adjusted to better reflect the financial sector in the Americas, in particular the role of public sector financial institutions was identified and investment funds were split into money market mutual funds, private investment funds and public investment funds; and (2) a new template was developed to capture offshore shadow banking activities in international financial centers8 and their relationship with onshore financial centers. This was done as no comprehensive framework for data collection and analysis exists. However, this is an important part of the total puzzles as ‘presumably large volumes of bank and ­nonbank credit intermediation activities flow through IFCs’.9 The first point of analysis is that for the region as a whole, and as indicated above, banks still dominate financial activities as they hold close to 40% of financial assets. This rate has been declining in a relative fashion given the growth of OFIs. The relative weighting of the most important categories (banks, OFIs and pension/insurance funds) is fairly similar in the region mirroring the global outlook. To be precise, banks account for 40% in the Americas versus 51% in the global survey, pension funds and insurance firms for 19 and 15%, respectively, and OFIs for 24 versus 17%.10 The OFIs are the largest in percentage terms in developed financial centers including the US, Canada, Brazil and Mexico. Banks are the largest holders of assets in most countries, except the US, the Cayman Islands and Jamaica, with Panama topping the ranks with over 70% of total assets. Pension funds and insurance firms are more important in countries as Chile and Colombia.11  IMF, (2007), Concept of Offshore Financial Centers: In Search of an Operational Definition, IMF Working Paper, Washington. 9  FSB, (2014), FSB Regional Consultative Group for the Americas. Report on Shadow Banking in the Americas, pp. 3–4. Other adjustments were made to the global template; see for details: pp. 4–5. 10  For further details, see FSB, (2014), FSB Regional Consultative Group for the Americas. Report on Shadow Banking in the Americas, pp. 7–9. 11  See for a nice write-up of the evolution and status quo of the Colombian shadow banking segment: P. Cardozo and H. Vargas, (2015), Changes in Colombian Financial Markets over the Past Decade, in BCBS, (2015), What Do New Forms of Finance Mean for Central Banks, pp. 113–135; The shadow banking (SB) in Colombia has not grown faster than the traditional financial sector. However, it plays an important role with regard to bank funding. Assets amounted to USD 31 billion, equivalent to 14% of traditional financial sector assets and 8.5% of GDP (2013). Money market funds (MMFs) represent most of the activities conducted by SB entities in Colombia (65% of total assets). It may be concluded that MMFs concentrate the most important systemic risks, given their size and connection to the traditional financial system. In 2013, their total assets were equivalent to 4.6% of GDP, while their assets and liabilities with credit institutions accounted for 80% of their total assets. Their holdings of bank liabilities amounted to 8% of bank deposits in the same year. The share of illiquid assets in the total assets of MMFs is close to 60%, far higher than 8

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The size of the OFI is heterogeneous across the region when expressed against GDP. The FSB identified three clusters in this respect: ‘[i]n the first group, which is characterized by relatively large financial sectors, Canada and Panama have bank-dominated financial sectors, whereas Caymans Islands and the United States have sizable OFI sectors. In the second group (with medium-­sized financial sectors) Jamaica has a relatively larger OFI sector than Chile and Brazil. The remaining jurisdictions are in the third group with relatively small banking and OFI sectors.’12 Within the OFI sector, ‘the largest subsegment are investment funds (money market funds and other investment funds, which include public and private funds) and broker dealers’. ‘Other investment funds make up a significant share of the OFI sector in Brazil, Canada, Chile, Colombia, Mexico and the United States. Broker-dealers are important in Jamaica, Panama and Peru.’ Compared to the rest of the world, the breakdown of the OFI segments compares as follows: MMFs account for 8% in the Americas versus 7% globally, and other investment funds 35% versus 39%, respectively; broker-dealers account for 24% versus 9%, leaving a large unspecified rest category of 33% versus 45%. This rest category is heterogeneous and includes various types of finance companies (Chile, Mexico, Panama, etc.), structured finance vehicles (Brazil, Colombia, Canada, Cayman Islands, etc.) and nonbank credit card issuers. The structured finance vehicles, broker-dealers and nonbank credit card issuers were the largest-growing segments both in recent years and when judged over half a decade. Broker-dealers are an important class, not so much because of their size but because of leverage, liquidity mismatch and heavy reliance on short-term repo funding. Because of that broker-dealers in, for example, Colombia have to comply with a liquidity indicator, similar to Basel III LCR. Another risk under this topic is the intraday liquidity risk faced by broker-dealers. Given that they are not required to hold reserves at the Central Bank (CB), as banks do, they start their daily transactions with little cash at the CB. For the settlement of their transactions they depend on the cash they receive from other operations and on intraday credit provided by some banks. This dependence of

the same figure for US MMFs (40%). Nonfinancial cooperatives also involve risks that are nonnegligible. The assets of such entities, which comprise mostly loans, represented 2.1% of GDP in 2013. Hence, nonliquid assets and assets with maturities longer than one year amounted to 95% and 75%, respectively, of their total assets. Nonfinancial cooperatives do not have access to central bank open market operations or lender of last resort (LOLR) facilities, although their liabilities are partially guaranteed by a special deposit insurance fund. New regulation was enacted to deal with vulnerabilities in the repo market and with the liquidity risk of broker-dealers and money market funds. Regarding repo markets, first, the set of assets allowed as collateral was (more) restrictively defined. Second, rules that had been issued previously by the Colombian Stock Exchange (BVC) were included in a government decree, as a public regulation. Those rules set limits on transactions conducted on behalf of clients. In addition, exposures to transactions by an individual and to a single asset were restricted to 30% and 100% of the broker-dealer’s equity. Furthermore, an aggregate limit on the level of outstanding repos on a particular stock was established at 25% of the floating value of the stock. In a related area, haircuts were established as mandatory for sell/buybacks to cover the market risk of the underlying asset. New regulation was also enacted to deal with the liquidity risk of broker-dealers and MMFs (for details, see pp. 119–120). 12  FSB, (2014), FSB Regional Consultative Group for the Americas. Report on Shadow Banking in the Americas, pp. 9–13.

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incoming cash to settle the transactions poses a liquidity risk to the payment system. This can only be settled with material levels of collateral.13 The importance of the OFI segments is not only in its growing size but also its linkages with the banking sector. Canada tops the ranks with an exposure of the banking sector of 10%, followed by quite a distance by Brazil, Peru and Mexico. In fact, the balance sheet interconnectivity in the rest of the region is very low (1–4%), although this does not include derivative off-balance sheet positions between banks and OFIs, including possible derivative positions. In the opposite way, banks in Chile, Brazil and the Cayman Islands rely heavily on OFIs for funding. The involvement of the public sector is the largest in Brazil, Costa Rica and Uruguay, in particular through ownership of commercial banks. Mexico and the US have relatively large public financial institutions: ‘[i]n Mexico these are deposit-taking development lenders and government agencies that manage workers’ savings, mortgages and consumer durable loans. In the United States, these public financial institutions are the Government Sponsored Enterprises (GSEs) involved in providing housing finance.’14

4.4.2 Structure of the Americas Financial Systems Broadly speaking, the relative importance of the different entities in the financial sector of the jurisdictions in the Americas in scope has not changed significantly from the last assessment (2013–2014). Banks account for a relatively smaller share of total assets in the relevant in-scope jurisdictions (43%), while OFIs are relatively larger (19%), together with pension funds and life insurance companies (19%). Nonbank deposittaking institutions (nonbank DTIs) are a relatively small group. Brazil, Costa Rica, Panama and Uruguay stand out because of their high public sector ownership of commercial banks; the US and Mexico stand out for their large public financial institutions (development banks, government-sponsored entities [GSEs])), both very active in housing finance. There is significant heterogeneity across individual jurisdictions in terms of the relative importance of different financial entities. Banks have the largest shares of assets in all jurisdictions, except the US, the Cayman Islands and Jamaica; Panama the highest, exceeding 90% of total assets. In Chile and Colombia, insurance companies and pension funds are relatively more important. The OFI sector varies from close to 81% of total domestic assets in the Cayman Islands to less than 3% of assets in Uruguay and Panama.15

 See in detail on the position of broker-dealers in Colombia: FSB, (2014), FSB Regional Consultative Group for the Americas. Report on Shadow Banking in the Americas, p. 27. 14  FSB, (2014), FSB Regional Consultative Group for the Americas. Report on Shadow Banking in the Americas, p. 14. 15  See in detail: FSB, (2015), FSB Regional Consultative Group for the Americas Working Group on Shadow Banking, Second Report, October 9, pp. 8–11. 13

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4.4.3 Other Financial Intermediaries16 The size of the OFI sector is heterogeneous across the jurisdictions when measured against GDP. In most jurisdictions, the ratio of OFI assets to GDP is below the global average, which is consistent with the fact that most jurisdictions in the region are less financially developed. Larger economies, such as the US, Canada, Brazil and Mexico, have the largest OFI sectors. The Cayman Islands has the fifth largest OFI sector measured by onshore assets, and smaller jurisdictions such as Chile and Colombia are more dependent on bank intermediation and most of the financial assets are therefore held by banks. Based on that intensity, three OFI categorizations can be made for the Americas: (1) characterized by relatively large financial sectors, Barbados, Canada and Panama have bank-dominated financial sectors, whereas the Cayman Islands and the US have sizable OFI sectors; (2) jurisdictions with medium-sized financial sectors where Jamaica has a larger OFI sector than Chile and Brazil, and (3) they have relatively small banking and OFI sectors. The OFI sector has grown in recent years most in Argentina, Colombia and Costa Rica (through investment funds). Jamaica, Uruguay and Panama have known contractions. The largest subsectors of OFIs in the region are investment funds—money market funds and other investment funds, which include public and private funds. Investment funds make up more than 60% of the OFI sector in Barbados, Brazil, Chile, Colombia, Peru and the US. The second subsectors of OFIs are finance companies and structured finance vehicles (Panama, Uruguay). Composition is somewhat mixed as it can include leasing and factoring real-estate credit, and nonbank credit card issuers. Argentina, the Cayman Islands, Costa Rica and Uruguay have structured finance vehicles accounting for more than 30% of total OFIs.

4.4.4 Interconnectivity Between OFIs and the Banking Sector17 In Panama, exposure to credit risk from OFIs is more than 20% of bank assets. In the Cayman Islands, Panama, Brazil, Chile and Colombia banks rely on OFIs for funding— usually through investment funds. Balance sheet interconnections between banks and the OFI sector in the remaining jurisdictions are very low. They however do not always include off-balance sheet positions between OFIs and banks—like derivative positions. Somewhat of a blind spot (still) is the role and size of IFCs within the Americas: Bahamas, Barbados, Bermuda, British Virgin Islands, Cayman Islands and Panama. They operate, depending on the jurisdiction, via private funds, licensed banks, and (re)insurance companies. Some of these entities are regulated, but some very mildly.18  See in detail: FSB, (2015), FSB Regional Consultative Group for the Americas Working Group on Shadow Banking, Second Report, October 9, pp. 12–16. 17  See in detail: FSB, (2015), FSB Regional Consultative Group for the Americas Working Group on Shadow Banking, Second Report, October 9, pp. 17–18. 18  See in detail: FSB, (2015), FSB Regional Consultative Group for the Americas Working Group on Shadow Banking, Second Report, October 9, pp. 17–18. 16

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4.4.5 Remaining Blind Spots Despite the fact that finance companies (including microcredit) and open-­ended funds (in the context of liquidity and illiquid markets) were only the list of areas to further analysis, very little insight was provided and more is to be expected in that corner.

4.5 T  he Role of International Financial Centers in the Region19 Three jurisdictions are included here, that is, the Cayman Islands, Panama and Uruguay. An attentive reader could object as there are many more in the region. Indeed, the full set of IFCs in the region would include the following: Bahamas, Barbados, Bermuda, British Virgin Islands, Cayman Islands, Panama and Uruguay. But only the Cayman Islands, Panama and Uruguay are FSB members and provided the necessary data for analysis. For Panama and Uruguay, the reported offshore assets correspond to banks that operate with special licenses, while in the Cayman Islands they include special license banks, captive insurance companies, catastrophe bonds and non-public funds. Those special bank licenses normally prohibit deposit-­taking (from residents) and are limit the type of activities they can engage in (in the local market). These entities tend to be well regulated and supervised but intensity and prudential requirements tend to differ (sometimes materially) compared to full license onshore banks. In terms of asset volumes, the Cayman Islands front-runs the rest with about USD 3.3 trillion (or 1600 times their GDP), followed by Panama with USD 16.6 billion (45% of GDP) and Uruguay with offshore assets less than 1% of GDP. Of that large pool of Cayman island assets, almost 56% is held by OFIs, mostly investment funds, while the remaining 44% of offshore assets is held by special license banks. Those investment funds include hedge funds with different investment strategies: multi-strategy funds, commodities funds, index-tracking funds, global macro funds, emerging markets funds and funds that invest in distressed securities. However, as the FSB indicates, these data are prone to vulnerabilities and in particular underestimations. There are three reasons for this: (1) securitization vehicles are listed as included as they are not listed with the Cayman Islands supervisors, (2) broker-dealers don’t have to report their assets to the regulator (CIMA, or Cayman Islands Monetary Authority) in case they ‘(i) provide services exclusively to other companies in their group; (ii) provide services exclusively to sophisticated or high-net worth individuals; or (iii) are regulated in another jurisdiction’,20 and (3) closed-ended private funds and funds that have fewer than 15 investors are not required to report to CIMA. Lastly, also the role of nonbank deposit-taking institutions (credit unions, savings and loans cooperatives and building societies) shouldn’t be overlooked. Throughout the  FSB, (2014), FSB Regional Consultative Group for the Americas. Report on Shadow Banking in the Americas, pp. 15–18. 20  FSB, (2014), FSB Regional Consultative Group for the Americas. Report on Shadow Banking in the Americas, p. 16. 19

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region, they often are organized as cooperatives and maintain ‘a large share of deposits and consumer or mortgage lending’ while not having to adhere to Basel rules. With Basel III coming in, regulatory arbitrage is around the corner as they are the closest substitutes for traditional banking firm and their activities. They often hold large amounts of many customers, and therefore have the potential to meaningfully dislocate public trust under distress, in particular as not all of them are supervised, enjoy deposit insurance and have access to central banking liquidity.21

4.6 E  xisting Risks from Credit Intermediation in the Region Four areas have been identified in which shadow banking activity and volumes were significant and potential risks to the financial system could arise, also given their nexus to the traditional banking sector. These include22: • Open-ended investment funds: These are a sizeable part of the OFI subsegment, with material nexus with the banking sector (US, Brazil, Chile, etc.). That occurs either through MMFs (US, Chile) or through fixed-­income investment funds holding material portions of sovereign debt. Banks finance themselves through repos backed by sovereign funds as collateral thereby reducing liquidity risk. But the exposure (of banks to OFIs) can also be indirect. For example, large changes in positions in the asset management world in general can dislocate asset valuations (and liquidity) held by banks. Runs on funds can impact bank asset liquidity or access to their funds (when the funds invested in are experiencing heavy redemptions), even in case fixed net asset value (NAV) MMFs are absent. Direct and indirect linkages can be relevant channels for the transmission of liquidity shocks (contagion). Open-ended-funds and exchange-traded funds (ETFs) (in fact every fund that has short redemption periods but invests in longterm illiquid assets) deserve equal attention vis-à-vis MMFs in the shadow banking debate.23 • Broker-dealers: As indicated, in some jurisdictions in the region broker-­dealers are sizeable, highly leveraged and conduct in maturity transformation. Additionally, they offer their products to households and small- and medium-sized enterprises (SMEs), that is, by offering short repo-products (retail public debt markets) with imperfect legal collateral protection (Jamaica and Panama). These broker-dealers often are part of banks, creating liquidity risk for the latter. • Nonbank deposit-taking institutions: They perform similar roles to banks (providing credit thereby engaging in maturity transformation). Either they have no access to  See for a review of their regulatory and supervisory status per country: FSB, (2014), FSB Regional Consultative Group for the Americas. Report on Shadow Banking in the Americas, p. 18. 22  See in detail: FSB, (2014), FSB Regional Consultative Group for the Americas. Report on Shadow Banking in the Americas, pp. 18–21. 23  R.  Cifuentes, et  al., (2005), Liquidity Risk and Contagion, Bank of England Working Paper Series Nr. 264. 21

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deposit insurance mechanisms and central bank liquidity facilities or when they do, the typical moral hazard is largely visible. They can impact the financial infrastructure through linkages with banks and through confidence shocks originating from the retail saving segment of the market. • Finance companies and nonbank credit card issuers: They embody risks in some American jurisdictions (Chile,24 Mexico and Uruguay) by providing excessive leverage to households or as they engage in riskier credit segments (due to competition). Asymmetric regulation (car loans, leasing, factoring, etc.) makes the (regulatory) analysis somewhat shaky, or sometimes regulation and supervision are absent.

4.7 T  he Case of Shadow Banking in the Caribbean The Caribbean and its many offshore financial centers are somewhat of a particularity within the context of an SB analysis for the Americas. It was already illustrated that a significant portion of SB assets and activities occur in (or better through) the Caribbean region.25 Besides the large size of the shadow banking sector relative to its local GDP,26 another feature deserves separate attention, that is, that of the financial connectedness of the sector in the region and its material level of concentration in terms of the dominance of financial conglomerates involved. Indeed, financial sector linkages have been on the rise for quite some time and are characterized by a limited number of agents involved and with a significant portion of the transaction being cross-­border in nature. The greater connectedness can increase the level of systemic risk, but when properly managed can enhance financial stability for the greater good of the region and allows them to overcome scale constraints and fosters financial inclusiveness. That would require ‘consolidated supervision, increased cooperation across supervisors in the region, and the establishment of deposit insurance and crisis resolution frameworks’.27 Although historically the financial interconnectedness was fostered through the traditional banking channel, the OFI sector is steeply on the rise, which poses additional regulatory challenges. For a long time, the nonavailability of granular data regarding the interconnectedness and the nonbank sector was a material problem. But since in recent years most of the countries in the region have participated in the annual FSB exercise,  The government is bringing the General Banking Law into Basel III compliance, following a crackdown on shadow banking institutions, EIU, (2017), Chile Financial Services, October 4, via eiu.com. 25  The Caribbean countries covered are the Bahamas, Barbados, Belize, the Eastern Caribbean Currency Union (ECCU) countries, Guyana, Jamaica, Suriname and Trinidad and Tobago. The ECCU consists of Antigua and Barbuda, Dominica, Grenada, St. Kitts and Nevis, St. Lucia, St. Vincent and the Grenadines, and two British territories of Anguilla and Montserrat; the Organization of Eastern Caribbean States (OECS) consists of the ECCU countries and the British Virgin Islands. 26  However, in most countries the offshore and onshore banking systems are insulated and separated by ‘Chinese walls’. 27  S.  Ogawa et  al., (2013), Financial Interconnectedness and Financial Sector Reforms in the Caribbean, IMF Working Paper Series, Nr. WP/13/175. 24

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things have started to shine up. Interconnectedness is a double-edged sword ‘which, on the one hand, could increase risks, but on the other hand, could also help diffuse the impact of shocks given the scope for risk diversification in an interconnected “network”’.28 The dynamics and intensity of that and the relationship between interconnectedness and contagion risk are part of an ongoing debate with mixed results.29 The regulatory effort to supervise the (shadow) banking sector in the region doesn’t stop with supervisory frameworks of large banking groups and conglomerates. Ogawa et  al. comment: ‘[t]he operation of subsidiaries and branches across several jurisdictions, some of which lack strong consolidated supervision frameworks, could potentially lead to regulatory arbitrage or underestimation of risks.’30 That regulatory arbitrage can be of a country nature but also between traditional and shadow banking nature, especially with the OFI segment materially on the rise. In terms of systemic risk, it can be illustrated that notwithstanding dominant foreign ownership, the banking sector has been relatively resilient to external shocks. This stability can be attributed to the following mitigating factors: • The largest four banks in the region are well capitalized and their assets remain liquid. • The top three banks are part of an international network of Canadian banks whose share of foreign activities is largely made up of local currency and they are not dependent on wholesale funding markets. • The banking sector’s expansion into the overseas market has focused on traditional and commercial retail banking.

4.8 S  hadow Banking in Canada: Why Was Canada Not Badly Hit During the Crisis? The (shadow) banking system in Canada compared to its direct counterpart the US shadows many similarities, except for the way how services are provided.31 The Canadian shadow banking system is more concentrated (or the US one more fragmented), and that difference is largely due to regulation.32 They fueled the shadow banking system to take off. The other phenomenon is that when deregulation kicked in during the 1980s, Canadian banks absorbed securities brokerages, mortgage lending and other activities

 Ogawa et al., (2013), ibid., p. 9.  See for an overview Ogawa et al., (2013), ibid., p. 9, and a quantification of the financial sector interconnectedness in the region pp. 9–19. 30  Ogawa et al., (2013), ibid., p. 26. 31  See also P.  Watkins, (2011), Shadow Banking: Accounting for Canada’s Productivity Gap, International Journal of Productivity and Performance Management, Vol. 60, Issue 8, pp. 857–864. 32  See, for example, the regulation and supervision of credit union in Canada: FSB, (2015), FSB Regional Consultative Group for the Americas Working Group on Shadow Banking, Second Report, October 9, pp. 23. 28 29

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that occur outside of the banking sector in America.33 The Canadian shadow banking market stayed because of that much smaller than the US one, but most of its activities were and are regulated and explicitly guaranteed by the government, for example, through insurance or access to a lender of last resort. Canadian banks also kept their originate-to-hold model for mortgages. Less than a third of Canadian mortgages were securitized before the financial crisis, compared to almost two-thirds of mortgages in the US, Haltom illustrates. He adds: ‘[i]n Canada, banks can’t offer loans with less than 5 percent down, and the mortgage must be insured if the borrower puts less than 20 percent down. Mortgage insurance is available, moreover, only if the household’s total debt service is less than 40 percent of gross household income.’34 Canada’s shadow banking system grew to about 40%35 of the Canadian traditional banking system and GDP. Its four main subdivisions are (1) government-­insured mortgage origination, (2) private label securitization, (3) repos and (4) money market funds.36 All in all they are considered to be having a crisis-proof financial infrastructure37 with strict adherence to the newly enhanced regulatory initiatives.38 Also, in recent years the assessment is that although theoretical risk of systemic exposure is available, the shadow banking sector does not pose large vulnerabilities for the Canadian financial system at this time, mainly because of the limited degree of liquidity and maturity mismatch as well as low leverage in most parts of the sector. The relatively small size of individual subsectors currently also limits the potential for systemic stress.39

 For example, over 70% of government-insured mortgage securitization (about 60% of total ‘shadow banking’) is issued by the six largest banks, which also sponsor most of the outstanding asset-backed securities/asset-backed commercial paper (ABSs/ABCP; see: IMF, (2014), Canada: Financial Sector Stability Assessment, IMF Country Report Nr. 14/29, p. 10 footnote 7 and p. 31. 34  R. Haltom, (2013), Why Was Canada Exempt from the Financial Crisis, Economic Research, Quarter 4, pp. 22–25, in particular 24. 35  See for recent estimations: IMF, (2014–2019), Canada: Financial Sector Stability Assessment, IMF Country Reports, via imf.org, latest edition 24 June 2019. 36  See for data and details on each category: T. Gravelle, et al., (2013), Monitoring and Assessing Risks in Canada’s Shadow Banking Sector, Bank of Canada/Banque de Canada, Financial System Review, June, pp. 55–63, in particular pp. 57–61. See also: P. Chatterjee, et al., (2012), Reducing Systemic Risk: Canada’s New Central Counterparty for the Fixed-Income Market, Bank of Canada Financial System Review (June), pp. 43–49; A. Côté, (2013), Toward a Stronger Financial Market Infrastructure for Canada: Taking Stock, Remarks to the Association for Financial Professionals of Canada, Montréal, 26 March; J.  Witmer, (2012), Does the Buck Stop Here? A Comparison of Withdrawals from Money Market Mutual Funds with Floating and Constant Share Prices, Bank of Canada Working Paper Nr. 2012–25. 37  World Bank Research, (2012), Golden Growth, G. Indermit and M. Raiser (eds.) pp. 30–33. 38  T.  Lane, (2013), Shedding Light on Shadow Banking, Remarks by Timothy Lane Deputy Governor of the Bank of Canada CFA Society Toronto 26 June 2013 Toronto, Ontario Shedding Light on Shadow Banking. 39  See in detail: B.Y.  Chang et  al., (2016), Monitoring Shadow Banking in Canada: A Hybrid Approach, Bank of Canada Financial System Review, December, pp. 23–37. 33

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In recent years, evidence was tabled that Canadian bond funds face a redemption run risk.40 A series of four reports41 so far has been produced by the Bank of Canada whereby it monitors and reports shadow banking activity in the country. In the most recent edition,42 an overview is provided of which entities are operational in the Canadian market. Nonbank financial institution (NBFI) grew materially in recent years to 1.5 trillion CAN.43 The asset-­backed commercial paper (ABCP) market is modest, but growth can be identified in the segments investment funds, securities financing transactions and private lending. The bottom line is that there is material growth in the segment unregulated lenders, and measures have been taken to address particular areas of concern like the mortgage lending market (mortgage finance companies, or MFCs, and mortgage investment corporations, or MICs).44 Mortgage underwriting taking place at institutions that are not directly subject to prudential regulation or supervision generally falls within two types of entities: MFCs and MICs. A mortgage investment corporation is an investment and lending company designed for mortgage lending. It must invest at least 50% of its assets in Canadian residential mortgages or insured deposits. Funds are typically raised through the sale of equity shares to investors or through debt and other lines of credit. MICs typically lend to borrowers that are not eligible to qualify for a conventional mortgage at a prudentially regulated financial institution. These typically include people with poor credit history, recent immigrants, self-employed individuals and real estate investors. MICs provide short-term loans (6–36 months) secured by real estate property. They usually prefer loans with low loan-to-value ratios. MFCs are large financial institutions that underwrite and service residential mortgages (usually insured). These mortgages tend to be packaged and sold to regulated financial institutions or securitized through government-sponsored programs. As a result, MFCs must adhere to underwriting guidelines and are thus often considered to be quasi-regulated. MFCs have a complex relationship with the major banks that is both cooperative and competitive.45

 Outflows due to fund underperformance are larger than inflows due to outperformance, and we interpret this asymmetry as evidence of redemption run risk in Canadian corporate bond mutual funds. The risk of redemption runs increases during periods of market volatility, but funds holding more liquidity can reduce this risk. R. Arora, (2018), Redemption Runs in Canadian Corporate Bond Funds? Staff Analytical Note 2018–21, July; R.  Arora, and G.  Ouellet Leblanc, (2018), How Do Canadian Corporate Bond Funds Meet Investor Redemptions? Bank of Canada Staff Analytical Note Nr. 2018–14. 41  (1) J. Chapman et al., (2011), Emerging from the Shadows: Market-Based Financing in Canada, Bank of Canada Financial System Review, June, pp. 29–38; (2) T. Gravelle et al., (2013), Monitoring and Assessing Risks in Canada’s Shadow Banking Sector, Bank of Canada Financial System Review, June, pp.  55–63; (3) B.  Y. Chang, (2016), Monitoring Shadow Banking in Canada: A Hybrid Approach, Bank of Canada Financial System Review, December, pp. 23–37. 42  G. Bédard-Pagé, (2019), Non-Bank Financial Intermediation in Canada: An Update, Bank of Canada Staff Discussion Paper Nr. 2, January. 43  See for a write-up of the evolution and status G. Bédard-Pagé, (2019), ibid., p. 3 ff. 44  G. Bédard-Pagé, (2019), ibid., pp. 9–13. 45  G. Bédard-Pagé, (2019), ibid., p. 14. 40

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4.9 Recent Evolution in the Americas 4.9.1 Introduction As indicated at the beginning of this chapter, in December 2012, the FSB Regional Consultative Group for the Americas (RCGA) decided to conduct a shadow banking monitoring exercise similar to that of the FSB at the regional level to achieve a better understanding of shadow banking in these jurisdictions and identify specific characteristics of the shadow banking sector in the Americas. The findings of this initial assessment, finalized and published in 2014, concluded that interesting follow-up dynamics to be considered were consolidated around four areas (open-ended investment funds that hold illiquid assets, large and highly leveraged broker-dealers, nonbank deposit-taking institutions and finance companies). That is obviously beyond more jurisdictional inclusion and more granular data availability, in particular by jurisdictions engaged in significant IFC activities.46 The Bahamas, Barbados, Bermuda and the British Virgin Islands were added to the analysis. The findings of the second round of consultations, which occurred throughout 2015 and which were published in October 2015,47 are summarized and discussed in Table 4.1.

4.9.2 Recent Trends in the Americas (2016–2019) Since 2014, the RCGA within the FSB conducts an annual survey dedicated to the shadow banking markets in the Americas.48 Since 2016, and in line with their global reporting, they introduced a narrow metrics of shadow banking. Consistently, two major areas of concern have been identified over the years which warrant further analysis, that is, open-ended funds and finance companies. Overall, the inclusion of nonbank financial entities or activities in the narrow measure does not imply or constitute a judgment that policy measures applied to address financial stability risks from shadow banking of these activities and entities are inadequate or that regulatory arbitrage is a relevant factor. The assessment of risks is based on distress scenarios on an ex ante mitigant basis. It allows also to be positioned in a way that regulators and supervisors are able to identify ex ante any potential areas of residual risk that might warrant a policy response and tackle remaining issues on a consistent basis. The other key findings in recent years for the region can be summarized as follows49: 46  See for a reference to the newly used methodology: FSB, (2015), FSB Regional Consultative Group for the Americas Working Group on Shadow Banking, Second Report, October 9, pp. 7–8. 47  See in very much detail: FSB, (2015), Shadow Banking Monitoring Report 2015, November 12, pp. 53–56 and FSB, (2015), FSB Regional Consultative Group for the Americas Working Group on Shadow Banking, Second Report, October 9. 48  A full overview of the types of funds reported by each jurisdiction can be found in Annex 4 of FSB/RCGA, (2017), Working Group on Shadow Banking, Third Report, May 10, pp. 57–60. 49  See FSB, (2017), Global Shadow Banking Monitoring Report 2016, May 10, Annex 8, pp. 91–94; FSB/RCGA, (2017), Working Group on Shadow Banking, Third Report, May 10; FSB/RCGA, (2018), Working Group on Shadow Banking, Fourth Report, March 5. For an interim evaluation:

Nonbank deposit-taking institutionsa: While their assets represent a relatively small share of national financial assets, the growth rate in assets of nonbank DTIs has exceeded that of banks in recent years (e.g. credit unions and cooperatives). Financial links between nonbank DTIs and banks were found to be relatively low with bank assets to nonbank DTIs rarely exceeding 2% of bank assets. All nonbank DTIs are regulated and most are supervised, and they are often regulated and/or supervised by the banking regulator/supervisor (although approaches differ materially among jurisdictions). Accordingly, the gaps between bank and nonbank regulatory requirements represent a potential source of regulatory arbitrage. In contrast to capital requirements, leverage and liquidity requirements for nonbank DTIs are far less common in the Americas. Few countries have requirements in place for resolution plans among its nonbank DTIs. Broker-dealersb: Broker-dealers are an important part of the financial system in most jurisdictions. They take proprietary positions or act as a broker in financial security transactions on their own account or on behalf of their clients. These entities are regulated and supervised in all reporting jurisdictions, but there is a lack of regulation in specific areas (e.g. maturity and/or currency mismatches, holding of specific assets [derivatives, loans] and issuance of liabilities, concentration of counterparty) Broker-dealers are usually highly levered (avg. 60% of total assets) and have significant liquidity risk using repurchase agreements as an important source (>50%) of (short-term) financing. Countries to be mentioned in this respect: Colombia, Bermuda, Chile, Colombia and Jamaica

b

a

FSB, (2015), FSB Regional Consultative Group for the Americas Working Group on Shadow Banking, Second Report, October 9, pp. 19–24 FSB, (2015), FSB Regional Consultative Group for the Americas Working Group on Shadow Banking, Second Report, October 9, pp. 24–29

Banks dominate financial activities in the Americas as they hold more than 40% of financial assets; however, their share of financial assets has been declining from 2008 due to faster growth in OFIs, and is lower on average than the share for banks in Analytical Group of Vulnerabilities (AGV) member jurisdictions (49% of financial assets). The size of the OFI sector relative to GDP is heterogeneous across the Working Group Shadow Banking (WGSB) jurisdictions and is larger in economies with most developed financial sectors. The OFI sector in several jurisdictions has exhibited positive growth rates since the global financial crisis, although some jurisdictions with the highest growth rates start from a relatively low base for their OFI sector. The largest subsector of OFIs in the region is investment funds—money market funds and public and private funds. In several jurisdictions, the links between OFIs and domestic banks are significant. The offshore assets of the IFCs in the Americas are significant at USD 4.6 trillion, and the relative importance of various offshore financial entities (banks, insurers and private funds) varies by IFC.

Table 4.1  Key findings of the second Americas shadow banking consultation round (2015)

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• Monitoring Universe of Nonbank financial intermediaries (MUNFI), comprised of OFIs, insurance corporations and pension funds, reached just over USD 60 trillion (end 2015) and USD 65.3 trillion (2016).50 • The narrow measure of shadow banking (excluding pension funds, insurance corporations, equity funds and prudentially consolidated entities), which was designed for the first time based on the 2015 number, yields USD 17.5 trillion or 29% of MUNFI (2016: USD 16.7 trillion, 26% of MUNFI). These totals do not include offshore assets of IFCs. They accounted in 2016 for USD 16.7 trillion (64% of offshore MUNFI).51 The process and criteria for narrowing down to a reduced shadow banking definition are different than in the global report.52 They also produce a similar overview like the FSB does in their global reports based on economic function.53 • All OFI subsectors grew in 201554 across participating jurisdictions with investment funds being the fastest growing subsegment.55 Larger economies, such as the US, Canada, Brazil56 and Mexico, have the largest OFI sectors. The largest subsectors of OFIs in the region are investment funds—MMFs and other investment funds, which include public and private funds. The second-largest OFI subsector is finance companies. The demarcation line, in terms of which firm included and which did not, is blurred and differs per jurisdiction.57 FSB, (2018), FSB RCG (Regional Consultative Group) for the Americas assesses financial market developments and discusses effects of reforms, FinTech and crypto-assets, December 6. 50  Often the distinction is made between the onshore MUNFI and the offshore MUNFI sector, the latter growing the fastest. 51  Let’s say that offshore shadow banking in narrow terms is way more material than onshore in the Americas. 52  The criteria used to be considered part of the narrow OFI/shadow banking definition are as follows: (1) being a part of a credit intermediation chain; (2) not being fully (in all aspects of regulation) consolidated into a banking group for the purposes of prudential regulation; (3) exhibiting risks associated with SB including (but not limited to) maturity and liquidity transformation, and/ or leverage. All three criteria need to be met. See in detail: FSB/RCGA, (2017), Working Group on Shadow Banking, Third Report, May 10, pp. 22–25. 53  See in detail: FSB/RCGA, (2018), Working Group on Shadow Banking, Third Report, May 10, pp.  17–21. The economic function (EF) 1 (management of collective investment vehicles with features that make them susceptible to runs) is the largest across the region followed by economic function 3 (intermediation of market activities that is dependent on short-term funding or on secured funding of client assets). Securitization-based credit intermediation and funding of financial entities (EF 5) only ranks third but shows strong growth in countries like Uruguay and the Cayman Islands. 54  For 2016 that holds true except for broker-dealers. 55  FSB/RCGA, (2018), Working Group on Shadow Banking, Fourth Report, March 5, pp. 12–13. 56  IMF, (2018), Brazil, Financial Sector Assessment Program, Technical Note on Stress Testing and Systemic Risk Analysis, IMF Country Report Nr. 18/344, November p. 111; BCB, (2018), Banco Central Do Brazil Financial Stability Report, Vol. 17, Nr. 1, April, pp. 40–45. 57  Starting in their fourth annual report, they specified their questionnaire when it comes to finance companies. This resulted in a number of new findings: (1) finance companies account for relatively large shares of OFI assets in a number of Latam countries (10–24% of OFI assets [2016]), although in absolute term the US and Canada are dominant; (2) a significant portion of finance company assets are lending assets (> 70%) with the minor part being leasing companies; (3) maturity transformation and leverage is in general low to moderate; and (4) regulatory restrictions regarding

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• The relative size of onshore insurance companies and pension funds has been stable over the past couple of years, while their absolute size grew steadily (2016: USD 31.1 trillion). Pension funds and insurance companies account for 59% (Bermuda)—3% (Cayman Islands), with an average of 22% (2016). • Offshore assets in IFCs in the Americas grew from USD 7.9 trillion to USD 8.1 trillion between 2013 and 2015. The OFI sector in the Cayman Islands accounted for a large part of that regional growth. • OFI assets grow for all countries, also in countries where one does not except so (2016: Uruguay [+39%]). The largest subsectors of OFIs in the region are investment funds, including MMFs and other investment funds, both public and private. The ‘other’ subsector, which includes trust companies, nonbank credit card issuers, central counterparties and captive fi ­ nancial institutions and moneylenders, represents often 10% of assets except for Canada (51%) and Uruguay (44%).58 • The median ratio of OFI assets to GDP in the Americas is 25%.59 • Finance companies are relevant, in terms of size, in Panama and Mexico. Brokerdealers are particularly large in Jamaica (2016: 35%). • Data on the interconnectedness of investment funds to banks and OFIs were only reported by a limited number of jurisdictions and remain consequently a blind spot. • There is no consistency in the use of the terminology leverage or liquid assets (insofar as regulation regarding these matters exist in each of the individual jurisdictions). • Bermuda, the Cayman Islands and Mexico do not impose leverage limits on any investment funds. • It is common to use some combination of redemption gates, suspensions of redemptions, redemption fees, side pockets or stress-testing mechanisms to manage redemption pressures in stressed market conditions. In times of market stress, most regulators allow funds to adjust their redemption policies unilaterally. In order to manage redemption pressures, assets concentration limits are imposed and are common in the region. Many of the limits target the percentage of NAV invested in one issuer and/or can vary from 10% to 40%.60 • Banks dominate financial activities in the region, holding less than half the financial assets. That percentage has been declining for years now due to increases in OFIs, insurance companies and pension funds. Each of the categories’ share in total shadow banking assets has stayed relatively constant over the years. There is however a liquidity and leverage are very limited: FSB/RCGA, (2018), Working Group on Shadow Banking, Fourth Report, March 5, pp. 4–5 & 21–26. The particular interest in finance companies is driven by potential vulnerabilities, which are identified as: ‘households may build up leverage through borrowing from finance companies; there may be risks arising from interconnections with the banking section, whether through direct exposures of banks holding credit in their loan portfolio, or competition between finance companies and banks leading to credit being offered to more risky borrowers’ (FSB/RCGA, [2018], ibid., p. 21). Also, the fact that types of entities and regulation across countries are highly heterogenic adds to the structural opaqueness of the segment. 58  2016 data. 59  2016 data. 60  See for an overview of the asset concentration limits in the region: FSB/RCGA, (2017), Working Group on Shadow Banking, Third Report, May 10, pp. 36–37.

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s­ignificant heterogeneity across the individual countries in terms of the relative ­importance of different financial entities.61 There is significant heterogeneity across individual jurisdictions in terms of the relative importance of different financial entities, but with bank topping the chart in most jurisdictions. The OFI connection with the banking system is material (mainly through investment funds) but only in a limited number of jurisdictions. The link is particularly important between OFIs and banks as banks rely on OFIs for funding (Cayman Islands, Brazil). The interconnectivity at balance sheet level is limited for other countries, but is often underestimated as the data do not include off-balance sheet positions.62 Bank assets to OFIs as a share of bank assets have trended downward post-crisis, but bank liabilities to OFIs (funding) are still above pre-crisis levels. Within the region, the conduct of IFCs is of utmost importance. Not only because quite a number of jurisdictions provide offshore financial services (Bahamas, Barbados, Bermuda, British Virgin Islands, Cayman Islands and Panama)63 but predominantly because large volumes of bank and nonbank credit intermediation activities of other jurisdictions flow through IFCs, which triggers systemic risk consideration. What makes the scenery particularly complicated is the fact that the IFCs emerge as different legal vehicles in the respective jurisdictions (special license bank, insurance companies [catastrophe reinsurance], private funds, structured finance vehicles) each carrying their regulatory and supervisory conditions which vary materially.64 Maturity transformation for funds in the region: regulatory limits on asset maturity mostly are only present for money market funds. There are however regimes that require a maturity of no more than 90/365 days, but the basic rule is that there are no maturity restrictions. Liability reporting is still scarce. Throughout the book, it has been reported that investing in illiquid assets through open-ended funds leads to liquidity mismatches which might trigger runs combined with a variety of redemption terms. Reporting on (il)liquid assets is limited, and the definition of liquid assets varies across jurisdictions or doesn’t exist at all.65,66

61  See for details: FSB/RCGA, (2018), Working Group on Shadow Banking, Fourth Report, March 5, p. 9. 62  See for details: FSB/RCGA, (2018), Working Group on Shadow Banking, Fourth Report, March 5, pp. 13–14. 63  The Bahamas and Barbados data are not included. See for Trinidad and Tobago: Central bank of Trinidad and Tobago, (2017), Financial Stability Report, Shadow banking and Systemic Risk, Box 3, p. 34. 64  Special license banks can often take no deposits from residents and limit the activities that these banks can conduct in local markets to conducting business with other licensees. In other countries, both domestic and international clients are served unsegregated (e.g. Bermuda). 65  See for an overview of the limits on investments in illiquid assets: FSB/RCGA, (2017), Working Group on Shadow Banking, Third Report, May 10, p. 32. 66  A prime example is the fact that non-MMF open-ended funds may invest not more than 15% of their net assets in illiquid assets. MMFs may invest no more than 5% of their total assets in illiquid securities. This is based on ‘Investment Company Liquidity Risk Management Programs’, Investment Company Act Release No. 32315 (13 October 2016) via www.sec.gov. The rule is

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• Regulatory liquidity buffers are uncommon in the region; and in case they exist, they are limited to MMFs and other open-ended funds. Often, the liquidity buffers are not quantified but described (qualified).67 • With the exception of funds in Colombia, funds in the Americas have no access to central bank liquidity. • A variety of market conduct rules exist, including transparency, nondiscrimination, prioritization of fund’s interest before that of the fund manager and so on. • Disclosure exists in most jurisdictions but varies in size and depth as well as whom to report to (investor, regulator and/or general public).68 • In terms of geographical exposure, most funds hold predominantly domestic assets, and this with the exception of the Cayman Islands where funds hold almost exclusively foreign assets. • In terms of funds leverage, funds in the Cayman Islands have the highest leverage ratios. Leverage is however measured in many ways across the Americas.69 There are a distinct number of leverage restrictions, limits and calculations among the jurisdictions.70 • The use of derivative strategies and short-selling techniques is in general allowed with only few restrictions. • Insurance-linked securities are financial instruments71 that bear insurance risk and can be found predominantly in Bermuda. These instruments are issued by insurers holding a specific license and are denominated as SPIs (special purpose insurers/reinsurers), which is a status called into life in 2009. An SPI bears predetermined insurance risk and funds itself (to cover those risks) through the issuance of insurance-linked securities (ILS) and which should guarantee its solvency at all times.72 A typical protocol works like this: The client73 of an SPI is often an insurer that wants to transfer some of applicable as of 1 December 2018 and 1 June 1 2019 for the smaller funds (< USD 1 billion). MMFs are subject to the 2a-7 rule under the Investment Company Act of 1940 and will continue to do so. See for a full overview of the limits on investment in illiquid assets: FSB/RCGA, (2017), Working Group on Shadow Banking, Third Report, May 10, p. 33. 67  See for a full overview of the liquidity buffers in the region: FSB/RCGA, (2017), Working Group on Shadow Banking, Third Report, May 10, p. 33. 68  See in detail: FSB/RCGA, (2017), Working Group on Shadow Banking, Third Report, May 10, pp. 37–39. 69  See for details: FSB/RCGA, (2017), ibid., p. 41: Types of leverage include regulatory, balance sheet, synthetic and market-led. Regulatory leverage is a restriction on debt or borrowing imposed by a regulator. Balance sheet leverage refers to the borrowing of money from other market participants. Synthetic leverage is leverage acquired through the use of financial instruments, such as options, futures, forwards, swaps and other types of derivatives. Market-led leverage (often called embedded leverage) refers to a position where the amount of market exposure per unit of committed capital is leveraged against financial institutions that face regulatory capital constraints. 70  FSB/RCGA, (2017), Working Group on Shadow Banking, Third Report, May 10, pp. 41–44. 71  Debt or equity instruments. 72  See for details and visualizations: FSB/RCGA, (2018), Working Group on Shadow Banking, Fourth Report, March 5, pp. 30–31. 73  The word ‘client’ can be replaced by the word ‘sponsor’ in case the structure is designed to operate intragroup.

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its business risks. That creates additional insurance capacity (diversity of capacity) and comes at a lower cost than typical reinsurance. The SPI absorbs the risk of the client and capitalizes itself through the issuance of ILS. The amounts of capital raised should be commensurate with the risk exposure absorbed minus the premium paid by the sponsor. An SPI investor should, given the complexity of a typical transaction in this field, be considered a ‘sophisticated investor’. Investors could be interested as the risk involved is typically not correlated to traditional financial market risk and so it is a way of diversifying risk in a portfolio. However, the claim of the investor is fully subordinated to the insurance obligation of the SPI. In order to mitigate the credit risk (the risk that reinsurers may be unable or unwilling to pay claims) for the client, the proceeds from investors and the premiums paid by the client are typically placed in a trust account of which the client is the beneficiary. The funds in the trust account are invested in line with the investment objectives and typically include high-quality assets, thereby minimizing credit and liquidity risk. In case of a calamity at the level of the client, the SPI will compensate the client reducing the investment return for investor or might even endanger repayment of capital (depending on the type of product issued and the offering memorandum). As such, the product or structure does not embody potential shadow banking risks as the risks are disclosed at the level of the SPI and are considered very low. However, one can wonder, in a low-yield environment, what investment returns (and thus risks) are required to offset the absorbed insurance risks of the client. I was unable to identify whether or not the Bermuda monetary authority diligently, beyond the full disclosure requirements, observes some of the shadow banking risks potentially involved. I could not identify a strict prohibition for the trust to invest in more risky assets (equities, leveraged structured products) or to engage in credit transformation, maturity or liquidity transformation or leverage the trust account itself.74

 Ultimately the SPI is subject to regulatory overview in this matter. The trust itself might qualify as a private vehicle subject to more common financial regulation or might even be in a regulatory light position. That leaves quite some discretion on behalf of the trustee to invest according to his or her insight. 74

5 Shadow Banking in Asia

5.1 Introduction The Financial Stability Board (FSB) and its working group for the Asia region (officially the ‘FSB Regional Consultative Group for Asia’ [FSB RCGA]) have been conducting an Asiaspecific research program into the dynamics of the shadow banking (SB) industry in the region.1 It must be stated upfront, as the FSB does so, that the data gathering for the region has been done in a ‘bottom-­up’ fashion, working up from the individual responses of the Asian jurisdictions. Combining the typical limitations of data availability and granularity implies that the findings of this study2 have not been subject to a ‘top-down’ qualitative, comparative or quantitative assessment (by the FSB). Therefore, the scope of the study has been defined somewhat wider than in normal FSB shadow banking studies to include the ‘profile of non-bank financial intermediaries (NBFIs), the regulations governing these entities, the definition of shadow banking applied by members, the distinction between shadow banking and NBFIs, and the potential risks emanating from NBFIs’.3 Unlike the global reporting the term ‘other financial intermediaries’ (OFIs), which include NBFIs except insurance companies, pension funds or public sector financial entities, was used as a conservative proxy for the size of shadow banking. That was done to ensure that all aspects were captured in the relevant countries regardless of the terminology that was given in the individual countries. In a way, the 2014 Asia study was also an attempt to share the contours of

 That happened in cooperation with the International Organization of Securities Commissions’ (IOSCO’s) Asia-Pacific Regional Committee (APRC). 2  The study meant here is FSB, (2014), FSB Regional Consultative Group for Asia. Report on Shadow Banking in Asia. No further reports have been issued by the Group specifically on shadow banking, but the frequent updates of the Group indicate that the growth of nonbank financial intermediation continues to stay on the list of topics being worked on, including the recent press release of 14 June 2019, via fsb.org. 3  FSB, (2014), Global Shadow Banking Monitoring Report, p. 46. 1

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a possible definition of shadow banking in Asia. That makes sense as the banking sector in Asia, consisting of mainly emerging or developing economies, is complemented by many forms of credit intermediation in the region, filling a credit void, broadening access to finance, deepening financial markets and promoting financial inclusion. Such an analysis warrants a large degree of (national) discretion in the analysis and a prudent approach toward policy responses and its implications which require taking into account national circumstances and systemic implications.

5.2 Key Findings of the Asia-Specific Study Given the fact that most Asian economies are emerging or developing, the perspective needs to be developed that nonbank financial institutions (NBFIs) offer financial services to customers that otherwise might lack access to finance as the traditional sources of funding might be closed for them. In that sense NBFIs contribute to financial deepening of young economies and financial inclusion. The consequence of that situation is also that most of the credit transactions are domestic and thus cross-border risk is minimal. The financial system in the Asia region is to a large degree bank dependent. Banks’ assets make up about half of all financial assets and those of NBFI account for about one-third which is materially below the 25% level on an average global level. There are some exceptions to that, for example Japan, where the NBFI assets account for nearly 50%. In relative terms, the OFI asset base is the largest in the Asian financial centers (Singapore4 and Hong Kong).5 The research demonstrates that very few Asian jurisdictions have properly defined ‘shadow banking’ and its activities which leaves a lot of wiggle room in terms of what to include and what not. The consequence is that the distinction between shadow banking and NBFIs is not always clear and consistent and jurisdictions consider different characteristics when categorizing shadow banking activity, including existing regulatory regimes and potential systemic risks.6 One such area of asymmetry is the collective investment schemes (CIS) where some jurisdictions included them in the risk measurement and others didn’t. Those that didn’t argue their position referring to the fact ‘that CIS are subject to adequate regulatory regimes, not directly involved in lending and deposit-taking activi See regarding the shadow banking market in Singapore, which is rather typical for a financial center: C. Hofmann, (2017), Shadow Banking in Singapore, Singapore Journal of legal Studies, pp. 18–52, also published in the Research Handbook on Shadow Banking, (Eds.) Iris H.-Y. Chiu and Iain G. MacNeil, Edward Elgar Publishing, Cheltenham, pp. 423–452; Monetary Authority of Singapore, (2017), Do Trust Companies in Singapore Pose Shadow Banking Risks? pp. 65–67, only modest liquidity and maturity transformation risk was observed as they hold large portions of short-term liquid assets. 5  Besides the traditional OFI/HF (other investment fund/hedge funds) presence in Hong Kong as a financial sector, the country has seen shadow lenders emerge like mushrooms, to benefit from the overheated real estate market and are offering shadow banking credit to eager homebuyers who fail to meet the normal criteria for securing bank loans. See E. Yu, (2018), Shadow Banking—‘A Time Bomb in the Making’, July 6, via Chinadailyhk.com. Part of the problem is the continued pegging of the HKD to the USD. 6  FSB, (2014), Global Shadow Banking Monitoring Report, p. 47. 4

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ties, mitigate risks in the financial system as loss absorbers since CIS investors bear the risks of potential loss’.7 Another point of contention is the high degree of heterogeneity and diversity in the business model of NBFIs and even within the same type of NBFIs. Most of these NBFIs are adequately regulated8 in Asia, albeit with different level of intensity (regulatory variation), but further enhancements are welcomed. Consequently, risks arising from regulatory variability appear insignificant. The most visible shadow banking risks identified in the region are leverage, maturity/ liquidity mismatch (funding risk), but only on a domestic level. Very few argued that interconnectedness between the shadow banking and the banking sector and regulatory arbitrage pose material issues or risks at present (risk is considered none or negligible). National regulators are in the understanding that the shadow banking risk in Asia is materially lower than in Europe/US due to the fact that ‘Asia has relatively less developed financial markets, offers less complex financial products and the scale of the non-bank sector remains small in size and non-systemic in nature’.9 The consequence is that the FSB policy recommendations regarding money market fund (MMF) and securitization are adequate but need to adjust to reflect the structure and scale of the MMF industry in each Asian jurisdiction. The same holds true for the issues of securitization, where it needs to be noted that most jurisdictions are currently only in the process of creating a legal framework for their securitization industry. The same comments and objections were made regarding the FSB policy recommendations done with respect to ‘securities lending and repos’ and some are concerned about possible unintended consequences of implementing those policies full blown (i.e. without adjustments) such as reduced market activity or a limitation of further market developments. Most of the countries saw the benefit of having a central counterparty (CCP) in their interdealer markets. The haircut on repos policy as suggested by the FSB in 2014 is a major concern as it, according to some jurisdictions, has the potential to overregulate local sovereign bond repo markets. At this stage, and in general for the Asian region,10 it can be observed that the two most important features going forward, besides consistent measurement of the shadow banking market, are the need to make the policy recommendations tailor-made for nascent economies and make them fit for the size and depth of their economies and the different roles the shadow banking sector plays in Asia compared to other regions of the world. As their economies mature and become more open/international, deeper coordination in terms of measurement and interconnectedness risk will be required, preferably within the context of deeper regional (regulatory and policy) coordination and cooperation. As indicated above, banks continue to hold a large share of the financial system assets,11 with nonbank financial intermediaries accounting for about a third. OFIs, which are a subset of the NBFIs, account for less than 15% of the financial assets in the region which  FSB, (2014), Global Shadow Banking Monitoring Report, p. 48.  Including registration and licensing requirements, conduct regulations, prudential regulations and consumer protection measures. 9  FSB, (2014), Global Shadow Banking Monitoring Report, p. 49. 10  FSB, (2014), Global Shadow Banking Monitoring Report, pp. 50–51. 11  FSB, (2014), Financial Stability Report, Regional Consultative Group for Asia, Report on Shadow Banking in Asia, pp. 21–22. 7 8

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is below the 25% global average for this subset.12 But there are sizeable exceptions, for example, Japan where NBFI assets account for nearly 50% of total OFI assets. The OFI segments are the largest (relative to the size of their economies in gross domestic product [GDP] terms) in Singapore and Hong Kong which makes sense given their role as financial centers. The OFI sector, as such, has been growing rapidly since 2008, and in line with global growth of the OFI sector. That needs to take into account that definitions are still somewhat blurred as the ‘distinction between shadow banking and NBFIs – the same type of NBFIs in different jurisdictions in Asia may not be consistently characterised as shadow banking (even when they may appear to pose similar risks) because of the domestic interpretation of the term “shadow banking”. Jurisdictions take into account different characteristics when categorizing shadow banking activity, including existing regulatory regimes and potential systemic risks.’13 A good example is the involvement of CIS which have been categorized as shadow banking or not by a variety of Asian supervisors. Arguments against categorization of CIS as shadow banking engaged entities are ‘CIS are subject to adequate regulatory regimes; they are not directly involved in lending and deposit-taking activities; they mitigate risks in the financial system as loss absorbers because CIS investors bear the risks of potential loss’. Two direct risks were identified as the key potential risks of shadow banking in their jurisdictions, namely, leverage risk and maturity and liquidity mismatch. Excess leverage can amplify procyclicality. Maturity and liquidity mismatch can expose entities to liquidity and funding risks. Also indirect risks stemming from interconnectedness of the banking and the nonbank sectors, and regulatory arbitrage in the domestic context, were seen as key potential risks in some Asian jurisdictions. Most supervisors, however, in the region don’t see shadow banking activities as a real threat at least compared to the US/EU. Consequently, they see some of the FSB’s policy recommendations applicable (securitization, MMFs) with some modifications to cater to the local outlook. Others they consider not applicable in their current format, for example, securities lending and repos. It is obviously limited to those countries where these activities occur and then only when taking into account ‘the current size of markets in their jurisdictions, the composition of their securities financing markets and stringent regulatory frameworks already in place’.14 Of particular concern (overregulation) are the costs and benefits of introducing a central counterparty in their interdealer repo markets and the regulatory framework for haircuts for repos. Besides, banks, insurance companies and pension funds are large SB entities, particularly in Singapore, Hong Kong, Japan, South Korea and Australia.15 Also public finance institutions are material in size (Thailand, Pakistan, Malaysia) and provide basic financial

 See in detail: FSB, (2014), Financial Stability Report, Regional Consultative Group for Asia, Report on Shadow Banking in Asia, pp. 24–34. 13  FSB, (2014), Financial Stability Report, Regional Consultative Group for Asia, Report on Shadow Banking in Asia, p. 7. 14  FSB, (2014), Financial Stability Report, Regional Consultative group for Asia, Report on Shadow Banking in Asia, p. 10. 15  FSB, (2014), Financial Stability Report, Regional Consultative Group for Asia, Report on Shadow Banking in Asia, p. 23. 12

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services such as traditional lending or a development role (e.g. securitization to broaden and deepen the domestic debt market, provide guarantees to mortgages and small- and medium-sized enterprises or SMEs) and support education, and provide home financing to lower- and medium-income households and promote ownership and address poverty. They also support green technologies.

5.3 Scoping and Role of OFIs in the Asia Region I have highlighted above the size of the OFI sector in the Asian countries and their relative size to their economies. The varieties per countries are also reflective of the variety of roles and significance of the sector. OFIs in Asia, and quite in contrast to the developed world, tend to play a material role in the socio-economic fabric development of those countries, including financial inclusion. This occurs often through credit unions and cooperatives, micro-finance institutions and building societies. They are also instrumental in developing local capital markets, hedging platforms and alternative investment schemes. Given their role and function their activities engaged in are often less complex and include ‘loan provision, management of client cash pools, intermediation of market activities, facilitation of credit creation and securitisation-based credit intermediation and funding of financial entities’.16 The collective investment schemes and MMFs are another large OFI subsegment. CIS manage assets for investment using money or similar funds pooled by inviting two or more persons to participate in the investment. Financial investment business entities comprise mostly CIS. CIS are mostly present in Korea and Thailand; MMFs in Korea in terms of volume of entities; Japan, Korea and China in terms of volume of assets under management (AUM). What is remarkable is the fact that the MMF sector is very small compared to developed markets.17 Even in a market like China, the MMF size is only 4% of that in the US.18 Finance companies are best represented in Malaysia, the Philippines, India and Japan, with mostly credit card and installment finance activities.19 Also credit unions and mutual savings banks (MSBs), which are also involved in basic financial transactions, are included in the OFI segment. It is a large segment in India, the Philippines, Korea and Malaysia in terms of numbers of entities and Japan in volumes of assets under management. Korea was the only country that reported a profile of mutual savings banks, a category with about USD 50 billion in assets. ‘MSBs are local financial institutions mainly for the

 FSB, (2014), Financial Stability Report, Shadow Banking in Asia, p. 26. 17  FSB, (2014), Financial Stability Report, Shadow Banking in Asia, Exhibit 20, p. 34. 18  FSB, (2014), Financial Stability Report, Shadow Banking in Asia, p. 26. 19  FSB, (2014), Financial Stability Report, Shadow Banking in Asia, Exhibit 12, p. 27. 16

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underprivileged and small companies having low credit ratings but sound solvency.’20 India reported the largest numbers of brokerages (Japan in terms of volume of total assets) who in the region provide the traditional buying and selling activities of securities and occasionally provide margin lending to clients.21 Japan, Australia and South Korea have the largest ‘structured finance’ subsegment, amid limited and incomplete reporting. ‘Structured finance vehicles (SFVs) typically pool assets and sell claims on the cash flows backed by these pools to investors. SFVs are used by financial institutions to transform the maturity and liquidity of financial products.’22 The OFI sector in Asia has been growing in line with global growth rates. However, when markets shift, that is mature, their size in the financial system grows. In Asia that translates into the fact that Japan, Australia and Hong Kong still have the largest OFI sector (in asset terms) but that the segment in China, South Korea, Malaysia and India is consistently growing over time (as a % in total of SB assets). In terms of interconnectedness, Asian banks have only a limited portion of their assets with OFIs ( 15%), pp. 16, 25, 34. Regarding the systemic risk in Indonesia’s banking system, see: A.  Mansur, (2018), Measuring Systemic Risk on Indonesia’s Banking System. Published in: Kajian Ekonomi dan Keuangan, Vol. 2, Nr. 2, 4 June, pp. 94–105. 120  FSB, (2014), ibid., p. 56. 121  FSB, (2014), ibid., p.  45. H.S.  Lee, (2015), Korea’ Shadow Banking: A Risk Diagnosis and Future Development, KCMI Paper, via kcmi.re.kr 122  Y.  Pan, (2014), Shadow banking Systems in ASEAN, Presentation Institute of Sino-ASEAN Research. 119

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banking credit intermediation has now arrived at levels that structural monitoring is required also since practices as securitization and collateralization have been introduced in Malaysia in recent years.123 The central bank in Malaysia considers the risk embedded in nonbank financial intermediation to be low, maturity and liquidity transformation to be low, and that the low complexity of activities and entities allows proper judgment despite an evolving industry.124 In Malaysia,125 shadow banking is defined as a ‘system of credit intermediation that involves entities and activities outside BNM’s (Bank Negara Malaysia i.e. Malaysia’s Central Bank) regulatory capture’. Based on this definition, the Malaysian shadow banking system comprises nonbank entities that engage in (1) loan origination, (2) purchase of debt securities, (3) securitization, (4) credit guarantee or enhancement exercises and (5) credit rating or scoring activities, which account for approximately 93% of the 2011 GDP. Similar to the structure of the shadow banking system in Asia, the shadow banking system in Malaysia is relatively less complex and smaller than the banking system. The market share of assets held by NBFIs has shown gradual increment in the past decade, with 27% of total assets in the financial system in 2000, rising to 28% in 2010. The gradual growth of the Malaysian shadow banking system reflects the increase in the complementary role assumed by NBFIs in deepening the Malaysian financial system. On the other hand, banks’ assets market share remains above 50% every year.126 Credit intermediated by banks accounted for 61% of total credit intermediated in 2011 while the remaining was dispersed among various NBFIs. The typical credit intermediation process in Malaysia encompasses: • • • • •

Credit origination Purchase of debt securities Credit transfer (e.g. securitization) Credit enhancement/guarantee Credit rating/scoring

The key observations of the main components of the shadow banking system in Malaysia, which include (1) provident and pension funds, (2) unit trust funds, (3) securitization activities and (4) other nonbank credit providers are:  M. Y. M. Isa and Z.H. A. Rashid, (2014), Shadow Banking Credit Intermediation: Determinants of Default Risks in Securitization and Collateralization, Journal of Modern Accounting and Auditing, November, Vol. 10, Nr. 11, pp. 1–11; C.A. Zabala, and J.M. Josse, (2014), Shadow Credit and the Private, Middle Market: Pre-Crisis and Post-Crisis Developments, data trends, and two examples of private, nonbank lending, The Journal of Risk Finance, Vol. 15, Issue 3, pp. 214–233. See for a full study on Malaysia’s shadow banking market: N.  S. Yi et  al., (2017), Risks and Vulnerabilities of Shadow Banks: the case in Malaysia, Bachelor Thesis, August, via utar.edu.my 124  BNM, (2011), Financial Stability and Payment Systems Report 2011, Kuala Lumpur, pp. 43–48. 125  See in detail M.A.M.  Farid, (2011), Monitoring Shadow Banking and its Challenges: the Malaysian Experience, BNM Working Paper, also via bis.org. 126  See BNM’s Financial Stability and Payment Systems Report 2011, White Box Article: Non-bank Intermediaries in Malaysia. 123

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1. Provident and pension funds127 Provident and pension funds (PPFs) are the largest component of the Malaysian shadow banking system, accounting for 41% of total assets of NBFIs in Malaysia and 18% of total financial system assets as at end-2010 and the largest provider of liquidity to the financial system mainly due to their deposit placements. PPFs also play a significant role in providing liquidity in the domestic capital and bond markets with the Employee Provident Fund (EPF) and Retirement Fund Incorporation (KWAP) being the most significant players. The asset composition of PPFs has been stable over time since 2003, with investments in debt securities accounting for more than 40% of total assets on average, followed by equity holdings at 16% on average. 2. Unit trust funds128 The unit trust funds (UTFs not akin to MMFs129) industry in Malaysia has grown significantly over the years. This growth was attributed to several factors including the role of the UTFs as an avenue for household to accumulate wealth, the generally high savings level in Malaysia and the introduction of a scheme by the EPF, which allows members to withdraw their funds to invest in UTFs. UTFs in Malaysia are heterogeneous, comprising variable and fixed net asset value (NAV) funds. Unlike UTFs, MMFs in the US are homogenous where these funds are required to maintain a fixed NAV at USD 1 akin to bank deposits. UTFs in Malaysia are also a major provider of liquidity to the financial system through their deposit placements in the banking system and significant holdings of securities in the capital market. 3. Securitization activities130 While Malaysia is among the few countries in Asia that has some presence of securitization activities, mainly due to the government’s concerted efforts in transforming Malaysia from an unknown bond market to the largest bond market in South-East Asia over the past two decades, asset securitization accounts for only a small share of credit intermediation by NBFIs. The low reliance on securitization in Malaysia, given the ample liquidity environment and well-capitalized banking system, resulted in securitization activities to continue to remain small. a subsidiary of the national mortgage corporation Cagamas Berhad is the major issuer of asset-backed securities (ABS) in Malaysia. The ABS issued are backed by the Treasury housing loans, which makes it safer than privately issued ABS. The Treasury housing loans are provided only to government employees and are based on repayment at source (i.e. monthly salary deduction).

 Farid, (2011), ibid., pp. 7 ff.  Farid, (2011), ibid., pp. 10 ff. 129  MMFs are usually funds that invest in high-quality and low-duration fixed-income instruments such as commercial paper and the US Treasury Bill, which are not prevalent in Malaysia. Therefore, UTFs do not transmit the same kind of shocks to the financial system as the MMFs do in the US. 130  Farid, (2011), ibid., pp. 11. 127 128

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4. Other nonbank credit providers131 Other nonbank credit providers account for a sizeable share of credit extension to households. These credit providers include credit cooperative societies, building societies, moneylenders, pawnbrokers, factoring and leasing companies. These ‘shadow’ credit providers exist mainly to serve certain sections of the population. Generally, this segment of population comprises borrowers in the middle- and lower-income groups who usually reach for nonbank credit providers for personal financing or to finance their small businesses. They account for +/− 60% of outstanding personal financing to household (BNM 2011). Another salient feature of shadow banking in Malaysia is most activities and entities are subject to certain oversight by various authorities. This shows the stark contrast between the shadow banking system and shadow economy in Malaysia. UTFs, securitization entities and credit rating agencies are subject to oversight by the Securities Commission Malaysia (SC). PPFs such as EPF and KWAP, meanwhile, are governed by their specific legislations and monitored by the Ministry of Finance. Shadow banking entities in Malaysia complement the banking system through provision of financial services to specific segments in the economy. In some Asian countries including Malaysia, the emergence of these nonbank credit providers and shadow banking entities in general is the outcome of deliberate policies by the government of the respective country to serve the financial and other supportive needs of specific sectors of the economy.132 Nonbank credit providers in Malaysia, which include cooperative societies, building societies and other institutions, are the key providers of personal financing. However, in terms total financing to households, banks remain the major provider of credit followed by the Treasury particularly for financing the purchase of properties and cars. In developed markets, the growth of NBFIs is mainly driven by the benefits that accrue to specialization while in the emerging markets they often play a broader role in deepening financial markets and overcoming legal and regulatory shortcomings. However, the recent financial crisis has shown that regulatory arbitrage has been the main factor that drives the growth of NBFIs in developed markets.133 Nonbank credit providers such as DFIs have grown in prominence in the provision of credit to this segment of the economy. Nonetheless, the banking system, with its extensive branch network and increasingly flexible financing packages, remains the largest provider of household credit in Malaysia. The banking system acts as the main mobilizer of funds in the Malaysian economy and has been able to meet the increasing demand for credit arising from the growth in household asset accumulation. They also play a material role in the creation of credit to households.134 Macroeconomic stability, financial sector

 Farid, (2011), ibid., pp. 12 ff.  M.B.  Shrestha, (2007), Role of Non-Bank Financial Intermediation: Challenges for Central Banks in the SEACEN Countries, Working Paper, mimeo. 133  Z.  Pozsar, et  al., (2010), Shadow Banking, Staff Report Nr. 458, Federal Reserve Bank of New York; J. Carmichael and M. Pomerleano, (2002), The Development and Regulation of NonBank Financial Institutions, World Bank Working Paper. 134  N. Endut and G.H. Toh, (2009), Household Debt in Malaysia. BIS Paper Nr. 46, Bank for International Settlement, Basel. 131 132

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development and government policies have been identified as important in influencing the supply and demand of mortgages and other household credit. The emergence of a more diversified and competitive banking system has resulted in downward pressure on interest rates, expanded credit coverage and increased loan amounts.135 Nonbank lenders have continued to grow despite the persistent economic turbulence. Farid calculated that in Malaysia the growth of nominal GDP explains the financing disbursement to the household sector by nonbank credit providers. An increase in GDP growth may translate into higher financing to the household sector by the credit providers.136 Farid suggests three layers of monitoring for the Malaysian shadow banking sector. The first level would focus on systemic risk and maturity, liquidity and credit transformation, leverage and the purest forms of regulatory arbitrage. The second (broader) layer will focus on credit intermediation outside the regulated banking sector. The third and broadest layer would focus on financial intermediation outside the banking sector in Malaysia.137 That embodies everything qualifies under a system as a system of credit intermediation that involves entities and activities beyond the regulatory parameter of Bank Negara Malaysia (BNM) (central bank).138 The growing level of household debt139 in Malaysia (and many other emerging countries) is a continued cause for concern. This is particularly the case since shadow banking’s focus in recent years has been on securitization and collateralization.140 The interconnectedness that is emerging is often little understood especially in the early years after the emergence of securitization and reuse of collateralization.141

5.10 Shadow Banking in China 5.10.1  Introduction The shadow banking system in the US consists of securitized loans and obligations, as well as money market funds. In contrast, apart from engaging in direct credit extensions made by nonbank entities. China’s shadow banking system involves informal securitization through a ‘funding pool’ provided by banks and has direct links to commercial

 Farid, (2011), ibid., pp. 13–14.  Farid, (2011), ibid., pp. 16–17. 137  Farid, (2011), ibid., pp. 18–21. 138  See also the NBFI case study in the FSBs Global Monitoring Report 2014: FSB, (2014), Global Shadow Banking Monitoring Report 2014, August 22, pp. 74–78. 139  C.A. Zabala and J.M. Josse, (2014), Shadow Credit and the Private Middle Market: Pre-Crisis and Post-Crisis Developments, Data Trends and Two Examples of Private Non-Bank Lending, The Journal of Risk Finance, Vol. 15, Issue 3, pp. 214–233. 140  See also Bank Negara Malaysia’s Annual Report and Financial Stability and payment Systems Report, KL. 141  See recently on the Malaysian situation: M.J.M. Isa and Z.H.A. Rashid, (2014), Shadow Banking Credit Intermediation: Determinants of Default Risks in Securitization and Collateralization, Journal of Modern Accounting and Auditing, Vol. 10 (November), Nr. 11. 135 136

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banks. Furthermore, the banks act as important distribution channels for financial products designed by trust companies. A series of restrictive policies have been imposed by the China Banking Regulatory Commission (CBRC) since 2010, including the raising of the required reserve ratio (RR), credit rationing and interest rate controls. As a result, different kinds of off-balance sheet financing activities in banks have been indirectly encouraged.142 But the Chinese financial infrastructure has and will stay for now largely dominated by large state-­controlled banks through which the regime provides direction. The constraints it has yielded are part of the shaping process of the shadow banking segment in China.143 A lot of what is going on in the shadow banking segment are ‘loans in disguise’ with somewhere in the chain a bank as the central node and ultimate risk-taker. The estimations regarding the SB volume create a wide bandwidth which ranges 110–140% of China’s GDP144 but many variations exist and some are as low as 50–65% of GDP.145 In recent times (2014 ff.) the system is slowing down due to a number of interventions (except securitizations).146 Conceptually, one can distinguish three layers in the Chinese shadow banking segment as reflected in Table 5.4.147

 See for a very comprehensive overview of the Chinese shadow banking system: J. Li and S. Hsu, (2012), The Annual Report of China Shadow Banking System, Project Sponsored by the National Natural Science Foundation of China, Project Number 71173246; CFA, (2015), Shadow Banking: Policy Frameworks and Investor Perspectives on Market-Based Finance, April, pp. 31–37. 143  Some of those constraints include the following: (1) there are caps on bank lending volumes imposed by the People’s Bank of China (PBOC); (2) the limit of bank loans to deposits of 75% is constraining (the four largest banks are exempt from this rule; they have much lower loan-todeposit ratios); (3) regulators discourage lending to certain industries; (4) most nonbank channels have lower capital and liquidity requirements; (5) shadow banks are not subject to bank limits on loan or deposit rates; (6) shadow banking avoids costly PBOC reserve requirements; see: D. Elliott et al., (2015), Shadow banking in China: a Primer, Economic Studies at Brooking, March, pp. 1 & 11–12. See for a further analysis of (some of ) these criteria as a trigger for the Chinese SB system: K. Hachem and Z. M. Song, (2015), The Rise of China’s Shadow Banking System, Chicago Booth School of Business Working Paper, January. 144  FSB, (2015), China Peer Review Report, August 13, pp. 28–29. See also for a comparison across the different estimation sources: D.  Elliott et  al., (2015), Shadow banking in China: a Primer, Economic Studies at Brooking, March, pp. 8–9 and appendix B (pp. 25–26). 145  W. Jiang, (2015), The Future of Shadow Banking in China, Columbia Business School, White Paper, p. 4. 146  D. Elliott et al., (2015), ibid., pp. 10–11. 147  Adapted from: B.  Hu, and Z.  Liansheng, (2014), The Shadow Banking System: In a Nontraditional Credit Intermediation Perspective, [In Chinese], In China Annual Financial Regulation and Supervision Report, Social Sciences Academic Press, May. See for a full scope analysis of the Chinese Shadow banking System: FGI (Fung Global Institute), (2015), Bringing Shadow banking into the Light: Opportunity for Financial Reform in China, (eds. A.  Sheng and N.G.  Soon), March; also: L. Guo and D. Xia, (2014), In Search of a Place in the Sun: The Shadow Banking System with Chinese Characteristics, European Business Organization Law Review, Vol. 15, pp. 387–418. 142

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Table 5.4  The three-layered Chinese shadow banking system Scope Narrow dimension

Broader dimension

Broadest dimension

Nontraditional credit intermediation and financing included Private lending, third-party money management, online credit financing, unregistered private equity funds, small loans, financing guarantees Products involved in the narrowest sense of shadow banking, plus money management, trust, finance companies, MMFs, asset management for clients, financing business of funds and insurance subsidiaries, asset securitization and so on Interbank business for credit expansion, and a small portion of letter-of-credit drafts, and payment services

Regulatory coverage Unregulated or unlicensed

Credit intermediation outside the banking system

Nontraditional credit financing within the banking system

5.10.2  The Different Components of the Chinese Shadow Banking System Components of the Chinese shadow banking system are148: • Wealth management products (WMPs): WMPs are investment vehicles, the majority of which are closed-ended funds that are not redeemable prior to maturity. A number of financial institutions—banks, trust companies and securities and insurance firms— can issue WMPs (in the case of trust companies, these products are also known as trust beneficiary rights). Banks create WMPs (which are higher-yielding compared to normal deposit products) and sell them to a variety of clients for periods between a few days and five years out.149 Bank WMPs are mainly short-term products with a maturity of less than one year and invest in a variety of assets, including bonds, equities, interbank placements, trust products and so-called non-standard credit assets. Around one-third of bank WMPs are guaranteed by the distributing bank (or subsequent third party), so they are included in the bank’s balance sheet as a deposit liability; the other two-thirds are non-guaranteed products, which are off-balance sheet for the distributing bank and  See for a good overview of the China shadow banking segment: FSB, (2015), China Peer Review Report, August 13, pp. 27–42 and 54–58. See for a nice write-up of the SB segment within the context of the total China financial infrastructure: P. Buitelaar, (2014), Chinese Banks: Risks and Challenges, DNB Occasional Studies, Vol. 12 Nr. 4, pp. 17–27; also: S. Hsu et al., (2014), Shadow Banking and Systemic Risk in China, Political Economy Research Institute, University of Massachusetts Amherst, Working Paper Nr. 349, May, pp. 4–8; S. Hsu and J. Li, (2015), The Rise and Fall of Shadow Banking in China, Political Economy Research Institute, University of Massachusetts Amherst, Working Paper Nr. 375, February, pp. 6–12. 149  See in detail: FSB, (2015), ibid., p. 31. N. Zhu et al. (ADB), (2014), Knowledge Work on Shadow Banking – Trust Funds and Wealth Management Products, Project Number: SC 102486, May. 148

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are therefore not included in the definition of deposits for accounting and regulatory purposes.150 The demand for WMPs comes down to the following elements: (1) the incentive of depositors due to interest rate ceilings and inflation has structurally exceeded official interest rate levels; (2) the incentive of banks to sell. It is an interesting product group next to deposits and banks can rely on WMPs to meet loan-to-­deposit ratios for further lending; and (3) distorted demand and supply for funding. As long as the equilibrium interest rate is being manipulated, distortions will occur in demand and supply terms and will fuel this SB segment. A fourth element can be the fact that small banks tend to be most active in this segment. Smaller banks lack a broad or deep deposit base and have to rely more on borrowing from other banks or selling WMPs to investors. They collectively have occupied a 60% share of the WMP market, with an average of 20–30% of total deposits in WMPs. Only roughly 4% of bank-issued WMPs are contractually guaranteed to bear a minimum rate of return.151 • Collective trust programs/trust companies: You can call them asset managers who manage assets on behalf of their customers. They invest across asset classes. They raise money from investors through the issuance of different types of trust products. These are similar to closed-ended investment funds with fixed maturity dates and without the right to exercise early redemption. The trust beneficiary rights are transferable—that is, trust products can be sold to other investors prior to their maturity.152 These products are now gradually taken over by proper asset management services provided by securities firms and asset managers. Market is valued at about RMB 8 trillion (2014). Banks are not allowed to lend to trust companies to avoid contagion under distress, but structures have been developed to bypass that restriction. • Entrusted/trust loans153: (Entrusted loans154 are a form of lending used by nonfinancial firms155 as well as securities firms and insurance companies for B2B loans, but

 See in detail: FSB, (2015), ibid., pp. 31 and 56–57. Also D. Awrey, (2015), Law and Finance in the Chinese Shadow Banking System, Cornell International Law Journal, Vol. 48, Issue 1, pp. 3–49, in particular pp. 21–45 for the WMP analysis. 151  See in detail: S. Wei, (2015), Wealth Management Products in the Context of China’s Shadow Banking: Systemic Risks, Consumer Protection and Regulatory Instruments, Asia Pacific Law Journal, Vol. 23 Nr. 1, pp. 55–85, in particular pp. 62–65. For the systemic risk dynamics in the product group and the moral hazard issue with tools for neutralizing them, see pp. 66–78. 152  FSB, (2015), ibid., pp. 31 and 55. The trust industry exists since 1979 but has been firmly redesigned in 2004. There is a variety of parties behind the trust companies; remarkable though is that the trust companies without state backing have the highest leverage. Given that more than 90% of the trust fund sector is managed by trust companies with at least one state-owned enterprise (SOE) or local government as parent company, this is likely to reduce the probability of systematic default risk. 153  FSB, (2015), ibid., pp. 30–31 and 54. 154  The volume of entrusted loans increases when the official credit is tight and therefore are a market solution to credit shortage; see in detail: F. Allen et al., (2015), Entrusted Loans: A Close Look at China’s Shadow Banking System, Working Paper, June, mimeo. F.  Allen, et  al., (2005), Law, Finance, and Economic Growth in China, Journal of Financial Economics, Vol. 77, Issue 1, pp. 57–116. Moody’s, (2013), Risks to China’s Lenders from Shadow Banking: Frequently Asked Questions; Z. Song, et al., (2011), Growing Like China. American Economic Review, Vol. 101, Issue 1, pp. 196–233. 155  They tend to be large firms with large cash holdings that engage in and offer entrusted loans. They provide affiliated and nonaffiliated loans with the latter carrying a much higher interest rate and the affili150

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which are not allowed to engage in lending business since 1996; the transaction runs through a bank without it appearing on the balance sheet of the bank; the bank receives a risk-free fee.) Frequently used in the property industry. They constitute one of the largest segments in the Chinese SB market. Trust loans are extended by trust companies to companies, governments and citizens. To finance these loans, trust companies issue WMPs through the banking network.156 • Asset-backed bonds/securities (securitization) • Local government financing vehicles (LGFVs)157 or more broadly local government financing platforms (LGFPs): LGFPs are the backbone of local governments in promoting infrastructure and social development in China. As the principal financing agents for local governments, their crucial role in upgrading China’s infrastructure and promoting economic growth has been widely acknowledged. By not encouraging higher local fiscal deficits or imposing more pressure on local government to issue bonds, LGFPs could, to some extent, be seen as a fortune for Chinese local governments, as they act as a vehicle to provide off-balance sheet quasi-fiscal support for local governments.158 Their rapid expansion, however, has created concern about the sustainability of their aggregate debt load and its sustainability. Nevertheless as it stands now, the central government keeps backing the model to support even economic and infrastructural development across the nation.159 This area includes outright Chengtou bonds (aka local muni bonds) which are often issued by local government financing vehicles. Despite the implicit guarantee by the central government spreads on these bonds vary widely.160

ated one often below-market rates. They constitute an alternative investment channel for these lenders. Pricing of these instruments seems to be risk based. For a further typology, see F. Allen et al., (2015), Entrusted Loans: A Close Look at China’s Shadow Banking System, Working Paper, June, pp. 4–5. 156  They are prone to a lot of moral hazard due to their closeness to local governments: S. Hsu and J. Li, (2015), ibid., pp. 8. 157  See Asia Development Bank (‘ADB’), (2013), Local Debt in the People’s Republic of China: Local Government Financing Vehicle’s Debt Management and Risk Control – Replacing Shadow Bank Financing with Local Government Bond, October. 158  See for a full analysis of LGFPs: Y. Lu and T. Sun, (2013), Local Government Financing Platforms in China: A Fortune or Misfortune, IMF Working Paper Nr. WP/13/243. Also see: Y.S. Zhang and S. Barnett, (2015), Fiscal Vulnerabilities and Risks from Local Government Finance in China, IMF Working Paper Nr. WP/14/4; L.F. Goodstadt, (2014), The Local Government Crisis 2007–2014: When China’s Financial management Faltered, Hong Kong Institute for Monetary Research Paper Nr. 27/2014, October; Claret Consulting, (2015), Overview of Local Government and Infrastructure Finance in China, Presentation, November; L. Fan, (2014), Quench a Thirst with Poison?—Local Government Financing Vehicles’ Past, Present and Future, via web.law.columbia.edu 159  L. Wei, (2015), China Backtracks on Local Government Debt, WSJ, May 15. The authorities relaxed controls on the ability of local governments to raise money by allowing them to tap government-sponsored financing companies. That despite the fact that they in October 2014 issued a resolution intended to prevent those financing firms from taking on new debt. Things need to be placed and judged within the framework of the Long-Term development plans of the Party. See also: J. Anderlini, (2015), China Orders Banks to Keep Lending to Insolvent State Projects, Financial Times, May 15. 160  Reflecting the nature of their collateral, real estate variables are important drivers of Chengtou bond yields, as are other macro-fundamentals and liquidity characteristics. Ang et  al. find a

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• Undiscounted bankers’ acceptances (are credit guarantees by banks and historically used for trade finance purposes) but now used to settle accounts by risky borrowers. • Money market funds (and which have overshadowed WMPs in recent years as they offer daily liquidity and access to liberalized interest rates and which normally have a constant NAV)161 • Pawnshops • Folk/informal lending162 • Leveraged lease companies163 • Small lending companies. Mainly short-term lending on a small scale. • Credit guarantee companies164: who do exactly what they say—that is, they guarantee credit risk. They are not so much discussed internationally when it comes to shadow banking in China. But they do come to the forefront when they anticipate a government bailout.165 • Internet finance: peer-to-peer online lending platforms (P2P platforms)166 • Mutual fund subsidiary asset management167: mutual fund subsidiary asset management is set up by traditional asset management companies to specialize in investments

significantly positive relation between Chengtou yields and an index of local government corruption; see: A.  Ang et  al., (2015), The Great Wall of Debt: The Cross Section of Chinese Local Government Spreads, Working Paper, May 5, mimeo. Interesting further was that they found a positive correlation between Chengtou yields and an index of local government corruption. 161  Although our discussion regarding MMFs has put the light on the floating NAV mode, Chinese regulators are still assessing the risks involved with the rapid growth of MMFs and have yet to take any concrete measures to address the susceptibility of MMFs to ‘runs’. 162  F. Allen, et al., (2013), Understanding Informal Financing, Working Paper, mimeo; M. Ayyagari, et al., (2010), Formal versus Informal Finance: Evidence from China. Review of Financial Studies Vol. 23, pp. 3048–3097. 163  J. Li et al., (2014), Shadow Banking in China: Dimensions, Risks, Prospects, Working Paper, mimeo, pp.  13–14. See also for the less known negotiable securities company (pp.  12–13) and small loan companies (pp. 16–17). 164  J.  Li et  al., (2014), Shadow Banking in China: Dimensions, Risks, Prospects, Working Paper, mimeo, pp. 6–9. Also: Y. Huang, et al., (2012), China’s Shadow Banking be Another Sub-prime Debt?, International Economic Review, Vol. 2, pp. 42–52; P. Wang, Pan, et al., (2012), Folk Lending: Transforming with Obvious Risk Transmission, Economic Information Daily, May 7, p. 6. 165  G. Wildau, (2015), China Shadow Banks Appeal for Government Bailout, Financial Times, August 18. The case regards Hebei Financing Investment Guarantee Group who guaranteed about USD 8 billion in credit and could lead to a default of a few dozen WMPs when it would default itself. 166  They operate in four models and are both unregulated: (1) a platform for simply matching lending and borrowing information; (2) a platform with guarantee or other credit support facilities from the P2P platform operator or its affiliates; (3) a repackaging and sale of credit assets through securitization and other financial engineering techniques, and (4) a transfer of credit assets created by a P2P platform operator or its affiliates to end investors. See: Clifford Chance, (2015), Shadow Banking and Recent Regulatory Developments in China, January, p. 6. Model two and four facilitate credit creation by leveraging the creditworthiness of the P2P platform and its affiliates, while Model 3 additionally involves liquidity mismatch if it uses ‘asset pool’ techniques to fund long-term assets by taking in short-term investments from clients on a rolling basis (pp. 7–8). 167  D. Tao and W. Deng, (2015), China: Trust Funds and Shadow Banking, Credit Suisse Economic Research, February 17, p. 26.

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of non-listed assets. In other words, they are special investment vehicles for traditional asset management companies.168 • Broker asset management services: Broker asset management is the asset management division of the brokers and securities companies. While the mutual fund subsidiary asset management companies are special purpose vehicles for the traditional asset management companies, the broker asset management companies are investment vehicles for traditional brokers. Compared to trust fund companies, broker asset management companies also have the capacity to perform all types of channel business that trust fund companies could provide.169 • Repo market A variety of shadow banking products can be found in China. Those range, as listed above, from collective trust programs and entrusted loans to bank wealth management products and local government financing vehicles. Since 2009, these alternative financing vehicles have largely been created to fund real estate and infrastructure construction projects by unsecured developers and local governments who are unable to raise capital through bonds.170 Many of these projects are over-invested and are unlikely to generate returns in the short term. Although the Chinese corporate sector in general seems not to be over-levered, some industries such as real estate developers and firms in industries with substantial over-capacity have continued to increase their leverage positions. Those tend to be all state-owned enterprises. It were those that benefited and benefit maximally from implicit guarantees and lower funding costs. That has gone so far that some state-owned entities (SOEs) have started to engage in credit intermediation themselves rather than to obtain credit via the formal financing channels.171 The growth of nonbank credit intermediation in China can be attributed to a number of factors.172 Continued rapid economic development has increased the demand for lending as financial broadening and deepening take place, giving rise to new forms of intermediation. Economic stimulus by the government and various regulatory restrictions (loan-to-deposit limits and ceilings on deposit rates) do contribute to the rise of the SB system. It has caused borrowers to bypass the formal bank lending channel. With a limited corporate bond market and a closed or constrained banking sector some sectors and firms had limited options left. As a result, investors (both institutions and individuals) are  See a comparison with trust companies: D. Tao and W. Deng, (2015), ibid., pp. 26–27.  D. Tao and W. Deng, (2015), ibid., pp. 27–28. 170  Thompson Reuters/RMBISA, (2014), Chinese Shadow Banking: Key Risk Indicators and Risk Scenarios, p. 4. 171  See in detail: W. Zhang et al., (2015), Corporate Leverage in China: Why has It Increased Fast in Recent Years and Where do the Risks Lie?, Hong Kong Institute for Monetary Research Working Paper Nr. 10/2015, April. That overleveraging has yielded weakened debt-service capacity and overall weakening of fund-use efficiency. Also see: H.  Wang, (2015), How Bank Competition Affects Lending Terms in China?  — Evidence from Loan Level Data, Hong Kong Institute for Monetary Research Working Paper, mimeo. 172  See in detail: T. V. Dang et al., (2014), Chinese Shadow Banking: Bank-Centric Misperceptions, Hong Kong Institute for Monetary Research Working Paper Nr. 22/2014, September. 168 169

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incentivized to use nonbank products to earn higher yields on their investments, while borrowers are incentivized to seek funding from nonbank entities.173 Typical about the SB segment in China is that the regulated banks tend to be heavily involved along the way. The FSB describes: ‘[o]ne of the distinguishing characteristics of nonbank credit intermediation in China is that the banking sector is closely involved in several aspects of the intermediation chain. An example is the so-called “tunnelling business”, in which banks are involved at every step of the process, from raising funds for a trust through their distribution networks to selling financial assets (including loans) to that trust. The close interaction between banks and nonbanks has partly been a by-product of the rapid transition towards a more market-based financial system, which necessitated the reliance by other intermediaries on banks’ networks.’174 That is true for all the major shadow banking classes, being WMPs, trusts and entrusted loans. The Chinese shadow banking market is still small (less than 20% of total financial system assets) and not as synthetically structured as their Western counterparts. Also the use of leverage in the product structure is limited. WMPs and trust products operate with no leverage and trust companies can leverage up to 20% of equity which by any standard is quite modest. The risks in the Chinese SB system can be summarized as: • Due to the close involvement of regulated banks in SB, a lot of its credit could be swiped back on their balance sheet under distressed scenarios. • Opaque credit chains and the emergence of innovative new instruments and entities make monitoring tiresome and prone to errors and wrong-way judgment calls. • The short maturities of trust products combined with regulatory restrictions on maturity mismatches between the underlying trust assets and their funding imply that a large part of the credit provided through the nonbank sector is of a short-term nature. • Legal aspects related to WMP and who ultimately bears the return guarantee risk. • The SB system reinforces a credit boom, with procyclical effect. • Interconnectedness between SB and other parts of the financial infrastructure through obscure and complex models. • Massive exposure of SB sector to the real estate sector. • Savers offload large amounts on SB model to bypass rate ceilings and enhance returns. • Large maturity and default mismatches and risks across the different SB segments in China.175

 FSB, (2015), ibid., p. 29.  FSB, (2015), ibid., p. 30. 175  See also: P. Buitelaar, (2014), Chinese Banks—Risks and Challenges, DNB Occasional Studies Vol. 12 Nr. 4, pp. 24–25. 173 174

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And the State Council has taken, in 2014, a number of steps to reduce some of these abovementioned risks.176

5.10.3  The Wealth Management Product Group Market and Outlook WMPs have been the major source of funding, with issuance estimated to be RMB 7.6 trillion (approximately USD 1.24 trillion) at year-­end 2012—a 55% increase over 2011.177 By 2018 that amount has risen to approximately USD 3 trillion (30% of GDP). As WMPs are rolled over based on short-term intervals, more and more new issuances and liquidity are needed to pay off the expiring ones. A vicious cycle has developed, sparking growth in shadow banking activities in China and rendering these types of investments highly vulnerable to a sudden shortage of funds. It can be referred here to our analysis and chapter on MMFs and wholesale funding in the traditional banking industry. A particular fear is that risk exposure might be heightened owing to a lack of transparency on these types of investments.178 The refinancing risk within the banking industry, as well as the liquidity risk in the Chinese housing market, has heightened the default risk of borrowers and even overall market risk in financial markets. But what could be adequate risk parameters beyond the growth of the volumes itself (which in itself don’t constitute intrinsic risk in itself, i.e. the emergence of credit, liquidity, maturity and transformation risk)? The following five elements are suggested to be used as a proxy179: • House Prices: The current Chinese housing market is supported mainly by new investments and domestic real estate speculation, where large sums of money for real estate developments are sourced from WMPs.180  FSB, (2015), ibid. pp., 33–36. See also Clifford Chance, (2015), Shadow Banking and Recent Regulatory Developments in China, January. Their efforts mainly relate to circular 107 that, although drafted in 2013, became public only in 2014. The circular provides for a three-layered shadow banking division and warns of some systemic risk implications. Circular Nr. 107 is meant to apply to: (1) ‘unlicensed, unregulated credit intermediation’ (e.g. online finance companies); (2) ‘unlicensed but lightly regulated credit intermediation’ (e.g. credit guarantee and microcredit companies); (3) ‘licensed but insufficiently regulated financing activities (including those conducted by money market funds, informal finance securitization, and some wealth management businesses)’; see M. Badkar, (2014), China is getting serious about its crackdown on shadow banking. Business Insider, January 6. 177  Data source: CBRC. 178  Thompson Reuters/RMBISA, (2014), ibid. 179  See in detail: Thompson Reuters/RMBISA, (2014), Chinese Shadow Banking: Key Risk Indicators and Risk Scenarios, pp. 6–7. D.J. Elliott and K. Yan, (2013), The Chinese Financial System. An Introduction and Overview, John L.  Thornton China Center Monograph Series, Number 6, July 2013. 180  Thompson Reuters/RMBISA, (2014), ibid., p. 6. 176

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• Interest and Inflation Rates: Investing in shadow banking products can earn a high net interest margin between the controlled and the black market rates. This high margin attracts investors seeking high returns, further stimulating the rapid development of shadow banking in China. • Capital Flows: China still has imposed capital account control, that is, control on both capital inflow and outflow. China is moving toward the opening of its capital account and financial reform181 which might lead to the massive outflow of domestic capital to search for higher yield/return. • Repo Rates: A high repo rate increases banks’ financing costs on WMPs, thus increasing default risk. It also puts pressure on mortgage rates, resulting in reduced speculative investments in real estate, in turn driving housing prices down. • Required Reserve Ratio (RRR): China’s RR is about 20%, which is much higher than that in the US (about 10%) and Europe (1%). A high RR reduces banks’ ability and willingness to lend to high-risk companies like SMEs. These companies are therefore forced to obtain funding through off-balance sheet activities. It is clear, however, that the Chinese shadow banking industry plays a meaningful role that cannot be ignored. Part is caused by the make-up of the traditional banking sector in China and their preferred methodologies and industries to invest in disfavoring the SME sector. An abrupt end to the shadow banking system will undeniably have severe unintended consequences. What are some of the options to rebalance the situation?182 • Restrictions on WMPs: As WMPs are rolled over at short-term intervals to fund longterm investments, maturity mismatch is the main underlying risk. By setting a limit on mismatch ratios or on liquidity requirements for companies using short-term WMPs, regulators could restrict the use of short-term WMPs to fund long-term investments. • Reform of Interest Rate Liberalization: Investors are earning high margins on shadow banking products. Interest rate liberalization will allow interest rates to return to the market level, reducing the net interest margin and thus the scale of shadow banking. Product returns would then be constrained by inherent credit risks. • Reforming Banking Regulations: Regulators should consider relaxing the restrictions for loans so as to shift risk back to the traditional regulated platform. More direct measures to regulate off-balance sheet activities should also be implemented.

 A. Sheng and Ng. Chow Soon (eds.), (2016), Shadow Banking in China: An Opportunity for Financial Reform, Wiley & Sons, Hoboken. 182  See Thompson Reuters/RMBISA, (2014), ibid., p. 9. 181

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Since 2013 China has started to regulate its shadow banking segment and which included regulation of these WMPs, liquidity management, the creation of a financial regulation coordination entity and an audit of local government debt and this nationwide.183,184 Much has been said and written about the origins of the shadow banking segment in China. But good solutions take into account the historical causes of the current situation: The Chinese government intervenes in the allocation of financial resources through financial repression. Financial repression creates a privileged sector and an unprivileged sector, with the former having access to cheap credit and the latter being rationed out.185 The maintenance of a wide spread between the ceiling on savings deposit rates and a floor on bank lending rates has enabled banks to generate substantial profits. By the same token, SOEs and other large businesses have benefited from subsidized credit.186 Gao indicates: ‘[f ]inancial repression operates through a set of laws and regulations, like those that control interest rates, entry barriers to the banking industry, and intervention into credit allocation. Financial repression brings tremendous benefits to the state, including revenue and rents, but it can also harm the stability of the financial system and skew the fairness of distribution by blocking access to formal finance for private enterprise and ordinary citizens.’187 China’s financial system is significantly affected by official credit supply restrictions and credit allocation incentive structures. Both aspects distort the market mechanism for credit and cause a shadow banking system to develop.188 Shadow banks are there to satisfy demand for private sector credit. The shadow banking market is the response to suppressive legal institutions by creating more efficient zones to operate. Let’s call it regulatory arbitrage. So although the Chinese shadow banking model is very different than its Western peers, the tampering with monetary and regulatory aspects of the financial system leads to the same systemic risk, contagion, enhanced credit risk and capital misallocation.

 See further: Y. Altunbas, et al. (2011), Bank Risk during The Financial Crisis – Do Business Models Better?, ECB Working Paper Series Nr. 1394; K. Chen, (2013), Loans to Local Government Financing Vehicles (LGFV) Pose Risks to Chinese Banks, Moody’s Investors Service, Credit Suisse Economics Research (2013), China: Shadow Banking – Road to Heightened Risks, Working Paper; L.  Fung, and D.  Wang, (2011), Unmasking the Shadow Banking System  – Shadow Banking Exposure less than Feared and More Than Priced In; W. Kurtz, (2013), Country Risk – China’s Economy: New Warning Signs, Pragmatic Capitalism, Working Paper; C.  Li, (2013), Shadow Banking in China: Expanding Scale. Evolving Structure, Federal Reserve Bank of San Francisco – Asia Focus; Moody’s Investors Service (2013), Risk to China’s Lender from Shadow Banking: Frequently Asked Questions. 184  T. Jingi, (2013), China Starting to Regulate Shadow Banking, Nomura Research, Iakyara Vol. 181, November 11. 185  S. Gao, (2015), Seeing Gray in a Black-and-White Legal World: Financial Repression, Adaptive Efficiency, and Shadow Banking in China, Texas International Law Journal, Vol. 50, Issue 1, pp. 95–142. Gao provides an excellent overview of the history of the root causes of SB in China and the different barriers to entry China’s financial repression has created. 186  K.S. Tsai, (2014), The Political Economy of State Capitalism and Shadow Banking in China, HKUST IEMS Working Paper No. 2015–25, May, p. 41. 187  S. Gao, (2015), ibid., p. 141. 188  A.M.  Wiegelmann and H.-G.  Petersen, (2013), New Institutional Economics Perspective on Credit Transformation in China’s Financial System, May, Working Paper, mimeo. 183

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Regulations have started to come in since 2009 (obtaining approval for banks to issue WMPs), banning WMPs in secondary markets, better information disclosure (2011), assessing third-party products (2012), limitation of non-standardized debt products as WMPs (2013), separating wealth management from other bank business (2014). For now, the shadow banking segment is, from a regulatory point of view, covered by a patching together of different niche pieces of regulation without any holistic approach attached to it. That is not going to change somewhere soon.189 The various origins190 of the Chinese shadow banking system and the intertwining of monetary policy and outright financial repression make it a daunting task to crack down on the system. The SB system itself has become part of the financial infrastructure to arrange finance for all those that were one way or the other cut off from the system through government intervention in the past decade.191 Removing implicit guarantees and effective market subsidies will be the crux. That is in order to promote a more diversified and resilient financial system increasing reliance on market-based pricing mechanisms. Allowing bad agents to fail is still uncommon in China as the Party and political system have unified themselves with the financial system. With only one-third of the WMP guaranteed by the distributing bank (and which in its turn might benefit from an implicit state guarantee), two-thirds are not (they are effectively ‘off-balance’ and don’t qualify as deposits). But since banks are so close to the SB intermediation channel their implicit guarantee might be a lot larger than legally prescribed. Often this happens for reputational reasons but when, where and how is totally obscure.192 It is no surprise that widespread implicit guarantees and interest ceilings were and are major distortions in China’s financial system and has lead and will lead to major misallocations of resources. From a welfare perspective that is devastating. Anzoategui et al. lament that comprehensive reforms (would) generate better outcomes than partial ones (assuming that is what is actually taking place in recent years): removing the deposit rate ceiling alone increases output in a general equilibrium setting, but the efficiency of capital allocation does not improve. Removing implicit guarantees improves output through lower cost of capital for private companies and better resource allocation.193  See also: FSB, (2015), ibid., pp. 37–41; also: A. Sheng et al., (2015), Bringing Light Upon the Shadow Bank. A Review of the Chinese Shadow Banking Sector, Fung Global Institute, Oliver Wyman, pp. 23–25. 190  For example, S.J. Tong, (2013), Shadow Banking System in China—Origin, Uniqueness and Governmental Responses, Journal of International Banking Law and Regulation, Issue 1, pp. 20–26. 191  E. Sekine, (2015), Reforming China’s Financial Markets: The Problems of Shadow Banking and Non-performing Loans, Policy Research Institute, Ministry of Finance, Japan, Public Policy Review, Vol. 11, No. 1, March 2015, pp. 93–139. Also: S.L. Schwarcz, (2013), Shadow banking, Financial Risk, and Regulation in China and Other Developing Countries, The Global Economic Governance Program, University of Oxford. He concludes, ‘Any such regulation, however, should attempt to strike a balance between reducing that risk and preserving shadow banking as an important channel of alternative funding to developing economies, particularly in the face of significant retrenchment by large banks that had dominated the credit supply.’ 192  I.  Kaminska, (2015), China Has a Moral Hazard Problem, FT Alphaville, Financial Times, August 18. 193  D. Anzoategui et al., (2015), Financial Distortions in China: A General Equilibrium Approach, IMF Working Paper Nr. WP/15/274. 189

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5.10.4  Wealth Management Products and Trust Companies in China Chinese WMPs are investment vehicles marketed to retail and corporate investors and sold by both banks and nonbank financial institutions, sometimes with explicit principal or interest guarantees. They differ from conventional mutual funds in that their returns are fixed and the products have a set maturity (which is usually fairly short). However, WMPs are also distinct from bank deposits in that the funds raised are invested in a range of loans and securities and the returns offered significantly exceed regulated deposit rates194 on bank WMPs (i.e. there is an active bank involvement or trust company195 involved). There are different types of WMPs. Banks can raise and invest WMP themselves or use another financial firm (channel firm) to do so. The latter is done to keep the WMPs off the balance sheet of the bank and avoid capital requirements. They account for almost half the WMPs offered, whereas the active bank WMPs account for only 11%. The latter offer products that are most similar to deposits, but still offer yields higher than regulated deposit rate ceilings. This category of WMPs has explicit principal guarantees by the bank and is required to be accounted for on the balance sheet of the issuing bank. Those WMPs that are nonbank-managed use either the abovementioned trust structures or any other type of intermediation (direct bank-trust cooperation products, indirect bank-trust cooperation products and collective trust products).196 The differences between these models all come down to who makes the investment decisions and who backs the often guaranteed returns. There is a growing number of WMP that are set up and managed by a variety of NBFIs that have no bank involvement and no data are often readily available. The links between WMPs and trust companies are significant and account for sourcing about 60% of the AUM through the issuance of WMPs. Also banks invest in trust companies to execute those investments that would cause regulatory hassle in case executed out of their own balance sheet directly.197 A particular problem related to who guarantees the returns. Often it is the bank itself, but for a number of categories that is unclear as well as for those returns that are not legally guaranteed.198 Those WMPs should be clearly distinguished from the collective trust products (CTPs). The distribution of CTPs is limited to wealthier investors, who tend to face fewer restrictions on their investment activity, and they typically have terms of between one and two years, though sometimes significantly longer. CTPs invest in a single asset or asset type and so  E. Perry and F. Weltewitz, (2015), Wealth Management Products in China, Reserve Bank of Australia, Bulletin June, pp. 59. 195  Trust companies are financial institutions that manage assets and make investments on behalf of clients. 196  See in detail E.  Perry and F.  Weltewitz, (2015), ibid., pp.  60–61; also see: J.  Bedford and A. Rothman, (2013), China WMPs: Assessing the Risk, CLSA Speaker Series Report, 6 May; Y. Hu, (2014), Day of Reckoning for China Trusts, Haitong International Research Report, 25 July. 197  See for more granular data sets: D. Tao and W. Deng, (2015), China: Trust Funds and Shadow Banking, Credit Suisse Economic Research, February 17. 198  See for a specification of the product groups at risk: E. Perry and F. Weltewitz, (2015), ibid., pp. 61–62. 194

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do not have the diversification benefits of many other WMPs.199 Given their investment strategy, they are exposed to undiversified credit risk, but their disclosure is better and returns as well. The key risks regarding WMPs come down to who backs the guaranteed returns and the fact that on the front side these WMPs are considered deposit alternatives (but with better returns) but behind the curtain a lot is going on in terms of investing in all sorts of (illiquid) assets classes to produce those promised returns leading to all sort of maturity and liquidity mismatches. On top of all that, banks tend to pool different pools of assets or trust companies and invest them as one portfolio. The limited disclosure of info makes the WMP segment very elusive and risk management is, because of that, very difficult.200 To make things worse, many investors regard WMP as covered by an implicit guarantee and are therefore considered risk-free. That perception has been further enforced by a set of WMP bailouts by the Chinese government in recent years. And the capacity to absorb risk by asset managers, securities firms, fund managers and the likes is in general very limited. That needs to be judged against the backdrop that in some segments up to three-fourths of the WMPs have no legal return guarantees attached. The WMP segment is a fruitful domain for a thorough law and finance analysis given the many different legal and financial interactions they facilitate. Awrey has been looking into that and concludes: ‘WMPs possess a number of distinctive legal and economic features. First, despite being marketed by banks and other intermediaries as substitutes for conventional deposit accounts, the liabilities generated by the majority of these products do not reside on bank balance sheets. Second, while WMPs typically lock-in investors’ capital for relatively short periods of time, this capital is often invested into less liquid, longer-term assets. The resulting maturity and liquidity mismatches thus recreate the fragile capital structure of banks. Third, WMPs have emerged largely in response to China’s interventionist approach toward both banking regulation and broader macroeconomic policy.’201

 E. Perry and F. Weltewitz, (2015), ibid., pp. 62–63.  E. Perry and F. Weltewitz, (2015), ibid., pp. 63–66. 201  D. Awrey, (2015), Law and Finance in the Chinese Shadow Banking System, Cornell International Law Journal, Vol. 48, Issue 1, pp. 3–49, in particular pp. 21–45 for the WMP analysis. 199 200

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5.10.5  The Interconnectedness of the Chinese Shadow Banking Segment Given its historic emergence, it is no surprise that there are multiple ways in which the formal banking sector has a stake in the shadow banking sector.202 There are many traditional linkages as we found them across the globe, but two stand out as they are specific: (1) banks do make on-balance sheet loans directly to nonbank financial institutions. These would be transparently shown on the banks’ balance sheets and (2) banks or their affiliates sometimes have ownership stakes in trust companies or other nonbank financial institutions.203 The overall size of the SB segment is small in international terms and potential exposure is very localized.204

5.10.6  The Chinese Shadow Banking Market and ‘Information Asymmetry’ An important feature of the Chinese shadow banking sector is its close-connectedness with the traditional banking system. It can therefore be seen as bank-centric. In contrast to the US, the Chinese shadow banking system is built on different mechanisms and operates on different platforms. For example, the Chinese model is built on the asymmetric perception of information sensitivity among shadow banking entities, banks and investors. The Chinese model is built on implicit guarantees versus the US-based model that is built around financial engineering (to reduce funding costs and create safe assets for investors in the wholesale banking sector). The Chinese model is bank-model-based whereas the US system is capital markets–based.205 The other key difference concerns how the two shadow banking systems seek to create ‘safe’ assets that offer higher yields than demand deposits and government bonds. MMFs are innovations; WMPs are considered safe only because banks distribute them and clients expect an implicit guarantee.

 See for a good visualization: W.  Hou, et  al., (2014), Chinese Banks  – Initiating Coverage; Deleveraging, De-risking and (Finally) Diverging?, Sanford Bernstein Research, September 16, exhibit p. 34. 203  D. Elliott et al., (2015), Shadow Banking in China: a Primer, Economic Studies at Brooking, March, pp. 14–16. 204  Although much depends on the definition and measurement criteria: D. Elliott et al., (2015), ibid., pp. 17 and 21. 205  See for a comparison between the Chinese and US shadow banking system: T.V. Dang et al., (2014), Chinese Shadow Banking: Bank-Centric Misperceptions, Hong Kong Institute for Monetary Research, Working Paper Nr. 22/2014, pp. 9–12. The similarities are mainly to be found in regulatory arbitrage and the causes of financial repression. The difference is largely built around the already indicated ‘US market-based versus Chinese Ban-based system’ (p. 11). An updated version of the paper was released in 2015; see: T.V. Dang et al., (2015), Shadow Banking Modes: The Chinese Versus US System, Working Paper, December, mimeo. In the latter paper they employ the concept of information sensitivity to model implicit credit guarantees, asymmetric perception of credit guarantees and the role of the government, which was absent in previous working papers. 202

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Despite that there are similarities. Dang et al. illustrate that the emergence in the US of MMFs and trust loans in China shows similar dynamics and they were endorsed by similar financial deregulation. An important question, however, is whether the growth and structure of the Chinese shadow banking system follow the US counterpart and are thus subject to the same risks and vulnerability.206 It needs to be reminded here that the Chinese banking sector207 lacks diversity, is largely state-controlled and regulation has caused distortions in the economy and the invisible political hand has led to a bias in credit allocation toward state-owned firms and official projects.208 The initial regulatory constraints were good to guide China’s early economic developments but constrain its further growth in recent years.209 Taking into account that the shadow banking market in China has been fueled in recent years by (1) interest rate controls, shifting wealth from savers to borrowers, (2) the desire for higher returns has created the desire of wealth management products, (3) credit and macroprudential regulation has curbed lending and (4) the aforementioned bias to allocate credit to certain agents, banks have started to cooperate with shadow banks to conduct credit intermediation off-balance sheet. Regulatory arbitrage has therefore been a strong driver in recent years. The massive economic stimulus performed by the government has channeled large amounts of credit to the market and a significant part of that occurred off-balance. That regulation causes financial repression is a historical fact (US MMF funds emerged when regulation Q in the 1970s constrained deposit intakes), and explains the limited similarities between the US and Chinese shadow banking system (supra). If the Chinese shadow banking sector is as closely linked to the traditional banking sector, Dang asks the pertinent question: ‘why do banks participate in these off-balance sheet operations when they could lend through on-balance-sheet channels?’210 And further, ‘How does it create “safe” assets? What is the role of the government in Chinese shadow banking?’211 That requires an understanding of the drivers of the shadow banking segment in China.

 T.V. Dang et al., (2015), ibid., p. 3.  See for an historical institutional analysis of the Chinese (shadow) banking sector: T.V. Dang et al., (2015), ibid., pp. 4–8. 208  Z. Song, et al. (2009), Growing like China, American Economic Review, Vol. 101, pp. 196–233. 209  See for a review of the History of the Financial Systems reform in China: T.V.  Dang et  al., (2014), Chinese Shadow Banking: Bank-Centric Misperceptions, Hong Kong Institute for Monetary Research, Working Paper Nr. 22/2014, pp. 4–5. 210  T.V. Dang et al., (2014), ibid., p. 6 and T.V. Dang et al., (2015), ibid., pp. 8–10. Dang et al. Already the concept of information sensitivity already in 2013: T.V. Dang, et al., (2013), Ignorance, Debt and Financial Crises, Working Paper, mimeo; T.V. Dang, (2013), The Information Sensitivity of a Security, Working Paper, mimeo. 211  T.V. Dang et al., (2014), ibid., p. 3. 206 207

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The drivers of the Chinese shadow banking212 segment can be identified as being: 1. The desire for banks to circumvent regulation. Regulation has caused low interest levels and overall financial repression, which has led to a shift of deposits in higher-risk products (to avoid negative real interest rates) like wealth management products213 with market-based interest compensation. Banks also desire to avoid reserve requirements and credit quota.214 2. The investor demand for alternative investments. That is largely driven by high saving rates and few investment channels and the limitation to invest overseas. There are therefore structural supply and demand justifications for the rise of shadow banking. But there is more. The diversification of the Chinese financial infrastructure as a consequence of the rise of the shadow banking segment has been endorsed from a regulatory point of view. It is also a good test pool to see what the interest rate dynamics are under full rate liberalization215 and ultimately a full-fledged market-based financial infrastructure. This goes hand in hand with the historical dynamic of financial deregulation and lifting the ban for banks to venture out into many other domains. Also the cutback on stimulus spending in 2010 forced banks, with material long-term contracts outstanding were in dire need for a continuation of credit availability. They orchestrated that ‘in order to protect their balance sheets, banks further expanded their off-balance sheet operations and became increasingly reliant on shadow banking to intermediate credit’.216 The aforementioned notion of ‘information sensitivity’217 as a measure of ‘tail risk’ helps explain the key characteristics of the Chinese shadow banking model. Information asymmetry follows out of the fact that bank debt (which is deposit-based) requires investments in liquid and low-risk assets. The Chinese shadow banking institutions invest in ‘risky assets but issue liabilities that are widely seen as risk-­free’. As Dang et al. explain, ‘an institution that finances risky projects has “information-sensitive” assets on its balance sheet. These assets are, in turn, used as collaterals to back its liabilities. Therefore, if the collateral is intrinsically information-sensitive so are the liabilities. In such a case, the

 T.V. Dang et al., (2014), ibid., pp. 6–8. A. Sheng et al., (2015), Bringing Light Upon the Shadow Bank. A Review of the Chinese Shadow Banking Sector, Fung Global Institute, Oliver Wyman, pp. 8–10. 213  Structuring wealth management products allows them to avoid the deposit ceiling regulation. 214  G. Plantin, (2014), Shadow Banking and Bank Capital Regulations, HKIMR Working Paper Nr. 32/2014. See for a quantification of financial repression in China and the impact of monetary policy on shadow banking in China: M. Funke et al., (2015), Monetary Policy Transmission in China: A DSGE Model with Parallel Shadow Banking and Interest Rate Control, Bank of Finland Discussion papers, Nr. 2015/9. See in a broader monetary perspective: R. Nuutilainen, (2015), Contemporary Monetary Policy in China: A Move Towards Price-Based Policy?, Bank of Finland Discussion papers, Nr. 2015/10. 215  X. Zhang, (2012), China Monetary Policy, China Financial Press, Beijing and X. Zhang, (2013), Shadow Banking and Financial Crisis. China Reform, 2013/8 (in Chinese). 216  T.V. Dang et al., (2014), ibid., p. 9. 217  T.V. Dang et al., (2013), Ignorance, Debt and Financial Crises, Working Paper. 212

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value of private money (i.e. the liabilities it issues to investors) becomes volatile, and investors might not be able to withdraw it at par value.’218 To counter that, the demand for information-insensitive products rises, which has been serviced ­off-balance ­sheet. They look safe and liquid, but there is a veil of uncertainty about those statements that can easily be ignored or qualified as ‘misperception’ about risk. As dang et al. comment regarding shadow banking products (trust and wealth management products): ‘the involvement of banks as non-risk-­bearing intermediaries does not alter the information sensitivity of these products. However, the extensive involvement of banks in structuring and distributing the products creates the misperception that credit guarantees have been provided.’219 Information sensitivity becomes a new measurement of tail risk in those shadow banking products, once investors understand that all products only distributed by the traditional banking sector are intrinsically risky. It explains why projects that are highly information-sensitive will not get sufficient financing from traditional banks. The underdevelopment of the Chinese capital markets fuels the alternative financing circuit. They (SBs), lacking credibility, will have to use the traditional banking system to engage in liquidity and maturity transformation. The misperception of risk in the shadow banking market has led to widespread risk mispricing and moral hazards, and has created the illusion of high(er) returns with limited risks. That risk sits with the shadow banking entities, not with their traditional counterparts. The underlying assets, however, imply material risk that doesn’t go away and so asymmetry in risk perception persists. To solve the problem Dang et al. suggest that ‘(1) the “implicit guarantee” provided by banks can be made “explicit” by requiring banks to bring information-sensitive assets back on balance sheet. Banks can then choose to retain these assets and be the ultimate risk bearer, or sell them and transfer risks to others, and (2) to guide shadow banking towards the US system, turning a “bank-centric” model into a “marketoriented” regime.’220 That market mechanism will perform the function of risk distribution and credit allocation and it will increase the diversity of the Chinese financial system. Further and given the context of implicit guarantees Dang et al. conclude that ‘a consequence of asymmetric perception (or agreeing to disagree or biased beliefs) of credit guarantees is that it generates trades. If the underlying loan defaults then ex post one party is right and the other one wrong regarding the actual payment of guarantees.’221 Dang et  al. also conclude: (1) under rational expectations securitization is welfare improving but the system becomes fragile when agents neglect tail risks; (2) asymmetric perception of credit guarantees can also be welfare improving but the system might become fragile when the government scales back its role to enforce implicit guarantees; (3) shadow banking in China is based on the idea, rather than neglecting risks, that investors assert that banks will (be ‘asked’ to) honor implicit guarantees; (4) one reason for the government to establish formal deposit insurance in 2015 is to have the option to let a

 T.V. Dang et al., (2014), ibid., p. 13. See also: T.V. Dang, et al., (2014), Banks as Secret Keepers, NBER Working Paper Nr. 20255. 219  T.V. Dang et al., (2014), ibid., p. 17. 220  T.V. Dang et al., (2014), Chinese Shadow Banking: Bank-Centric Misperceptions, Hong Kong Institute for Monetary Research, Working Paper Nr. 22/2014, pp. 2–3. 221  T.V. Dang et al., (2015), ibid., pp. 18–21. 218

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bank fail without having (small) depositors losing their savings (reducing) the probability of a run on the whole banking system; (5) shadow banking is likely to remain stable as long as the Chinese government is willing to enforce implicit guarantees and provide backstops; (6) if the government places higher weight on ex post fairness than ex ante fairness transfer depends only on the payoff of the bank and the investor, while ignoring other information222; and (7) a move from managed capitalism to more market-based dynamics removing implicit guarantees and so on needs to be handled with utmost care as it is extremely prone to runs and panics.223 A final note: one can wonder to what degree implicit guarantees are a typical Chinese phenomenon. Also in Europe and the US, firms have set up off-balance sheet vehicles, assuming that despite their non-consolidation they would be covered by bailouts or access to the central bank liquidity window.224

5.10.7  Securitization in China Before the global financial crisis,225 there were only a limited number of securitization transactions in China, all mainly driven by policy considerations. While the US securitization market developed as a means to accelerate liquidity, the Chinese securitization market was initially established to deal with NPLs. In China, securitization has been promoted as a means of reducing reliance on the shadow banking system, and to ensure enough credit keeps flowing to a slowing economy. Deals driven by commercial considerations have started only in recent years.226 Generally speaking, securitization is less of a shadow banking issue in China. One reason is that although there is an overall trend toward deregulation, securitization in China is still subject to stricter regulation than in most developed markets. The other reason is that the current structures used in securitization deals in China are relatively straightforward.227 The securitization market got kick-started in 2005 with the introduction of the CBRC securitization regime (also known as Credit Assets Securitization Scheme). Under these regulations, banks and nonbank financial institutions licensed by the CBRC may entrust loan receivables comprising ‘credit assets’ to a CBRC-licensed trust and investment company as trustee. The most significant component of China’s securitization market is this credit asset securitization regime, under which banking and financial institutions approved  See also: S. Chassang, and C. Zehnder, (2014), Rewards and Punishments: Informal Contracting Through Social Preferences, Working Paper, mimeo. 223  T.V. Dang et al., (2015), ibid., pp. 21–25. 224  See, for example, L. A. Górnicka, (2015), Shadow Banking and Traditional Bank Lending: the Role of Implicit Guarantees, UvA/Tinbergen Institute Working Paper, October, mimeo. 225  See for a historical write-up of the Chinese securitization market: B.  Buchanan, (2015), Securitization in China – Déjà Vu?, Journal of Structured Finance, Vol 21, Issue 3, pp. 36–50. 226  See for a detailed volume analysis over the years: A. Rutledge, (2015), Who Will Take the Lead in Shaping China’s Securitization Market Model, SWIFT Institute Working Paper Nr. 2014/3, September 23, p. 3. 227  Clifford Chance, (2015), Shadow Banking and Recent Regulatory Developments in China, January, p. 7. 222

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by the PBOC (China’s central bank) and the CBRC can legally securitize their credit assets (e.g. loans). This model resembles at best the US-styled true sale securitization model (although legally they differ quite a bit).228 The alternative securitization model229 available is the ‘corporate asset special management regime’, aka ‘selective asset management plan’ (SAMP) or ‘asset-­backed special plan’ (ABSP) which involves broader underlying assets (which, apart from credit assets under the credit asset securitization regime, may include commercial receivables, lease agreements, trust interests as well as infrastructure and other real properties).230 Securities backed by SAMP assets were issued by the securities company to investors and which could be traded on the Shanghai and Shenzhen stock exchanges. Only a handful of SAMP transactions were done as it heavily relies on thirdparty guarantees. The SAMP lasted for only a year (introduced initially in 2005) and was revitalized in 2013. Under the new rules a firm can apply to the China Securities Regulatory Commission (CSRC) to establish a ‘special scheme’ whereby funds entrusted by investors to the securities company could be used to purchase receivables and other assets to be managed by the securities company. That company would issue ABS which could be traded on the exchanges. In 2014 the system was once again overhauled. The biggest change vis-à-vis the 2013 model is the change of statutory underpinning for the CSRC securitization scheme.231 Another difference is the inclusion of subsidiaries of fund management companies as entities eligible along with securities companies to engage in the asset securitization business.232 Given the novel dynamics of the securitization framework in China, nothing has been tested in a domestic or cross-border insolvency setting. The fact that both systems heavily rely on administrative guidelines rather than incorporated in law makes any potential outlook all the more troublesome.233 Despite the growth in recent years of the securitization market,234 it would make perfect sense for the regulator to create one securitization framework (merge the two existing ones) and enact one securitization statute.

 See for a volume analysis: A.  Rutledge, (2015), Who Will Take the Lead in Shaping China’s Securitization Market Model, SWIFT Institute Working Paper Nr. 2014/3, September 23, pp. 10–12. The collateral is divided into six categories: NPLs, RMBS, collateralized loan obligations (CLO), credit card ABS, automobile loan ABS and light equipment lease ABS, with the CLOs accounting for 75% of the volume in collateral. 229  The models are known as respectively the CBRC and CSRC model. 230  Neither the ‘special purpose trust’ under the CBRC scheme nor the ‘special scheme’ under the CSRC scheme constitutes an independent legal entity with separate legal personality. See for a full write-up of the technicalities of both systems: J.H. Chen and L. Haiping, (2015), Securitization in China—Overview and Issues. Can China Develop a Viable Cross-Border Securitization Market, pp.  1–2 and A.  Rutledge, (2015), Who Will Take the Lead in Shaping China’s Securitization Market Model, SWIFT Institute Working Paper Nr. 2014/3, September 23, pp. 9–14. 231  The 2005 and 2013 regulations relied on a principal-agency entrustment concept contained in the PRC Civil Law (enacted April 1986), whereas the 2014 regulations are grounded on the PRC Securities Investment Funds Law (enacted December 2012 and made effective June 2013), which in turn incorporates the Trust Law. 232  J.H. Chen and L. Haiping, (2015), ibid., pp. 2–3. 233  In detail: J.H. Chen and L. Haiping, (2015), ibid., pp. 4–11. 234  F. Law, (2015), China Becomes Asia’s Biggest Securitization Market, WSJ, September 24. 228

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Also insurance firms and asset managers can issue asset-backed notes in the interbank market through a registration system administrated by the National Association of Financial Market Institutional Investors, which apparently may accept innovative structures similar to traditional securitization deals. Since 2013 securitization are on the rise to approximate RMB 202 billion in late 2014 and skyrocketed to RMB 2.7 trillion (end 2018)235 compared to only RMB 10 billion in late 2013.236 Most of it can be explained as an attempt to kick-start the economy and lending to the real economy. But also here, just like in advanced economies, the real tricky part is the securitization of SME financing. As Hu illustrates, ‘SME securitizations also entail significant risks associated with asset performance, legal and deal documentation clarity, structural integrity, and various conditionality embedded in the transaction.’237 SMEs performance is sensitive to the overall economic credit conditions and bankruptcies tend to rise in economic downturns. Therefore rating agencies tend to use a tight set of criteria.238 The Alibaba small business loan securitization program, as was approved in July 2013, was much appreciated and embeds a number of interesting features.239 Bottom-up disruption is also the way forward in the Chinese securitization market.240 But many issues remain including the concept of ‘fair value’, and the problematic funding-arbitrage (true sale where the payoff has a credit basis on a new balance sheet241) versus pricing arbitrage (capital arbitrage; to optimize the risk-adjusted value of old balance sheets; it is primarily a channel for banks to sell risky collateral to a special purpose entity (SPE) at the highest possible price) conundrum.242 With funding arbitrage, the essence of this process is to design a capital structure so that the credit risk of each tranche is exactly cushioned by sufficient contingent capital (credit enhancement) to neutralize the risk, consistent with the meaning of the rating.243 Rutledge explains: ‘[s]ince the rating is the pricing benchmark for structured transactions, in a rational market the level of yield should compensate structured investors for

 Chinadaily, (2019), Securitization Provides growing Debt Funding to Chinese Economy, March 29, chinadaily.com.cn 236  Clifford Chance, (2015), ibid., pp.  8–9. Also: F.  Law, (2015), China Becomes Asia’s Biggest Securitization Market, WSJ, September 24. 237  See J.  Hu, (2013), SME Financing through Securitizations in China: Global Perspectives, Prepared solely for Harvard US-China Financial System Symposium, August. 238  See J. Hu, (2013), ibid., pp. 10 and 12. 239  See in detail: J. Hu, (2013), ibid., pp. 4–5. For a comparison between the Indian and Chinese Shadow banking market: D.  Sherpa, (2013), Shadow Banking in India and China Causes and Consequences, Economic and Political Weekly, Vol. 48, Nr. 43, pp. 113–122. 240  See for some illustrative recent examples: and A. Rutledge, (2015), Who Will Take the Lead in Shaping China’s Securitization Market Model, SWIFT Institute Working Paper Nr. 2014/3, September 23, pp. 15–17. The Chinese securitization market is a highly domestic affair (pp. 17–21). 241  Which makes at least one party better off economically without increasing risk to the other: (1) the investor is better off bearing the risk based on its own capital management strategy; or (2) the borrower has locked into a cost of funds that is lower than the on-balance sheet cost (p. 22). 242  A. Rutledge, (2015), Who Will Take the Lead in Shaping China’s Securitization Market Model, SWIFT Institute Working Paper Nr. 2014/3, September 23, pp. 21–27 and 32–33. 243  A. Rutledge, (2015), ibid., p. 21. 235

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the payment uncertainty of their position in the capital structure. The equilibrium between the risk embodied by the rating and the value realizable in the yield has a name: risk certainty-equivalence. Risk certainty-equivalence leads to pricing arbitrage.’ ‘Pricing arbitrage starts on the right side of the balance sheet when the tranches are sized based on standard default risk measures, a.k.a. ratings. Assuming risk standardization, there exists within the system of measures and rules an optimal, top-heavy capital structure, which is to say a maximally leveraged capital structure. Maximizing leverage minimizes the funding cost.’244 Maximizing liquidity and minimizing the cost of funding are the objectives. Not all structured finance deals involve funding arbitrage but all structured finance deals, including securitization, entail pricing arbitrage. Funding arbitrage occurs along the lines of ABS, RMBS and commercial mortgage-backed securities (CMBS) and CLO obligations; capital arbitrage occurs mainly along the lines of collateralized debt obligations (CDOs), collateralized bond obligations (CBOs), ABS/RMBS CDOs, CDO-squared, ABCP and SIVs. Synthetic CDOs are the advanced benchmark arbitrage, a synthetic advancement of capital arbitrage. There was not even a sale in assets here. Rutledge clarifies: ‘[t]he investors did not purchase securities; they wrote credit default swaps (CDS) on the reference portfolio and were paid a premium commensurate with the market-required credit risk premium on like-rated assets.’ ‘CDS were the building blocks of credit-linked notes (CLNs); hybrid cash-­synthetic CDOs, with some synthetic and some true sale features; bespoke CDOs, where certain portions of a customized capital structure are carved out and sold; funded synthetic CDOs, where the sale proceeds are used to purchase treasuries; and CDS index products, for hedging and speculation on structured asset sectors. The risks of this market mirror the risks of capital arbitrage but are compounded by the possibility of selling the same mispriced risk to multiple buyers.’245 The part of the market is essentially there to stimulate secondary market liquidity. Although the Chinese market has no CDS component, exchanges are opening up in China for repackaged, distressed and obscure collateral by the tens or hundreds. This mushrooming of markets is strikingly different from the securitization experience elsewhere.246 Within a Chinese context it can be argued that re-securitizations and synthetic structures are prohibited in China. Nevertheless, functionally, the micro-structure of Chinese and global structured finance markets is very similar.247

5.10.8  Systemic Risk in the Chinese Shadow Banking System It was argued before that given the relative simplicity of structure and products used in the Chinese shadow banking system, the systemic risk is limited and concentrated in the financial infrastructure. However, in recent years, during which volumes grew, eco A. Rutledge, (2015), ibid., p. 23.  A. Rutledge, (2015), ibid., p. 24. 246  A. Rutledge, (2015), ibid., p. 27. 247  See for a localized analysis of the three categories (true sale/funding arbitrage, pricing/capital arbitrage and benchmark arbitrage): A. Rutledge, (2015), ibid., p. 26–2 244 245

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nomic growth slowed down and monetary interventions were abundant, more efforts were done to understand the true systemic nature of the Chinese shadow banking segment. It is a fair question, in a multilayered financial environment where political interventions are commonplace and institutions guarantee the credit or returns of other entities in the system.248 Dispersion of risk across the ‘under-developed’ shadow banking system has led to localized cases of concentrated risk, but not to large levels of systemic risk across the entire shadow banking system. That was the initial position. Hsu et al.249 recently, however, found that some systemic risk is presented in the system at the level of the trust companies and that banks absorb most of the risk in the financial system.250 It is obviously the banks that are in the tightest grip of the political system in China. The two factors leading to the trust factors posing higher risk are: (1) asset/liability or balance sheet risk, and (2) trust companies greatly depend on cooperation with other institutions, especially banks, concentrating the distribution of debtors (‘spillover risk’).251 Remember systemic risk is ‘the risk that an event will trigger a loss of economic value or confidence in, and attendant increases in uncertainty about, a substantial portion of the financial system that is serious enough to quite probably have a significant adverse effect on the real economy’. It emerges as a liquidity or solvency risk and can be triggered due to balance sheet structures, interconnectedness or the nature and design of contracts. Hsu et al. further concluded that insurance firms, securities companies and repo bond markets had non-significant levels of systemic risk attached and fund management companies a rather low-end risk profile. In contrast the WMP segment poses higher risk as discussed before. Banks are the central nodes in the system and absorb about 85% of the shadow banking risk and are therefore the key externality absorber in the system. The overall volume of systemic risk in the shadow banking system is growing and in some years exponentially, often due to the rise in volumes and accompanying interconnectedness and that will magnify the default risk at the infrastructure level as well as the individual entity levels.252 But most of it will turn out to be isolated default risk rather than overall and holistic systemic risk. Attempts have been made to measure the systemic risk in the Chinese (shadow) banking market by estimating the conditional value at risk (CoVaR), the marginal expected shortfall (MES), the systemic impact index (SII) and the vulnerability index

 J. Li and Y. Xue, (2014), Systemic Risk in Chinese Shadow Banking Systems: Risk Contagion Mechanism, Influence and Control, Journal of Quantitative and Technical Economics, Vol. 31, Issue 8, pp. 117–130. 249  S. Hsu et al., (2014), Shadow Banking and Systemic Risk in China, Political Economy Research Institute, University of Massachusetts Amherst, Working Paper Nr. 349, May. 250  They use a Markov model that asserts that shadow banking risk contagion is a dynamic ongoing process that can be regarded as a series of time intervals. Systemic risk is measured by how many defaults occur in the whole system as a consequence of potential contagion. See for set-up of the model (pp. 8–9). 251  S. Hsu et al., (2014), ibid., pp. 15–16. 252  See for the initial position: J. Li and S. Hsu, (2013), Shadow Banking in China: Institutional Risk, Political Economy Research Institute, University of Massachusetts Amherst, Working Paper Nr. 334, August. 248

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(VI). Although these measures show different patterns (which makes sense as they capture different aspects of systemic risk in the banking system), the results suggest that systemic risk in the Chinese banking system decreased after the financial crisis, but started rising in 2014. Chinese banks have the highest CoVaR and the lowest MES compared to most countries, suggesting that the Chinese banking system is systemically riskier but that it seems better capable of avoiding losses from banking system distress. Besides, Chinese banks are also systemically riskier than US banks according to the SII and the VI approaches.253 Trust and investment companies contribute to that systemic risk through their high level of interdependence with other parts of the financial infrastructure and their high level of leverage applied.254

5.10.9  The Political Dimension in the Chinese Shadow Banking Segment It was highlighted before that the shadow banking sector has evolved into a multilayered infrastructure where monetary and legal positions are reflected but also where political decision-making and political-economic issues of China had their role in the development of the system. Even local governments that saw themselves constrained from lending by the central government found the solutions in the SB segment (trust companies) to fuel their infrastructure spending. But shadow banking was and is about meeting both investment (looking for yield) and financing demands.255 The writings have been all over the wall for years in China (Box 5.1) but things started to move only in 2013.

 Q.  Huang et  al., (2015), Analyzing Systemic Risk in the Chinese Banking System, CESifo Working Paper Nr. 5513, September. See for other aspects of the Chinese systemic risk patterns in the SB and overall banking system: (1) Y. Chen, et al., (2014), Domestic Systemically Important Banks: A Quantitative Analysis for the Chinese Banking System. Mathematical Problems in Engineering, Working Paper, mimeo; (2) Y. Dong, et al., (2014), Evaluating the Performance of Chinese Commercial Banks: A Comparative Analysis of Different Types of Banks, Working Paper, mimeo; (3) J.P. Fenech, et al., (2014), Can the Chinese Banking System Continue to Grow Without Sacrificing Loan Quality? Journal of International Financial Markets, Institutions and Money, Vol. 31, pp.  315–330; and (4) Y.  Wang, Y., et  al., (2015), Estimating the Systemic Risk of China’s Banking Industries based on Merton Model, Applied Mathematics & Information Sciences, Vol. 9, Issue 2, pp. 957–964. 254  A. Maharani, (2015), Chinese Shadow Banking Institutions: Understanding Factors Contributing to the Systemic Risks of Trusts and Investment Corporations, Wharton Research Scholars Journal Working Paper Nr. 4–2015. 255  S. Hsu and J. Li, (2015), The Rise and Fall of Shadow Banking in China, Political Economy Research Institute, University of Massachusetts Amherst, Working Paper Nr. 375, February, pp. 5–6. 253

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Box 5.1  China Starts (Starting Late 2013) to Crack Down (Somewhat) on Shadow Banking China Starts to Crack Down (Somewhat) on Shadow Banking In late 2013, China’s cabinet imposed new controls on the multi-trillion-dollar shadow banking industry with an order that targets off-the-book loans and shores up enforcement of current rules. The rules include a ban on transactions designed to avoid regulations, such as moving interbank loans off balance sheets to reduce reported levels of lending. The regulatory initiative was partly induced by JPMorgan Chase’s estimation that the Chinese shadow banking size had reached 69% of gross domestic product, thereby threatening the financial systems’ stability. In 2014, the Chinese shadow banking industry was estimated at a value of approximately USD 6 trillion (which has grown to about USD 9 trillion in 2015). Indeed, the leverage piling up had become a threat to the system. Many moneylosing industries have been relying on such financing (from the shadow banking industry one way or the other) to roll over their debt. Currently, most of China’s shadow banking is a result of banks’ interbank business that is designed to take advantage of regulatory loopholes and ends up pushing up leverage in the whole financial system.256 The new directives also include a ban on using third parties to evade restrictions on lending directly to certain borrowers as well as restrict lending to property developers as part of the effort to control house prices. The rules order banks to set up separate units for their wealth-management businesses, and to create provisions and set aside capital for them. The regulations also ban banks from using the products, which are funded by customers’ savings, to buy loans from the bank’s balance sheet. The State Council order also bans trusts from pooling deposits from more than one product and investing them in non-tradable assets, while private equity firms are barred from lending to clients. Simultaneously, a Chinese audit of local governments exposed an increased reliance on shadow banking. Local government debt overdue at the end of June 2014 was RMB 1.15 trillion, or 10.56% of borrowings.257 One of the problems was the fact that the Chinese economy is not yet a fully developed market economy and therefore the economy is not yet fully driven by market forces and demand for funds in some sectors does not necessarily reflect the real situation on the ground. Part of it is driven by the fact that savers have been looking for higher-yielding alternatives to bank deposits258 and the fact that more (continued)

 Z.  Hao, a Shanghai-based economist at Australia and New Zealand Banking Group Ltd. in J. Luo and C. Somayaji, (2014), China’s Cabinet Imposes New Rules in Shadow Banking Fight, 7 January 2014, Bloomberg. 257  National Audit Office data. 258  Banks and other financial institutions have offered wealth management products, off-balance sheet quasi-savings vehicles, to retain depositors who have been moving money out of the banking system for higher returns. The value of such wealth products stood at RMB 9.1 trillion at the end of June 2013, according to the China Banking Regulatory Commission; source ibid., note i). 256

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Box 5.1  (continued) than 90% of the 42 million small companies have little or no access to capital through the official financial system in the country. A large chunk of the capacity of the official financial system (state-­owned system) goes toward financing either the government and/or the large (quasi-)state-owned companies. It is therefore that the government allowed five privately owned lenders to start operations in 2014. The largest and increasing part has to do with the fact that financial institutions have become increasingly involved in interbank business, taking short-term loans from peers and lending to companies for longer durations to circumvent capital requirements, lending quotas and restrictions in loans to sectors such as real estate and local government financing vehicles. Regulators are concerned that banks are using short-term interbank borrowing to fund payouts on maturing WMPs, even when the underlying assets—including loans, bonds and bank acceptance bills—haven’t yet matured. This demonstrates the link between the shadow banking system and the real economy. It is very doubtful if regulation alone will solve the problem. But also the government itself is part of the problem. China’s audit of local governments exposed an increased reliance on shadow banking, swelling the risk of default on RMB 17.9 trillion (USD 3 trillion) of debt. As banks tightened their purse strings,259 local governments had no choice but to resort to shadow banking and incur more expensive borrowing costs. That will further constrain their repayment ability and eventually overwhelm some lower-level entities which have borrowed way beyond their means.260 The leveraging of the Chinese economy did happen not only through the state-owned infrastructure but largely through the shadow banking system.261 Local government debt overdue at the end of June was RMB 1.15 trillion, or 10.56% of borrowings, the audit report showed. That compares with the 1.3% overdue ratio in the banking system, reflecting the practice of rolling over regional debt instead of classing it as delinquent.262 The China Banking Regulatory Commission estimated already in 2010 that about half of the bank loans to LGFVs were being serviced by secondary sources including guarantors because the ventures couldn’t generate sufficient revenue. In 2012, the agency suggested banks cap loans to such vehicles to levels reached at the end of 2011 and reiterated it in December 2013. As a result, growth in bank loans to local governments slowed to 19% to RMB 10.1 trillion from the end of 2010 to 30 June 2013, compared with a 67% jump in total debt. Trust financing to LGFVs surged to RMB 1.4 trillion263 from zero and bond issuance (continued)

 Bank lending dropped to 57% of direct and contingent liabilities as of 30 June from 79% at the end of 2010, while bonds rose to 10% from 7%, National Audit Office data show. 260  Tang Jianwei, a Shanghai-based economist at Bank of Communications Co. in H.  Sun and S. Hendry, Shadow Banking Risks Exposed by Local Debt Audit, 6 January 2014, Bloomberg. 261  China’s borrowing spree since 2008 has evoked comparisons to debt surges that tipped Asian nations into crisis in the late 1990s and preceded Japan’s lost decades. 262  Ibid., note v. 263  Total trust loans outstanding early 2014 were valued at RMB 4.62 trillion. 259

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Box 5.1  (continued) more than doubled to RMB 1.8 trillion. Asset quality concerns on loans to LGFVs have been a major valuation overhang for Chinese banks264 especially since China’s local governments are responsible for 80% of spending while getting about 40% of tax revenue. Local governments have set up more than 10,000 financing vehicles to fund projects such as subways and airports because regulations limit their ability to borrow money directly.265 Deprived of relatively cheaper loans from banks, some LGFVs are paying more to borrow from trust companies. Local governments are normally charged more than 10% annually for funding from such sources.266 Also trusts play their part in the system. Trusts typically get people to invest at least RMB 1 million in alternatives to bank accounts linked to PBOC’s 3% benchmark deposit rate. They had RMB 10.1 trillion of assets under management as of 30 September 2013, an increase of 60% from a year earlier.267 Borrowing costs are climbing as regulators are freeing up interest rates. The nation started the trading of negotiable certificate of deposits in December 2013, a sign that regulators accelerated the liberalizing of rates, after the ruling party’s third plenary session in November 2013 decided to grant the market a ‘decisive’ role in allocating resources. As the top decision makers attempt to free controls on interest rates, they understand a stable market environment is necessary to achieve the goal, but is a conundrum as these LGFVs get implicit guarantees from the state. Beijing is concerned that many LGFV loans obtained in 2008–2009 were poorly collateralized and project cash flow estimates were overstated.268 But that is not it for the Chinese shadow banking system. As already mentioned a large part of the Chinese shadow banking system relates to curbside lending. A combination of many small businesses (mom-and-pop shops) who can’t supply the kind of collateral that banks typically demand even if the businesses have grown exponentially over the years. This has created this murky pool of curbside lenders, microcredit institutions, pawnshops which one can qualify as the informal part of the shadow banking system on top of the more ‘official’ side discussed above.269 Such unrestrained growth naturally worries China’s central bank, which fears that a flood of bad shadow loans could prompt a financial (continued)

 S. Ho and P. Ran, (2014), Citigroup Inc. Analyst Report, January 3.  See further: Bloomberg News, (2012), China’s Ghost Towns Highlight Shadow Banking Risk, November 20. 266  Source: Xinhua News Agency reported in November 2013. That compares with the People’s Bank of China’s 6% benchmark one-year lending rate. 267  Source: China Trustee Association. About 26% of their proceeds were invested in infrastructure projects. 268  See further and for an overview of projects that were downgraded: M. Zhang, (2013), China’s local government financing vehicles: 7 things you should know about China’s local debt bomb, International Business Times, September 27. 269  Although ‘informal lenders’ charge about 24–30% annually for their money, demand remains virtually unlimited. Obviously, one cannot defend a USD 5 trillion industry referring to a couple of (successful) examples; truth of the matters is that there is less leverage in the informal shadow 264 265

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Box 5.1  (continued) meltdown similar to the US subprime crisis in 2008. A liquidity squeeze in June 2013, when the central bank allowed interbank lending rates to rise to as high as 20% before intervening, was widely interpreted as a warning to banks to clean up their shadow portfolios.270 If the new rules are strictly implemented, the deleveraging push could put China’s economy on a more sustainable long-term path by reducing the risk of a bad-­debt crisis. But short-term growth would likely fall as a reduction in credit growth spurs a fall in spending. There might even be need for debt restructuring in some industries; if not, funding chains might become broken or, worse, defaults will arise as the growth of total social financing will slow and fixed asset investment will also slow. Going forward will be a balancing act between a further regulatory crackdown, managing interest rates and deleveraging the public, corporate and household debt outstanding. It is clear that the new rules do not initiate a fullblown crackdown on the sector, was it not for the fact that it is seen by leadership as a key source of credit for the economy (in particular that part not served by the formal banking sector) even though it has contributed to industrial over-capacity and high debt levels at local governments. Meaningfully tackling shadow banking presumes a comprehensive regulatory framework for the financial system which was lacking at that stage in China (and to a certain degree still is).

With the 2014 real estate downturn in China, the government felt the need to step in. Besides the necessary monetary loosening, real estate policies were eased and trusts were ordered to absorb any losses. The central bank went as far as to dictate trust companies to provide funding for defaulting companies and create tax schemes for second-and thirdtime buyers (initially limited first-time homebuyers).271

banking part and losses are absorbed by the entrepreneur without affecting the taxpayer. J. Zhang, author of the book Inside China’s Shadow Banking: The Next Subprime Crisis? Enrich Professional Publishing Inc. (2013) argues: ‘[s]hadow banking has flourished in China for one simple reason: financial repression. By keeping interest rates artificially low, authorities have forced savers to search for more lucrative financial products. By favoring banks  — which, in turn, favor stateowned or well-connected private-sector companies with loans — they have forced small enterprises to seek out people like me (i.e. shadow bankers). Meanwhile, projects that might look sketchy at 9% interest rates suddenly look feasible at 6%. Under such conditions, traditional banks have steadily lowered their lending standards — from prime loans to subprime and then to simply silly loans. Sound familiar? That’s how the 2008 financial crisis began, too. Leaders are right to worry about the possibility of a banking crisis in China. But instead of focusing their ire on shadow bankers, they should raise benchmark interest rates in order to reduce the amount of credit flowing to dodgy loans through the formal banking sector. That is luckily enough what is happening in 2014.’ 270  J. Zhang, (2013), The True Confessions of a True Shadow Banker, Financial Post, 9 July 2013. 271  S. Hsu and J. Li, (2015), The Rise and Fall of Shadow Banking in China, Political Economy Research Institute, University of Massachusetts Amherst, Working Paper Nr. 375, February, pp. 12–15.

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Shadow banking became the scapegoat for everything that went wrong in China in 2014, in particularly everything that went wrong in real estate. The crackdown on shadow banking, as discussed above in 2014, has led to declines across the board for the different subsegments (except securitization). However, the real crackdown that you would expect with all the rhetoric didn’t come through.272 Besides the already discussed circular 107, the regime issued a circular encouraging banks to invest in WMPs, and circular 127 which restricted loan to enterprises disguised as interbank lending (May 2014; this regulation prohibits interbank repo built on non-standard credit type assets)273 as well as regulating P2P through a ten-principle model. Also further guidance was provided how to execute risk monitoring for trust companies274 and regulated to cover entrusted loans (January 2015).275 So, a bit of everything but never consistent or coherent really.276 And the real underlying problem (poor asset quality) stayed largely untouched. And there is nothing more to expect as the only real cure lies in a broader redesign of the financial system as a whole including further liberalization of the accounts. Getting rid of repressed deposit rates and ingrained bank lending preferences has created a risk control–free shadow banking system with aligned shady rating mechanisms.

 In contrast to the rest of the world and, for example, the US, see S.  Hsu and J.  Li, (2014), Shadow Banking Systems in the U.S. and China. Chapter in ‘Challenges to Financial Stability: Perspectives, Models and Policy’ (ed. R. Karkowska), ASERS Publishing and S. Hsu et al., (2013), Shadow Banking and Systemic Risk in Europe and China, CITYPERC Working Paper Nr. 2013/2. 273  D. Tao and W. Deng, (2015), China: Trust Funds and Shadow Banking, Credit Suisse Economic Research, February 17, pp. 19–20. 274  CBRC (China Banking Regulatory Commission), (2014), The Guidance on Risk Supervision to Trust Companies. April 8. In that lists belongs as well: CBRC’s ‘Notice on Regulating Commercial Banking Interbank Business’ (document Nr. 140, May 2014). Discipline on the interbank market began in June 2013, when the PBOC engineered a liquidity squeeze that briefly drove overnight interest rates to nearly 30%. One of the main purposes of this exercise was to curb the enthusiasm of smaller banks that had been borrowing heavily on the interbank market to fund higher-risk lending activity, often routed through shadow banking, D. Elliott et al., (2015), Shadow Banking in China: A Primer, Economic Studies at Brooking, March, p. 22. 275  See for a full mapping of regulatory initiatives taken by the Chinese government: D. Tao and W. Deng, (2015), China: Trust Funds and Shadow Banking, Credit Suisse Economic Research, February 17, pp. 33–35. For an evaluation: D. Richardson et al., (2015), Shedding Light on China’s Massive Shadow Banking Market: Regulations: for Better or for Worse, The Banking Law Journal, January, pp. 27–34. 276  So argue that this is due to the regulatory framework in China and the way the SB segment has been built up. See for a comparative analysis of the Chinese regulatory initiatives in recent years with the regulatory reform agenda and implementation in the West: R.H.  Huang, (2015), The Regulation of Shadow Banking in China: International and Comparative Perspectives, Banking and Finance Law Review, Vol. 30, pp. 481 ff., in particular pp. 488–502. Given the intertwining between the SB and regulated banking sector and the fact that they originate, structure and distribute as well as share risk over their joint platforms, an entity- or even activity-based approach comes with many complications. It refers to the complicated institutional setting that created the Chinese SB to begin with. As Huang indicates ‘In short, there is a mismatch between China’s regulatory structure and the underlying market it regulates, which has affected the efficacy of the regulation by creating regulatory inconsistency, gaps and overlaps’ (p. 491). 272

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Also a redesign of the regulatory decision-making process would be welcomed.277 And yes, the Chinese system is in many ways different from its Western peers and therefore justifies as a sophisticated approach toward dealing with it.278 And not to forget, it will require international cooperation as its wings now start to spread internationally into Asia.279 Part of the answer on how to deal with the Chinese shadow banking segment lies in its origin. Its origin, as discussed, was caused by the interplay of monetary policy,280 a non-fully liberalized financial infrastructure, the state-dominated banking sector and the asymmetric servicing of the credit demand market. All these elements will ultimately have to be taken into account when ‘framing’ the Chinese shadow banking sector.281 An important milestone was the opening up of the bond market in late December 2015 (while during the same period the RMB was added to the basket underlying the special drawing rights (SDR) at the IMF).282 For the time being shadow banking in China must be viewed in the context of a system which remains dominated by banks, especially large state-controlled banks, and in which the state provides a great deal of direction to banks, through a variety of regulations and formal and informal guidance.283 Since shadow banking in China is mainly conducted by commercial banks to evade regulatory restrictions on deposit rate and loan quantity it essentially constitutes a dual-track pragmatic approach to gradually liberalize the country’s repressed interest rate policy. A full interest rate liberalization leads to additional gain in social surplus.284 And also China is prone to a changing shadow banking landscape. The ‘mutual fund subsidiary asset management’ and the ‘broker asset management companies’ mentioned at the beginning of this chapter are essentially shadow banking channels rather than asset manage J. Gruin, (2014), Asset or Liability? The Role of the Financial System in the Political Economy of China’s Rebalancing, Journal of Current Chinese Affairs, Vol. 42, Issue 2, pp. 73–104. 278  Y. Li, (2013), Don’t Regulate Shadow Banking in a Rude Way, [in Chinese], China Securities Journal, July 19. Q. Yan and Li Jianhua, (2014), China’s Shadow Banking System and its Regulation, [in Chinese], China Renmin University Press, Beijing, China. 279  The FSB reminded China of that in their latest peer review 2015 (supra); also: Z. Liansheng, (2015), The Shadow Banking System of China and International Regulatory Cooperation, New Thinking and the New G20 Series, Working Paper Nr. 6, March, pp. 5–6. 280  R. Nuutilainen, (2015), Contemporary Monetary Policy in China: A Move Towards Price-Based Policy? BOFIT Discussion Papers Nr. 10, Helsinki. 281  For example, a pertinent question related to the impact on the SB segment in case of an interest rate liberalization, how it will feed through and impact the SB infrastructure: see, for example, M. Funke et al., (2015), Monetary Policy Transmission in China: A DSGE Model with Parallel Shadow Banking and Interest Rate Control, BOFIT Discussion Papers Nr. 9, Helsinki (was also released as HK Monetary Authority Working Paper Nr. 12/2015, May). For reserve requirement changes and their impact, see Z. Fungáčová et al., (2015), Reserve Requirements and the Bank Lending Channel in China, BOFIT Discussion Papers Nr. 26, Helsinki. 282  Entering China’s onshore fixed-income market is a complicated process. The initial license for a renminbi-qualified foreign institutional investor (RQFII) quota gives access only to the small pool of bonds traded on exchanges. Trading in the much larger interbank bond (IBB) market requires a further application for permission to the People’s Bank of China; see: S. Greene, (2015), Chinese Bonds Lure Foreign Fund Managers, Financial Times, December 6. 283  D. Elliott et al., (2015), Shadow Banking in China: a Primer, Economic Studies at Brooking, March, p. 1. 284  H.  Wang et  al., (2015), Shadow Banking: China’s Dual-Track Interest Rate Liberalization, Working Paper, May, mimeo. 277

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ment services. And they have a much greater flexibility and can engage in all sorts of transactions. The mutual fund subsidiary asset management and broker asset management businesses can conduct almost all types of investment transactions from listed to non-listed assets from private placement to equity repo.285 Chinese regulators have increased liquidity standards and cracked down on loan-to-deposit ratios, yet debt-to-GDP has only grown faster. The model developed by Hachem and Song provides further clearance.286 They argue that the big four banks are using WMPs to defend their market share. Overall, savings in China are not yet sufficiently elastic to WMP returns, so high-return WMPs by cap-constrained banks poach deposits from the big four banks. The big four banks defend their market share by manipulating the interbank liquidity market.287 They argue: ‘[m]ore precisely, when shadow banking by cap-constrained banks begins poaching deposits from the Big Four, the latter can issue their own WMPs and/or respond strategically by reducing liquidity supply to these other banks. Strategic reductions in liquidity supply increase interbank rates and compel the other banks to scale back their WMP issuance.’288 They start by showing that big banks are typically not constrained by the loan-to-deposit cap because they internalize the effect of their reserve holdings on the interbank market. They then show that a tighter cap has two effects. First, it pushes cap-constrained banks off balance sheet and fuels a credit expansion. Second, it leads to more aggressive on-balance sheet lending by big banks as the latter try to fend off the cap-­constrained banks by reducing interbank liquidity. The second effect curtails some of the initial credit expansion but also contributes directly to credit growth.289 They show and conclude that the net effect is an increase in overall credit and an increase in the equilibrium interbank rate.290 Their results also have policy implications as assuming standard policy implications in an environment with non-standard transmission mechanisms might be the wrong way to go. The manipulation by the big four banks has helped regulators by curtailing some of the shadow banking that would have otherwise been pursued by cap-constrained banks. But in order to manipulate that interbank market, they need to approach their loan-to-deposit constraint. When that would become binding the Chinese financial infrastructure will all of a sudden look very fragile.291 Bringing it all home, one could argue in line with Elliott et al.292 that the following list of objectives should drive any shadow banking reform and regulation. In Table 5.5 I summarize the main thoughts in this respect.293  D. Tao and W. Deng, (2015), China: Trust Funds and Shadow Banking, Credit Suisse Economic Research, February 17, pp. 28–31. 286  K. Hachem and Z. M. Song, (2015), The Rise of China’s Shadow Banking System, Chicago Booth School of Business Working Paper, January, pp. 3–8. 287  Higher interbank rates discourage cap-constrained banks from expanding their off-balance sheet activities to evade liquidity standards (ratios drop). 288  K. Hachem and Z. M. Song, (2015), ibid., pp. 3–4. 289  Which is again on the rise in 2015: Bloomberg Business, (2015), China Credit Growth Jumps as Shadow Banking Comes Back, Bloomberg News January 15, via bloomberg.com 290  K. Hachem and Z. M. Song, (2015), ibid., p. 4. 291  K. Hachem and Z. M. Song, (2015), ibid., pp. 4–5. 292  D.J.  Elliott et  al., (2015), Reforming Shadow Banking in China, The Brooking Institute Economic Studies, May, 293  See in detail the excellent overview in D.J. Elliott et al., (2015), ibid., pp. 6–12. And the strategy options for implementation pp. 12–16. 285

Expand financial services to SMEs, rural businesses and households

Dimensions

Access for many is constrained due to asymmetric buildup of the financial infrastructure and policy directions (implicit guarantees, market share, Party involvement) Social and utility function of expansion credit access: are the very companies that are the most efficient overall and have been contributing the most to China’s growth and employment. They are reported to have provided 70% of employment and 60% of China’s GDP in 2012, while receiving only 20% of bank loans.a SMEs have many profitable opportunities for which they have difficulty obtaining funds.b The SB segment has been filling that gap. It would make sense if that gap would close and the regulated banking sector could serve the economy across the board, which will be a time-consuming and agonizing trajectory as the party seems largely unwilling to oblige in this respect. The SME funding gap has proven to be an enduring structural feature of both emerging and advanced market economies. Regulation to capture the SB segment should avoid reducing the capital flows to these underserved segments. The policy objective on the left will serve the following objectives: Diversify financial services  Financial stability provision beyond the current bank-centric model  Competition  Efficiency  Fuel market-based choices and reduce capital allocation inefficiencies.  Decentralization of capital allocation decision-making should be included. Increase the efficiencyd of Through serving more markets and segments and with better product categories the financial sector Strive for a level playing field Will fuel efficient and safe financial system across the financial sector Rules should be different for different SB segments in line with economic rationale and functionalities. Capital competition should be equal across segments and industries. Promote the wider financial Two-thirds of SB activities are regulated bank activities in disguise. Full reforms will avoid costly and inefficient detours. reforms being introduced in China Increase systemic safety SB now creates systemic risks through (1) lower prudential standards than normal banks, (2) implicit guarantees, (3) lack of transparency, (4) regulatory inconsistency and (5) lack of fully integrated regulatory framework.

Policy objective

Table 5.5  Policy objectives for Chinese shadow banking reforms

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Reduce systemic risk through untangling of interconnectedness, reduce contagion risk and highly levered entity buildup.

SB wild emergence has led to unsafe products (e.g. WMP with no or unclear return guarantee). Standardization of product offering is required. Monetary policy should cater to both segments of the financial infrastructure.

a

A. Sheng, et al., (2013), Asia Finance 2020: Framing a New Asian Financial Architecture, Oliver Wyman and Fung Global Institute, Hong Kong b See for a convincing account regarding the position and value-add of the Chinese SME segment: K.S. Tsai, (2015), Financing Small and Medium Enterprises in China: Recent Trends and Prospects beyond Shadow Banking, HKUST IEMS (Hong Kong University Institute for Emerging Market Studies), Working Paper Nr. 2015–24, May. He argues five elements that restrict the availability of SME lending capacity (pp. 8–13). He argues that to the degree that SB meets real economic needs, these activities should be excluded from any SB regulatory framework. Demand outstrips supply in a structural way (pp. 14 ff.) c E. Lee, (2015), Shadow Banking System in China After the Global Financial Crisis: Why Shadow Banks Can Distort the Capital Market Order, University of Hong Kong Faculty of Law Research paper Nr. 2015/24. B. F. Jackson, (2013), Danger Lurking in the Shadows: Why Regulators Lack the Authority to Effectively Fight Contagion d See in bank efficiency and costs: N. Ding et al., (2015), What Drives Cost Efficiency of Banks in China?, China & World Economy, Vol. 23, Issue 2 (March–April), pp. 61–83

Increase consumer opportunity and safety Help ensure the PBOC can exercise appropriate monetary policy tools Avoid dysfunctional capital marketsc

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Tsai concludes that the Xi-Li administration faces the dual challenge of managing state capitalism and shadow banking as China enters a phase of more moderate economic growth. During China’s first three decades of reform, private sector development occurred in parallel with prioritization of state-owned enterprises in strategic industries, and growth surged. This pattern of state capitalism rested on an unarticulated bifurcated financing arrangement whereby the formal banking system primarily served public enterprises, while private businesses relied primarily on informal finance. However, China’s response to global financial crisis disrupted the preceding equilibrium of financial dualism under state capitalism. Unprecedented expansion of bank lending after 2008 created opportunities for a host of state economic actors—including SOEs, state banks and local governments—to expand their participation in off-balance sheet activities.294 Informal finance driven by the institutional economy reform agenda has converted into a full-fledged shadow banking model.295 Tsai indicates, ‘[o]ne of the defining features of state capitalism in China is the system’s structural bias towards the allocation of capital to state, collective, and joint stock enterprises.’ ‘Arguably, the contemporary map of informal finance and shadow banking represents a parallel political economy that complements, and is therefore just as functionally entrenched as, the vested interests in the state sector’.296 Private entrepreneurs have engaged in financial arbitrage between state-mandated ceilings on interest rates on the one hand, and market demand for SME financing and higher returns on savings, on the other.297 The concomitant spread of Internet and social media fueled an equally unexpected ‘liberalization’ in the technologies of and participants in informal finance. Middle-class savers are investing in wealth management products through mobile devices, and those same products are being invested in a variety of private business ventures promising high returns. State capitalism and shadow banking have now intersected and developed areas of mutual dependence or, more accurately, mutual liability.298 The fact that the public sector is involved in shadow banking means that possible risks are not confined to local businesses and entrepreneurs. The premier therefore indicated already in March 2014, that shadow banking is not just about regulating and supervising the informal finance layer in China, but it also would have to invariably include various reform measures, which, if implemented, would erode the edges of state capitalism and reduce some of the risks associated with shadow banking. These include deepening SOE reform, increasing market access in the services sector, establishing private small- and medium-sized banks, and setting up channels for the issuance of debt by local governments.299  K.S. Tsai, (2014), The Political Economy of State Capitalism and Shadow Banking in China, HKUST IEMS Working Paper No. 2015–25, May. 295  K.S. Tsai, (2014), ibid., pp. 11–12. 296  K.S. Tsai, (2014), ibid., pp. 10–11. 297  K.S. Tsai, (2014), ibid., p. 20. Also see: Cindy Li, (2013), Shadow Banking in China; Expanding Scale, Evolving Structure, Asia Focus, Federal Reserve Bank of San Francisco, April. 298  K.S. Tsai, (2014), ibid., p. 27. 299  K.S. Tsai, (2014), ibid., pp. 27–29. F. Allen, et al. (2005), Law, Finance, and Economic Growth in China. Journal of Financial Economics, Vol. 77, Issue 1, pp.  57–116; Y.S.  Huang, (2008), Capitalism with Chinese characteristics, Cambridge University Press, New York; S.X. Jiang, (2009), 294

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For the time being, and assuming data accuracy, it can be observed that the Chinese shadow banking segment is shrinking and this ever since Xi Jinping took office and deleveraging has surpassed debt-fueled growth as the top policy priority. From that end, China is moving upstream relative to the global shadow banking market where it recently was observed that ‘the global shadow banking risk has not improved since the Global Financial Crisis, with the average shadow-banking-to-GDP ratio rising from 55% in 2012 to 59% in 2014’.300 The truth is, Lo301 commented recently, that its global share is only one-tenth that of the US and a fifth of its counterpart in Europe, according to the FSB. True, China’s shadow banking has grown rapidly, but from a very low base in international terms. And Beijing is aware of the problem and started to address it in 2013, which should make China’s shadow banking risk manageable. The future will be the judge of that. More is needed but the China specifics require their own approach and so far the initiatives were adequate without being fully comprehensive in their own right. Gradual phasing in will avert panics and runs.

5.11 C  hinese Shadow Banking in Recent Years (2016–2019) 5.11.1  Stimulus, Regulatory Intervention and a Changing Marketplace Given the continued attention the Chinese banking sector was given in recent years, the literature evolved from specific issue analysis to mapping and framing an evolving sector to provide for a coherent and consistent picture of the structure and interlinkages of the Chinese shadow banking system. At the center of such mapping exercise is always the commercial banks in China.302 As such the shadow banking sector in China stands always in the ‘shadow’ of those banks. The consequence is that market-based finance and securitization play a relatively limited role.303 But maybe more important recent studies demonstrate what the barrage of newsflashes on a daily basis already hint at and that is that the sector is rapidly changing creating a relative importance of the individual segments. The overall conclusion is that change combined with an expanding shadow banking universe in China, overall, has led to a more complex shadow banking universe where more The Evolution of Informal Finance in China and Its Prospects. In J.  J. Li and S.  Hsu (Eds.), Informal Finance in China: American and Chinese Perspectives, Oxford University Press, New York. 300  FSB, (2015), Global Shadow Banking Monitoring Report 2015, via fsb.org 301  C.  Lo, (2015), Chi Time: Revisiting the Systemic Risk of China’s Shadow Banking, BNPP Report, December 9, p. 3. 302  See in detail: C. Feldman, (2017), Banks’ Role in China’s Shadow Banking System, Working Paper, December. 303  See for an overview of the regulatory space and recent market trends in China: King Wood Mallesons, (2018), State of Securitization in China, in ASIFMS Securitisation in China 2018, pp. 16–52. Other interesting related securitization topics include the ratings framework (pp. 88–93) and taxation issues (pp. 94–98).

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‘structured’ shadow credit intermediation has occurred and bond markets are heavily reliant on the ‘wealth management product’ funding channel.304 The stylized mapping of the shadow banking system in China can take many shapes and forms. A very illustrative model is the one from Ehlers et al. who provide a three-staged model built around the three stages of shadow credit intermediation in China: (1) the ultimate creditor stage, (2) the intermediate stage and (3) the ultimate borrower stage.305 What is remarkable is the fact that each stage is known for its individual and distinct set of financial products but also in the shadow banking market as such, although having the same drivers underlying relative to other countries, the shape and form of the market as such are vastly different. They identify five key characteristics of shadow banking in China,306 some reflecting items discussed before in this chapter on shadow banking in

 See in recent years: A.  Sheng and Ng Chow Soon, (2016), Shadow Banking in China: An Opportunity for Financial Reform, Wiley, Surrey; A. Collier, (2017), Shadow Banking and the Rise of Capitalism in China, Palgrave Macmillan, Basingstoke; S.  Wei, (2016), Shadow Banking in China: Regulation and Policy, Edward Elgar Publishing, Cheltenham; M. Teter, (2017), Shadow Banking in China, CreateSpace Independent Publishing Platform; D. McMahon, (2018), China’s Great Wall of Debt: Shadow Banks, Ghost Cities, Massive Loans, and the End of the Chinese Miracle, Houghton Mifflin Harcourt, Boston, MA; Q. Yan and J. Li, (2016), Regulating China’s Shadow Banks, Routledge, Abingdon; N. Zhu, (2016), China’s Guaranteed Bubble: How Implicit Government Support Has Propelled China’s Economy While Creating Systemic Risk, McGrawHill Education, NY; T.  Adrian and A.B.  Ashcraft, (2016), Shadow Banking: A Review of the Literature, in ‘Banking Crises’, Palgrave Macmillan, Basingstoke, pp.  282–315; H.  Wang et  al., (2016), Shadow Banking: China’s Dual Track Interest Rate Liberalization, mimeo; E. Sekine, (2015), Reforming China’s Financial Markets: the Problems of Shadow Banking and Non-Performing Loans, Policy Research Institute, MinFin Japan, Public Policy Review, Vol. 11, Nr. 1, March, pp. 93–139; G. Tian, et al., (2016), Systemic Risk in the Chinese Shadow Banking System: A Sector-Level Perspective, Emerging Markets Finance and Trade, Vol. 52, Issue 2, pp. 475–486; L. Sun, (2018), Financial Networks and Systemic Risk in China’s Banking System, MPRA Paper Nr. 90658, January 6; Huang et al. measure the systemic risk in the Chinese banking sector through the conditional value at risk, the marginal expected shortfall, the systemic impact index and the vulnerability index. They find that these measures show different patterns, capturing different aspects of systemic risk of Chinese banks. However, rankings of banks based on these measures are significantly correlated. See in detail: Q. Huang et al., (2019), Analysing Systemic Risk in the Chinese Banking System Pacific Economic Review, Vol. 24, Issue 2, pp.  348–372; M.  Lindgren, (2018), Regulating the Shadow Banking System in China, University of Chicago Law School, International Immersion Program Papers Nr. 78, March. 305  T.  Ehlers et  al., (2018), Mapping Shadow Banking in China: Structure and Dynamics, BIS Working Paper Nr. 701, February, p. 4. 306  See also on the specifics of the China shadow banking market: W. Shen, (2018), Understanding Shadow Banking in the Chinese Context: Shadow Banking with Chinese Characteristics, in Research Handbook on Shadow Banking. Legal and Regulatory Aspects, I.H.-Y.  Chiu and Iain MacNeil (eds.), Edward Elgar, Cheltenham, pp. 399–422. Some scholars observe a somewhat passive stance by Chinese regulators and supervisors when it comes to embracing and participating in the development global financial regulatory governance and a discontinuity of embracing global financial standards. See: P. Knaack and J. Gruin, (2017), From Shadow Banking to Digital Financial Inclusion: Regulatory Framework Contestation Between China and the FSB, GEG Working Paper Nr. 134, September. 304

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China. First, there is the aforementioned dominance of commercial banks in China.307 Second, shadow banking plays a vital role, providing credit to a certain part of the market that otherwise would have no access to the credit market.308 Third, the interlinkages in the financial system are tight due to varying models of shadow credit intermediation, including links to the bond market.309 Fourth, all in all the shadow banking market is relatively uncomplex310 and, finally, the system is known for a vast amount of perceived and actual guarantees.311 Also in this market, and referring to our earlier discussion regarding the need

 They dominate the shadow banking market, not only as originators of securitized debt. The market-based channels typical for a Western shadow banking system are near-absent in China. They are the most important linkage between borrowers and suppliers of credit in both the formal and informal (shadow) banking market. They also facilitate credit between nonfinancial firms as direct lending in that case is prohibited. In detail: T. Ehlers et al., (2018), ibid., p. 10. Also: D. Hinge, (2018), China’s Shadow Banking Market Dominated by Banks, February 12, via centralbanking.com; C. Li, (2016), The Changing Face of Shadow Banking in China, Federal Reserve Bank of San Francisco, Asia Focus, December; J. Du et al., Shadow Banking activities in Non-Financial Firms: Evidence from China, Working Paper, mimeo (also abbreviated and updated via voxchina.eu, 19 July 2017); J. Du et al., (2016), A Comparative Study of Shadow Banking Activities of Non-Financial Firms in Transition Economies, China Economic Review, Vol. 46, December, pp. S35–S49. 308  K.S. Tsai, (2016), When Shadow Banking Can Be Productive: Financing Small and Medium Enterprises in China, The Journal of Development Studies, pp. 1–24, H. Löchel et al., (2016), The Funding of Small and Medium Companies by Shadow-Banks in China, Frankfurt School of Finance and Management Working Paper Series Nr. 220, March (including four case-studies), and Y.  Lu et  al., (2015), Shadow Banking and Firm Financing in China, International Review of Economics and Finance, Nr. 36, pp. 40–53. Private firms are often more productive than stateowned firms and credit provided often leads to economic gains. Also a lot of bank deposits have been re-routed into shadow banking products in search for higher yield given the low deposit rate ceiling in place until October 2015. Another reason is that access to bond markets is still in its infancy and the WMPs provide for an alternative, especially since they are marketed as safe. In detail: T. Ehlers et al., (2018), ibid., pp. 10–11. 309  Those interlinkages exist between commercial banks and shadow banking vehicles but also with the bond market as significant proceeds of WMP are invested in the bond market. WMPs are an effective way for retail investors to invest in the bond markets as by law at least 75% of the underlying assets need to be standardized debt products (bonds, MMFs, etc.). The proceeds of WMPs are often channeled to trust companies or the wealth management branches of banks. Non-standardized products are ‘non-tradable debt securities such as trust and entrusted loans, direct equity stakes, equity-repos, and beneficial ownership rights including entrusted rights and TBRs’ (Ehling et al., [2018], ibid., p. 15–16). In both cases, these funds go off-balance sheet. But given the products invested in, interlinkages are reciprocal between the formal and informal part of the banking sector. It also leads to the fact that the bond market cannot provide for the diversification it normally does: F. De Fiori and H. Uhlig, (2015), Corporate Debt Structure and the Financial Crisis, Journal of Money, Credit and Banking, Vol. 47, Nr. 8, pp. 1571–1598. Bank assets often become investment receivables generating even tighter and opaque interlinkages. See for the process: T. Ehlers et al., (2018), ibid., pp. 11–12. 310  Products are plain-vanilla and intermediation is a one- or two-step model. See for a comparison with the Western intermediation models: T. Adrian and A.B. Ashcraft, (2016), Shadow Banking: A Review of the Literature, in ‘Banking Crises’, Palgrave Macmillan, Basingstoke, pp. 282–315. 311  In line with Western models, the shadow credit intermediation occurs without access to the central bank’s liquidity window or deposit insurance backstop, or without there being explicit or 307

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for safe assets, the demand-supply relationship in the US and European shadow banking market, particularly of institutional cash pools, the supply is modeled in line with demand from the ultimate borrowers. It is only since 2015 that demand from ultimate borrowers slowed down, but the volume and size of the product group at the level of the ultimate creditor have continued to grow. The more complex product group that since then has emerged seems to find its justification in the need to re-classify bank assets to ease regulatory burdens (due to provisioning for NPLs or ceilings imposed on the LTV ratio).312 As indicated, there is plenty of research out there regarding the shadow banking market in China, but often it focuses on a narrow field or the specific features that characterize the China shadow banking market (often wealth management products or entrusted loans).313 implicit guarantees in place. In the West that implicit assumption deals with G-SIBs assuming that in case of default the Fed will step in. In China, the distributing bank of WMPs is assumed to absorb the risk of default on any of the underlying instruments. There is no obligation to do so on the side of the banks but past bailouts, precedents and the assumed desire by the government to maintain a stable financial infrastructure create that implicit guarantee. And although that might be true for commercial banks, it definitely is not for lightly regulated credit guarantee companies. T. Ehlers et al., (2018), ibid., pp. 12–13. 312  T. Ehlers et al., (2018), ibid., p. 1; also see: V. Acharya et al., (2019), In the Shadow of Banks: Wealth Management Products and Issuing Banks’ Risk in China, Working Paper, mimeo, June 4. Also WMPs are a regulatory arbitrage play. Acharya et al. comment: ‘[w]ith regulatory ceilings on both deposit rates and loan-to-deposit ratio (LDR), banks with higher LDRs issue more WMPs, especially when the gap between the market rate and deposit rate ceiling is high. This is consistent with the regulatory arbitrage hypothesis that banks offer deposit-like WMPs with higher yields to attract funding. The growth of WMPs imposes rollover risks for the issuers, as reflected by higher yields on new WMPs and their willingness to borrow at higher rates in the interbank market. Overall, the swift rise of shadow banking in China seems to have been triggered by the stimulus and has contributed to greater fragility of the financial system’. 313  See, for example, F.  Allen et  al., (2019), Entrusted Loans: A Close Look at China’s Shadow Banking System, Journal of Financial Economics Vol. 133, Issue 1, July, pp. 18–41. Entrusted loans are a market response to credit shortages or tightening; K. Chen et al., (2016), What We Learn from China’s Rising Shadow Banking: Exploring the Nexus of Monetary Tightening and Banks’ Role in Entrusted Lending, NBER Working Paper Nr. 21890; K. Chen et al., (2017), The Nexus of Monetary Policy and Shadow Banking in China, NBER Working Paper Nr. 23377 (later on published in American Economic Review 2018, Vol. 108, Issue 12, pp. 3891–3936). They concluded that (1) in response to monetary policy tightening, non-state banks actively engaged in intermediating shadow banking products; (2) these banks, in sharp contrast to state banks, brought shadow banking products onto the balance sheet via risky investments; (3) bank loans and risky investment assets in the banking system respond in opposite directions to monetary policy tightening, which makes monetary policy less effective; Z. Chen, et al., (2017), The Financing of Local Government in China: Stimulus Loan Wanes and Shadow Banking Waxes, mimeo; K.C. Hachem et al., (2016), Liquidity Regulation and Unintended Financial Transformation in China, NBER Working Papers, Nr. 21880; C.  Li, (2016), The Changing Face of Shadow Banking in China, Federal Reserve Bank of San Francisco, Asia Focus, December; K. Mcloughlin and J. Meredith, (2017), The Rise of Chinese Money Market Funds, Reserve Bank of Australia Bulletin, March, pp.  75–84. Ruan assesses that entrusted lending is more prevalent and more profitable in cities where traditional bank loans grow slower. Entrusted lenders also appear to use existing cash rather than raise external finance to make the loans; see T.  Ruan, (2018), The Economics of Shadow Banking: Lessons from Surrogate Intermediaries in China, NYU Stern Working Paper, January 30; W.R. Lam and J. Wang, (2018), China’s Local Government Bond Market, IMF Working Paper Nr. WP/18/219, September. They observe the rising relevance of local government finance and con-

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Given the swift evolution of the marketplace it is of utmost importance that the actual context and data are used for further analysis and understanding of the evolution in the marketplace.314 Given the comprehensive analysis already performed regarding shadow banking in China, the focus in this subsection will be on the structural dynamics in recent years.315 And even then, the picture painted is often static and needs adoption over time. The pace at which new instruments are developed and intermediation channels develop is often staggering.316 Staggering indeed when taking into account the enormous rise in recent years of low-quality debt,317 which we’re familiar with and the fact that low-quality debt often hides in the opaque corners of the shadow banking systems worldwide.318 During the October 2017 Communist Party Congress, there seems to be willingness to engage and awareness that this financial stability risk has the potential to seriously undermine the longterm growth trend of the Chinese economy.319 The question remains to what degree that willingness to engage and tackle the problem is limited to an ex post bailout of any distressed lender or whether ex ante interventions could be on the table. So far, the leaders of

clude that low liquidity, weak credit discipline and structural fiscal deficit in local governments have become more visible. Measures are taken: also P.  Wingender, (2018), Intergovernmental Fiscal Reform in China, IMF Working Paper Nr. WP/18/88, April, and R.C. Mano and J. Zhang, (2018), China’s Rebalancing: Recent Progress, Prospects and Policies, IMF Working Paper Nr. WP/18/243, November. That evolution would definitely include a further integration into the global bond markets; see E. Cerutti and M. Obstfeld, China’s Bond Market and Global Financial Markets, IMF Working Paper Nr. WP/18/253, October. 314  For example, Moody’s ‘Quarterly China Shadow Banking Monitor’ could be a good recurring reference document for actual data. For a general overview, see M. Gupta and M. Caporin, (2018), The Evolution of Shadow Banking System in Emerging Economies: The Role of Entrusted Loans in China’s Capital Market, Working Paper, May 17, mimeo. 315  The barrage of daily news regarding the Chinese shadow banking sector is immense, but equally swiftly outdated. I artificially limited myself from providing a comprehensive ‘data’ overview as that would prove to be not useful by the time this manuscript goes to press or the years thereafter. 316  See, for example, FSB, (2018), Global Shadow Banking Monitoring Report 2017, 5 March, where it was reported that of the USD 45.2 trillion in global shadow banking assets linked to credit that could pose systematic risks, the FSB attributed USD 7 trillion to Chinese companies. The sudden increase in bank credit provided by commercial banks leads to the conclusion that shadow banking, rather than the real economy, is being fed: S. Hsu, (2018), Recent Surge in Chinese Bank Credit Reflects Necessary Crackdown On Shadow Banking, February 20, via forbes.com. or D. Weiland, (2018), China Shadow Bank Clampdown Eyes $2tn of Entrusted Loans, Financial Times, January 8; A. Monahan, (2018), Cracks Are Showing in China’s Shadow Banking Industry, Bloomberg, January 24, (via Bloomberg.com). 317  M. Chui and C. Upper, (2017), Recent Developments in Chinese Shadow Banking, SUERF Policy Note Nr. 20, November. 318  J. Plenders, (2018), Beware Threat of Low-Quality Debt and Opaque Shadow Banks, Financial Times, March 7. 319  See for an analysis of the influence of China’s shadow banking system on the stability of the financial system: B. Liu et al., (2016), An Empirical Study About the Influence of China’s Shadow Banking on the Stability of the Financial System, International Journal of Economics and Finance, Vol. 8, Nr. 4, pp. 104–112; more in general; M. Zheng and W. Xiong, (2018), Risks in China’s Financial System, Bank of Finland, BOFIT Discussion Papers Nr. 1, January 15.

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China have shown limited willingness to engage ex ante to limit credit intermediation or credit growth altogether.320 Ehlers et al., as mentioned above, used this three-stage model to analyze the structure of the shadow banking segment.321 It was built around (1) the ultimate creditor stage, (2) the intermediate stage and (3) the ultimate borrower stage. (1) The ultimate credit stage is crowded with the products already extensively discussed such as wealth management products322 and trust products. In reality these products are product groups in their own right.323 They often provide higher yield but are seen as equally safe as deposits. As most WMPs do not occur on the balance sheets of the issuing bank, the PBOC324 strengthened its macroprudential assessment so that asset management products (with implicit guarantee) fall under the bank capital rules (including required reserves and deposit insurance).325 Typically, the largest chunk of investors in these products are retail investors, although starting 2015 this has become interbank investing. That in itself, Ehlers et  al. indicate, demonstrates that the nature of the product has shifted from being an alternative savings document ‘towards supporting the more complex forms of “structured” shadow credit intermediation’.326 The issuer, which typically were large state-owned banks, have now become ‘joint-stock banks’327 who in case of default are less likely to benefit from a government bailout, overall increasing the risk for investors.

 Although earlier in March 2018, the government indicated it would stop setting the M2 growth rate (for the first time in nine years); see the 2017 Government Work Report (via gov.cn) 321  See for an alternative: K. Hachem and Z.M. Song, (2015), The Rise of China’s Shadow Banking System, updated 2017, Chicago Booth Working Paper, mimeo; Z.M. Song and W. Xiong, (2018), Risks in China’s Financial System, NBER Working Paper Nr. 24230, January. 322  The come in two segments: (1) the principal- or return-guaranteed WMP (similar to certificates of deposits) where the issuing bank absorbs the default risk and the product is subject to normal banking regulation; and (2) non-principal-guaranteed WMPs with no implicit or explicit guarantee. The bank acts as an asset manager and default risk is passed on to the customer. The latter segment is the largest with a typical coverage of 80% of the market. Both categories operate as closed-ended funds. S.  Wei, (2015), Wealth Management Products in the Context of China’s Shadow Banking: Systemic Risks, Consumer Protection and Regulatory Instruments, Asia Pacific Law Review, Vol. 23, Issue 1, pp. 91–123. 323  See in detail: T. Ehlers et al., (2018), ibid., pp. 13–17. 324  People’s Bank of China (i.e. China’s central bank). 325  Moody’s, (2017), China’s New Guidelines on Asset Management Products Are Credit Positive, November 27. They also agreed to implement (11 January 2018) the already discussed BCBS controlling large exposures in order to further curtail bank risk. 326  T. Ehlers et al., (2018), ibid., p. 14. 327  The joint-stock banks typically have a much smaller deposit base and a greater reliance on interbank markets and bond issuance for funding than the large banks. Smaller city commercial banks as well as rural banks have significantly expanded their WMP issuance activity over time. T. Ehlers et al., (2018), ibid., p. 15. 320

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On the other hand there are the trust products328 issued by trust companies329 who perform credit intermediation functions like bank but aren’t regulated the same way. They emerged as a solution for riskier or less privileged borrowers330 and the relatively loose regulation helped to accommodate credit availability for these segments. The incoming 2007 regulation had the intention to turn them into third-party wealth managers. The impact of the share of investments in tradable assets by trusts increased, but didn’t prevent that trust loans are the most sizeable investment held by those companies.331 Their product group ranges from single- to collective-­investor products or dedicated asset (e.g. property) products. They each target their own audience and they all are linked to the type of credit intermediation the trust companies perform. The collective-investor products do not only bundle resources from multiple investors but also invest in a variety of assets. It makes them more diversified both ways relative to single-investor assets who often invest in a single asset.

 See regarding the pricing determinants of trust products: H. Park and S. Sohn, (2018), Pricing Determinants of Shadow Banking Products: Evidence from Chinese Collective Fund Trusts, Working Paper, January, mimeo. The implicit guarantee causes a wider default spread and increases the probability of the trust issues and decreases the trust spread, implying that the default risk strengthens investors’ demand for trust products. The consequence is that the price of the trust fund products is largely driven by credit market conditions. 329  Trust companies generate leverage cycle dynamics by intermediating less regulated credit to the financial markets in China. Xu et al. find that the leverage factor constructed from trust companies can explain the (time-series and cross-sectional) asset returns. The bottom line is that the financial innovations created by shadow banks significantly amplify leverage in less sophisticated financial markets. This not only affects financial fragility, but also determines asset prices. See in detail: F.  Xu et  al., (2019), Shadow Banks, Leverage Risks, and Asset Prices, Working Paper, April 21, mimeo. Gruin and Knaack see WMPs and online lending as the latest stage of the Chinese Communist Party’s efforts to construct a more efficient and sustainable market economy while simultaneously preserving political supremacy and custodianship of macro-social development. See in detail: J.  Gruin, (2019), Not Just Another Shadow Bank: Chinese Authoritarian Capitalism and the ‘Developmental’ Promise of Digital Financial Innovation, New Political Economy, online, https://doi.org/10.1080/13563467.2018.156243 7, January 31. The difference in policy response is commensurate with the degree to which each financial sector meets the Party’s twin objectives of economic development and political control, they add. Also see: Wei, S. (2019). The Political Economy of China’s Shadow Banking. In E. Avgouleas and D. Donald (Eds.), The Political Economy of Financial Regulation (International Corporate Law and Financial Market Regulation), pp.  445–478, Cambridge, Cambridge University Press. 330  See for the legal dynamics: L. Lu, (2017), Shadow Banking for Cash-Strapped Entrepreneurs: A Study of Private Lending Agreements under Chinese Contract Law, Journal of Business Law (2018), Sweet & Maxwell, Issue 3, pp. 216–229. Also: L. Lu, (2018), Black Swans and Grey Rhinos: Demystifying China’s Financial Risks and the Financial Regulatory Reform, Butterworths Journal of International Banking and Financial Law, Vol. 33, pp. 594–597. 331  T. Ehlers et al., (2018), ibid., p. 16. Regarding the regulatory dimension for trust companies, see N.  Zhu and J.  Conrad, (2014), The People’s Republic of China: Knowledge Work on Shadow Banking–Trust Funds and Wealth Management Products, Consultant’s Report for Asian Development Bank. 328

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(2) The intermediate stage is also the segment where the interconnectedness intensifies.332 The banks as being the dominant players channel funds from banks to shadow banking entities (and back, through investments by those shadow banking entities in banks and more recently the bond markets).333 During that process quite some balance sheet engineering occurs as the assets raised from investors often get requalified as investments rather than as liabilities. The channeling of funds occurs via different structures, for example, the bank-trust cooperation (from bank to trust) or the bank-security brokerage cooperation (from bank to brokerage firm). It is within those relationships that material maturity334 and credit transformation occur as the WMPs (through which funding is raised) have considerably shorter maturities than the maturity of the underlying assets, leading to material liquidity risk in the absence of any backstop or public liquidity window. A more recent phenomenon is the funding of the bond markets through WMPs and trust products (to a lesser degree). It was triggered by regulatory changes that favored investing in tradable debt assets as well as the rapid growth of the Chinese bond markets.335 The incoming regulation tried to steer most funding into the officially regulated and transparent financial infrastructure and diversify at the same time firm’s funding sources. But that seems only possible as long as commercial banks can roll-over large volumes of WMPs with much shorter maturities than the underlying investments.

 It requires more data and internal coordination. See M.  Liao et  al., (2016), China’s Financial Interlinkages and Implications for Inter-Agency Coordination, IMF Working Paper Nr. 16/181, August. 333  T. Ehlers et al., (2018), ibid., pp. 18–19. 334  Maturity transformation leads particularly to liquidity risk rather than interest rate risk. Drechsler et al. assessed that aggregate net interest margins have been near-constant over 1955–2013, despite substantial maturity mismatch and wide variation in interest rates. They explain the phenomenon through market power of banks. Market power allows banks to pay deposit rates that are low and therefore relatively insensitive to interest rate changes. Banks hedge these liabilities by investing in long-term assets, whose interest payments are also relatively insensitive to interest rate changes. See in detail: I.  Drechsler et  al., (2017), Banking on Deposits: Maturity Transformation Without Interest Rate Risk, NYU Stern Working Paper, March. Also see: R.  Duchin et  al., (2017), Precautionary Savings with Risky Assets: When Cash Is Not Cash, The Journal of Finance, Vol. 72, Issue 2, pp. 793–852; J. Luo, (2017), Shadow Banking, Interest Rate Marketization and Bank RiskTaking: An Empirical Study of the 40 Commercial Banks in China, Journal of Financial Risk Management, Vol. 6, pp. 27–36. Raising either WMPs or expected losses (ELs) leads to a transfer of wealth from equity holders to the debt holders, and hence increases the deposit insurance liabilities. The multiple shadow banking activities of WMPs and ELs captured by scope equities may produce superior return performance for the bank. The results documented by Lin et al. provide an alternative explanation for the decline in bank interest margins, which better fits the narrative evidence on bank spread behavior under capital regulation in particular during a financial crisis. See in detail: J.-H. Lin et al., (2018), Bank Interest Margin, Multiple Shadow Banking Activities, and Capital Regulation, International Journal of Financial Studies, Vol. 6, pp. 63–83, July 3. 335  P. Łasak, (2015), Regulatory Responses to the Chinese Shadow Banking Development, Jagiellonian Journal of Management, Vol. 1, Nr. 4, pp. 305–317. 332

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Although still relative un-complex336 (compared to its Western counterparts),337 the Chinese shadow banking segment is rapidly building a segment of complex structured intermediation products. One particular dynamic is the ‘reclassification of bank’s onbalance-sheet assets into ‘investment receivables’.’ The benefit for banks in this case is that loans and debt products on their balance sheet can be reclassified to investments thereby dodging regulatory burdens or ceilings.338 The reclassification creates linkages between bank and trust companies and security firms and blurs the actual underlying credit risk. Two forms of reclassification exist: (a) the bank transfers339 an on-balance sheet loan to a trust company or lookalike. In return, the bank receives trust beneficiary rights (TBRs) or direct asset management products (DAMPs) which mean they become entitled to participate in gains and losses generated by the transferred assets. It is the TBR or DAMP that will show up on the bank’s balance sheet as an investment receivable; (b) in a more complicated model, a bank is asked to extend a loan by another bank who faces regulatory constraints in doing so itself. The issuing bank records an investment receivable and issues a WMP to the constrained bank. The constrained bank, through the WMP, can participate in the gains and losses on the extended loan. The gimmick is that the WMP doesn’t count as a loan for the constrained bank (toward e.g. its NPL/LTD ratio).340 More concerning, even, is that most of these WMPs are held by joint-stock companies and commercial banks in cities where traditionally exposure to private sector loans and smaller SOEs has been notoriously known for higher NPLs.341  History and culture are decisive elements in the rise and nature of informal finance, also in China; see: J. Hu et al., (2017), History, Culture and the Rise of Informal Finance in China, Hong Kong Institute for Monetary Research Working Paper Nr. 12/2017, June. 337  See for a recent comparative analysis: M. Ganguly and M. Ojo, (2018), Unregulated Financial Markets and the Shadow Banking Narrative: China, India and the United States, American Journal of Economics, Vol. 8, Issue 1, pp. 47–67. For a comparison of the different regulatory approach, see S. Gao and Q. Wang, (2014), Chasing the Shadow in Different Worlds: Shadow Banking and its Regulation in the U.S. And China, Manchester Journal of International Economic Law, Vol. 11, Issue 3, pp. 421–458. While financial reform has taken place in India, financially repressive policies still prevail in China. Although several regulatory measures have been adopted in India and China, the size of the shadow banking sector in these two countries remains underestimated, claim Arora and Zhang; R.U. Arora and Q. Zhang, (2019), Banking in the Shadows: A Comparative Study of China and India, Australian Economic History Review, Vol. 59, Issue 1, March, pp. 103–131. 338  For example, the non-performing loan ratio or the loan-to-deposit (LTD) ratio. Although the latter was lifted in 2015, the product can still be used in case a bank is looking for ways to expand its loan book. See also: L. Li and A. Yavas, (2017), Land Share, Mortgage Default, and Loan-toValue Ratio as a Macro-Prudential Policy Tool, Hong Kong Institute for Monetary Research Working Paper Nr. 10/2017, May. 339  That transfer can take different forms. The transfer can be facilitated as a sale or the initial loan can be terminated and replaced by a new loan (or loans) coming from the trust company. Alternatively, the bank can arrange a new loan actually provided by the trust company. Direct loan transfers to trust companies are prohibited and so the initial transfer is often done as a WMP with the initial loan underlying. 340  See in detail: Y. Lu, et al., (2015), Shadow Banking and Firm Financing in China, International Review of Economics and Finance, Nr. 36, pp. 40–53. 341  T. Ehlers et al., (2018), ibid., p. 20. S. Seki, (2016), The Growing Problem of Excessive Debt in China. Estimating the Implied Non-Performing Loan Ratio and the Amount of Bad Loans, RIM Pacific Business and Industries, Vol. 16, Nr. 61, pp. 1–16. 336

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(3) The ultimate borrower stage is known for its high concentration into trust and entrusted loans (besides informal credit).342,343 Growth has been rapid in recent years and became a concern for the government. In early 2018, they therefore decided to intervene.344 That was due to its rapid growth but also the fact that no standard procedures exist and so a wide variety of practices emerged. For instance, some companies without a lender license borrow from commercial banks at the benchmark interest rate and re-lend it to another company at a higher rate through entrusted loans in order to earn the arbitrage margin, which is not in line with the original intention. Besides, enterprises such as asset management plan providers take the form of shadow financing and lend money to borrowers designed by commercial banks, bringing entrusted loans to real estate sector and local government financing platforms345 that are not subject to the ‘encouraged industry’ in China.346 The Notice starts by indicating that entrusted loans operate as an agency business for commercial banks. The commercial lenders should neither help confirm the borrower, nor involve in decision-making, nor provide any kind of guarantee, for and on behalf of the lender. Moreover, instead of commercial banks, the lender should independently

 Often via online platforms (e.g. P2P platform). See in detail: C. Na et al., (2017), China’s P2P Lenders Now Required to Appoint Commercial Banks as Fund Custodians, online via caixingglobal.com, February 24. For how technology is shaping the Chinese shadow banking market, see: R.N. Lai and R. A. Van Order, (2017), Fintech Finance and Financial Fragility — Focusing on China, November 27, mimeo. 343  The entrusted loan concept was discussed earlier in this chapter. Conceptually, the bank is in case of an entrusted loan a trustee (for a fee) collecting principal and interest but the ultimate credit risk sits with the provider of the funding (which can be virtually anyone). The model is driven by the fact that direct lending between nonfinancial firms is not allowed. See: F.  Allen et  al., (2017), Entrusted Loans: A Close Look at China’s Shadow Banking System, CEPR Discussion Paper Nr. 12864, April 16. They focus on fundamental and informational risks and consequent pricing of entrusted loans; C.  Kaiji et  al., (2017), What We Learn from China’s Rising Shadow Banking: Exploring the Nexus of Monetary Tightening and Banks’ Role in Entrusted Lending, NBER Working Paper Nr. 21890, January; Z. Chen et al., (2019), The Financing of Local Government in China: Stimulus Loan Wanes and Shadow Banking Waxes, University of Chicago, Becker Friedman Institute for Economics Working Paper Nr. 29, providing a market-based view of the development of the shadow banking market in China after the 2012 RMB 4 trillion stimulus package; X. Li and J.-H. Lin, (2016), Shadow-Banking Entrusted Loan Management, Deposit Insurance Premium, and Capital Regulation, International Review of Economics and Finance, Vol. 41, pp.  98–109, January; Z. Song, (2017), Risks in China’s Financial System, Princeton University Working Paper, November, mimeo; Y.  Liu, (2018), An Equilibrium Model of Entrusted Loans, University of Lausanne (IBF) Working Paper, May 29, mimeo. 344  On 5 January 2018, the China Banking Regulatory Commission issued the ‘Notice about commercial banks’ management on entrusted-loans’ (Yinjianfa [2018] Nr. 2) to standardize the entrusted loans business by strictly tightening fund sources and usage of such funding. The Notice took immediate effect. In fact, it was based on draft guidelines that existed since 2015. 345  Local public debt has crowded out private investments. See in detail: Y. Huang et al. (2019), Local Crowding Out in China, EIEF Working Papers Series Nr. 1707, Einaudi Institute for Economics and Finance (EIEF), revised February. 346  See in detail for both models: P. He, (2018), China Tightens Entrusted-Loans of Commercial Banks, The Bank of Tokyo-Mitsubishi UFJ, News Focus Nr. 2, January 24, p. 1. 342

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check items such as borrower’s credit, projects and usage of funding, and bear the credit risk of entrusted loans. More importantly, entrusted loans under cash management are not subject to the guidelines, which means that intro-group cash-sweeping and funds transfer will not be influenced.347 The guidelines urge banks to verify whether the funding provided is in line with the normal financial capabilities provided by the funder and take into account credit the funder has outstanding with the bank. Prohibited sources of funding are funds from fiduciaries, bank credit, special funds created for a specific purpose, other forms of debt capital and funds with unproven sources. The usage of entrusted loans should be in line with the current law regime, macroeconomic management and industrial policies. Funding for the following purposes is prohibited: funds used to produce, operate or invest in/to usages/ areas that are prohibited by country; funds used to invest in bonds, futures, derivatives348 and asset management products; funds used as/for registered capital/capital verification; and funds used as equity investment or capital increase (except for those regulated by the authorities). A final product worth mentioning is the ‘bank acceptance’ (BA). They are essentially letters of credit issued by banks. A bank promises the future payment by a firm to another firm, which it guarantees. The shadow banking nexus of these guarantees is that the bank guarantee now can be used for a wide variety of business transactions, serving the interlinkage between the shadow banking segment and its regulated counterpart. It, however, does not imply credit intermediation in its own right. When combining the three discussed segments and producing a timeline one can observe some interesting features.349 At the level of the ultimate intercreditor stage, it can be observed that of all the funds raised exceed largely the amounts of direct shadow credit, of which a material portion is invested directly in the bond market, which now constitutes an indirect form of shadow credit. Also the complex structured credit does not lead to direct credit to ultimate borrowers. At the intermediate stage it can be observed that financial interlinkages continue to increase at a rapid pace due to banktrust cooperation and structured credit intermediation and this despite the regulatory intervention in recent years. In fact, it might be the cause of the increase as the growth in structured credit tends to occur after regulatory interventions and point at a form of regulatory arbitrage.350 On the ultimate borrower side, a much lower growth has been observed in recent years.  P. He, (2018), ibid., p. 2.  See for the current state of OTC derivatives in China: HKEC, (2017), OTC Clearing Solution for Mainland China’s Increasing Cross-Border Derivatives Trading, Research Report, November. 349  See for stylized maps: T. Ehlers et al., (2018), T. Ehlers et al., (2018), Mapping Shadow Banking in China: Structure and Dynamics, BIS Working Paper Nr. 701, February, pp. 23–26. 350  T. Ehlers et al., (2018), ibid., pp. 28–29; also see: N. M. Boyson, et al., (2016), Why Don’t All Banks Practice Regulatory Arbitrage? Evidence from Usage of Trust-Preferred Securities, Review of Financial Studies, Vol. 29, pp. 1821–1859; G. Buchak et al., (2017), Fintech, Regulatory Arbitrage, and the Rise of Shadow Banks, NBER Working Paper Series, Nr. 23288, October. For China in particular it has been observed that banks are using WMPs as vehicles for their regulatory arbitrage 347 348

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The findings351 demonstrate that, despite regulatory interventions, there is a persistent demand for shadow banking products that yield a higher return than savings instruments. The emergence of structured products based on the collateralization of bank assets points at an increasing level of sophistication. Often it is driven by NPL and LTD constraints that drive funding into structures that convert loans into assets or receivables, often obscuring the underlying credit risks (but also lower provision requirements). This increased complexity makes it look gradually more like a Western shadow banking model (although the complexity models are still materially different). The link with the bond market is countryspecific but might pose an additional transmission channel for financial shocks. The regulation enacted in the period 2015–2018 has pulled its weight.352 Intensified regulation in China has demonstrated a growing impact across the shadow banking sector.353 In particular, the aggregate growth of entrusted loans, trust loans and undiscounted bankers’ acceptances has slowed, due to tightened oversight. The crackdown on certain segments has yielded an overall impact on the shadow banking industry. It even starts to impact the supply of credit to the real economy (and in particular the more marginal borrowers). The drivers of the slowdown were declines in the banks’ wealth management products, and nonbank financial institutions’ asset management plans. The latter wasn’t discussed yet. In early 2018, Chinese authorities banned collective asset management plans from investing in entrusted loans or other credit assets.354 It will defior window dressing behaviors. Cai et al. document that the WMPs’ maturity dates cluster toward the end of a month and then decrease significantly at the beginning of the following month as well as that a negative relationship was observed between a bank’s loan-to-deposit ratio (LDR). See in detail: J. Cai et al., (2016), Regulatory Arbitrage and Window-Dressing in the Shadow Banking Activities: Evidence from China’s Wealth Management Products, Global Research Unit Working Paper Nr. 2016–006; S. Gao, (2015), Seeing Gray in a Black-and-White Legal World: Financial Repression, Adaptive Efficiency, and Shadow Banking in China, Texas International Law Journal, Vol. 50, Nr. 1, pp. 95–143; N. Ding et al., (2019), Shadow Banking, Bank Ownership, and Bank Efficiency in China, Emerging Markets and Trade Journal, online, https://doi.org/10.1080/15404 96X.2019.1579710, February 27. 351  In extenso: T. Ehlers et al., (2018), ibid., pp. 27–30, and for a stylized write-up of the discussed shadow banking products, ibid., pp. 35–37. 352  See ex ante on regulation: S.L. Schwarcz, (2016), Shadow banking, Financial Risk, and Regulation in China and Other Developing Countries, Duke School of Law Working Paper, November. 353  It was argued that China’s rising shadow banking was inextricably linked to potential balance sheet risks in the banking system. See: K. Chen et al., (2016), What We Learn from China’s Rising Shadow Banking: Exploring the Nexus of Monetary Tightening and Banks’ Role in Entrusted Lending, Federal Reserve bank of Atlanta, Working paper Series Nr. 2016–1, January. A number of findings supported their view: (1) commercial banks in general were prone to engage in channeling risky entrusted loans; (2) shadow banking through entrusted lending masked small banks’ exposure to balance sheet risks; and (3) two well-intended regulations and institutional asymmetry between large and small banks combined to give small banks an incentive to exploit regulatory arbitrage by bringing off-balance sheet risks into the balance sheet. See also the interesting overview of the relevant Chinese regulations in historical perspective: pp. 52–54. Also see: K. Hachem and Z.M. Song, (2015), The Rise of China’s Shadow Banking System, Working Paper, January, mimeo. 354  It does not only crack down on a massive shadow banking segment but will over time also lead to credit allocation: Z. Yangpeng, (2018), China’s Ban on Entrusted Loans to Set to End a Popular Form of Shadow Financing, (via scmp.com), January 9. In the article Richard Xu argues, ‘Since the only channel for asset management plans to allocate funds to the end borrowers is via entrusted loans, the ban on using funds from the plans from brokers, fund management subsidiaries and

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nitely not miss its impact and might recalibrate the relationship and competition between the different banking segments in China.355 As China’s rise on the world stage continues, while it tries to reinvent its domestic economy, the Chinese shadow banking segment will continue to look like shifting paradigms all the time.356

5.11.2  China’s Corporate Debt Problem Although not directly part of the shadow banking analysis, the corporate debt outstanding in China might be an indirect reflection of the issue intrinsic to the Chinese shadow banking model. Much has been said in recent years. It is fair to say that the credit boom is related to the large increase in investment after the global financial crisis.357 One of the issues that come with increased debt availability is that investment efficiency typically falls and the financial performance of corporates358 structurally deteriorates, in turn affecting asset quality in financial institutions. You might have observed that when the Chinese regulator intervenes, it normally does so, late in the cycle and normative rather than ex ante and comprehensive. It might be just that what is needed to solve the corporate debt private funds for entrusted loans will effectively put an end to the most popular structure for nonstandardized credit assets.’ The question remains to what degree it will push some borrowers offshore, especially since the bond markets will also be impacted by this crackdown. 355  Y. Tan, (2017), Competitions in Different Banking Markets and Shadow Banking: Evidence from China, University of Huddersfield Working Paper, October 20, mimeo (also published in the North American Journal of Economics and Finance, Vol. 42, pp. 89–106, 2017). Tan pioneers on the topic of competition between different banking segments (deposit market, loan market and non-interest income market) and shadow banking. She also analyzes the determinants of competition in different banking markets as well as the factors influencing the size of shadow banking in China. Her findings suggest that a larger volume of shadow banking leads to a decline in the level of competition in the Chinese deposit market, loan market and non-interest income market, while an increase in the level of competition in the loan market, deposit market and non-interest income market leads to an expansion of the shadow banking industry in China. Improving the performance of Chinese commercial banks is key, which is a challenge as most of them are state-owned banks. See for the overall competitive relationship between shadow banks and traditional banks: C.  Shu, (2017), Banking Competition Revisited: Shadow Banks vs. Commercial Banks, Working Paper, June, mimeo; L. Jiang et al. (2016), Competition and Bank Opacity, HKIMR Working Paper Nr. 5, April. 356  C. Xi and L. Xia, (2017), Shadow Banking in China: Then and Now, Shadow Banking in China: Then and Now, Journal of Banking and Finance Law and Practice, Vol. 28, pp. 146–157; see also the nice overview of all regulatory measures regarding the shadow banking market from 2010 to October 2016 (pp. 151–152). 357  And obviously the 2012 RMB 4 trillion stimulus package. Although credit booms have some things in common across the globe, the complex nature and involvement of the different shadow banking agents and the combination of high savings, current account surplus, small external debt, and various policy buffers can help mitigate near-term risks. See also: S.  Chen and J.S.  Kang, (2018), Credit Booms – Is China Different?, IMF Working Paper Nr. WP/18/2, January. Regarding the contribution of China’s high savings, see H. He et al., (2018), China’s High Savings: Drivers, Prospects, and Policies, IMF Working Paper Nr. WP/18/277, December. 358  In a broader context it can be argued that firm performance in China is driven by corporate governance, or the lack thereof: in detail: M. Molnar et al., (2017), Corporate Governance and Firm performance in China, OECD Economics Department Working Papers, Nr. 1421, ECO/ WKP(2017)53, October 10.

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problem.359 Part of the problem, and which links it to the shadow banking issue at hand, is that although the credit quality has worsened (and the NPLs are up), the credit quality might even be much worse in the shadow credit products.360 The excess credit supply can often be traced back to the large state-owned companies and their typical dismal financial performance. The strategy of the Chinese government is gradual and prudent as nothing should endanger the overall economic growth and its shift toward more domestic market and aligned consumption. Their strategy aims to restructure debt,361 reduce over-capacity, and eliminate nonviable ‘zombie’ firms.362 At the same time, the government is pursuing gradual deleveraging and reforming state-owned enterprises363 to reduce

 Which is what is suggested by: W. Maliszewski et al., (2016), Resolving China’s Corporate Debt Problem, IMF Working Paper Series, Nr. WP/16/203. Key elements should include, according to them, identifying companies in financial difficulties, proactively recognizing losses in the financial system, burden sharing, corporate restructuring and governance reform, hardening budget constraints and facilitating market entry. 360  See for an attempted quantification and details: J.  Caparusso and K.  Yan, (2017), China: Financial System Vulnerabilities—Shadow Exposures, Funding, and Risk Transmission, China: Selected Issues––IMF Country Report, July 14, pp.  17–23 and 26–32, as well as R.  Lam et  al., (2017), Resolving China Zombies: Tackling Debt and Raising Productivity, IMF Working Paper Series Nr. WP/17/266, November. Lam et al. do not only assess, qualify the vulnerabilities in the system and the crowding out of zombie firms, they particularly illustrate empirically the linkages between zombie firms and state-owned enterprises in contributing to corporate debt vulnerabilities and low productivity (pp. 8–10). They also analyze the effects of different restructuring options and the potential output gains from resolving these weak firms. 361  See for past experiences in this field: D.A. Grigorian and F. Raei, (2016), Government Involvement in Corporate Debt Restructuring: Case Studies from the Great Recession, IMF Working Paper Nr. WP/10/260; J. Daniels et al., (2016), Debt-Equity Conversions and NPL Securitization in China–– Some Initial Considerations, IMF Technical Notes and Manuals 16/05, August. 362  The reference to zombie firms in literature typically is to those whose liquidation value is greater than their value as a going concern, taking into account potential restructuring. For the Chinese government the qualification of a zombie banks is ‘firms that incur three years of losses, cannot meet environmental and technological standards, do not align with national industrial policies, and rely heavily on government or bank support to survive’. Alternatively used as a benchmark is ‘firms incurring persistent losses and with interest payment costs below market lending rates—a proxy for support from creditors or the government’. Zombie firms are not a typical Chinese issue. See: D. Andrews and F.  Petroulakis, (2017), Breaking the Shackles: Zombie Firms, Weak Banks and Depressed Restructuring in Europe, OECD Working Paper, ECO/WKP(2017)65, November 16 and M. A. McGowan et al., (2017), Insolvency Regimes, Zombie Firms and Capital Re-allocation, Economic Department Working Paper Nr. ECO/WKP(2017)31, June 28. For a stylized and comparative analysis of zombie banks, see: R. Lam et al., (2017), Resolving China Zombies: Tackling Debt and Raising Productivity, IMF Working Paper Series Nr. WP/17/266, November, p. 7. 363  See in detail: W.R.  Lam and A.  Schipke (2017), State-Owned Enterprises Reforms, in Modernizing China: Investing in Soft Infrastructure, IMF Publishing; W.  Leutert, (2016), Challenges Ahead in China’s Reform of State-Owned Enterprises, Asia Policy Issue 21, January, pp. 83–99; A. Batson, (2016), Villains or Victims? The Role of SOEs in China’s Economy, in The State Sector’s New Clothes, GaveKal China Economic Quarterly, No. 20/2, June 2016; W. Lam and A. Schipke, (2016), China’s Emerging State-Owned Enterprises (SOE) Reform 359

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credit misallocation.364 The most pressing corporate debt vulnerabilities are concentrated among SOEs, zombies firms (who often undertake non-commercial functions such as pursuing national development strategies and performing social service functions), and over-capacity firms (that suffer from low capacity utilization rates and persistent losses).365 In particular the zombie firms are of concern as ‘[z]ombies have contributed to the rising share of corporate debt, overlap significantly with SOEs, and have particularly weak fundamentals. Implicit guarantees366 allow these firms to survive despite persistent losses and high leverage’.367 It was demonstrated before that zombie firms tend to crowd out private investment, contribute to lower productivity growth and hinder competition.368 Implicit government support is a key contributing factor to the rise of zombies and that the misallocation (of credit)369 amplifies business cycles and inequality in the economy.370 Strategy, China: Selected Issues––IMF Country Report 16/271; B.  Naughton, (2016), State Enterprise Reform: Missing in Action. In The State Sector’s New Clothes: Will SOEs Save China’s Economy or Drag It Down, China Economic Quarterly, Vol. 20, Issue 2, June; N. Liack, (2017), Alternative Finance and Credit Sector Reforms: The Case of China, Bank of England Staff Working Papers Nr. 694, November. 364  See for a full overview of measures taken and assessment: R. Lam et al., (2017), Resolving China Zombies: Tackling Debt and Raising Productivity, IMF Working Paper Series Nr. WP/17/266, November, pp. 13 ff. 365  The most common industries to find them in are steel, aluminum, textile, automotive and so on. 366  J. Huang et al., (2019), The Risk of Implicit Guarantees: Evidence from Shadow Banks in China, Working Paper, Mazy, mimeo. They focus on the qualitative and quantitative properties of implicit guarantees for shadow banking debt. They document that a bank extends stronger implicit guarantees to its shadow bank debt (i.e. wealth management products) when its reputation deteriorates. The key mechanism of the model is that as a bank’s reputation becomes worse, it has stronger incentives to send positive signals to the market, that is, to boost the realized returns of its shadow bank debt, although it is not obliged to do so. Their findings imply that riskier banks should have higherrisk weight for their off-balance sheet exposure because they are more tempted to offer implicit guarantees and take losses for their off-balance sheet operations. 367  R. Lam et al., (2017), Resolving China Zombies: Tackling Debt and Raising Productivity, IMF Working Paper Series Nr. WP/17/266, November, p.  7; M.  Jaskowski, (2015), Should Zombie Lending Always Be Prevented?, International Review of Economics & Finance, Issue 40, pp. 191–203. See for a Western analysis: R. Chami et al., (2016), What’s Different About Bank Holding Companies, Working Paper, December 5, mimeo. 368  See most recently: Y. Tan, et al., (2017), The Crowding-Out Effect of Zombie Firms: Evidence from China’s Industrial Firms, Economic Research Journal (Jingjiyanjiu), Vol. 52, Nr. 5, pp. 175– 188; G. Shen, et al., (2017), Zombie Firms and Over-Capacity in Chinese Manufacturing, China Economic Review, Elsevier, Vol. 44(C), pp. 327–342; W. Guo, et al., (2017), Zombie Firms and the Stimulating Policies: Evidence from China, mimeo. 369  See regarding the relationship between misallocation and productivity: D.  Restuccia, and R. Rogerson, (2013), Misallocation and Productivity, Review of Economic Dynamics, Vol. 1, Issue 16, pp.  1–10; also see: L.W.  Cong et  al., (2017), Credit Allocation Under Economic Stimulus: Evidence from China, Chicago Booth Research Paper Nr. 17–19, August. 370  See most recently: L.  Caliendo et  al., (2017), Distortions and the Structure of the World Economy, NBER Working Paper Nr. 23332; H. Chen et al., (2017), To Guide or Not to Guide: Quantitative Monetary Policy Tools and Macro-Economic Dynamics in China, Hong Kong Institute for Monetary Research Working Paper Nr. 09/2017, May.

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But there is more: in a market-based system the pricing discovery in the market leads to bank lending rates that (properly) reflect the default risk of the borrower. But China is not a full market-based banking model. The consequence is that lending rates are default-­ appropriate in relation to non-SOE, but that bank lending rates are less sensitive to the default risks of state-owned enterprises. Also industry variation is observed in this respect: the real estate sector and other government-supported industries tended to enjoy better terms on loan pricing in terms of default risks. The link with government stimulus being tilted toward those industries is obvious.371 Although all the interventions discussed will surely not miss their effect on the size and nature of the shadow banking market, there is the continuous threat of a pure banking crisis with spillover effects to the shadow banking market, given the dominant and central role of (state-owned) commercial banks.372 The Bank for International Settlements (BIS) recently highlighted the early indicators of a banking crisis373 (of which the credit-to-GDP ratio [‘credit gap’]374 is the most important). China had both a high credit gap and a high level of debt servicing ratio. That was after the IMF in December 2017375 already highlighted major tensions in the Chinese financial infrastructure. Of the three major issues identified, shadow banking and its increased complexity was number two on the list. It complicates further the supervisory efforts undertaken. Varga put it this way: ‘[t]he Chinese supervisory toolset gives the flexibility for the supervisory authority to handle the risks and challenges that may arise. However, with the spread of the shadow banking system, supervisory bodies were unable to respond with sufficient efficiency with the flexibility afforded by the applied toolset.’376 The reality is always more complex than the theory, especially in China. In practice, structures can be much more complex than the example provided above. For example, WMPs and AMPs can invest in other WMPs and AMPs. The asset pool of the SPV can include a wide range of assets, such as bank-accepted bills, corporate bonds, repos, equities and other AMPs. Guarantee companies can also play a role in the structure, particularly where the ultimate borrowers are small- and medium-sized businesses (which can lack long credit histories and high-quality collateral, making it difficult for them to borrow from a

 See in extenso: H. Chen et al., (2017), Corporate Default Risk and Loan Pricing Behavior in China, Hong Kong Institute for Monetary Research Working Paper Nr. 22/2017, October. 372  The complexity of the economic transformation China is undergoing will co-shape the future size and nature of their shadow banking landscape; see: G. Han, (2017), Structural Transformations and Its Implications for the Chinese Economy, Hong Kong Institute for Monetary Research Nr. 8/2017, April. 373  I. Aldasoro et al., (2018), Early Warning Indicators of Banking Crises: Expanding the Family, BIS Quarterly Review, March, pp. 29–45. 374  The credit-to-GDP gap measures the difference between the percentage of debt in an economy and its long-term trend. 375  IMF, (2017), China—Financial System Stability Assessment, IMF Country Report Nr. 17/358, December 6, in particular pp. 29–33. 376  B.  Varga, (2017), Current Challenges Facing Chinese Financial Supervision and Methods of Handling These Challenges, Financial and Economic Review, Vol. 16. Special Issue, January 2017, p. 136. 371

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bank). Or, better, sometimes there are informal agreements between the engaged parties where the senior tranche of an SPV is purchased by another bank, and the organizing bank promises to buy it back in the event of default. Credit risk for the end investor is reduced, and that leaves room for the borrower to extend raising debt beyond normal capacity. The transfer of risk is often not readily identifiable and in many cases the risk transfer is imperfect.377 Especially, taking into account that many corporate organizations (not being banks) borrow to lend (re-lending).378 Firms with better growth opportunities, stronger corporate governance and more financial constraints engage less in re-lending. State-controlled companies are particularly active in re-lending probably because of their better access to financial markets (and in particular state banks) and more interesting conditions, as well as lower profitability and lack of growth opportunities in their main business activities.379 It points once more at the very complex nature and multifaceted aspects of China’s shadow banking market. Hachem argues that the peculiarities in the Chinese shadow banking market do not

 J. Bowman et al., (2018), Non-Bank Financing in China, Reserve Bank of Australia, Bulletin March, p. 12. They categorize the shadow banking market in five departments: trust loans, other shadow debt, entrusted loans, bank-accepted bills and alternative financing (pp. 6–7). See also for a write-up: X. Zhu, (2018), The Varying Shadow of China’s Banking System, University of Toronto, Working Paper Nr. 605, may 17. An provides interesting insights in a hidden segment of the SB market, that is, guaranteed off-balance sheet (consists of banker’s acceptance, letter of credit and letter of guarantee). He argues that the Desirability Lending Policy conducted by People’s Bank of China during the period 2011–2014 is the unique fundamental driving force, rather than traditional regulatory constraints, such as reserve requirement ratio and loan-to-deposit ratio. See in detail: P. An, (2018), Neglected Part of Shadow Banking in China International Review of Economics & Finance, Elsevier, Vol. 57(C), pp. 211–236. 378  Interesting is the observation that it was after the deregulation wave in the financial industry that bank competition rose and new entrants into the space were those that have been extensively lending to inefficient state-owned enterprises that have implicit government guarantees. See H. Gao, et al. (2018), Rise of Bank Competition: Evidence from Banking Deregulation in China, Working Paper, April 16, mimeo. The Chinese style of shadow bank transforms risky corporate loans into interbank lending. Therefore, risky weight assets are underestimated resulting in bias of the observed high capital and liquidity measures. Moreover, the weights of the capital and liquidity measures are distorted. Bank regulators and shareholders should incorporate the effect of shadow bank into observed financial ratios in assessing the safety and soundness of the banking system claims C.-H.  Shen et  al., (2018), How Does Shadow Bank Affect Bank Ranking in China?, Emerging Markets Finance and Trade Journal, online, https://doi.org/10.1080/1540496X.2018.1530654, December 20. 379  J. Du et al., (2016), Shadow Banking Activities in Non-Financial Firms: Evidence from China, Chinese University in Hong Kong Working Paper, mimeo. Key to this analysis is the linkage between financial liability and financial assets or the financial assets and fixed assets investment, which is different for a ‘borrow to lend’ firm and a ‘borrow to invest’ firm. Small private firms engage in the usual ‘borrow to invest’ activities while the large state-owned firms and less profitable firms are more involved in the ‘borrow to lend’ activities. Also see: Z. Tan, (2018), Liquidity Shocks and ‘Borrow to lend’ Shadow Banking Activities, HKIMR Working Paper Nr. 13 May, who also points at the liquidity shocks (like the one China experienced in 2013) that might result out of an increase of ‘borrow to lend’ activities and how liquidity shocks also contribute to the development of such shadow banking activities. Q. He, (2016), Who Gains from Credit Granted Between Firms? Evidence from Intercorporate Loan Announcements Made in China, CFS Working Paper Series, Nr. 529, Center for Financial Studies, Goethe University. Entrusted lending is more prevalent and more profitable in cities where traditional bank loans grow slower, which has been giving rise to ‘surrogate intermediaries’ as Ruan coins them. Entrusted lenders also appear to use existing cash rather than raise external 377

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set it apart from the textbook definition, but that these characteristics mirror those characteristics to be found in the rest of the economy at large.380 The combination of measures taken by the Chinese government seems to have yielded their first effect in 2018, when the shadow banking market, worth USD 9.1 trillion, contracted for the first time in 2018, although corporate defaults were up and fears of a new shadow banking blow up, creating material uncertainty going forward.381

finance to make the loans. He sees limited financial stability risk, likely as a consequence of reasonable geographical dispersion. T. Ruan, (2017), The Economics of Shadow Banking: Lessons from Surrogate Intermediaries in China, NYU Stern Job Market Paper, December 19. 380  K. Hachem, (2018), Shadow Banking in China, Annual Review of Financial Economics, Vol. 10, pp. 287–308. Not sure what the point is. Nobody has ever claimed that the Chinese fundamentals are different from other shadow banking systems. What has been claimed is that the appearance has been fundamentally different than most Western SB systems, simply due to the different structure of their financial systems. Ultimately every SB system emerges and models itself based on regulation, financial infrastructure and economic market design as fundamental principles. 381  D. Weinland, (2019), China Shadow Banking Cools for First Time in a Decade, FT, March 19; H. Lockett and Y. Jia, (2019), Chinese Stocks Fall on Fears of Fresh ‘Shadow Banking’ Purge, FT, April 22.

6 Shadow Banking in (South) Africa

6.1 Introduction On the African continent, the South African financial sector is among the most developed and regulated. And for a number of years they have been participating in the Financial Stability Board’s (FSB’s) global shadow banking exercise. The feedback reveals the expected moderate outlook for shadow banking on the continent and South Africa in particular. Some highlights include: • In line with developments in the global shadow banking system, this industry’s assets also grew rapidly between 2002 and 2007 (at about 40% per annum) in all categories in South Africa. However, following the financial crisis, the annual growth rate moderated significantly to approximately 6% per annum between 2008 and 2012.1 • South Africa’s shadow banking system expanded, growing from approximately 13% of financial assets of all financial intermediaries to 18% by the end of 2014. However, this is still a relatively small part of the financial system. Furthermore, more than half of the shadow banking system is made up of money market funds, which are regulated and therefore not markedly ‘shadowy’.2 • The traditional insurance and pension fund sector made up 41% of total financial system assets in South Africa.3

 FSB, (2013), Global Shadow Banking Monitoring Report 2013, p. 30.  South African Reserve Bank, (2015), Changing Patterns of Financial Intermediation: Implications for Central Bank Policy, in BCBS, (2015), What Do New Forms of Finance Mean for EM Central Banks, BIS Working Paper Nr. 81, October, pp. 347–370. 3  FSB, (2014), Global Shadow Banking Monitoring Report 2014, p. 11. 1 2

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• The share of nonbank financial intermediaries is well below 100% of gross domestic product (GDP), but the growth of the nonbank intermediation sector has been growing at a rate above 20% per annum starting 2013.4 • The share of the other financial intermediary (OFI) segment is on the rise, however, since the early 2000s,5 and accounts for more than 20% of total financial assets. The gain of the OFI segments is lost by the traditional banking sector.6 • Credit extended by OFIs had increased over the past decade; it remained more or less constant as a share of total credit extended at about 8%. Banks therefore still provide the bulk of credit at about 92%. • Finance companies as part of the OFI segment account for about 10% of the OFI credit provision.7 The majority of finance companies are not affiliated to banks and therefore form part of the shadow banking system in South Africa. Nel therefore concludes that ‘in a global context, but also in relation to the size of the financial sector in South Africa, shadow banking is relatively small and does not currently raise any systemic concerns. According to the latest estimates, less than 10% of total credit extended in South Africa is provided by the shadow banking industry.’8 Although the data granularity has materially improved in recent years, it used to be, and is still somewhat, a concern that the interconnectedness and the nature of the relationship between OFIs and banks remain opaque in South Africa.9 Although the narrow measurement by the FSB has brought the South Africa (SA) OFI segment materially down, trends have broadly remained unchanged. The narrow measure10 is helpful in avoiding inappropriate regulatory regimes advertently being imposed on those entities that play an important role in the mobilization of savings and finances in emerging markets but do not have a direct relation to credit intermediation.11  FSB, (2014), Global Shadow Banking Monitoring Report 2014, p. 12.  FSB, (2014), Global Shadow Banking Monitoring Report, p. 52. 6  FSB, (2013), Global Shadow Banking Monitoring Report 2013, p. 30. 7  FSB, (2013), Global Shadow Banking Monitoring Report 2013, p. 30. ‘Finance Companies are established in terms of the Companies Act (2008) with the specific purpose of obtaining funds through loans, debentures or notes with the objective of lending or investing these funds again in the form of mortgage loans, factoring instalment sales and/or leasing finance. The main types of finance companies are vehicle finance companies, consumer finance companies and retail finance companies.’ They are regulated by the National Credit Regulator. That institution was established in 2006 to regulate all credit extensions in South Africa. 8  H. Nel, (2014), Shadow Banking Case Study for South Africa, pp. 30–31 in FSB, (2013), Global Shadow Banking Monitoring Report, Basel. See also: L. Kganyago, (2014), Introductory remarks by Lesetja Kganyago, deputy governor of the South African Reserve Bank, at the launch of the financial stability review: September 2014 at the Johannesburg branch of the South African Reserve Bank 29 October 2014, pp. 2–3. 9  See extensively: R. Du Randt, (2015), An Empirical Study of Potential Risks of Shadow Banking in South Africa, DCom, mimeo. 10  The FSBs narrow measure, which excludes OFIs that have no direct relation to credit intermediation. This resulted in a drop in the estimation of the size of OFIs’ assets as a percentage of assets of all the financial intermediaries in South Africa. 11  South African Reserve Bank, (2014), Financial Stability Review 2014, September edition, p. 24. 4 5

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The trend in more recent years (as of 2010) is somewhat concerning as the assets of OFIs, a broad proxy for shadow banking, continued to increase at a faster pace than the assets of banks during the period under review. This higher growth rate is rooted in the increases in assets held by unit trusts (excluding money market funds). The OFIs now account for about 20% of financial assets in South Africa and the only category demonstrating an upward sloping curve (combined with the assets held by insurance and pension funds).12 In February 2015 and with effect from 1 April 2015, the hedge funds have been requalified as collective investment schemes and regulated accordingly.13 Retail hedge funds will be regulated more strictly than qualified investor hedge funds, although both types of funds will have measures in place to protect consumers.14 Nevertheless, the South African regulator appreciates the fact that growth in shadow banking activities could therefore provide broader access to finance to more people and thereby also contribute to economic growth. Growth in credit extension by nonbank financial intermediaries has remained moderate over the past few years, growing at roughly the same pace as credit extension by banks.15 When excluding valuation effects (i.e. equity market performance and the returns on unit trust funds from the asset values of unit trust funds, pension funds and insurance companies), the distribution of assets among financial intermediaries in South Africa changes significantly. The asset holdings of OFIs excluding valuation effects remained more or less constant as a percentage of financial intermediaries’ assets between 2008 and 2014, at about 14%. Furthermore, the decrease in banks’ share of assets ranged from 43% to 36% over the same period.16 During the information-sharing exercise (with the FSB for their global monitoring program), the broad measure of shadow banking (OFIs) was narrowed to arrive at a measure of shadow banking based on economic activities. More than 50% of OFIs were not classified and therefore do not form part of the narrow shadow banking measure. As a percentage of total assets, the share of shadow banking’s assets (the narrow measure) dropped significantly from 18% of total financial assets (broad measure) to 8% in 2014. The asset share of shadow banking entities as a percentage of total assets of financial intermediaries has remained relatively constant since 2008 at less than 10%.17 Although the shadow banking in South Africa is advantageous in terms providing alternative source of credit to support  Federal Reserve Bank of SA, (2015), Financial Stability Review, March, pp. 16–18.  The new Hedge Fund Determination will ensure that regulators have better oversight over any systemic issues that may arise from these funds, among other things. The Determination also covers the duties of managers for both types of funds, leverage, liquidity, collateral and monthly reporting to the Registrar of Collective Investment Schemes. One of the major provisions in the Determination relates to disclosure of information to investors. Furthermore, the Determination stipulates exposure limits for permitted asset classes, see: SA Reserve bank, (2015), FSB March, pp. 32–33. 14  A qualified investor is defined as any person who invests a minimum investment amount of R1 million per hedge fund and who has knowledge to assess the merits and risks of a hedge fund investment, or who has appointed a financial services provider who has the knowledge and experience to advise the investor regarding the merits and risks of a hedge fund investment. 15  SA Reserve Bank, (2015), FSR September, p. 13. 16  Ibid. 17  SA Reserve Bank, (2015), FSR September, p. 14. 12 13

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economic activities by extending banking services and investment opportunities to the unbanked as well as those who lack knowledge of how to access capital, however issues of regulations, management and transparency have not been adequately dealt with. These create a great risk to the economy if not properly addressed.18

6.2 The Remaining African Continent There is very little known about the size and segment construction of the shadow banking markets on the African continent outside South Africa. Part of that elusiveness is due to the fact that South Africa is the only country on the continent that participates in the annual global monitoring exercise organized by the FSB. What we do know is that the entire continent is primarily built around two large economies, that is, South Africa and Nigeria, which account for more than 50% of the African GDP. Since 2014, Nigeria has the largest economy of the two and has a large but not necessarily sophisticated banking system compared to the Western or the South African standard. We also know that many development agencies and micro-lenders are active on the continent and that most financial infrastructures are largely built around the traditional banking sector and are regulated as such. Most African countries adhere to the Basel framework. It therefore seems that shadow banking is not so much of a direct concern to the local regulators and/or a threat to the financial stability in the region, although the use of plain vanilla unsecured debt for low-income earners is widespread. Initiatives are often domestic and are few and far between, regarding the shadow banking market: • For Zimbabwe, shadow banks include hire purchases, mobile call loans, lending by individuals, group lending schemes and cooperatives.19 It was commented that ‘in an economy like Zimbabwe where there is generally lower disposable income and a high informal market, shadow banks like cooperative schemes and unregistered group lending arrangements provide easier credit to the lower income market that would have been excluded by banking institutions’.

 K.D.  Ilesanmi and D.D.  Tewari, (2019), Management of Shadow Banks for Economic and Financial Stability in South Africa, Journal Cogent Economics and Finance, Vol. 7, Issue 1, https:// doi.org/10.1080/23322039.2019.1568849; E.  Kemp, (2017), Measuring Shadow Banking Activities and Exploring its Interconnectedness with Banks in South Africa, South African Reserve Bank Occasional papers, Nr.1, December 15. While the shadow banking system in South Africa remains relatively small when compared to global peers, its assets under management are growing at a faster pace than those of banks. Furthermore, banks in South Africa obtain a relatively large portion of their funding from nonbank financial intermediaries, and generally interconnectedness among financial intermediaries in South Africa is relatively high 19  J.  Chishamba, (2014), The Rising Dominance of Shadow Banking, Zimbabwe Independent, October 24. 18

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• Nigeria is making efforts to monitor and quantify their shadow banking system, but no legislation is in place yet.20 Nigeria also reports very little about its own shadow banking industry and analysis limits itself to foreign experiences.21 • The Central Bank of Egypt is developing a set of control to monitor the domestic shadow banking market.22 • In the Middle East and North Africa (MENA) region, the shadow banking system (like in other parts of the African continent) is seen as a welcome complement to the traditional banking sector and is seen as a major provider of finance for small- and medium-sized enterprises (SMEs).23

6.3 It’s Direct Neighbor: The Middle East This set of countries obviously belong to the MENA region, and for the purposes of this overview I got it adopted for the African region (as its geographical nearest cousin) as it doesn’t justify a separate chapter or section. Most shadow banking segments are immaterial in this part of the world and, therefore, considered not relevant for systemic risk purposes.24  Nigeria News, (2010), The Rise and Fall of the Shadow Banking System in Nigeria, Part 1 and 2.  G. Okorie, (2014), Shadow Banking, Central Bank of Nigeria, Understanding Monetary Policy Issues Paper Nr. 39; M.K. Tule and S.F. Onipede, (2017), Shadow Banking and Central Bank’s Growth Support Initiative in Nigeria: Facts and the Evidence, Journal of Economics and Sustainable Development, Vol. 8, Nr. 6, pp. 92–101. 22  M.  Salem, (2014), Central Bank Develops Controls for Shadow Banking, almalnews.com, October 30; Y.M.G.  Salem, (2017), How Far Is Shadow Banking in Egypt from International Experiences?, International Journal of Innovation, Management and Technology, Vol. 8, Nr. 3, pp.  197–200; Y.M.L.D.  Gharieb et  al., (2017), Growth of the Shadow Banking System and Effectiveness of the Monetary Policy in Egypt: An Empirical Analysis, The Social Sciences, Vol. 12, Issue 8, pp. 1344–1352. 23  M’Fadel El Halaissi, (2014), Région MENA: accroître les financements bancaires des TPE/PMIPME, Revue Banque, February 25; Y. Dinc, (2015), Conversion from Shadow Banking to Regular Banking an Empirical Analysis, MPRA Paper Nr. 85333, April 15. 24  For example, in the UAE the central bank reported: the size of shadow banking system in the UAE is not material and, therefore, it has not been included (in their analysis). UAE central bank, (2013), Financial Stability Review 2013, Dubai, p. 13. The Central Bank of Oman indicates that shadow banking in the country remains infant and well regulated. The Nonbank financial institutions (NBFI) sector is dominated by finance and leasing companies (FLCs) and insurance companies. The assets growth of FLCs continues on the back of strong growth in loans and advances. For their funding needs, FLCs rely excessively on bank borrowing. Heavy reliance on bank borrowing might restrict their future growth should the bank funding dry up or become prohibitively expensive when interest rates go up and might destabilize FLCs during banking sector troubles. Insurance companies continued to grow on the back of ongoing concentration activity and mushrooming fleet of automobiles. The unstable weather conditions, and increasing level of road accidents and the claims arising out of them, are a cause of concern for the insurance sector; Oman Central Bank, (2013), Financial Stability Report 2013, Muscat, p. IV. Over 94% of the total assets of the Omani financial system belong to banks. The Central Bank of Oman apart from the banks also regulates specialized banks, nonbank finance and leasing companies and money exchange establishments (pp.  38–39). In 2015 also, the Central Bank of Lebanon was preparing for shadow banking 20 21

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OFIs structurally are less than 10% of domestic assets in each of the region’s countries, and there is hardly any intertwining between traditional and shadow banking sectors (both ways). Reference can be made to the FSBs annual global shadow banking monitoring report, although data sets are not sufficiently granular and few and far between, as most countries in the Middle East are not in the FSBs scope.

i­nterventions; see: D. Halawi, (2015), Central Bank Prepares to Crack Down in Shadow Banking, The Daily Star Lebanon, February 28. See also for coverage of the region: B.  Michael, (2014), Playing the Shadowy World of Emerging Market Shadow banking, Skolkovo Business School, Institute of Emerging Market Studies, (IEMS), Vol. 14–02, April, pp. 1–27.

7 Future Directions

7.1 Introduction In this chapter, I will attempt to disclose some (or many) of what I believe are the loose ends, untied knots, and mainstream issues going forward when it comes to shadow banking (SB) as a channel of credit intermediation, provider of (safe) assets and object for regulators and supervisors who continuously will experiment with their macroeconomic and macroprudential thought processes on a shadow banking market that will continuously evolve, due to market dynamics, innovation and changing and incoming regulation. You could see it as the sunset flight of the ‘Owl of Athena’1 after we have extensively reviewed the shadow banking and all its intricacies worldwide. You can definitely see it as an anthology of closely connected topics that directly to our existing analysis we’ve went through already. It will allow us to close in on our thinking and supplement with further reflections before we come to some kind of conclusions in the next chapter.

7.2 T  he Effect of Bank Capital Requirement on Growth Many studies have been performed regarding the impact on the economy and economic growth of bank capital requirements, and all point in the direction that there is very little direct effect.2 Most of the studies therefore focus on the ‘indirect effects’, that is, credit

 Intellectually borrowed from G.W.F. Hegel: ‘die Eule der Minerva beginnt erst mit der einbrechenden Dämmerung ihren Flug’; in Grundlinien der Philosophie des Rechts oder Naturrecht und Staatswissenschaft im Grundrisse (1820). 2  There are very few studies that try to measure the direct effect of bank capital regulation. 1

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­supply, bank asset risk and cost of bank capital, which in turn can affect economic growth.3 Better-capitalized banks enhance financial stability4 by reducing bank risk-taking incentives and increasing banks’ buffers against losses.5 But the impact is dependent on the way banks solve the need for higher capital requirements. As Martynova illustrates, they have three options: (1) raising equity, (2) cutting down lending and (3) reducing asset risk. The following considerations should be taken into account: (1) Traditionally seen as the least preferred option due to being expensive. It has been argued that the cost is related to the information asymmetry about a bank’s effective net worth. But in most cases, this higher capital cost is passed on to borrowers, but the cost of capital doesn’t decrease later on when the bank becomes less risky.6 (2) An option mostly chosen by banks. Furfine demonstrated that 1% point increase in risk-based capital requirement results in 5.5% reduction in loan growth.7 Other studies demonstrate more moderate impacts of bank capital requirements. Martynova concludes: ‘[t]hus, most empirical evidence suggests that increase in capital requirements by one percentage point force banks to cut their total lending in the short run by 1.2–4.5% or reduce credit growth by 1.2–4.6 percentage points.’8 (3) Also known as a ‘flight to safety’. It is evidenced that such a credit contraction due to bank capital pressures contributes to the decline in real economic activity.9

 Banks facing higher capital requirements can reduce credit supply as well as decrease credit demand by raising lending rates which may slow down economic growth. 4  N.  Martynova, (2015), Effect of Bank Capital Requirements on Economic Growth: A Survey, BNB Working Papers, nr. 2015/467, pp. 2–6. 5  N.  Martynova, (2015), Effect of Bank Capital Requirements on Economic Growth: A Survey, BNB Working Papers, nr. 2015/467. 6  See in detail and for quantifications: N.  Martynova, (2015), ibid., pp.  10–14; F.  Allen and E.  Carletti, (2013), Deposits and Bank Capital Structure, ECO Working Paper Nr. 2013/03; M. Baker and J. Wurgler, (2013), Do Strict Capital Requirements Raise the Cost of Capital? Banking Regulation and the Low Risk Anomaly, NBER Working Paper Nr. 19,018; BCBS [Basel Committee on Banking Supervision], (2010), An Assessment of the Long-Term Economic Impact of Stronger Capital and Liquidity Requirements, Interim report, August; H. DeAngelo and R. M. Stulz, (2013), Why High Leverage Is Optimal for Banks, NBER Working Paper Nr. 19,139; A. Kashyap, et al., (2010), An Analysis of the Impact of ‘Substantially Heightened’ Capital Requirements on Large Financial Institutions, Journal of Economic Perspectives Vol. 25, pp.  3–28; P.  Slovik, and B. Cournède, (2011), Macroeconomic Impact of Basel III, OECD Economics Department Working Papers, Nr. 844, OECD Publishing, and P. Bolton, and X. Freixas, (2006), Corporate Finance and the Monetary Transmission Mechanism, Review of Financial Studies Vol. 19, pp. 829–870. 7  C. Furfine, (2000), Evidence on the Response of US Banks to Changes in Capital Requirements, BIS Working Papers, Nr. 88. 8  N. Martynova, (2015), ibid., p. 8; see for a full overview pp. 6–9 and the most recent literature review: J.  Noss and P.  Toffano, (2014), Estimating the Impact of Changes in Bank Capital Requirements During a Credit Boom, Bank of England Working Paper Nr. 494. 9  N. Martynova, (2015), ibid., p. 10; also see: U. Albertazzi and D. J. Marchetti, (2010), Credit Supply, Flight to Quality and Evergreening: An Analysis of Bank-Firm Relationships After Lehman, Banca d’Italia Working Paper Nr. 756; J.  Peek and E.  Rosengren, (2000), Collateral Damage: 3

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In general, as the results of most studies are very sensitive to the assumptions used, it can be concluded that higher capital requirements may reduce credit supply. On the other hand, higher capital requirements reduce the probability and severity of a possible financial crisis.10 Or as a one-liner, ‘studies providing an overall assessment of the effect of higher capital requirements on economic growth agree that the current level of capital ratios is too low’,11 and Martynova (2015) adds, ‘more stringent capital regulation can achieve a positive longrun effect on GDP growth, since the benefits of reducing the expected cost of avoiding banking crises outweigh the costs of complying with more stringent capital requirements, such as higher lending spreads and reduction in lending’.

7.3 T  he Holistic Financial Industry and Its Function The financial industry and its function, a question that deserves much more than a paragraph at the end of a book. Nevertheless, the question about the business model dimensions of the financial industry is important. It is not only regulation that has shifted activities from the regulated banking sector to the (unregulated) shadow banking sector, but also the unwillingness of the sector to change and develop new business models that can cater to the economy for the next century or so. The limitations of innovation to ‘technology’ and the unwillingness to go back to the traditional ‘intermediation function’ and aligned business models are part of that problem as well. The focus is still too much on value creation through growing the financial sector itself rather than value creation in the real economy as a proxy for the value creation by the financial institution and industry as a whole. Not financialization as value driver but ‘operational’, ‘economic’ and social advancement as objectives and measurements of the value creation by the financial sector should be the target. The online payments, customer-to-customer (C2C) lending, crowdfunding and currency platforms that have emerged in recent years are trivial in the larger evolution of the sector. The sector has always been built on trust, and a fund-raising platform, or online advisor will not replace that, not now not later. A large part of trust is the robustness of the business and business model. The fragility of the contemporary banking system had, understandably so, reduced that trust like never before. This fragility, which is also common to the shadow banking sector, makes people, regulators and supervisors nervous—especially in this day and age when the financial sector has colonized many spheres of life. There are clear demarcation lines as to how far and where the financial sector can add value to this world. That is, besides a philosophical question, Effects of the Japanese Bank Crisis on Real Activity in the United States, American Economic Review, Vol. 90, Issue 1, pp. 30–45, and A. Popov and G.F. Udell, (2012), Cross-Border Banking, Credit Access, and the Financial Crisis, Journal of International Economics Vol. 87, pp. 147–161. 10  J.-C. Rochet, (1992), Capital Requirements and the Behaviour of Commercial Banks, European Economic Review Vol. 36, issue 5, pp. 1137–1170. 11  N. Martynova, (2015), ibid., p. 16.

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predominantly a regulatory question. But can we say something useful about those ­demarcation lines. More and more the answer to that is yes. The first element is that of allocation of resources. As long as the sector will prefer to invest its resources in financial rather than operational assets, the productivity growth will continue to be fragile12 and its growth will equally be fragile and uneven. A second component is of the emerging negative relationship between the rate of growth of the financial sector and the total factor productivity growth rate. Or put differently, an exogenous increase in finance reduces total factor productivity growth. This implies that the growth of the financial sector as of a certain level and rate comes at the detriment of the real economic, that is, crowds out the real economy and consequently hampers those industries that are most financially dependent.13 Cecchetti and Kharroubi have a long track record of looking into the matter. In the chapter on Pigovian taxes, their earlier work14 was already discussed that dealt with the question of how financial developments affect aggregate productivity growth and why the growth and development in and of the financial sector add value to the economy only up to a point, after which it becomes a drag on real economic and productivity growth. Even when one tampers with the many variables in the analysis, the robustness of the conclusion stands.15 Their earlier question was on the ‘when’ and ‘how much’ question of this relationship. More recently, their focus shifted to the ‘why’ question. Why does financial sector growth harm real growth? The ‘how’ question, that is, how does financial sector growth16 reduce real economic growth, can be answered by referring to the fact that the financial sector growth disproportionately benefits high-collateral/low-productivity projects (e.g. construction and real estate). The skilled worker can be hired to improve the banks’ efficiency to lend or by entrepreneurs and firms to improve their returns. Being employed in one sector comes at the detriment to the other and creates an ‘externality’. Cecchetti and Kharroubi further elaborate: ‘[t]he externality works as follows: financiers who hire skilled workers can lend more to entrepreneurs than those who do not. With more abundant and cheaper funding, entrepreneurs have an incentive to invest in projects with higher pledgeability but lower productivity, reducing their demand for skilled labor. Conversely, entrepreneurs who hire skilled workers invest in high return/low pledgeability projects. As a result,

 See in detail: J.W.B.  Bos and P.C. van Santen, (2015), The Importance of Reallocation for Productivity Growth: Evidence from European and US Banking, Sveriges Riksbank, Working Paper, Nr. 296. 13  S.G. Cecchetti and E. Kharroubi, (2015), Why Does Financial Sector Growth Crowd Out Real Economic Growth, BIS Working Papers, Nr. 490, Monetary and Economic Department, Basel (also later on updated as NBER Working Paper Nr. 25,079, September 2018). 14  S.  Cecchetti and E.  Kharroubi, (2012), Reassessing the Impact of Finance on Growth, BIS Working Papers, Nr. 381. 15  See also: R. Levine, (1997), Financial Development and Economic Growth: Views and Agenda, Journal of Economic Literature, Vol. 35, pp. 688–726, and R. Levine, (2005), Finance and Growth: Theory and Evidence, Handbook of Economic Growth, Vol. 1, Elsevier, pp. 865–934. S.G. Cecchetti and E. Kharroubi, (2015), ibid., p. 24. 16  See regarding the financial sector growth: R. Greenwood and D. Scharfstein, (2012), The Growth of Modern Finance, mimeo Harvard Business School. 12

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financiers have no incentive to hire skilled workers because the benefit in terms of increased ability to lend is limited since entrepreneurs’ projects feature low pledgeability.’17 When the financial sector employs those skilled workers, the productivity growth in the real economy is lower (compared to businesses employing these workers), while the financial sector advances.18 Given the relative bargaining power of banks, the outcome for the economy as a whole is suboptimal. The industries that will suffer most are those industries that compete directly for resources with the banks (manufacturing, R&Dintensive industries, etc.).19 Interesting as well in their analysis are some of the secondary conclusions. Those include the following: (1) the productivity of industries with higher financial dependence has grown disproportionately faster in countries (a) with tighter monetary policy, (b) a higher cost of capital or (c) a more restrictive fiscal policy, measured as the ratio of the fiscal deficit to GDP, and (2) the productivity of industries with higher R&D intensity has grown disproportionately faster in countries with tighter fiscal policy.20 Financial booms (including credit booms) are not, as often thought, growth enhancing, because the financial sector competes with other industries for resources. More than reason enough to reconsider the relationship of finance and real growth in our economic system and financial business models.21

7.4 Is More Market-Based Funding the Solution? The Financial Stability Board (FSB) has been changing gears somewhat over time. This starts from the G20 mandate years ago, to monitor, measure and suggest regulation to structure and inventorize a complex and multidimensional industry, with many variations when comparing the country-specific systems all the way to allowing the system to flourish, and to allow a system of market-based financing to emerge and become a relevant and equal-worth system that can finance the real economy. It is clear that the Basel III rules will drive banks into T-bonds and away from commercial lending in particular small- and medium-sized enterprises (SMEs) lending. Whether that warrants the emergence and tolerance toward a parallel financing universe is highly doubtful. If the SB system would be a standalone equity-based risk-absorbing model, no one would complain. But when it predominantly becomes a debt-infused and debt-producing system, all red flags light up. It seems there is more need for a structured analysis of what we expect from such a system and what the drivers are for encouraging it to emerge. It needs to be considered that in the current state of high-regulatory inefficiency and effectiveness, and with very

 S.G. Cecchetti and E. Kharroubi, (2015), ibid., p. 3.  S.G. Cecchetti and E. Kharroubi, (2015), ibid., pp. 18–24. 19  S.G. Cecchetti and E. Kharroubi, (2015), ibid., p. 4. 20  S.G. Cecchetti and E. Kharroubi, (2015), ibid., p. 24. 21  S.G. Cecchetti and E. Kharroubi, (2015), ibid., p. 25. 17 18

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weak or non-existing (economic) models behind it, macroprudential regulation has become somewhat of a trial-and-error environment. But is our body of law not always on that path? The second feature is that any system that has no real autonomous ‘backstop’ will likely fail every now and then. It is part of the creative destruction characterizing capitalist systems. But that mechanism can destroy more than the value the capitalist system has built. And that is where the pain comes in. Every self-respecting country or sovereign region will try to protect the value that is built up under its watch, whether it is of an economic, social, cultural or ethical nature. However, neoliberalism as an economic but even more as a political project has taken the edges of that momentum and has left that central theme materially weakened. Loss of social norms, narcissism, bureaucratic and managerial excessive self-congratulation in the public and private sphere, and the persistent willingness to consume more and to invest less are all consequences of the society-transforming dynamics of the neoliberal political project as it has been powering through our societies for some decades now.22 It has alienated the regulatory domain from its financial cousin.23 But why would we endorse a financial parallel universe to the banking system? Is it because we paralyzed our banking system through endless command-and-control (C-aC) regulation? Or because there is demand for ‘apparently’ risk-free assets by institutional pools, often driven by the need to generate higher than cash-based return in a zero-rate environment. Or because we need those returns to keep our zombie welfare system alive, which were built on the premise that the market interest rate will stay within a reasonable bandwidth from the interest level applicable when those systems were designed decades ago. A mature/maturing economy benefits from a decent balance between bank financing and market-­based financing24 and the research discussed in the Pigovian chapter illustrate that the market-based financing takes over from the bank-­financing system in an economy as it matures. That in itself is okay and can’t be contested. In its original format, it implied that equity and debt financing were raised and that there is always somebody that absorbs losses in the end: the equity investor in case of an equity investment and the lender in case of a debt investment. A risk profile25 will lead to a ­risk-adjusted compensation in those cases that takes into account the risk of the borrower. This is a different kind of animal compared to a market-based financing system, predominantly to exclusively focused on debt with no real backstop and a material nexus to the

 See in detail: L. Nijs, (2015), Neoliberalism 2.0. Regulating and Financing Globalizing Markets. A Pigovian Approach to 21st Century Markets, Palgrave Macmillan, London. In particular chapters 1–3. 23  See, for example, L.  Cornelis (ed.), (2014), Finance and Law. Twins in Trouble, Intersentia, Cambridge. 24  And in Europe there is a need for a better balance as in most countries the system is predominantly bank-focused. See, for example, Sveriges Riksbank, (2015), Less Bank Funding, More Market Funding in Structural Changes in the Swedish Financial System, Sveriges Riksbank Studies, February 2015, pp. 11–22. 25  An undiscussed issue here is the quality of the ratings and to what degree there is information asymmetry in those judgments; see, for example, C. Broto and L. Molina, (2014), Sovereign Ratings and Their Asymmetric Response to Fundamentals, Bank of Spain, Working Paper Nr. 1428. 22

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traditional banking sector. This is a whole lot harder to justify regardless of what arguments are brought to the table in recent times, realizing that market-based financing is not particularly fault-free.26 It is not because we forced our banks to de-lever, an attempt that was only partly successful anyway, that we need to throw vulnerable parts of our economy under the market-based financing bus, especially in the case of SME.27 And should we pay more focus on some related issues. For example, we have turned our banking system in a ‘collateral collector’ which allowed that the banks have turned into real estate moguls, and are continuously in the treadmill of market value positioning of their real estate financed, as an increase of the collateral value will allow more lending without extra leverage or equity and thus better financial performance. Their industry knowledge–based financing has decreased in favor of asset-based financing. In an economy where more and more values are centered around non-tangible assets, the need for financing, whether it is market- or bank-based, will have to shift from asset-based lending to cash flow-based lending. This seems an impossible task for banks, and the regulator has made it even more impossible.28 The market will then find solutions elsewhere, while the regulatory and other public and private elites are losing their intellectual self-­confidence to deal with these relevant kinds of issues.29 The FSB has been trying to shave the edges off the sharp U-turn it made in 2014, when it claimed that the development of a market-based financing system was hidden in the G20 agenda and which justified its regulatory efforts so far. All that was quite unconvincing. Let’s bring to mind for the last time its five-step program for the shadow banking sector: • • • •

Mitigating risks in banks’ interactions with shadow banking entities; Reducing the susceptibility of money market funds (MMFs) to ‘runs’; Improving transparency and aligning incentives in securitization; Dampening procyclicality and other financial stability risks in securities financing transactions such as repos and securities lending; and • Assessing and mitigating financial stability risks posed by other shadow banking entities and activities.30 Its agenda gets annually more sophisticated, but its regulatory proposals are continuously unilaterally built around ‘command-and-control’ legislation. That is a painful illustration of regulatory inefficiency. Economists, since Pigou started the fire in 1920 in a thematic way, are heavy endorsers of Pigovian taxes that neutralize negative externalities the market produces. Very often Pigovian taxes are seen as a better alternative to ­command-and-control regulation. Remarkably enough, it was only during the post-2008

 S.  Fleming and G.  Chon, (2014), Rulemaking Proves Tricky When Dealing with Shadow Banking, Financial Times, June 18. 27  G. Wehinger, (2012), Bank Deleveraging, the Move from Bank to Market-Based Financing, and SME Financing, OECD Journal: Financial Market Trends, Vol. 2012/1, pp. 1–15. 28  S.  Samuels, (2015), Withering Regulations Will Make for Shrivelled Banks, Financial Times, January 13. 29  G. Rachman, (2015), The West Has Lost Intellectual Self-Confidence, Financial Times, January 5. 30  FSB, (2014), Transforming Shadow Banking into Resilient Market-Based Financing, An Overview of Progress and a Roadmap for 2015, Basel, p. 1. 26

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crisis era that economists (not even regulators) started to consider applying the Pigovian tax model to the financial sector. The models are still embryonic and a lot of trial and error is going on, but the ambitions are aligned. I shared my thoughts in the Pigovian chapter in this book, a model that will be equally applied to the traditional and shadow banking model. Applying a Pigovian model to the financial sector has one distinct advantage, that is, it uses the market mechanism of pricing as the fundamental driver to steer behavior of bank and shadow banks alike. This is a tremendous benefit it has over command-and-­control regulation where efforts often go into ‘avoidance’ behavior by financial institutions. The regulator often seems confused about its ability to apply Pigovian tax models across a wide variety of economic and noneconomic issues.31 This raises the question of why they should not or will not be capable of doing so. Masur and Posner32 identified five hurdles in this respect: • Pigovian taxes don’t solve a significant information problem, which is how the regulator values the harm caused by economic activity. • Pigovian taxes may lack political support because they do not serve the interests of those with political power. Regulation often tends to often do so. • Pigovian taxes have negative symbolic resonance. They are seen as ‘taxes’ on often noneconomic features of life. • Pigovian taxes breach the divide between taxation and regulation. • Risk-averse regulators whose personal interests diverge from the public interest might see no advantage to regulatory innovation. They apply their findings also to the financial sector33 and come to the overall conclusion that ‘none of these obstacles is either normatively compelling or politically insuperable. If agencies and legislatures have refrained from using Pigovian taxes for some combination of these reasons, ‘they are unjustified in having done so’.34 The cost-benefit analysis is the mainstream thinking at the regulatory level and the shift to a Pigovianbased model is slow and burdensome.

7.5 W  hat Role Should Finance Have in Society and What Benefits Should Be Expected? At risk of becoming too philosophical, the question should be asked about what to expect from the finance function in society. Most retail investors would answer that question indicating that a transparent mortgage and an ATM at the corner of every street is more  J.S. Masur and E. A. Posner, (2015), Towards a Pigovian State, University of Chicago Law School Working Paper, pp.  2–3 (later on published in University of Pennsylvania Law Review 2015, Vol. 164, pp. 93–147). 32  Masur and Posner, (2015), ibid., pp. 3–4. 33  Masur and Posner, (2015), ibid., pp. 21–27. 34  Masur and Posner, (2015), ibid., p. 31. 31

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than sufficient and that we would need no further lubrication of society and the economy. SMEs will help to explain that their concern mostly lies with raising debt funding on a cash flow basis (i.e. everything that is not collateral based). They will undoubtedly hastily add that raising equity isn’t all too easy either and that the newer alternative forms of debt and equity fund-raising à la crowdfunding is and will continue to be too small to have a meaningful aggregate effect on their market segment. The multinational corporations (MNCs) tend to look for comprehensive service providers and assistance for bank-based fund-raising at a reasonable cost combined with what has become on average very low-cost market-based funds. Institutional investors (especially those with liabilities at exact points in time in the future—i.e. most of them) will continue to look for returns at the higher end of the risk spectrum. Their business models tend to not work very well with annual returns in the ballpark of what investment grade T-bonds yield these days (and ignoring the duration risk here for a second). They prefer to be in the higher-risk debt segments rather than go full blown into equities, although they tend to have the investment time horizon that would perfectly fit that asset class. And when they move into equities, they often do so in a bipolar way. The biggest part of capital goes into passive index-like products, often chosen based on their low-cost profile. The other (smaller) part earmarked for equities goes into ‘volatility-reducing’ vehicles. That space has received many names and dedications including market-­neutral, smart beta, leveraged beta and so on. It also explains why the tarnished hedge fund35 industry seems to revive well after every market dip despite their dismal results on average and their poor ‘volatility-neutralizing’ capacities. I wonder though if an institutional cash pool with a long-term investment horizon should be concerned about the daily or periodic noise in the stock market. Besides the fact that the regulator doesn’t make their lives easy by often asking them to value their portfolio’s mark-to-market, true long-term investments seem to hardly make it through the many bureaucratic layers, often characterizing the risk office of such institutional cash pools. I’m ignoring here their infrastructure investments, as their participation often takes place on the debt side and not on the equity side of the investment spectrum. The values each of these segments intends to derive from finance are very different and, yes, sometimes conflicting. Views on the role, benefits and function of finance in society and economy are very widespread. The academic arguments in favor of finance tend to somewhat ignore the fact that finance crowds out real economy activities and often

 See also in detail: Julia A.D. Manasfi (Whittier), (2011), The Global Shadow Bank—Systemic Risk and Tax Policy Objectives: The Uncertain Case of Foreign Hedge Fund Lending to U.S. Borrowers and Transacting in U.S. Debt Securities, Florida Tax Review Vol 11, pp. 643 ff. She argues that the IRS code has not been keeping pace with financial innovation in recent decades and illustrates that, for example, foreign persons lending to US borrowers and transactions in US debt securities are covered by legislation, hardly covering the reality of shadow banking and complex financial innovation which leaves uncertainty about application and interpretation. She uses the case study of foreign hedge fund lending and US debt securities transactions and demonstrates how the current law provides inadequate guidance as to how these transactions will be taxed. This may increase systemic risk making the US financial system more fragile. 35

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c­ ompetes head-on-head with resources with other industries. The financialization of our ­economies has also led to the fact that finance as a function tends to have an inclination to degenerate and become ‘rent-seeking’.36

7.6 The Future of Securitization Throughout the book and from many different angles, the industry of securitization37 has been reviewed and analyzed, from how it started, till how it contributed to creating the 2008 crisis, its reemergence after the crisis and the regulatory avalanche which also followed during the years after the crisis. The least that can be said is that in all regions of the world, the coverage through command-and-control regulation is a work in progress. In many countries, there is no ‘securitization’-specific legislation or it is hidden, often without proper definitions, in a wide variety of other financial regulations, although this is far from optimal. We have seen the Bank for International Settlements (BIS) struggle to come to terms, most likely prone to severe forms of lobbying, with the topic, and it took them seven years to arrive in December 2014 with some aggregate understanding of the direction the topic should go and what the impact of the activity would be on the capital adequacy for financial institutions with securitization practices. And the suggested rules are very wide and still quite discretionary. With a minimal risk floor of 15% and a maximum risk weighting of 1250%, it resembles not much more than an open window which can become problematic when combined with the suggested European Union (EU) relaxation rules in terms of due diligence and disclosure for some securitized products. Many observers considered that ‘securitization’ products would not return after the 2008 crisis. But it nevertheless did, starting with the US, shortly after being followed by China. In Europe, with its protracted economic malaise, the regulator and banking supervisor saw a vibrant securitization industry as a way to free up capital needed to kick-start the struggling European economy.38 It is truly a challenge to regulate a product group and, at the same time, put your faith in it to help achieve economic growth. Especially, since the EU securitization market was badly tarnished during the crisis and hardly revived post-2008.39 All this, besides the fact that securitization is no preferred product, nor efficient product to kick-start lending in the eurozone. A recommended

 L. Zingales, (2015), Does Finance Benefit Society?, Harvard Business School and NBER/CEPR Working Paper, January. 37  J. Varellas III, (2016), Contract Law, Securitization and the Pre-Crisis Transformation of Banking, in Reshaping Markets. Economic Governance, the Global Financial Crisis and Liberal Utopia, (eds. B. Lomfeld, A. Somma and P. Zumbansen) in Cambridge University Press, Cambridge, pp. 45–59. 38  A.  Barker and C.  Binham, (2015), EU Seeks to Relax Securitisation Rules, Financial Times, February 17. The idea ‘that skin-in-the-game’ (i.e. the issuing financial institution would have to retain part of the issued securities) was needed has been and/or is up for revision in the context of high-quality securitizations. The idea is to relax some of the disclosure and due diligence requirements that normally come with issuing securitized products. See also: The Economist, (2014), Securitisation: It’s Back, January 11. 39  ECB/Bank of England, (2014), The Impaired Securitization Market: Causes, Roadblocks and How to Deal with Them, Brussel/London, pp. 2–3. 36

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reading of Admati and Hellwig’s The Bankers’ New Clothes40 would be a major help in the understanding of the banking business model and its drivers. It would help regulators and supervisors to improve performance and to maintain focus on what matters and avoid sidetracking when being exposed to ‘deep lobbying’. This has not withheld the European Central Bank (ECB)/Bank of England to continuously support the relaxation of capital adequacy, due diligence and disclosure requirements for ‘transparent, simple and risk-free ABSs’, also as a response to the abovementioned EU’s consultation paper of early 2015.41 In Europe, the securitization activity and its impact on regulatory capital were taken care of in the discussed Capital Requirements Directive (CRD) IV/V,42 some of the components being more stringent than the BIS recommendations issue later on in December 2014. Other aspects of the securitization framework have been dealt with in a number of other directives. This often doesn’t make for regulatory beauty or efficiency. It explains the attempts which started in 2014 to ultimately arrive at an EU framework for simple transparent and standardized securitization.43 The efforts should be seen and judged within the more comprehensive efforts of the EU to build an integrated ‘Capital Markets Union’ (CMU).44 The EU is aware that a shift is needed to avoid a further overreliance on bank credit to fuel its economy.45 This is often forgotten in the bigger picture, that is, the fact that the credit intermediation channels might be impaired themselves and/or have become less efficient.46 All too often, the sovereign and the regulator and supervisors engage into fixer-upper legislation with enhanced supervision, but

 A.  Admati and M.  Hellwig, (2014), The Bankers’ New Clothes, Princeton University Press, Princeton, New Jersey. 41  See ECB/BoE, (2015), Joint response from the Bank of England and the European Central Bank to the Consultation Document of the European Commission (EC): ‘[a]n EU framework for simple, transparent and standardised securitisation’, Frankfurt/London, March 27. They further shared their views on the following key aspects of the consultation: criteria, prudential treatment, risk retention, transparency, SMEs and implementation. 42  That is frequently updated and upgraded by the European Banking Authority (EBA) through its opinions, technical standards and recommendations; see, for example, EBA, (2014), EBA Report on Securitisation Risk Retention, Due Diligence and Disclosure, December 22. 43   EC, (2015), Consultation Document, An EU Framework for Simple, Transparent and Standardized Securitization, Brussels, February 18. 44  A green paper was released in February 2015 to that effect. The objective of the EU program is threefold: (1) improving access to financing for all businesses across Europe and investment projects, in particular start-ups, SMEs and long-term projects, (2) increasing and diversifying the sources of funding from investors in the EU and all over the world and (3) and making the markets work more effectively so that the connections between investors and those who need funding are more efficient and effective, both within Member States and cross-border. See in detail: EC, (2015), Building a Capital Markets Union, COM(2015) 63 final, February 18. 45  See in detail: AFME, (2014), High-Quality Securitization for Europe. The Market at a Crossroads, London/Brussels, June. 46  T. Philippon, (2014), Has the US Finance Industry Become Less Efficient? On the Measurement of Financial Intermediation, Stern School of Business, Working Paper. 40

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don’t engage in the wider somewhat philosophical question and soul searching of what type of credit intermediation is needed or preferred for our economy and society. This is a question and challenge for the market, they think. Well, that is unlikely to happen, and the regulator and sovereign will end up picking up the pieces over and over again each time a financial storm has come through. What has surprised me a bit post-2008 is that very little attention has been given to the reason why there was such a vibrant securitization market pre-2008. As discussed, mainly through the analysis of Poszar, was the fact that products do not emerge only because it helps cleaning up bank balance sheets. There was also effective demand. Even more, as was demonstrated, there was more demand for ‘risk-free-alike’ products that the market at some points could produce. It is to Pozsar’s credit, who paints the full macro-picture, and helps us understand what explains the rise in demand. Reading carefully through the argumentation also clarifies the fact that demand maybe has been subdued for some time after the crisis, but has and will further reemerge, as it is a function of the need for many welfare systems to achieve a certain minimal return, far beyond the current risk-free interest rate. This will lead to branching out into many types of products (by growing institutional cash pools), some of which will have an asymmetric information model attached to it. The origin of that lies partly in the, already discussed, overall ‘information insensitivity’ of the debt markets (compared to the equity markets). Most of the efforts on the regulatory side regarding securitization have been focusing on a number of features: reduce incentive misalignments and conflicts which distorted markets and the accurate pricing of credit risk attached to securitization products. In detail this has translated into a number of areas of focus, which include the following: • Measures that directly address the conflicts of interest and misaligned incentives within the securitization chain and prevent the ‘originate-to-­distribute’ (OTD) model; this seems to be critical given other findings that point at an intentional strategy for those banks of which most loans were designated to be offloaded at a later stage. Those banks employing an originate-to-distribute model devoted little time when sourcing loans in the run-up to the crisis, thereby diminishing their ability to sell their securitized loan books. Even more, there seems to be a positive relation between those banks that engaged in noncommitted mechanical screening processes for loans and those that engaged more intensely in the originate-to-distribute market, reflecting an intentional process of ‘what doesn’t stay on our books we pay little attention to’.47 Lin et al. indicate: ‘[w]e find that the ability of the transfer of credit risk through the OTD model encouraged the origination of inferior quality loans by the banks. We also find

 G. Bhat and J. Cai, (2014), The Relationship Between Bank Credit-Risk Management Procedures and Originate-to-Distribute Mortgage Quality During the Financial Crisis, Washington University Working Paper. See also: A.  Purnanandam, (2011), Originate-to-distribute Model and the Subprime Mortgage Crisis, Review of Financial Studies, Vol. 24, pp. 1881–1915. 47

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that the OTD model affects banks’ attitude towards risk from risk aversion to risktaking investment behavior.’48 • Measures that address information asymmetry within the securitization process by increasing transparency within the securitization structure. • Measures that address inappropriate incentives created by accounting revenue recognition principles and compensation systems for securitizers or originators49 (for the role of accounting and the interplay with regulation, see Box 7.1). • Reforms designed to enhance the oversight of credit rating agencies’ governance and rating process and reduce regulatory reliance on ratings, making rating agencies more transparent and accountable.50

Box 7.1  Accounting Rules and Regulation: Stormy Twins51 Post-crisis many questions have been asked regarding the role of accounting in triggering and/or aggravating the financial crisis. The Basel Committee asks out loud: ‘[b]oth have been criticized as contributing to a pro-cyclical (continued)

 P.O.  Lin et  al., (2014), Originate-to-Distribute Model and UK Financial Institutions, in Challenges for Analysis of the Economy, the Businesses, and Social Progress, P. Kovács, et al. (eds.), pp. 656–665. 49  Accounting rules and the interplay between accounting rules and regulation continue to have a material impact on bank behavior; see, for example, BCBS, (2015), The Interplay of Accounting and Regulation and Its Impact on Bank Behaviour: Literature Review, Working Document Nr. 28, January, Basel. 50  EBA, (2014), EBA Report on Securitisation Risk Retention, Due Diligence and Disclosure, December 22, pp. 9–10. 51  See for the different strands of research on this matter: A. Amel-Zadeh, et al., (2014), Procyclical Leverage: Bank Regulation or Fair Value Accounting?, Rock Center for Corporate Governance at Stanford University Working Paper Nr. 147; A. Angkinand, et al., (2012), Market Discipline for Financial Institutions and Market for Information, Research Handbook on International Banking and Governance, (eds.) J. R. Barth, C. Lin and C. Wihlborg, Edward Elgar Publishing, Cheltenham, UK; M.E. Barth, et al., (2008), International Accounting Standards and Accounting Quality, Journal of Accounting Research, Vol. 46, pp.  467–498. U.  Baumann, and E.  Nier, (2004), Disclosure, Volatility, and Transparency: An Empirical Investigation into the Value of Bank Disclosure, Federal Reserve Bank of New York Economic Policy Review, pp. 31–45; J. Bertomeu, et al., (2011), Capital Structure, Cost of Capital, and Voluntary Disclosures, Accounting Review, Vol. 86, pp.  857 ff.; J. Bischof, (2012), Can Supervisory Disclosure Mitigate Bank Opaqueness and Reduce Uncertainties During a Financial Crisis? Evidence from the EU-Wide Stress-Testing Exercises, Working Paper, University of Mannheim; C. Borio and K. Tsatsaronis, (2005), Accounting, Prudential Regulation and Financial Stability: Elements of a Synthesis, BIS Working Papers, Nr. 180, Bank for International Settlements, Basel; R.  Cifuentes, et  al., (2005), Liquidity Risk and Contagion, Journal of the European Economic Association, Vol. 3, pp. 556–566. U. Wu and M. Bowe, (2010), Information 48

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Box 7.1  (continued) behavior52 in banks’ decision making, i.e. adding exuberance and fueling investments in the up-turn and triggering downward spirals and throttling investments in the down-turn of the credit cycle. If these accusations are justified, then a natural question to ask is whether regulatory intervention can help to prevent a reoccurrence of such developments in the future.’53 If it might be so that accounting rules have created undesirable incentives, then the next question is as to how regulation that mitigate such unintended consequences. Although many questions can be asked, some are more important than others. I will limit54 myself here to questions regarding the impact of ‘fair value accounting’ and ‘disclosure requirements’ on the behavior of banks and how they affect market discipline.55 (continued)

Disclosure, Market Discipline and Management of Bank Capital: Evidence from the Chinese Financial Sector, Journal of Financial Services Research, Vol. 38, pp. 159–186; B. Xie, (2012), Does Fair Value Accounting Exacerbate the Pro-Cyclicality of Bank Lending?, Dissertation University of Southern California; D.  Black and J.  Gallemore, (2012), Bank Executive Overconfidence and Delayed Expected Loss Recognition, Working Paper; Y. Chen and I. Hasan, (2006), The Transparency of the Banking System and the Efficiency of Information-Based Bank Runs, Journal of Financial Intermediation, Vol. 15, pp.  307–331; E.  Cubillas, et  al., (2012), Banking Crises and Market Discipline: International Evidence, Journal of Banking and Finance, Vol. 36, pp.  2285–2298; A. Ellahie, (2012), Bank Stress Tests and Information Asymmetry, Working Paper, London Business School; M. Flannery, (2001), The Faces of Market Discipline, Journal of Financial Services Research, Vol. 20, pp. 107–119; C. Leuz and R. Verrecchia, (2000), Economic Consequences of Increased Disclosure, Journal of Accounting Research, Vol. 38, pp. 91–124; C. Leuz and P. Wysocki, (2008), Economic Consequences of Financial Reporting and Disclosure Regulation: A Review and Suggestions for Future Research, University of Chicago Working Paper; E. W. Nier, (2005), Bank Stability and Transparency, Journal of Financial Stability, Vol. 1, pp.  342–354. E.  Nier, and U.  Baumann, (2006), Market Discipline, Disclosure and Moral Hazard in Banking, Journal of Financial Intermediation, Vol. 15, pp. 332–361. R. Repullo and J. Suarez, (2012), The Procyclical Effects of Bank Capital Regulation, Review of Financial Studies, Vol. 26, Nr. 2, pp. 452–90; D. Foos, et  al., (2010), Loan Growth and Riskiness of Banks, Journal of Banking and Finance, Vol. 34, pp.  2929–2940; P.  Hamalainen, et  al., (2005), A Framework for Market Discipline in Bank Regulatory Design, Journal of Business Finance & Accounting, Vol. 32, Nr. 1–2, pp.  183–209; R. Huang and L. Ratnovski, (2008), The Dark Side of Bank Wholesale Funding, Federal Reserve Bank of Philadelphia Working Paper Nr. 09-3; U.  Khan, (2009), Does Fair Value Accounting Contribute to Systemic Risk in the Banking Industry? Columbia Business Working Paper. 52  Fair value accounting has been blamed to act procyclically for the trading book and incurred loss provisioning to have similar effects for the banking book. 53  BCBS, (2015), The Interplay of Accounting and Regulation and Its Impact on Bank Behaviour: Literature Review, Working Document Nr. 28, January, Basel, p. 1. 54  Other questions could have related to the provisioning on corporate loan books and their impact on bank behavior and prudential filters that have been introduced by regulators as a means to mitigate certain ‘procyclical behavior’ and to what degree they are now more ‘forward looking’. 55  The questions then would sound as follows: How does fair value accounting, in particular through an increased volatility of profit and loss figures, affect investment and risk management decisions in banks? What are the potential implications of the reaction of investors, for example, to regulatory disclosure of stress test results? How will this affect banks’ investments and their risk management? (p. 1).

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Box 7.1  (continued) 1. Fair Value Accounting and the Financial Crisis Fair value accounting has been criticized for fueling the balance sheet c­ ontagion channel. Those rules would have created and fueled the mechanical link between the decrease in asset prices, accounting losses and the resulting fire sale in order to meet regulatory constraints. Given the information-insensitive debt markets, disclosing large fair value losses may have led to over responsiveness. Others have responded in a different way and claimed that ‘funding constraints amplified by the opaque balance sheet of banks and hidden losses have been the trigger of bank failure’.56 So, according to them, disclosing less information made things worse. In fact, in order to fully judge the issue one needs to consider if the newer business models that financial institutions (FIs) have been using in recent decades relate well to the ‘amortized cost model’ as standard in accounting systems. The main critique concentrated on the fact that fair value accounting would fuel irrational bubbles in expanding periods and amplify downswing movements in contracting periods of the cycle.57 It was found responsible for ‘over-edging the financial upswing and elongating the financial downswing’; they have tended to overemphasize return in the boom and underemphasize risk in the bust.58 The question is whether the market is in need for accounting data that are as updated as possible with market (not accounting) data and whether it justifies the negative feedback loop between fair value losses, regulatory capital requirements and asset fire sales. The Basel Committee correctly points out that despite the theoretical models indicating a spiraling effect derived from marked-to-market accounting, hard evidence is not on the table (yet). The same is true though for capital requirements under the Basel accords. The effect of those two components is anyway hard to disentangle (accounting rules and capital requirement rules) and the limited findings need to be treated with caution. Contagion can exist due to asset commonalities even if there is no link between accounting rules and asset market prices. Interbank links can amplify these effects, where regulatory constraints can act as a magnifier. The domino effect of fair value accounting is almost assumed in the different theoretical models tested after the financial crisis.59 However, those models ‘ignore the fact that banks may have had little incentives to engage in fire sales in the presence of implicit guarantees, accounting circuit breakers (i.e. accounting rules to mitigate the recognition of an asset price decline in accounting values) and ad-hoc changes in accounting rules’. To put differently, there is very little evidence of the ‘spiral effect’ claimed regarding the impact of fair value accounting. The implicit assumption in the fair value critique is that banks mechanically engage in fire sales whenever they cannot satisfy regulatory constraints. There might be other reasons why banks disclosed information only in limited amounts: reputation, avoiding further shifts (continued)

 BCBS, (2015), ibid., p. 3.  BCBS, (2015), ibid., pp. 2–3. 58  A.G. Haldane, (2011), Accounting for Bank Uncertainty, remarks at the Information for Better Markets conference, Institute of Chartered Accountants in England and Wales, London, 19 November. 59  See for a write-up and literature references BCBS, (2015). 56 57

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Box 7.1  (continued) from ‘information-insensitive to information-sensitive’ debt markets. In fact, assuming banks are rational players, they have very little incentive to offload assets to meet regulatory requirements but would benefit from just waiting for asset prices to return to ‘fundamental value’. That might explain why the results of the theoretical models and those of the empirical reviews deviate largely in results.60 2. The Effect of Disclosure Requirements Banks typically are less inclined to provide (detailed) information regarding their operations. Part of this can be explained by the risk-taking nature of their activities, the somewhat virtual concept of ‘maturity transformation’ and the steep competition in the industry in most countries around the world. Although understandable up to some point, ‘many have suggested that this opacity contributed to the recent financial crisis by magnifying uncertainty about the underlying value of bank assets as well as on- and off-balance sheet exposures to structured credit products’.61 This triggered counterparties to avoid trading and made customers lose confidence. The bottom line is that the lack of information avoids that third parties can adequately define high-risk and low-risk FIs and therefore cannot properly define the risk on their books (i.e. coordination failure). Overall and on the level of the market, as such, this coordination problem might even trigger that the supply of funding will go to FIs in levels not commensurate with the actual risk embedded in the FI, and ultimately risk got mispriced. Many efforts have been made to increase disclosure aimed at increasing transparency and fostering market and supervisory discipline more specifically. The idea was that it would reduce the likelihood and severity of a next crisis. But what can be said about the relation between disclosure rules and market discipline and bank behavior, and does one need to distinguish between normal times and times of duress?62 Upfront it needs to be said that we know very little about the direct relationship between disclosures and how banks, bank creditors and bank supervisors respond to disclosures under different economic conditions, or the overall macroeconomic impact of disclosures overall. Disclosures rules are typically justified by referring to three market failures: externalities, information asymmetries and coordination failures.63 (continued)

 BCBS, (2015), ibid., pp. 3–8.  BCBS, (2015), ibid., p. 22. 62  (1) To what extent do disclosure rules promote market discipline? (2) What are the consequences of disclosure rules on bank behavior? (3) Does the extent of market discipline differ in crisis versus normal times? (4) What shapes socially optimal disclosure rules? BCBS, (2015), ibid., p. 22. 63  BCBS, (2015), ibid., p. 23. ‘The externality and asymmetric information arguments suggest that, without intervention, banks may disclose less information than is socially optimal. Coordination problems imply that banks do not provide comparable information as they have no mechanism or incentive to cooperate over disclosures. In addition, there are external factors, including, for 60 61

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Box 7.1  (continued) But does disclosure improve market discipline? Or only when disclosures improve transparency?64 Market discipline65 is the mechanism by which markets monitor and discipline, through price and quantity responses, excessive bank risk-taking behavior. Many obstacles can prevent full transparency either explicitly or implicitly, for example, bailouts, deposit guarantees and so on. Disclosures have a number of distinct benefits, and lowering the cost of funding for FIs is probably the most dominant one. But costs and expropriations of investment returns might hinder full disclosure. The impact of disclosure on bank behaviors is more unclear: when risk is exogenous, disclosure no longer affects risk-taking behavior, but still induces negative feedback on failure probability because funding costs rise in response to disclosure.66 This is particularly problematic in case FIs have no full disclosure over risks (which is more and more the case) and disclosure then has perverse effects. This is because the market discipline channel becomes toothless when risk taking is not endogenous to the bank. Too much disclosure can also lead to unnecessary systemic crises if it improperly suggests that problems are systemic rather than idiosyncratic.67 They are called ‘noisy signals’ and can induce systemic crises especially when information is unexpectedly received. Under circumstances, disclosures can help to avoid systemic shocks, but most research focuses on the individuality of FIs and not only the impact of disclosures on the system as a whole. Also research does not focus on changing economic conditions and the impact of disclosures around those defining moments.68 Interesting is the understanding that many regulatory interventions reduce market discipline, regardless of what economic times, for example, deposit insurance schemes, ex ante or ex post bailouts and so on. But disclosures are costly and ‘public interest rules’ should be welfare enhancing, and thus limiting disclosures can under circumstances be welfare e ­ nhancing.69 (continued)

e­ xample, discretions allowed under accounting standards and capital regulations that further reduce the relevance of disclosures and aggravate coordination problems. These factors make it difficult for investors and creditors to assess a bank’s risk profile and compare risks across firms.’ 64  ‘Disclosure is the act of providing information to the market, while transparency arises only if the information is reliable and appropriately interpreted and used by the market. It is this concept of transparency that underpins effective market discipline’; BCBS, (2015), ibid., p. 24. 65  Market discipline refers to market-based incentive schemes in which investors in bank equity and liabilities, such as subordinated debt or uninsured deposits, effectively punish banks for taking greater risk either by demanding higher yields on or by cutting supply of such funding. 66  BCBS, (2015), ibid., p. 25. 67  See for literature reference BCBS, (2015), ibid., p. 25. 68  See for what is available in terms of research: BCBS, (2015), ibid., pp. 26–28. They also distinguish between the impact of market discipline in times of distress and normal economic times. 69  T. Dang, et al., (2012), Ignorance, Debt and Financial Crises, Working Paper, mimeo. They show that symmetric ignorance creates liquidity in money markets and that the provision of imperfect public information can trigger the production of private information—or, in other words, prompt market reactions and market discipline—that can lead participants to trade less, which has ­implications for the liquidity provision; see BCBS, (2015), ibid., p. 28.

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Box 7.1  (continued) Disclosure rules are therefore a balancing act in terms of costs, welfare optimum to be achieved and the perfectness of the information made available as asymmetries will have direct and often perverse and disproportionate consequences and trigger systemic shocks or other adverse consequences. Many obstacles lie in the way to achieving the optimal relationship between those elements and some of them are regulatory in nature, as discussed. Unclear so far is that if there is a differential in outcome between voluntary and mandatory disclosures, then through which channels disclosure rules gain effect and to what degree that fact is ‘individualistic’ in nature or also generates ‘aggregate c.f. macro-economic effects or industry-level effects’. This is critical to understand, preferably when analyzed over the economic cycles. But the biggest issue so far is that most research has not made a proper distinction between risk identification, through disclosure, that is exogenous or endogenous in nature. Both, however, trigger different market responses, use different transmission channels and have the propensity to generate different magnitudes of contagion within the financial infrastructure.

The overall objective of these initiatives on aggregate should be to allow securitization to play its role in diversifying risk and rekindling credit flows through a variety of securitized products (securitizations are characterized by material differences in risk characteristics, that is, in term of underlying assets and product structures). Along the credit intermediation chain, this would imply paying attention to four distinct features70: • The quality of underlying loan origination practices should be further beefed up to restore the appetite for securitization. This includes faulty loan origination, deteriorating lending standards and the regulation regarding sensitive areas including mortgage documentation and registration practices. Also volume-based compensation practices should be regulated. • Securitization intermediaries must be encouraged to develop structures that are transparent, straightforward to value and primarily designed to finance the real economy. Misaligned incentives71 for originators and the widening portfolio of complex and non-transparent products imply moral hazard and difficult to assess and price risks and products. Regulators have been paying attention through the ‘skin-in-the-game provision’ for securitized products across the board. Other areas of increased ­regulatory

 M.  Segoviano, et  al., (2015), Securitization: The Road Ahead, IMF Staff Discussion Note, SDN/15/01, pp. 4 and 9–19. 71  ‘Originate-to-distribute (OTD) model associated with the boom in securitization meant that originators often had little or no economic interest in the loans they underwrote and, hence, did not always originate loans that borrowers could realistically repay’; M. Segoviano, et al., (2015), ibid., p. 11. 70

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coverage are enforcement of ‘reps and warranties’, quality control impairments through conflicts of interest and deficiencies in technological infrastructure. Creating alignment of interest across the whole intermediation chain is going to be the policy challenge. As is the case in any intermediation chain, the benefits of misalignment for one particular party are often higher than the returns that come with compliance and alignment, at least in the short term. This implies timely disclosure of loan-level performance data. • Credit ratings can be put to better use. Standardized definitions of securitization characteristics and full disclosure of the rating process would increase transparency and confidence. That is, to avoid the old issues being (1) misalignments in the ‘issuer pays model’, (2) inappropriate methodologies for assessing complex structured securities and (3) insufficient disclosure of analytical techniques and model limitations. This implies eliminating statutory references to credit rating and improving corporate governance at credit rating agencies.72 In 2015, the EU issued regulations regarding the disclosure requirements for issuers, originators and sponsors on structured finance instruments and the reporting requirements for credit rating agencies (CRAs) on fees charged by CRAs to their clients.73 • Investors can be galvanized by ensuring consistent application of capital charges across asset classes and borders. A large aspect of this was covered by the capital charges as foreseen in the CRD IV/V Directive. In the US, new regulatory capital rules require banks to conduct due diligence for securitization exposures. It will be beneficial to avoid large-step changes in charges (the so-called cliff effects) between classes of securitized assets that do not differ much in underlying quality. This can occur under any of the three recommended models to assess risk and charges. Segoviano et al. ­comment, ‘Risk weights can be minimized irrespective of the underlying risk of the structure by

 The EU has made an effort in that direction through the Credit rating Agency Directive. It tries to achieve ‘(1) ensure greater transparency regarding the commercial relationship between issuers and rating agencies, including the separation of CRAs’ sales and analysis units; and (ii) provide investors with access to the results of stress tests and risk scenario analyses, as well as the underlying modelling assumptions used by rating agencies in arriving at their assessments of creditworthiness’; see: M. Segoviano, et al., (2015), ibid., p. 14. See for the Directive: Regulation (EC) No 1060/2009 of the European Parliament and of the Council of 16 September 2009 on credit rating agencies, O.J.  L 302 of 17 November 2009, pp.  1–31; Regulation (EU) No 513/2011 of the European Parliament and of the Council of 11 May 2011 amending Regulation (EC) No 1060/2009 on credit rating agencies, L 145 of 31 May 2011, pp. 30–56; Commission Delegated Regulation No 946/2012 of 12 July 2012 supplementing Regulation (EC) No 1060/2009 of the European Parliament and of the Council with regard to rules of procedure on fines imposed to credit rating agencies by the European Securities and Markets Authority, including rules on the right of defense and temporal provisions, L 282 of 16 October 2012 pp. 23–26; Regulation (EU) No 462/2013 of the European Parliament and of the Council of 21 May 2013 amending Regulation (EC) No 1060/2009 on credit rating agencies Text with EEA relevance O.J. L 146 of 31 May 2013, pp. 1–33. 73   Commission Delegated Regulation (EU) 2015/3 of 30 September 2014 supplementing Regulation (EC) No 1060/2009 of the European Parliament and of the Council with regard to regulatory technical standards on disclosure requirements for structured finance instruments, Text 72

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(i) optimizing certain parameters of the regulatory formulae (e.g., manipulating tranche size or engineering risk transfers above the maximum maturity of five years captured by the regulatory formulae); (ii) or exploiting differences across regulatory formulae and jurisdictions’.74 Different risk weights can occur under the different models and show a fast and material increase with the decrease in tranche thickness. Despite the new risk weighting and capital charge tools issued by BIS at the end of 2014, which take into account capital charges and types of underlying assets, granularity of collateral pool and so on, limitations still remain ‘in terms of incorporating some cash flow features that affect the risk characteristics of securitizations, potentially giving rise to regulatory arbitrage opportunities. For example, waterfall structures, risk mitigation mechanisms, interest-rate hedges, prepayment penalties, and loss allocations are not incorporated’.75 A further effort would focus on a more granular application of industry standards to measure and express risk. The benefit would be a more structured approach within the context of a due diligence with respect to securitization matters. The continuum between high risk and low risk has been instrumental in creating pricing shocks in the market and a reduced understanding of the materiality of risk, in case risk assessments were implicitly outsourced by the use of credit ratings. The preference should go toward the assessment of individual risk factors (duration, collateral quality, credit performance, prepayment risk, etc.) to provide a holistic but diversified risk analysis. However, within an ‘information insensitive debt market’ and with institutional cash pools becoming larger and larger, it will be a massive challenge for the institutional managers to allocate capital in a meaningful way across an intentional variety of risk exposures. If the securitization markets want to become a stable and consistent part of the financial infrastructure, they will have to monitor their investor base and seek a large involvement of a wide variety of nonbank institutional investors with a long-term investment time horizon. But this will require ‘the pan-European harmonization of loan-level reporting standards, documentation standards, insolvency regimes, and taxation treatment of securitizations’76 and a whole wish list of regulatory, institutional and product design

with EEA relevance O.J. L 2 of 6 January 2015, pp. 57–119 and Commission Delegated Regulation (EU) 2015/1 of 30 September 2014 supplementing Regulation (EC) No 1060/2009 of the European Parliament and of the Council with regard to regulatory technical standards for the periodic reporting on fees charged by credit rating agencies for the purpose of ongoing supervision by the European Securities and Markets Authority Text with EEA relevance O.J.  L 2 of 6 January 2015, pp. 1–23. 74  M. Segoviano, et al., (2015), ibid., p. 16. 75  M. Segoviano, et al., (2015), ibid., p. 16. See also BIS, (2014), Criteria for Identifying Simple, Transparent and Comparable Securitizations, Basel, December. 76  M.  Segoviano, et  al., (2015), Securitization: The Road Ahead, IMF Staff Discussion Note, SDN/15/01, p. 4.

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hurdles.77 The erratic and fragmented nature of the credit market and that of the s­ ecuritization market in particular has and is fueling misalignment and fuels the increase of leverage.

7.7 A  sset Management: A Blind Spot in Terms of Shadow Banking 7.7.1  Introduction The asset management (AM) industry normally (or better historically) does not get involved in credit, maturity or liquidity transformation and limits itself to financial intermediation. Nonetheless, concerns about potential financial stability risks posed by the asset management industry have increased recently as a result of that sector’s growth and of structural changes in financial systems. Now the AM industry is so wide and engaged in many different activities that one can wonder who a potential financial instability risk should be approached. No wonder that ‘opinions are divided about the nature and magnitude of any associated risks from less leveraged, “plain-vanilla”78 investment products such as mutual funds and exchange-traded funds [ETFs]’.79 Potential stability risk can however occur across the product spectrum. Even plain-vanilla products may pose financial stability risks through two channels: (1) incentive problems between end investors and portfolio managers (which potentially can lead to herding, among other things) and (2) run risk stemming from the presence of liquidity mismatches.80

7.7.2  Incentives and Benchmarking Besides the stability risk derived from products groups, structuring an alternative source of instability might come from incentive issues and often accompanying herding behavior of portfolio managers. More specifically, ‘[t]he delegation of day-to-day

 See in detail M. Segoviano et al., (2013), Securitization: Lessons Learned and the Road Ahead, IMF Working Paper, Nr. WP/13/255. 78  Because it is ‘plain-vanilla’, the risks are often less or badly understood, see: M.  Feroli, et  al., (2014), Market Tantrums and Monetary Policy, Chicago Booth Research Paper 14–09, University of Chicago Booth School of Business, Chicago. Plain-vanilla funds are exposed to liquidity risk as the shares of those funds (often mutual funds or exchange-traded funds [ETFs]) are redeemable and tradable on a daily basis, although the assets invested into them are often, or at least can be much more, illiquid. 79  IMF, (2015), Global Financial Stability Report. Navigating Monetary Policy Challenges and Managing Risk, April, p. 93. 80  IMF, (2015), Global Financial Stability Report. Navigating Monetary Policy Challenges and Managing Risk, April, p. xiii. 77

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­ortfolio management introduces incentive ­ p problems between end investors and ­portfolio managers, which can encourage d ­ estabilizing ­behavior and amplify shocks. Easy redemption options and the presence of a “first-­mover” advantage can create risks of a run, and the resulting price dynamics can spread to other parts of the financial system through funding markets and balance sheet and collateral channels.’ ‘The empirical analysis finds evidence for many of these risk-creating mechanisms, although their importance varies across asset markets. Mutual fund investments appear to affect asset price dynamics, at least in less liquid markets. Various factors, such as certain fund share pricing rules, create a first-mover advantage, particularly for funds with high liquidity mismatches.’81 It is not so much the size or volume of the ‘assets under management’ (AUM) that can cause an asset management firm to be designated as ‘systemically relevant’ but rather the ‘investment focus’. The International Monetary Fund (IMF) therefore advocates moving toward a more hands-on supervisory approach ‘supported by global standards on supervision and better data and risk indicators’ as well as a material upgrade of the risk management tools to better reflect the complexity of the product range offered by asset managers and its globalizing practices. This makes sense when judged against the background of a globalized and rapidly growing asset management industry where a large part of the global assets under management is managed by a handful of large asset management firms. As is the case in every industry, benchmarking is used to model compensation and so the fund manager’s career risk trickles down to the investors. This occurs since the fund manager in his investment decisions will be led by the benchmark (s)he adheres to or the one that drives his/her compensation model (see also Box 7.2). This also leads to the herding behavior in the market the IMF refers to in its reporting. This herding combined with the volumes of the ‘assets under management’ has the potential to derail market functioning, at least temporarily. Where the banking scene has become more ‘domestic’ (decline of cross-­border lending82 and raising a more local capital base) and, by doing so, less risky on many dimensions, the asset management world has become more ­globalized both in terms of concentration of ‘assets under management’ and in terms of the nature and dynamics of the top end of the asset management market.

 IMF, (2015), Global Financial Stability Report. Navigating Monetary Policy Challenges and Managing Risk, April, p. 93. 82  IMF, (2015), Global Financial Stability Report. Navigating Monetary Policy Challenges and Managing Risk, April, pp. 56–64. 81

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Box 7.2  The Effects of Peer Benchmarking in the Asset Management Industry83 The question often asked is as to what the implications are of peer benchmarking in the asset management industry when comparing fund and fund managers and their performance. Besides, the question if that is a sound and meaningful practice, the focus here is on the effect vis-à-vis the market. There are two distinct causes: (1) the first is the impact of peer benchmarking and (2) second is somewhat a collateral of the first as the former triggers asset managers to herd as well vis-à-vis their companion fund managers (aka career risk, reputational herding84) in terms of their security selection and timing practices.85 Both can lead to concentration which will have an impact on asset prices in the market. Acharya and Pedraza have been looking at the effects of peer benchmarking by institutional investors on asset prices.86 Their overall conclusion is ‘that these peer effects generate excess stock return volatility,87 with stocks exhibiting shortterm abnormal returns88 followed by returns reversal in the subsequent quarter. Additionally, peer benchmarking produces an excess in co-movement89 across stock returns beyond the correlation implied by fundamentals.’90 This effect will only grow as institutional investors manage a significant portion of the total assets and account for an ever larger portion of the trading volume. Although (continued)

 See for a full analysis on the role of asset managers and how they relate to the question of financial stability: IMF, (2015), Global Financial Stability Report, The Asset Management and Financial Stability, April, pp. 93–135 (chapter 3). 84  See most recently: D. Vayanos, and P. Woolley, (2013), An Institutional Theory of Momentum and Reversal, Review of Financial Studies, Vol. 26, Issue 5, pp. 1087–1145. 85  By analyzing the same indicator (investigative herding) or by eliciting information from the past trades of better-informed managers (informational cascades) and trade in the same direction. 86  S. Acharya and A. Pedraza, (2015), Asset Price Effects of Peer Benchmarking: Evidence from a Natural Experiment, Federal Reserve Bank of New York Staff Reports, Nr. 727, May. In order to identify trades purely due to peer benchmarking as separate from those based on fundamentals or private information, they exploit a natural experiment involving a change in a government-imposed underperformance penalty applicable to pension funds. This change in regulation is orthogonal (i.e. right-angled or perpendicular) to stock fundamentals and only affects incentives to track peer portfolios, allowing us to identify the component of demand that is caused by peer benchmarking; see also p. 2 for a broader write-up. Their study is the first that measures herding and its impact directly. Former studies have done so only indirectly and were measured as trade clustering; see pp. 2–3 for references and a write-up of the issues. This single largest issue is that ‘it is hard to distinguish actual herding from spurious herding’ in the former literature. 87  ‘A statistically and economically significant effect on asset prices’ and ‘[t]rades motivated by peer benchmarking generate 3.53 percent of contemporaneous abnormal returns on the average stock. These excess returns are fully reversed after six months, indicating that peer-effects among pension funds tend to generate excess volatility in stock prices’ (p. 3). 88  S. Acharya and A. Pedraza, (2015), ibid., pp. 10–13. 89  S. Acharya and A. Pedraza, (2015), ibid., pp. 13–16. 90  S. Acharya and A. Pedraza, (2015), ibid., p. 3. 83

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Box 7.2  (continued) the herding behavior of institutional managers can work both ways, that is, positive: ‘if institutions herd due to informational motives, such herding may promote price discovery, faster adjustment of fundamental information into securities and more efficient markets’91; the biggest concern is with the downside92 when institutional investors systematically overlook their own private signals and trade with the crowd, and so prices may move away from fundamental values and display excess volatility and, ultimately, may result in market failures and increased systemic risk.93 Although the work of Acharya and Pedraza focuses on the aspect of asset prices, they also observe enhanced volatility and reversal patterns after institutional herding occurred in the market. Their findings point at some material issues in terms of compensation structure of money managers and other complementarities in the asset management industry. It also contributes to our understanding of whether institutional traders move asset prices because they have market power or if the price effects relate to an informational advantage these large traders do have.94 These findings point at a wider problem, that is, the fact that institutional investors, which are by nature of their mandate long-term investors have never been seen as adding to systemic risk.95 I’ve claimed96 before that financial regulation may alter the behavior of pension funds and other long-term institutional investors and this contributes to that understanding. The regulation effectively incentivizes herding by relying on a benchmark based on peer returns. This in itself has implications that ‘these short-term market movements created make these long-horizon traders also behave pro-cyclically, adding to systemic risk rather than stabilizing the system as was previously thought’.97 (continued)

 S. Acharya and A. Pedraza, (2015), ibid., p. 1.  A.  Dasgupta and M.  Verardo, (2011), Institutional Trade Persistence and Long-Term Equity Returns, Journal of Finance, Vol. 66, Issue 2, pp. 635–653; V. Guerrieri, and P. Kondor, (2012), Fund Managers, Career Concern and Asset Price Volatility, American Economic Review, Vol. 102, Issue 5, pp.  1986–2017, R.  Gutierrez, and E.  Kelley, (2009), Institutional Herding and Future Stock Returns, University of Oregon and University of Arizona Working Paper; N. Brown, et al., (2014), Analyst Recommendations, Mutual Fund Herding, and Overreaction in Stock Prices, Management Science, Vol. 60, Issue 1, pp. 1–20. 93  V. Acharya, et al., (2013), Seeking Alpha: Excess Risk Taking and Competition for Managerial Talent, NBER Working Paper Nr. 18,891; V. Guerrieri, and P. Kondor, (2012), Fund Managers, Career Concern and Asset Price Volatility, American Economic Review, Vol. 102, Issue 5, pp. 1986–2017; A. Dasgupta and M. Verardo, (2011), The Price Impact of Institutional Herding, Review of Financial Studies, Vol. 24, Issue 3, pp. 892–925. 94  S. Acharya and A. Pedraza, (2015), ibid., p. 4. 95  H.S. Shin, (2013), The Second Phase of Global Liquidity and Its Impact on Emerging Economies, Princeton University Manuscript. 96  L. Nijs, (2015), Neoliberalism 2.0: Regulating and Financing Globalizing Markets, A Pigovian Approach to 21st Century Markets, Palgrave Macmillan, London, chapter 6. 97  S. Acharya and A. Pedraza, (2015), ibid., p. 16. 91 92

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Box 7.2  (continued) Also Duarte et  al.98 demonstrate that the competitive pressure to beat a ­benchmark may induce institutional trading behavior that exposes retail investors to tail risk. In their model, institutional investors are different from a retail investor because they derive higher utility when their benchmark outperforms. These preferences incentivize our institutional investors to gain higher exposures to the benchmark stock than the retail investor, consistent with the behavior of managers whose performances are evaluated relative to a benchmark. Consequently, our institutional investors can be interpreted as asset managers who derive log-utility from the compensation they obtain for managing portfolios. Investors in our model are heterogeneous because they differ from each other through their benchmarking and their time preferences.99 They conclude that stronger benchmarking incentives lead to higher (lower) tail risk exposure of the retail investor and the aggregate market when the benchmark stock underperforms (outperforms). More precisely, they find that strong benchmarking incentives incite institutional investors to take on leverage to overexpose themselves to the benchmark stock. This results in consumption and portfolio plans of institutional investors that are highly sensitive to the relative performance of the benchmark in states of the world in which the benchmark underperforms.100 Further they observed that institutional investors react strongly to news in such states of the world. They trade large amounts of the stocks, resulting in large market volatility. If bad news about the benchmark arrives in the form of a jump, then institutional investors initiate resales. That is, they sell large amounts of the benchmark stock at a discounted price and buy large amounts of the non-benchmark stock at a premium price. This constitutes a flight-to-­quality phenomenon. Even though this behavior reduces the tail risk exposure of the institutional investors, higher volatility and fire sales increase the tail risk exposure of the retail investor and the aggregate market in bad states of the benchmark. In contrast, institutional investors carry out buy-and-hold strategies in states of the world in which the benchmark outperforms.101 This kind of behavior reduces market volatility and also tail risk exposure of the retail investor and the market overall in those countries in which the benchmark outperforms. But since institutional investors hardly respond to good news states of the benchmark, they get exposed to higher tail risk. This leads to the conclusion that with large benchmarking incentives, the retail investor and the aggregate market are exposed to high tail risk in states of the world in which institutional investors are exposed to low tail risk and vice versa. Duarte et al. conclude that benchmarking introduces a channel through which the trading behavior of institutional investors can impact the tail risk exposure of the retail (continued)

 D. Duarte et al., (2015), The Systemic Effects of Benchmarking, Questrom School of Business, (Boston) Working Paper, August 31, updated regularly all the way in to 2019. 99  D. Duarte et al., (2015), ibid., p. 3. 100  D. Duarte et al., (2015), ibid., p. 3. 101  D. Duarte et al., (2015), ibid., pp. 3–4. 98

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Box 7.2  (continued) investor and the aggregate market. Benchmarking is welfare reducing for the retail investor and potentially also for the patient institutional investor ex ante, even though it does not affect the long-term performance of our investors ex post.102 Duarte et al. indicate that their findings have serious implications for the regulation of the asset management industry. More precisely, their findings indicate that benchmarking can create incentives for asset managers to alter portfolios in ways that do not fully take into account the effects on tail risk exposure of individual investors and the aggregate market. Their results further suggest that stronger benchmarking incentives generally make individual investors and potentially also patient fund managers worse off ex ante due to an increased tail risk exposure when compared to a world without benchmarking incentives. Still, tail risk does not materialize in the long run. These results indicate that it is imperative for regulators to formulate precise objectives for a potential regulation of the asset management industry. If the regulator is concerned about investor failure, then our results suggest that there may not be any scope for regulation. On the other hand, if the regulator is concerned about the tail risk exposure of retail investors, then regulating the compensation packages offered to fund managers may be one viable option. More research is recommended to study the cost of individual regulatory options. Having said that, Duarte et al. are in line with Jones103 and conclude that the regulation of the asset management industry needs to be designed differently than the regulation of banks. They find that in an economy with benchmarking, the retail investor and the aggregate market are only exposed to low tail risk in states of the world in which institutional investors are exposed to high tail risk. Consequently, standard regulatory tools for banks that target their tail risk exposure, such as Value-at-Risk measurements and stress testing, may not be able to identify scenarios in which retail investors and the aggregate market are at risk of tail events.104 The reporting requirements for asset managers sound like a good start to document different hypothesis and develop a consistent body of regulation out of that. Also the IMF, without drawing final conclusions, acknowledges that even plain-vanilla funds can pose financial stability risks. The delegation of day-to-­day portfolio management introduces incentive problems between end investors (continued)

 D. Duarte et al., (2015), ibid., pp. 3–4.  J.  Jones, (2015), Asset Bubbles: Re-Thinking Policy for the Age of Asset Management, IMF Working Paper, Nr. WP/15/27; S.  Basak and A.  Pavlova, (2013), Asset Prices and Institutional Investors, American Economic Review Vol. 103, pp.  1728–1758. A.  Bua, et  al., (2015), Asset Management Contracts and Equilibrium Prices, Working Paper, Boston University and London School of Economics; J.  Cvitanic, et  al., (2014), On Managerial Risk-Taking Incentives When Compensation May Be Hedged Against, Mathematics and Financial Economics Vol. 8, Issue 4, pp. 453–471; A.G. Haldane, (2014), The Age of Asset Management?, Speech given at the London Business School, London, UK; L. Ma, (2015), Portfolio Manager Compensation in the US Mutual Fund Industry, Working Paper. 104  D. Duarte et al., (2015), ibid., pp. 4–5. 102 103

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Box 7.2  (continued) and portfolio managers, which can encourage destabilizing behavior and amplify shocks. Easy redemption options and the presence of a ‘first-mover’ advantage can create risks of a run, and the resulting price dynamics can spread to other parts of the financial system through funding markets and balance sheet and collateral channels. The empirical analysis finds evidence for many of these riskcreating mechanisms, although their importance varies across asset markets. Mutual fund investments appear to affect asset price dynamics, at least in less liquid markets. Various factors, such as certain fund share pricing rules, create a first-mover advantage, particularly for funds with high liquidity mismatches. Furthermore, incentive problems matter: herding among portfolio managers is prevalent and increasing. The IMF however reiterates that it is the investment focus and not so much the size of the fund or the size of the total AUM of any particular asset manager that matters.105 Critical criteria seem to be (1) leverage, (2) early redemption clauses, (3) complex stapled strategies, (4) asymmetric incentives of fund managers, (5) liquidity mismatches,106 (6) heavily concentrated portfolios, (7) herding by fund managers, (8) concentration of fund flows, (9) open gates and (10) fund structures.107 If fund managers are rewarded based on a relative performance measure, there can be deleterious effects for investors translating into a lower expected utility. However, markets will typically be more informative and deeper, if information is free. However, when the acquisition of information is treated as an endogenous factor, the incentives to acquire information may be hindered by relative performance contracts. This last effect may, ex ante, reduce the informativeness and depth of the market. The result is that prices are more informative holds only for the case of free information, it is reversed when information is costly. These findings as a whole point to the need for a more nuanced understanding of the contracts that aim to solve the agency problem between managers and investors. Especially from a regulators perspective, there can be a trade-off between the benefits of aligning the principal’s interests with those of the agent and the potential costs associated with the effects on contagion, volatility and the informativeness of markets.108 If relative performance matters to asset managers, they will, in a contemporary low-yield environment, reach for yield (refers to the tendency to buy riskier assets in order to achieve higher returns) because of competitive pressures. La Spada109 concludes that when funds care about relative performance (and they do as the (continued)

 IMF, (2015), Global Financial Stability Report, The Asset Management and Financial Stability, April, pp. 93–135 (chapter 3). 106  See in detail S.  Chernenko and A.  Sunderam, (2015), Liquidity Transformation in Asset Management: Evidence from the Cash Holdings of Mutual Funds, Working Paper, July 21, mimeo. 107  Ibid.; see also D.J. Elliott, (2014), Systemic Risk and the Asset Management Industry, Economic Studies at Brookings Institute, May. 108  D.  Igan and M.  Pinheiro, (2015), Delegated Portfolio Management, Benchmarking and the Effects on Financial Markets, IMF Working Paper Nr. WP/15/198. 109  G. La Spada, (2015), Competition, Reach for Yield, and Money Market Funds, Federal Reserve Bank of New York Staff Reports, Nr. 753, December. See also L. Schmidt, et al., (2015), Runs on 105

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Box 7.2  (continued) market forces it upon them through two economic forces: fund ­competition over performance and risk of ‘breaking the buck’), an increase in the risk premium leads funds with lower default costs to increase risk taking, while funds with higher default costs decrease risk taking.110 Without changes in the premium, lower risk-free rates reduce the risk taking of all funds. Rank-based performance is indeed a key determinant of money flows to money market funds (MMFs). The concern is that lower returns on safe assets might exacerbate this risk-taking incentive and lead asset managers to delve into riskier assets is thereby justified. A final word which I will leave up till Cunliffe: ‘[t]o state the obvious, investment funds and asset managers are not banks. They do not offer the promise that you will get your money back. And they are typically much less leveraged. But increasingly they do offer a liquidity promise – that the investors can redeem the value of their investment at very short notice. In this way they can create liquidity mismatches when investors in funds are offered a greater degree of access to investment than is consistent with the ease with which the assets in which they are invested can be sold without a big impact on price. This risk has increased due to the growing importance of open ended mutual funds, especially now that open-ended funds account for about half of the 70 Trillion USD in AUM the asset management segment is managing.’111 And the exposures aren’t limited to MMFs, but also on a macro-level, benchmark impacts of asset managers have been observed making this a macroeconomic and macroprudential issue.112 The issue is not going to go away as asset managers are now also pouring billions into the market through the direct lending channel,113 the direct of which will also be determined by benchmarking (of some sort).

Money Market Mutual Funds. Working Paper, mimeo; P. Strahan and B. Tanyeri, (2015), Once Burned, Twice Shy? Money Market Fund Responses to a Systemic Liquidity Shock, Journal of Financial and Quantitative Analysis, Vol. 50, Issue 1–2, pp. 119–144. Also: G. Chodorow-Reich, (2014), Effects of Unconventional Monetary Policy on Financial Institutions, Brookings Papers on Economic Activity (Spring), pp.  155–204; M.  Di Maggio, and M.  Kacperczyk, (2015), The Unintended Consequences of the Zero Lower Bound Policy, Working Paper, mimeo. 110  Risk premia trigger risk taking but affect funds with low and high default costs in opposite ways. Low risk-free rates increase the buffer of safe assets necessary to maintain the equilibrium default probability and therefore reduce risky investment for all funds. Both effects are peculiar to MMFs and come from their distinctive feature of a stable net asset value and consequent risk of ‘breaking the buck’; see: G. La Spada, (2015), ibid., p. 2. 111  J.  Cunliffe, (2015), Market Liquidity and Market-Based Financing, Speech given by Sir Jon Cunliffe, Deputy Governor, Deputy Governor Financial Stability, Member of the Monetary Policy Committee, Member of the Financial Policy Committee and Member of the Prudential Regulation Authority Board British Bankers’ Association International Banking Conference, London, Thursday 22 October 2015, pp. 9–10. 112  S. Arslanalp and T. Tsuda, (2015), Emerging Market Portfolio Flows: The Role of BenchmarkDriven Investors, IMF Working Paper Nr. WP/15/263, Washington. 113  A.  Mooney, (2015), Asset Managers Pour Billions into Direct Lending, Financial Times, December 13.

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At the beginning of the section, I referred to the fact that asset managers tend to not get involved in credit intermediation. This was only half the truth since bond funds as part of the asset management sector typically do so.114 It is a niche part of this industry but an important one and foremost a growing one. It is growing in particular outside the sovereign bond sphere, so corporate loans, high-yield loans, leveraged loans and so on which constitute (compared to history where those bonds were largely invested in investment grade sovereign bonds) a higher-risk profile. Indeed, ‘[i]ntermediation through funds also brings funding cost benefits and fewer restrictions for firms compared with bank financing—it does, however, also expose firms to more volatile funding conditions, so the advantages have to be weighed against the risks’.115 In fact, we have witnessed that asset managers have increased the use of leverage across their investment strategies, triggered by squeezed returns due to monetary policy, tighter capital controls and higher transaction costs.116 This evolution has triggered an enhanced level of concern regarding the intrinsic risk regarding some of the activities conducted and products applied in the asset management industry.117 Even if the bond fund is not or limitedly levered, systemic risks might occur because of price externalities in the financial markets, in particular when product features have the inclination to amplify shocks or show the potential to destabilize the pricing dynamics in certain markets (compared to those situations where investors in funds would invest directly in securities in the market). The IMF comments: ‘if intermediation through funds raises the probability of fire sales of bonds that are held by key players in the financial sector or that are used as collateral, then the risk of destabilizing knock-­on effects on other institutions rises.’118 There also might be damage done to firms and economies in which funds were invested (naked credit default swap or CDS in Greece, Spain.

 See, for example, IMF, (2014), Global Financial Stability Report, ibid., pp.  73, 82–86. Specifically, they comment that ‘[t]hese funds tend to be exposed to some liquidity and maturity risk but score low on other risk dimensions. At least in the euro area, however, bond funds now tend to hold less-liquid and longer-maturity assets than five years ago. Similarly, in the United States, investment funds—which entail some maturity risk, but do not display high risk scores in other areas—have been the fastest-growing form of shadow banking, expanding from 35 percent to 70 percent of GDP’ (p. 82). 115  IMF, (2015), Global Financial Stability Report. Navigating Monetary Policy Challenges and Managing Risk, April, p. 95. 116  See extensively on the topic: F. Avalos et al., (2015), Leverage on the Buy Side, BIS Working Paper Nr. 517, October. 117  See in detail: D. Elliott, (2014), Systemic Risk and the Asset Management Industry, Economic Studies at Brookings, Brookings Institution, Washington; A. Haldane, (2014), The Age of Asset Management?, Speech at the London Business School, April 4; Center for European Policy Studies– European Capital Markets Institute (CEPS-ECMI), (2012), ‘Rethinking Asset Management from Financial Stability to Investor Protection and Economic Growth’. Report of a CEPS-ECMI Task Force. 118  IMF, (2015), Global Financial Stability Report. Navigating Monetary Policy Challenges and Managing Risk, April, p. 95. 114

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etc. during the crisis or volatile capital flows119 in and out of [small] emerging economies that used to be domestic and relatively sheltered economies). Collective investment ­vehicles can have that ‘tsunami effect’ compared to individual and thus more asymmetric investing by individual investors in the investment community. It was the aforementioned Elliott who conceptually distinguished between the different types of risks involved being (1) risks that result from the presence of intermediaries and (2) those that are merely a reflection of the behavior of end investors and would occur in the absence of intermediaries. Two main risk channels were identified: ‘(1) incentive problems related to the delegation of portfolio management decisions by end investors to funds, which, among other things, may lead to herding, and (2) a first-mover advantage for end investors (that is, incentives not to be the last in the queue if others are redeeming from a fund), which may result in fire-sale dynamics.’120 These risk channels have increased in recent years in importance due to the fact that asset managers have managed ever larger amounts of AUM and the fact that the asset managers have become market makers (largescale trading) in those spaces where banks have withdrawn. Also, the protracted period of low interest rates in advanced economies has created a large portfolio of new (fixedincome) products to help investors looking for yield which often (or better invariably) implies ‘more risk’ and ‘less liquidity’. Intermediation through (plain-vanilla) funds is not risk-free as indicated. The agency problem (information and observance issues) between investor and fund manager can ‘induce destabilizing behavior and amplify shocks’.121 The aforementioned benchmarking122 to evaluate asset managers creates additional complications as ‘this form of evaluation, in turn, can lead to a variety of trading dynamics with potentially systemic implications, such as herding or excessive risk taking’. Other implications123 could be (1) ‘a contagion effect’, that is, when risk managers become risk averse, this can induce the transmission of shocks across assets and result in momentum trading, (2) portfolio managers engaged in noise trading or churning to signal talent and superior knowledge, as this is difficult to identify by investors, (3) a higher price volatility of securities that are included in the benchmark (e.g. excess correlation of stocks in the followed index124).  Therefore, these many macroprudential instruments have been designed as both macroprudential and capital flow management in nature; see, for example, IMF, (2015), Group of Twenty, Measures which are Both Macroprudential and Capital Flow Management Measures: IMF Approach, Washington, April 10. 120  See also: IMF, (2015), Global Financial Stability Report. Navigating Monetary Policy Challenges and Managing Risk, April, p. 96. 121  IMF, (2015), Global Financial Stability Report. Navigating Monetary Policy Challenges and Managing Risk, April, p. 98. 122  ‘This evaluation can take direct or indirect forms: (1) managers’ compensation can be linked to relative performance or (2) investors inject money into funds that perform well relative to their benchmarks. The effect of the latter is similar to the effect of the former if compensation increases with assets under management (AUM)’. See IMF, (2015), ibid., p.  100; L.  Ma, et  al., (2013), Portfolio Manager Compensation in the U.S. Mutual Fund Industry, Working Paper. 123  See in detail IMF, (2015), ibid., pp. 100–101 with related literature. 124  S. Basak and A. Pavlova, (2014), Asset Prices and Institutional Investors, American Economic Review, Vol. 103, Issue 5, pp. 1728–1758. 119

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The second-risk channels are fueled by the understanding of a ‘first-mover advantage’125 (aka strategic complementarity) when exiting the fund first in case of a market shakeout. This is a known phenomenon as it also explains bank runs and runs on MMFs (which were discussed in this chapter). The mechanics of the issue are therefore the same. The asset managers will use the cash position or sell the most liquid assets first in a shakeout at the detriment of who stays behind in the fund and who will also absorb capital losses and selling expenses. This comes on top of the fact that liquidity mismatches are growing in most funds, often due to an attempt by the portfolio to manager to generate acceptable returns. The volumes handled will do all the rest to create downward pressure on asset prices in the market, which will create a behavioral feedback loop of more selling and even lower fire sale prices and collateral impacts.126 The scholarly analysis has demonstrated the contagion and amplification effects for markets in particular emerging markets. The debate however rages on as major observations have not been done in the market about the size and magnitude of the potential effects. There have been observations that demonstrate that ‘mutual funds helped transmit shocks from bank equities to nonfinancial firms’ equities’ and ‘mutual funds that incurred losses from securitized debt sold off corporate bonds, which induced a price impact on bonds held by these funds’.127 The aforementioned herding component aggravates those potential shocks. The herding is measured based on a methodology developed in 1992, and although not pointing at a smoking gun, it does provide appropriate amounts of information and assessment to conclude whether there is herding or not in a certain market at a certain point in time. Herding is on the rise in recent times and across all fund styles128 and asset classes. Herding is further pronounced in times of unconventional monetary policies when funds go ‘the extra mile’ in search for yield and is also prevalent when ‘investing relatively more opaque and less liquid markets’. The systemic risk is therefore a matter of size but investment strategy or focus.129 What is surprising is that retail funds show in a consistent way a higher level of herding than institutional-focused funds. This is explained by referring to the fact that retail investors are more and faster inclined to ‘quickly reallocate money from funds with poor recent performance to funds with high recent returns, possibly because it is more difficult for them than for institutional investors to assess and monitor portfolio managers’.130

 See in detail: IMF, (2015), ibid., pp. 101–103.  For example, ‘affecting the balance sheets of other actors in financial markets; reducing collateral values; and reducing credit financing for banks, firms, and sovereigns’, IMF, (2015), ibid., p. 99. 127  See in detail: H.  Hau and S.  Lai, (2010), The Role of Equity Funds in the Financial Crisis Propagation, Research Paper Nr. 11–35, Swiss Finance Institute, Geneva; A.  Manconi, et  al., (2012), The Role of Institutional Investors in Propagating the Crisis of 2007–08, Journal of Financial Economics Vol. 104, Issue 3, pp. 491–518. See also for the IMF specific analysis: IMF, (2015), ibid., pp. 104–106. 128  IMF, (2015), ibid., p. 113. 129  See in detail: IMF, (2015), ibid., pp. 114–115. 130  A.  Frazzini and O.  A. Lamont, (2008), Dumb Money: Mutual Fund Flows and the CrossSection of Stock Returns, Journal of Financial Economics Vol. 88, Issue 2, pp.  299–322; IMF, (2015), ibid., 113. 125 126

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This  assessment and monitoring problem exacerbates the role of the aforementioned incentive problem. It has led to the fact that the FSB and International Organization of Securities Commissions (IOSCO) have suggested and improved their assessment methodologies as to which asset managers could be ‘earmarked’ as ‘systemically relevant’.131 Fund flow and liquidity risk management at the level of the funds are key in understanding the outcomes of the scholarly work.132 It further has led to an ongoing revamp of the asset management regulation that traditionally focused on investor protection and which has now included ­systemic risk and macroprudential oversight. Also, liquidity risk has been given the attention it deserved because, although it existed, the regulatory requirements were rather general. The limitations of the current regulatory framework include the following: (1) it lacks specificity and detail regarding critical aspects of liquidity and risk management protocols in general; (2) there is insufficient supervision of individual and systemic risks with unilateral interest for disclosure rather than overall oversight of risks. The consequence is that the risk monitoring frameworks over supervisory bodies are weak and, to a large degree, this is true for the asset managers as well, despite some best practices here and there. The broadband consequence is that ‘in the presence of liquidity and price externalities, each fund and asset manager is likely to underestimate liquidity needs and the potential for correlated price effects in the presence of large shocks’.133 International coordination and guidance is very limited. Improvements134 could be generated in the following areas: (1) enhanced and more detailed regulation particularly in the field of liquidity requirements and the definition of what constitutes a ‘liquid asset’. The Basel III definition for a variety of technical reasons is not adequate or appropriate in this context. There should also be a link between the liquidity requirement and the redemption policy of a fund, (2) should focus on the microprudential supervision of individual asset management firms and the systematic review of their risk management protocols, (3) should monitor or even better limit the amount of leverage that can be used in their funds including synthetic leverage through derivatives,135 (4) should create supervision that caters better to the products and activities

 The draft: Financial Stability Board (FSB) and International Organization of Securities Commissions (IOSCO), (2014), Assessment Methodologies for Identifying Non-bank Noninsurer Global Systemically Important Financial Institutions, Consultation Document, Financial Stability Board, Basel. The 2015 revision: Assessment Methodologies for Identifying Nonbank Non-insurer Global Systemically Important Financial Institutions, The Second Consultation Document, Financial Stability Board, Basel. 132  IMF, (2015), Iibid., pp. 106–112. 133  N.  Liang, (2015), Asset Management and Financial Stability, Presentation at the Brookings Institution, January 9. IMF, (2015), ibid., p. 118. 134  See in detail IMF, (2015), ibid., p. 118–120. 135  T. Adam, and A. Guettler, (2015), Pitfalls and Perils of Financial Innovation: The Use of CDS by Corporate Bond Funds, Journal of Banking and Finance, Journal of Banking and Finance, Vol. 55, pp. 204–214. They document that ‘(1) the use of credit default swaps (CDS) rose from 20 to 60 percent between 2004 and 2008; (2) CDS are mostly used to enhance credit risk taking, rather than hedging; (3) funds belonging to a larger fund family are more likely to use CDS; (4) 131

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asset managers develop rather than generic supervision models and (5) should preferably create a global set of standards that can be applied consistently around the world. In addition to all this, a macro-view should be brought into systemic risk oversight which implies an analysis of interlinkages within the sector and between the asset management sector and other components of the financial industry. This implies rules regarding maximum concentration limits of investments and (6) creates a better awareness around the use of gates and suspensions and the potential they have to send negative signals to the market and create preemptive runs. It can be referred to the discussion about MMFs and in particular the discussion about the revision of the US MMF regulation in this regard where this topic has been extensively discussed. This enhanced supervision and attention for financial stability risks and better data sets to improve analysis and recommendations is new but builds on the historical parameters the regulators used and which were mainly focused and built around ‘investor protection’.136 The analysis and literature is incomplete and often focuses on individual aspects or the larger meta-problems in the asset management world. The destabilization of prices in certain asset classes (bonds in particular) has the potential to trigger contagion effects in other segments of the financial market. This occurs mainly through funding markets and balance sheet and collateral channels. Creating greater transparency and data sets will not only create a better understanding and allow to better position new regulations and risk management protocols but also reduce herding in markets.137 The need to continuously monitor the asset management industry at this stage and going forward lies in the structural changes that have occurred in the financial industry (and then predominantly in advanced economies). On top of that, the relative growth of the asset management industry has contributed to that need, combined with the retrenchment of traditional banks from market-making activities in a number of domains, leading to a reduction in market liquidity. The role of fixed-income funds, which include in general more contagion risk than equity funds, has grown considerably in recent times and so has the overall product portfolio of asset managers offered to the market. The monetary policy of low market interest rates and the enhanced need for yield has led to investments in less liquid asset classes which also often pose higher (credit) risk.138 Given the fact that in emerging markets there is less of an equity culture (especially among retail investors) compared to the West, the drive toward all types of fixed-income strategies is likely to continue and grow in importance in the decades to come.

­ nderperforming funds often increase their CDS exposures to enhance returns; and (5) CDS users u tend to perform worse on average than non-users’. See also: J.  Tian, (2010), Shadow Banking System, Derivatives and Liquidity Risk, Working Paper, who built a model to better understand how liquidity risks translate in fire sales in the presence of derivatives and under which conditions derivatives are instrumental to reduce or neutralize liquidity risk. 136  See M.J. White, (2014), Enhancing Risk Monitoring and Regulatory Safeguards for the Asset Management Industry, speech delivered at the New  York Times DealBook Opportunities for Tomorrow Conference, New York, December 11. 137  See in detail: G. Gelos, Gaston, (2011), International Mutual Funds, Capital Flow Volatility, and Contagion: A Survey, IMF Working Paper WP/11/92, International Monetary Fund, Washington. 138  IMF, (2015), ibid., p. 121.

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This has resulted into concerns regarding the potential for the asset management sector to contribute to the development of asset bubbles. Including in the traditional set of arguments139 as to why bubbles develop in the market are limits to learning, frictional limits to arbitrage and behavioral errors. But more recently, it is argued that driven by ‘the shortterm nature of the asset owner—manager relationship, and the momentum bias inherent in financial benchmarks’,140 the business risk of asset managers acts as strong motivation for institutional herding and ‘rational bubble-riding’.141 What is interesting is the word ‘rational’ used by Jones. Indeed, he argues: ‘this explanation does not require a baseline assumption of widespread irrationality in the conventional sense. Simply put, it can be entirely rational— from the perspective of business and compensation risk—for asset managers to knowingly ride bubbles because of benchmarking and the short-term performance appraisal periods often imposed on asset managers by asset owners.’142 The policy implication143 is that policies should, in contrast to existing macroprudential and monetary measures (which to a large degree are still focused on conventional leverage-driven asset booms), focus on the cause and not just the symptom, and ‘prominent among these should be reforms addressing principal-agent contract design and the implementation of financial benchmarks’. Bubbles will, because of the rationality argument, occur more frequent and more persistent, in particular when ‘assets under management’ will continue to grow and in a concentrated way within the industry. The reduction of leverage might be misleading when it comes to their ability to contribute to financial stability ‘subdued leverage is not a sufficient condition for financial stability—if systemic risk, and activity in the wider economy, is shaped importantly by large shifts in risk premia owing to the “rational herding” motivations of asset managers’.144 Moreover, as risktaking migrates out of the formal banking sector, policy makers must guard against the risk of ‘fighting the last war’, Jones comments. It will require improved models to expand the explanatory and predictive power of standard economic theory. One such suggestion is the use of ‘neuro-economic measures’. Their findings demonstrate that ‘decision mak-

 B.  Jones, (2015), Asset Bubbles: Re-thinking Policy for the Age of Asset Management, IMF Working Paper, WP/15/27, pp. 15–18. Jones provides an excellent overview of the literature on traditional and new age arguments of bubbles creation and persistence in the public markets. See also for recent literature overviews on ‘bubble creation and asset pricing bubbles’: A. Scherbina, (2013), Asset Price Bubbles. A Selective Survey, IMF Working Paper, Nr. WP/13/45. See also Jones with a novel pillar surveillance framework for identifying speculative bubbles: B. Jones, (2014), Identifying Speculative Bubbles. A Two-Pillar Surveillance Framework, IMF Working Paper Nr. WP/14/208. 140  B. Jones, (2015), ibid., pp. 19–30. 141  B. Jones, (2015), ibid. 142  B. Jones, (2015), ibid., p. 38. 143  B. Jones, (2015), ibid., pp. 31–36. 144  B. Jones, (2015), ibid., p. 38; see also: M. Feroli, et al., (2014), Market Tantrums and Monetary Policy, Working Paper presented at the 2014 U.S. Monetary Policy Forum, New York, February 28; A.G.  Haldane, (2014), The Age of Asset Management? Speech at the London Business School, 139

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ing during bubble or non-bubble periods of financial market activity is driven by, respectively, evolutionarily ancient or new neurocircuitry’ and ‘neuroimaging-based financial-system regulation may be useful for distinguishing bubbles from non-­bubble periods and preventing major asset-price bubbles’145 especially as they, under the ‘rationality umbrella’, are expected to become more frequent and persistent, and so distinguishing periods in itself will become a challenge.

7.7.3  Asset Management and Systemic Risk The incoming wave of regulation was meant to make the financial system more robust and less vulnerable to shocks. Systemic risk was the key concept and the shadow banking segment was identified as one of the key areas to consider and regulate. The asset management industry, which traditionally doesn’t belong to shadow banking segment was earmarked as one of the systemically important segments of the financial infrastructure. That is however a fairly new trend. This happens when you grow as much as the asset management industry did in recent decades. You come on the radar and you are examined more closely, and when you look under a microscope, nothing looks really good anymore. But regulation should be adequate and proportionate and should capture all issues and not fragmented features of the problem as it does so often. Roncalli and Weisang therefore asked themselves the question as to what degree the incoming proposals are adequate for managing the ‘systemically important’ aspect in the asset management industry, as that seems to be the real issue underlying the asset management industry concerns, as discussed above.146 So after they reviewed the notion of systemic risk,147 they wondered how the asset management industry is linked to systemic risk, given their very different business models, compared to (shadow) banks and other systemically important financial institutions (SIFIs), whereby they act as custodians and don’t run real market risks themselves, unless they invest their retained earnings themselves.148 From this perspective, they conclude that ‘at first glance, the asset management industry does not partake in two of the major channels of transmission of systemic risk, namely: the exposure/counterparty

London, April; J.C.  Stein, (2014), ‘Incorporating Financial Stability Considerations into a Monetary Policy Framework’, Remarks at the International Research Forum on Monetary Policy, Washington, DC, March 21. 145  See J.L. Haracz and D.J. Acland, (2015), Neuroeconomics of Asset-Price Bubbles: Toward the Prediction and Prevention of Major Bubbles, Goldman School of Public Policy, UC Berkeley Working Paper. 146  Trending in trading behavior and maturity transformation in modest volumes will not lead to issues of systemic risk. 147  T. Roncalli and G. Weisang, (2015), Asset Management and Systemic Risk, Working Paper, May 26, pp. 4–8. 148  ‘In practice, however, not all financial risks are borne by the asset manager’ clients. Because of its fiduciary obligation, the asset manager is also exposed to some financial risks, in particular counterparty, credit and liquidity risks; T. Roncalli and Systemic Risk, (2015), ibid., p. 9.

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channel and the asset liquidation/market channel’.149 Nevertheless, there is reason for concern as ‘functional source of systemic risk will arise whenever cessation of activity by an asset manager can disrupt significantly the financial system’. The suspension of convertibility risk of a bank equals the asset managers fund redemption risk, especially when these funds are so large that a disruption spreads to the functioning of the system. But can the risk embedded in a fund of even an asset management firm be of such a magnitude that it translates into systemic risk. This is where a lack of analysis is playing up as the interconnectedness between banks and crises is well documented but not between asset managers and financial crises.150 Those transmission channels are threefold: they indicate ‘exposures/counterparty channels (linked to counterparty and credit risks and network effects), asset liquidation/market channel (linked to liquidity risk and market effects), critical functions of service/substitutability channels (and its connection with reputational risk)’.151 Those transmission channels have been ‘benchmarked’ against the FSBs methodology to identify on-bank non-insurer global systemically important financial institutions (NBNI G-SIFIs) issued in 2014/2015.152 They conclude that ‘current proposals in part fail to adequately identify natural candidates for the “systemically important” designation and perhaps confuses large institutions with systemically strategic institutions giving wealth loss too much importance over the potential for “real” economic disruption and market dislocation’. There is therefore an enhanced need for a more risk-sensitive approach to identifying the relevant institutions from a ‘systemic risk’ point of view.153 Obviously, the qualification of asset managers as ‘shadow banks’ by the European Central Bank (ECB) has not been received with much joy154 but points at a rising awareness of the fact that their broadening set of activities and accompanying practices might pose material risks to financial stability. That would include peer-to-peer lending and direct lending by asset managers.

 T. Roncalli and G. Weisang, (2015), ibid., p. 8.  T. Roncalli and G. Weisang, (2015), ibid., pp. 9–11. 151  T.  Roncalli and G.  Weisang, (2015), ibid., p.  11 and in detail pp.  11–14. See for the FSB approach toward asset management: FSB, (2015), Assessment Methodologies for Identifying Nonbank Non-insurer Global Systemically Important Financial Institutions, 2nd Consultation Document, March 4, pp. 47–55. 152   FSB, (2015), Assessment Methodologies for Identifying Nonbank Non-insurer Global Systemically Important Financial Institutions, 2nd Consultation Document, March 4; Financial Stability Board (FSB) and International Organization of Securities Commissions (IOSCO), March 2015; T. Roncalli and Systemic Risk, (2015), ibid., pp. 14–17. 153  T. Roncalli and G. Weisang, (2015), ibid., pp. 32–41. 154  A.  Mooney, (2015), ECB’s Shadow-Bank Label for Funds Angers Asset Managers, Financial Times, November 1. See also: M. K. Philips, (2015), Shadow Casting, CFA Institute Magazine, July/August, pp. 24–28. 149 150

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7.7.4  V  ulnerabilities Deriving from Asset Management Activities Starting 2014, the first signs emerged that the asset management industry could be a niche within the financial infrastructure that could pose financial stability risks in case not properly managed. In the wake of the initial assessments during the period 2014–2016, the FSB released early 2017 their assessment regarding the matter.155 They built their analysis around four vulnerabilities: (1) the liquidity mismatch between fund investments and redemption terms and conditions for open-ended fund units156; (2) leverage within investment funds; (3) operational risk and challenges at asset managers in stressed conditions; and (4) securities lending activities of asset managers and funds. In this matter, and given the analysis on asset management in the context of financial stability risk we have gone through so far, the focus here will not be on the recommendations issued,157 but on the analysis of the five vulnerabilities. Now the biggest risk comes from open-ended funds within that space. They typically account for 50% of the total and global assets under management (AUM) in the industry. In the period 2017–2019, the industry was on track to become a USD 100 trillion powerhouse in terms of AUM.158 Within this space the fixed-income fund markets accounted for about 25% and tended to grow in line with the growth of the bond market in general.159 This sector has been concentrated in a small number of firms mainly located in the US and Europe. Inflows in recent years have mainly been through the ETF product group, tracking indexes related to countries or industries. Before discussing the structural vulnerabilities, it is worth noting that in contrast to banks which act as principals in the intermediation of funds, asset managers have a fiduciary relationship vis-à-vis the assets deployed. As such, they act as agents and have a fiduciary relationship with the parties making the assets available, which ultimately bears the investment risk.160

 FSB, (2017), Policy Recommendations to Address Structural Vulnerabilities from Asset Management Activities, January 12. Prior to that release they issued a proposal document: FSB, (2016), Proposed Policy Recommendations to Address Structural Vulnerabilities from Asset Management Activities, June 22, following which comments were submitted: Public responses to the June 2016 consultative document ‘Proposed Policy Recommendations to Address Structural Vulnerabilities from Asset Management Activities’, October 5. All to be retrieved via fsb.org. The OFR have already released their view years earlier, and classify the issues slightly differently; see: OFR, (2013), Asset Management and Financial Stability, September, pp. 9–21; and for the transmission channels pp. 21–23. 156  See for the banking counterpart: A.  Krishnamurthy, et  al., (2016), Measuring Liquidity Mismatch in the Banking Sector, NBER Working Paper Nr. 22,729. 157  The policy recommendations in this matter can be consulted under Annex 1: FSB, (2017), Policy Recommendations to Address Structural Vulnerabilities from Asset Management Activities, January 12, pp. 39–41. 158  Updated data can at any given time be found at the International Investment Fund Association (www.iifa.ca) 159  See for annualized data the IOSCO Securities Markets Risk Outlook (via www.ioco.org) 160  See for details: FSB, (2017), Policy Recommendations to Address Structural Vulnerabilities from Asset Management Activities, January 12, pp. 5–10. 155

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1. The liquidity mismatch between fund investments and redemption terms and ­conditions for open-ended fund units161 This is considered, together with the use of (synthetic) leverage, the most dominant vulnerability identified. It refers to the investment decision of the fund on the one hand and the daily redemptions162 that the fund contractually allows. Not every asset is 100% liquid, but daily redemptions require that at least a portion of the assets invested or liquid or alternatively that a portion of the assets are held in cash. Depending on the nature of the fund type and its strategy, the liquidity of a fund may be overestimated. In case redemptions are at hand, and no liquidity is available, assets will have to be sold—without a market-based reason (although the redemption can be because of market-based conditions and characteristics), creating volatility, and a fire sale of assets at (often) below par often, resulting in spillover effects (additional redemptions and public questioning of asset pricing accuracy).163 Now, not every fund allows daily or even weekly redemptions, but most MMFs do. In search for yield, funds, often triggered by investor demand, have diversified their asset holdings and have branched out into assets that typically are less liquid or into assets that seem liquid but aren’t really under market stress or when the perception of underlying credit conditions change. In case these funds are faced with material and unanticipated redemptions, the asset base may trigger or amplify fragilities, as now assets across the liquidity spectrum have to be sold at short notice. This combined with investor herding and momentum trading might aggravate market conditions under which assets need to be sold.164

 See in detail: FSB, (2017), ibid., pp. 11–23.  See how the concept of ‘redemptions’ can be traced back to credit theory and the role of the state: É. Tymoigne, (2017), On the Centrality of Redemption: Linking the State and Credit Theories of Money Through a Financial Approach to Money, Levy Economics Institute of Bard College, Working Paper Nr. 890, May (including an interesting literature list pp. 21 ff.). The reasoning in short goes a bit like this ‘[o]ne of the main financial requirements of any monetary instrument is that it be redeemable at any time. As long as this is the case, the fair value of an unconvertible monetary instrument is its face value.’ Now the functional approach to money is that ‘money is what it does’, that is, monetary and mercantile mechanics are conflated or put differently ‘unconvertible monetary instruments are worthless’. However, from a financial point of view monetary notes have always been promissory notes and, as such, their financial characteristics are central to their value and liquidity. Redemption therefore plays a critical role in the state and credit views of money. ‘[P]ayments due to issuer and/or convertibility on demand are central to the possibility of par circulation.’ 163  See also: S. Priazhkina, (2016), Liquidity Channels and Stability of Shadow Banking, Working Paper, mimeo. 164  Large amounts of literature have been released over the years regarding those topics. What is interesting however is the fact that in recent years it became clear that subcategories of investors also tend to develop herding behavior with specific characteristics for that niche group. See, for example, D.  Broeders et  al., (2016), Pension Funds’ Herding, DNB Working Paper Nr. 503, February. They categorize and conclude that ‘[w]eak herding occurs if pension funds have similar rebalancing strategies. Semi-strong herding arises when pension funds react similarly to other external shocks, such as changes in regulation and exceptional monetary policy operations. Finally, strong herding means that pension funds intentionally replicate changes in the strategic asset 161 162

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To make matters worse, some funds have regulations that allow investors to redeem whereby the cost of that redemption (e.g. in case assets are sold at a loss), partially or in full in passed on the remaining fund investors (there is a first-mover advantage). On the other hand, some fund specifics (contractual or strategy-­wise) will counterbalance that first-mover advantage. In order for liquidity transformation165 in open-ended funds to amplify risks to financial stability, a number of contingencies have to occur: (1) a material redemption of funds, (2) significant asset sales (of less liquid assets), and (3) those asset sales would need to be material enough (relative to a certain factor such as total assets or normal trading volume) that they lead to material price declines or spikes in price volatility in secondary markets so that access to markets are effectively constrained.166 Further amplification would occur due to leveraged players unwinding their leverage position due to the price dislocation in the market, which tends normally to be short-lived, but which could under circumstances be persistent and occur in a protracted way.

allocation of other pension funds. Without an economic reason.’ Regarding momentum trading, see: P. Barroso and P. Santa-Clara, (2012), Managing the Risk of Momentum, Nova School of Business Working Paper, April, mimeo; T.-L. Dao et al., (2016), Tail Protection for Long Investors: Trend Convexity at Work, Working Paper, July 11, mimeo; J. Brooks, (2017), A Half Century of Macro Momentum, AQR Report, August (via aqr.com) and P. Jusselin et al., (2017), Understanding the Momentum Risk Premium: An In-Depth Journey Through Trend-Following Strategies, Working Paper, September, mimeo. 165  A key problem in this debate is that it is difficult to measure liquidity transformation for asset managers. And that in contrast to shadow banks where maturity mismatch—the difference in maturity between assets and liabilities— this provides a reasonable measure of liquidity transformation. Chernenko and Sunderam argue: ‘[w]hile investors can withdraw unlimited quantities of deposits without any price impact, bank loans cannot be traded before maturity without creating substantial price impact. For asset managers, however, there is no comparable measure. Their assets are typically tradeable securities, though with varying levels of liquidity. Furthermore, some price impact can be passed on to investors because they own claims whose value is not fixed. Nevertheless, asset managers perform some amount of liquidity transformation because their ability to pool trades and space transactions over time flattens the price-quantity schedule faced by their investors.’ They use, in their analysis, the cash holdings of open-end mutual funds that invest in equities and long-term corporate bonds as a window into the liquidity transformation activities of asset managers. Their reasoning is that the way mutual funds manage their liquidity (in order to guarantee an open-end to investors) sheds some light on how much liquidity transformation funds are performing. So, a firm that acts as a pure pass-through and thus simply buys and sells asset will have little need for holding cash to manage liquidity and to ultimately meet redemptions. However, a fund investing in illiquid assets or engaging in substantial liquidity transformation will need material levels of cash to meet redemptions (or as they call it ‘will seek to use cash holdings to mitigate the costs associated with providing investors with claims that are more liquid than the underlying assets’). Cash management therefore acts as a proxy for liquidity transformation. See S. Chernenko and A.  Sunderam, (2016), Liquidity Transformation in Asset Management: Evidence from the Cash Holdings of Mutual Funds, HBS Working Paper Nr. 2016-01, July 15, p. 2. Also as NBER Working Paper Series, Nr. 22,391, July 2016/ESRB Working Paper Nr. 23/2016. 166  J. Coval and E. Stafford, (2007), Asset Fire Sale (and Purchases) in Equity Markets, Journal of Financial Economics, Vol. 86, pp.  479–512. N.  Cetorelli, et  al., (2016), Are Asset Managers Vulnerable to Fire Sales? Blogpost Liberty Street Economics, February 18; R.  Cont and E. Schaanning, (2017), Fire Sales, Indirect Contagion and Systemic Stress Testing, Norges Bank Working Paper 17-02, March 17.

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The existing mitigants consist of a wide variety of techniques, sometimes imposed by regulation or contractually through fund’s policies. The basic premises are to ensure that open-ended funds can meet redemptions in line with their own policy and in line with the general fiduciary relationship they have with their investors. More materially, regulation might limit the scope of assets a fund can invest in to avoid excessive illiquidity in the fund. Often stress tests and adequate risk management tools are required.167 A typical classification of these measures are preemptive measures and post-event measures. The former includes risk management and liquidity protocols, stress testing,168 diversification and portfolio composition guidelines as well as variable ways of dealing with notice periods and certain anti-dilution measures. Other techniques in that category limit the incentive to redeem under stress or excessive market volatility conditions (swing pricing) by effectively passing on the cost of redemptions to trading participants to the fund (rather than pass them on the remaining fund members).169 The latter category deals with situations that occur in case of markets disruptions or in case market conditions lead to large  outflows. In this category are measures such as redemption gates, suspension of

 See regarding the suggested standard set of liquidity management tools funds should/could have in place: IOSCO, (2015), Liquidity Management Tools in Collective Investment Schemes, Final Report, December. 168  Also see B.G. Malkiel, (2016), Next Steps in the Evolution of Stress Testing. Remarks at the Yale University School of Management Leaders Forum, September 26. For stress testing at banks, see: K. Dent and B. Westwood, (2016), Stress Testing of Banks: An Introduction, Bank of England Quarterly Bulletin, Q3, pp. 130–143, and T. Daniëls et al., (2017), A Top-Down Stress Testing Framework for the Dutch Banking Sector, Occasional Studies, Vol. 15, Issue 3, July; ECB, (2017), STAMP€: Stress-Test Analytics for Macroprudential Purposes in the Euro Area, eds. S.  Dees, J. Henry and R. Martin, February. See also: S. Mnuchin and C.S. Phillips, (2017), A Financial System That Creates Economic Opportunities Asset Management and Insurance Report to President Donald J. Trump Executive Order 13772 on Core Principles for Regulating the United States Financial System, October, pp. 11–71, and in particular pp. 29–32. 169  Swing pricing allows a fund manager to transfer to redeeming or subscribing investors the costs associated with their trading activity (bid-ask spread and market impact, and other trading-associated costs), thus potentially discouraging large flows. The remaining, non-redeeming investors, are thus (largely) protected from dilution effects (the drop in value, aka diluted NAV, for those investors that remain). Proceeds recovered via swing pricing are reinvested for the benefit of the fund, enhancing returns for longer-term investors. It has the potential to reduce systemic risk and is enacted in already quite a number of jurisdictions. But does swing pricing help dampen flows out of funds, especially during periods of market stress? Improvements are still welcome and many trade-offs (systemic risk mitigation vs. investor protection) exist in swing parameter calibration. See in detail: S. Malik and P. Lindner, (2017), On Swing Pricing and Systemic Risk Mitigation, IMF Working Paper Nr. WP/17/159, July. Swing pricing can be partial (coming into effect only when net flows exceed a predefined swing threshold) or in full. The swing factor (typically in the range of 0.5 to 3%) determines the amount by which NAV for redeeming investors is adjusted downward. Swing threshold and swing factor are key to ensuring that swing pricing as a systemic risk mitigant functions properly. Successful implementation of swing pricing also requires a conducive market infrastructure allowing for daily gathering of daily information on trade flow and related costs. See for a detailed analysis of each of those elements p. 9 ff. 167

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r­ edemptions, in-kind redemptions and side pockets170 as well as withdrawal limits and so on. Often, it is also regulated if and under what conditions a fund can borrow to meet redemptions. It is observed that the universe of measures is limited and that in case many funds apply the same techniques, or techniques with the same market- or fund effect, spillover effects might be emerging. There could be prolonged liquidity strains, and speculation about further measures needs to be taken leading to fund runs or interconnectedness in case leverage is used to meet redemptions. All these measures are ultimately in place to protect investors and/or fund interests and therefore might ignore system- or market-wide interests, which is particularly relevant in case the preemptive intervention powers of regulators or supervisors are limited. Given this reality, the FSB’s concern is built around three arguments: whether existing regulatory information and public disclosures are sufficient to assess the degree of liquidity transformation171 and its potential systemic implications; whether the liquidity risk management practices are appropriately calibrated to address potential risks; and whether the tools in place would be sufficient to deal with stressed market conditions.172

 Side pockets are segregated and ring-fenced pools of (often) illiquid assets to separate them from the more mainstream liquid assets in the fund. The idea is that only continuing investors in the fund can benefit from the proceeds upon sale at a late stage. See in detail also regarding other fund termination practices: IOSCO, (2017), IOSCO Report on Good Practices for the Termination of Investment Funds, Final Report, November (via iosco.org). 171  Chernenko and Sunderam evidence that to provide investors with claims that are more liquid than the underlying assets, funds engage in substantial liquidity management. Specifically, they hold substantial amounts of cash, which they use to accommodate inflows and outflows rather than transacting in the underlying portfolio assets. This is particularly true for funds with illiquid assets and at times of low market liquidity. They studied the cash holdings of mutual funds and concluded that ‘mutual funds’ cash holdings are not large enough to fully mitigate price impact externalities created by the liquidity transformation they engage in. They see evidence in the fact that (1) funds that hold a larger fraction of the outstanding amount of the assets they invest in tend to hold more cash. And (2) alternative liquidity tools (e.g. redemption restrictions, credit lines and interfund lending programs) are imperfect substitutes for cash and that cash is the key tool funds use for liquidity management validating the idea that cash holdings are a good proxy for the level of liquidity transformation going on in a fund. See S. Chernenko and A. Sunderam, (2016), Liquidity Transformation in Asset Management: Evidence from the Cash Holdings of Mutual Funds, Harvard Business School Working Paper Nr. 2016-01, July 15/NBER Nr. 22,391, July. Four elements play a role here: (1) mutual funds use cash to accommodate inflows and outflows rather than transacting in equities and bonds; (2) asset liquidity affects the propensity of funds to use cash holdings to manage fund flows; (3) funds that perform more liquidity transformation hold significantly more cash (how much is driven by asset illiquidity, the volatility of fund flows and their interaction); (4) the interaction of asset illiquidity and flow volatility is positive and statistically significant. See on the relationship between fund flows, monetary policy and financial stability: A. Banegas et al., (2016), Mutual Fund Flows, Monetary Policy and Financial Stability, Finance and Economics Discussion Series Nr. 2016-071, July, Washington: Board of Governors of the Federal Reserve System. Monetary policy can have an impact on allocation decisions of mutual fund investors (depending in intensity based on the investment strategy). Evidence points both ways, that is, in case of tighter-than-expected as well as more dovish scenarios with material policy ramifications. 172  FSB, (2017), Policy Recommendations to Address Structural Vulnerabilities from Asset Management Activities, January 12, ibid., p. 14. 170

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IOSCO, to improve certain liquidity protocols, has included its recommendations into its liquidity risk management guidelines from 2013. They include a.o. measures to deter the first-moving advantage issue in case of redemptions173 but also measures to finetune the redemption process and the techniques to reduce outflows.174 2. Leverage within funds as a potential structural vulnerability175 Leverage can be, regardless of the investment vehicle, a source of financial vulnerability. Most investment funds face regulatory limits as to how much leverage they apply (and in what way). However, these limits vary per jurisdiction and fund/product-type. Also the fact whether they are used to enhance returns or synthetically (through derivatives)176 to protect the funds’ portfolio from market volatility or to establish ‘cost-­effective investment positions with the same economic characteristics as holding the underlying asset’. The use of leverage can pose or amplify stability risk both in a direct and indirect way. In a direct way, it can increase the risk of a fund facing financial distress and transmit that distress to counterparties and eventually the market. Alternatively, a leveraged fund can spread risk through the system through interconnectedness with its investors, and the fact that it can impact other intermediaries it has funded. So both the counterparty and the interconnectedness channel can spread contagion.177 Also, leveraged funds are more sensitive to changes or swings in asset prices. Massive swings, adverse movements in prices, haircuts and margin calls might force them to sell assets to guarantee liquidity or create deleveraging. This process has the potential to affect other market participants through declining asset prices and the increase of margin calls. There is further perception that leveraged funds are more risky, leading to investor redeeming earlier when market  See IOSCO, (2018), Open-Ended Fund Liquidity and Risk Management – Good Practices and Issues for Consideration, FR02/2018, February; IOSCO, (2018), Recommendations for Liquidity Risk Management for Collective Investment Schemes, Final Report, FR01/2018, February. Risk management tools discussed include: swing prices (pp. 23–26), anti-dilution levies (pp. 27–29), valuation according to bid-ask prices (pp.  29–30), redemption gates (pp.  30–32), side pockets (pp. 32–34), notice periods (pp. 34–36), suspension of redemption (pp. 36–40) and redemptions in-kind (pp. 41–43), as well as focus on the stress-testing capabilities (pp. 44 ff.) 174  See the initial consultation in this matter: IOSCO, (2017), Open-Ended Fund Liquidity and Risk Management  – Good Practices and Issues for Consideration, CR05/2017, July 6. Also: F. Franzoni and M. C. Schmalz, (2017), Fund Flows and Market States, The Review of Financial Studies, Vol. 30, Issue 8, pp. 2621–2673. 175  See in detail: FSB, (2017), Policy Recommendations to Address Structural Vulnerabilities from Asset Management Activities, January 12, pp. 24–29. 176  See D. Deli et al., (2015), Use of Derivatives by Registered Investment Companies, SEC White Papers, Nr. 2015/12, December. 177  S.W.  Bauguess, (2017), Market Fragility and Interconnectedness in the Asset Management Industry. Keynote Address  – Buy-Side Risk USA 2017 Conference Market Fragility and Interconnectedness in the Asset Management Industry, June 20; I.  Goldstein, et  al., (2016), Investor Flows and Fragility in Corporate Bond Funds, Journal of Financial Economics, Vol. 126, Issue 3, pp. 592–613. See also the final report of IOSCO regarding ‘Liquidity in Corporate Bond Markets Under Stressed Conditions’, See IOSCO, (2019), Liquidity in Corporate Bond Markets Under Stressed Conditions Final Report FR10/2019, June 21, via iosco.org 173

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v­ olatility kicks in (relative to other funds) connecting the issue directly to liquidity issues. Looking at the behavior of leveraged funds, it is fair to say that they contribute to procyclicality as they tend to reduce leverage during downturns and releverage during market upswings. This is definitely the case when managers link their leverage to position inversely to the realized volatility of the underlying strategy. Meeting margin calls in itself is a source of procyclicality as it forces asset sales during periods of volatility or business downturns. The existing mitigants and risk management techniques control the risk associated with leverage and derivatives transaction yielding similar effects. They focus on forestalling transmission of distress to counterparties and the market as such (e.g. the derivative transactions of counterparties need to be contractually marked-to-market on a daily basis). The controlling itself then tends to happen through netting agreements and collateral requirements. Obviously, and especially for open-ended funds, there are hard requirements on the maximum limit of balance sheet leverage allowed. They vary per fund type and jurisdiction. And for some types, like hedge funds there is typically no cap on leverage, given the types of strategies they apply. The consequence is that regulators in both Europe178 and the US179 now force those funds to report the amount of leverage they have building up against their portfolio. Other measures try to limit the buildup of leverage in an indirect way in particular central clearing and margin requirements for noncentrally cleared derivatives.180 Also the fact that banks under Basel III181 need to report their exposures (derivatives, but also equity investments) in investment funds helps to paint a fuller and more nuanced picture and reduce the interconnectedness risk between bank and funds. It probably came to mind that most of these requirements are focused on ensuring that individual firms and funds meet all the measures. However, none of them focus on the macro-picture in the industry, or certain segments within that industry. Further, and as already mentioned before, leverage can be measured in many different ways,182 troubling the view on what the real situation might be at any given point in time in the industry. The most common way of measuring leverage is defined as ‘total balance

 Through the AIFMD directive, including the right to intervene in case leverage buildup is representing a financial stability risk. 179  The IOSCO issued general guidelines regarding the reporting of exposures in IOSCO, (2016), Implementation Report: G20/FSB Recommendations related to Securities Markets, FR11/2016, October. 180  Often these measures are built on the FSB’s framework, see FSB, (2015), Transforming Shadow Banking into Resilient Market-Based Finance. Regulatory Framework for Haircuts on Noncentrally Cleared Securities Financing Transactions, November 12, which was extensively discussed elsewhere in this book. 181  In Europe this is implemented through CRD IV and in the US through section 619 of the Dodd-Frank Act (known as the Volcker Rule). See for the BCBS guidance in this matter: BCBS, (2013), Capital Requirements for Bank’s Equity Investments in Funds, December. 182  See, for example, the responses of the GARP (Global Association of Risk Professionals) and the combined MFA (Managed Funds Association)/AIMA (Alternative Investment Management Association) to the asset management report in the shadow banking and financial stability context (via fsb.org), both dated 21 September 2016. 178

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sheet assets/NAV’ known as the on-balance sheet leverage. This measurement ignores the synthetic leverage from derivative transactions or off-balance sheet exposures. Variations to these measurements take into account the netting and hedging effects and evaluate their impact on the net exposure of the fund in leverage terms. The real underlying problem is not the different measurements, because they can be made consistent, but the fact that jurisdictions often allow different ways of measuring or even liberty to determine which measurement to use.183 Getting a better view of the true nature and size of leverage within a fund, segment of the fund industry or the industry as such should be a priority.184 But the overall understanding of these risk measures is that even combined the exiting ratio and different ways of measuring pose limitations as to what the real exposure is of a specific fund or segment. It would help if the supervisor or regulator would engage in the development of more holistic measures in this matter.185 Those holistic measures should include the following items: • Synthetic leverage from the use of derivatives, and in particular the risk of those exposures changing in the future taking into account the product-specific characteristics. • The netting and hedging assumptions that underpin leverage risk of underestimation in terms of distress. • Directionality of positions: long/short that might produce asymmetric payment obligations. • Better modeling of risk and spreads: sometimes simpler is better (less granular or less inputs) and realistic sensitivity analysis. 3. Operational risk within asset management firms Some of these operational risks might be common for financial institutions such as cybersecurity, while others are fund industry specific such as mandate transfers. Most of these operational risks have little potential to be so severe that they can cause financial instability risk or create contagion through the market channels.186 However, there is the concern that some of these risks can become a stability threat in case they would materialize during periods of market stress. Loss of confidence in fund happens overnight, leveraged funds

 Dunne and Shaw relate fund-specific characteristics, such as leverage or usage of derivatives, to funds’ exposure to a tail event in the fund sector (Marginal Expected Shortfall): see P. Dunne and F. Shaw, (2017), Investment Fund Risk: The Tale in the Tails. Working Paper Nr. 01/RT/17, Bank of Ireland, January. 184  See, for example, the IOSCO reporting measurements on the hedge fund industry including in recent years items such as leverage and liquidity management: see IOCO, (2017), Report on the Fourth IOSCO Hedge Funds Survey, Final Report, FR22/2017, November. 185  The FSB mandated IOSCO in this respect: see FSB, (2017), Policy Recommendations to Address Structural Vulnerabilities from Asset Management Activities, January 12, p. 27. 186  P. Glasserman and H. Young, (2015), How Likely Is Contagion in Financial Networks? Journal of Banking and Finance, Vol. 50, pp. 383–399; P. Glasserman and H. Young, (2016), Contagion in Financial Networks. Journal of Economic Literature, Vol. 54, Issue 3, pp. 779–831. 183

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have a proven track record of being very sensitive to market conditions, and loss of r­ eputation happens while we speak (and spreads easily across fund segments of different funds managed by the same firm). A combination of operational challenges, protracted periods of distress in the market and redemption clauses might lead to financial stability issues. Another area where operational issues might play a role is in case the fund provides services to other parties (price discovery, IT, etc.). In case the distress is very severe, the fund might feel the need to transfer client accounts to others leading to the termination of contracts (counterparties reserve the right to unilaterally terminate in case client accounts are transferred), particularly in case of over-the-­counter (OTC) derivatives, which are hard to renegotiate under distress market conditions. Replacing other critical services might prove to be equally challenging. This could include pricing, valuation and portfolio services, managing and executing orders, managing platforms, custodial and securities lending services and so on. Last but not the least, there are the legal and regulatory hurdles associated with transferring client accounts.187 In some jurisdictions, the regulator has imposed requirements for asset managers to install appropriate risk management processes and limits. Those models are often stress tested to reflect behavior under adverse market condition. Other existing obligations imposed on asset managers include having business continuity plans (BCPs) available, obliging the asset manager to have a side picket of capital on their balance sheet to cover the costs associated with handling operational risks, forcing funds to use custodians for clients assets (which helps in case of client mandate being transferred). Moreover, in general supervisory bodies might have tools in place to ex ante detect operational risks of all sorts, the central clearing of standardized OTC derivatives also helps in case client mandates are being transferred (although the central counterparty [CCP] sets its own rules in this respect), and the transition managers help to move portfolio between firms. Luckily enough, we have a history where these issues have not really materialized in a way for them to become a threat to financial stability. Part of it is that this is likely to occur only when operational risks and market stress occur simultaneously. It is clear that the real issues here are not only ex ante identifying risks, but primarily having BCPs available and transitions plans to enable orderly transfer of their clients’ accounts and investment mandates in stressed conditions. Ideally and not to realize overkill, these obligations would have to take into account or would be commensurate with the level of risks (depending on their funds’ strategies, asset exposures and organizational design) that the asset managers’ activities pose to the financial system. 4. Securities lending services provided by asset managers and funds188 Funds are often involved in security-lending activities as the beneficial owner of securities being lent. The actual lending occurs through agents (often custodian banks). On the other hand, some funds (mainly hedge funds) act as borrowers of securities, in most cases

 These obligations might include ‘registration, account openings at foreign depositories, reporting to investors, authorization by the relevant authority, reconciling valuations, and capturing outstanding receivables such as interest claims’; see FSB, (2017), ibid., p. 31. 188  See in detail: FSB, (2017), ibid., pp. 35–38. 187

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to cover short positions.189 Another position possible, but which occurs hardly in practice, is that asset managers act as agent lenders who provide insurance-like commitments (indemnification) to their clients and, as such, insulate their clients from potential losses when a counterparty default or cannot return borrowed securities. The risks associated with securities lending had been extensively discussed in the FSB’s 2013 report ‘Strengthening Oversight and Regulation of Shadow Banking. Policy Framework for Addressing Shadow Banking Risks in Securities Lending and Repos’. It has been discussed in the context of this book and so no need to reiterate here.190 Financial intermediaries also often provide guarantees that resemble out-of-the-money put options, exposing them to tail risk.191 The exiting regulatory, supervisory and risk management practices have been mapped before192 and show that practices vary across jurisdictions. Consistent implementation of

 See for actual data on who does what and for how much volume the data provided at regular intervals by the International Securities Lending Association (ISLA) through their monthly market reports (via www.isla.co.uk); also see the Securities Lending Data Collection Pilot Project of the Office of Financial Research (OFR) in partnership with the Federal Reserve and Securities and Exchange Commission (via financialresearch.gov). 190  In short, the risks boil down to ‘maturity/liquidity transformation and leverage associated with cash collateral reinvestment, procyclicality associated with securities financing transactions, risk of a fire sale of collateral securities, and inadequate collateral valuation practices’; FSB, (2017), Policy Recommendations to Address Structural Vulnerabilities from Asset Management Activities, January 12, p. 35. The agent lender indemnification risk can be added to that list as the absence of guarantee provided could lead to impairments, withdrawals and force borrowers to exit their positions affecting volatility, liquidity and price formation. It could also widespread and affect the ability of other agents to meet their indemnification commitments. Some of the risks associated with indemnification are similar to beneficial owner risks (counterparty, collateral value), others are novel and unaddressed by current practices and oversight: (1) asset managers in contrast to agent lender banks are not subject to Basel III rules and therefore often do not have a balance sheet large enough to absorb potential losses. That is in particular relevant as the AUM are often disproportionately large with their balance sheets; and (2) there is a certain opacity risk associated with indemnifications. It is often unknown what the maturity profile of these contingent liabilities is at asset managers. There is a whole set of tools that could help in this respect (p. 36). Forcing to reinsurance those indemnification risks could be on the table. It would not make the risk go away but shift it away from the asset manager’s balance sheet into a more regulated environment adequate for those risks. Given the different regulatory systems for agent lending activities a material risk of regulatory arbitrage exists. Systemic risk then would occur in case the value of the indemnification received is questioned leading to withdrawals squeezed short positions and collateral value erosion. Agent lender indemnification practices are very limited at this stage, and thus this risk is for the moment rather theoretical. 191  See for the technical study on the matter: A. Ellul et al., (2018), Insurers as Asset Managers and Systemic Risk, ESRB Working Paper Nr. 75, May. They present a model in which variable annuity (VA) guarantees and associated hedging operate within the regulatory capital framework to create incentives for insurers to overweight illiquid bonds (‘reach-for-yield’). We then calibrate the model to insurer-level data and show that the VA writing insurers’ collective allocation to illiquid bonds exacerbates system-wide fire sales in the event of negative asset shocks, plausibly erasing up to 20–70% of insurers’ equity capital. 192  FSB, (2012), Securities Lending and Repos: Market Overview and Financial Stability Issues, Interim Report of the FSB Workstream on Securities Lending and Repos, April 27. 189

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best practices has been promoted by the FSB since 2013.193 The same holds true for internal risk management tools at firms.194 There is a variety of research out there that doesn’t fit the qualification and segregation of issues and sources of vulnerability as depicted above. Danielsson and Zigrand195 advocate focusing on funds’ negative externalities in order to gauge their impact on financial instability. The externality stems from the price impacts generated by the asset liquidations of leveraged asset managers, which affect the market value of other investors’ portfolios.196 Fricke and Fricke conclude—based on data of US mutual funds—that the funds’ aggregate vulnerability according to this propagation mechanism is generally small and its time dynamics strongly depend on the choice of price impact parameters. In their model, systemic risks can arise due to significant overlap in funds’ investment portfolios, coupled with illiquid asset markets and additional funding shocks driven by outflows due to past negative performances.197

7.7.5  T  he Involvement of Pension Funds, Sovereign Wealth Funds and ETFs198 Pension funds tend to be categorized as ‘defined benefit’ or ‘defined contribution’. The former yielding a certain guaranteed end result. In case the accumulated wealth and investment income is not sufficient, the employer funds the gap. In the latter case, the exposure in terms of end result is absorbed by the participant to the plan. Given the nature of a typical participant’s career, their investment horizon is long term. Liquidity transformation and use of leverage is close to non-existing. Their stability risks are therefore minimal unless in defined contribution plans the ability to switch plans by participants is allowed on very short notice. The sudden withdrawal(s) also face investments in illiquid assets given the long-term investment horizon. Understanding of the portfolio

 FSB, (2013), Strengthening Oversight and Regulation of Shadow Banking. Policy Framework for Addressing Shadow Banking Risks in Securities Lending and Repos, August 29; and FSB, (2015), Transforming Shadow Banking into Resilient Market-Based Finance. Regulatory Framework for Haircuts on Non-Centrally Cleared Securities Financing Transactions, November 12. 194  Such tools include ‘stringent counterparty selection processes, collateral standards and haircuts, daily mark-to-market valuation, concentration limits, limits on the fraction of the portfolio lent at any one time, and periodic counterparty credit evaluations’. FSB, (2017), Policy Recommendations to Address Structural Vulnerabilities from Asset Management Activities, January 12, p. 36. 195  J.  Danielsson and J.P.  Zigrand, (2015), Are Asset Managers Systemically Important?, Voxeu. org – Opinion Piece, August 05. 196  M.  Getmansky et  al., (2016), Portfolio Similarity and Asset Liquidation in the Insurance Industry, Working Paper, April 15, mimeo. 197  C. Fricke and D. Fricke, (2017), Vulnerable Asset Management? The Case of Mutual Funds, Deutsche Bundesbank Discussion Paper, Nr. 32/2017. They expand existing models (the abovementioned Danielsson and Zigrand model) by including the well-documented flow-performance relationship, which means that negative returns will be followed by additional outflows. 198  See in detail: FSB, (2017), ibid., pp. 43–47. L.C. Backer, (2016), Regulating Financial Markets: What We Might Learn From Sovereign Wealth Funds in Reshaping Markets. Economic Governance, the Global Financial Crisis and Liberal Utopia, (eds. B. Lomfeld, A. Somma and P. Zumbansen) in Cambridge University Press, Cambridge, pp. 229–254. 193

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mix and understanding the portfolio rebalancing mechanisms after withdrawals occurred need to be understood. Within the category ‘defined benefit’, the risk in a low interest rate environment is a search for yield that forces the fund to branch out into illiquid assets or segments of the market that can easily turn illiquid under stress. It can lead to illiquidity positions and unexpected losses incommensurate with the funds strategy. For those funds that can leverage their positions (directly or through alternative assets) within the context of liability-driven investment strategies or just for ‘yield’ might pose risks, knowing that also in the pension industry there is a high concentration of assets within a limited number of pension plan providers.199 These same ‘defined benefit’ plans often turn to derivatives to improve return, obtain synthetic exposures or hedge risks.200 Sovereign wealth funds (SWFs) are special purpose funds initiated by certain governments to manage and invest the excess liquidity from the budget and/or the revenues derived by the state through commodity mining and so on. They operate across asset classes along the lines of certain financial objectives. The SWF market is smaller than the asset management market, but some of these funds are true juggernauts and the market is very concentrated.201 They have agreed to a set of 24 best practices known as the Santiago principles.202 In recent times, they have become investors in financial institutions as well as more illiquid alternative assets. Some mandates are to manage wealth, while others have a stability or development mandate required to address the underlying sovereign’s fiscal budget deficits. In case this could lead to sudden withdrawals, liquidity issues might occur. The use of leverage at SWFs is limited but often not regulated or restricted. The governance at SWFs in general is varying in nature and intensity and could hide a variety of issues.203 Further concerns have been ventilated with respect to liquidity transformation exposures at the level of exchange-traded funds. Given the explosive growth of the industry,204 further analysis was required. They are, in principle, open-ended investment schemes that

 See, for example, the annual Willis Towers and Watson list of largest pension funds in the world (via www.willistowerswatson.com). Also: I. Ben-David et al., (2015), The Granular Nature of Large Institutional Investors, Fisher College of Business Working Paper Nr. 2015-03-09. The same is often true for investing in unicorns by mutual funds, who then essentially act as venture capitalists. This is increasingly true as most assets are concentrated in the hands of a handful of asset managers. Large funds and those with stable funding, conclude Chernenko et al. See S. Chernenko et al., (2017), Mutual Funds as Venture Capitalists? Evidence from Unicorns, NBER Working Paper Nr. 23,981, October. 200  Longevity risk (i.e. the risk that plan beneficiaries live longer than expected) is the best-known risk in this respect: see BCBS, (2013), Longevity Risk Transfer Markets: Market Structure, Growth Drivers and Impediments, and Potential Risks, December. 201  The top decile of the funds manages 85% or so of the assets; see for actual data www.sfwinstitute.org 202  See www.iwg-wsf.org for details. 203  See, for example, S.E. Stone and E.M. Truman, (2016), Uneven Progress on Sovereign Wealth Fund Transparency and Accountability, Policy Brief 16–18, October. 204  See for actual data: www.etfgi.com, the industry website for research and consultancy of the ETF and Exchange-traded products (ETP) industry. 199

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trade like an equity security on the secondary market (i.e. through an exchange). Now, in contrast to individual securities where the owner can buy and sell at any given point in time, individual shares of ETFs can only be redeemed at net asset value (NAV) by authorized participants which mainly are financial institutions. Most of the time, they can only do so in blocks (creation units) of shares (often a predetermined set of securities or other assets).205 Now the redemptions occur on an in-kind basis and so the transaction costs associated with the transaction are imposed on redeeming shareholders rather than the fund and/or remaining shareholders. This should avoid similar liquidity issues as openended funds. However, in many cases additional fees are charged for cash redemptions. The ETF should carry a market price close to the value of the underlying assets, which enables participants to realize profits from nay premiums or discounts between the intraday price and the NAV of the ETF. This mechanism might come to a halt or be dysfunctional in case of market stress.206 Now APs are not obligated to trade, redeem or create ETF shares unless they consider doing so in the best interest of the AP. This impacts the ability to trade at reasonable discounts. In case of extreme market stress, a hypothetical scenario is imaginable where no AP is engaging, leading to ETF which operates as closeend funds. There would be no liquidity transformation or other financial stability risk, but discounts or premiums would deepen, which in turn would affect proper hedging of positions and pricing of securities linked to the ETF.  In those cases, the European

 See for details on ETFs and their modus operandi: IOSCO, (2013), Principles for the Regulation of Exchange Traded Funds Final Report, FR06/13, June. Given the explosive growth in terms of AUM, the opacity of new and more complex products, it was a matter of time before the industry would draw more scrutiny: see FT, (2017), $4tn Exchange Traded Fund Industry Draws More Scrutiny, FTfm, May 26. And like clockwork, half a year later IOSCO announced a further investigation into certain liquidity risk regarding a set of the product group: C. Flood, (2017), Global Regulatory Body to Launch Fresh Probe into ETFs, Financial Times, December, 2. IOSCO reported early 2018 on the—already discussed final—principles regarding the liquidity risks into open-ended mutual funds and ETFs: IOSCO, (2018), Recommendations for Liquidity Risk Management for Collective Investment Schemes Final Report, FR01/2018, February. This further question remained if and to what degree serious market distortions might occur as a result of the growth of ETFs and the impact on liquidity and valuations. The concern is that the use of ETFs could lead to market disruptions if large volumes of investors rushed for the exit during times of stress. The prime question is whether ETFs are leading to changes in market structure that could lead to misallocation of capital across different sectors in the financial space. Because of the fact that the ETF space is now occupied with such a diversified set of products, this due diligence might be suboptimal at this stage. Consequently, the question is: ‘[a]re we losing sight of fundamentals and valuation measures such as price earnings ratios because of the automatic nature of [capital] allocations by market capitalization-weighted ETFs?’ (Mr. Andrews, Secretary-General at IOSCO) in C. Flood, (2018), ibid. The role of authorized participants needs to become more transparent and formalized, although overkill is a recurring risk. For example, in Europe ETFs fall under the general fund rules (UCITS ETFs) and so coverage is guaranteed. 206  Some markets have rules that constrain the fluctuations of an ETF in a range above or below an estimate of their NAV (‘indicative NAV’ or ‘iNAV’) and therefore limit the risks of the ETF trading at significant premiums or discounts to its iNAV: FSB, (2017), Policy Recommendations to Address Structural Vulnerabilities from Asset Management Activities, January 12, p. 46. 205

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r­ egulator foresees in those cases (if the stock exchange value of the units or shares significantly varies from their NAV) the ability for investors to sell the units or shares acquired in that ETF directly back to the ETF.207

7.7.6  R  egional- and Country-Specific Reporting Regarding Asset Management Activities Within the Shadow Banking Sphere Country-specific reporting on the interlinkage between asset management and shadow banking is only gradually emerging after the 2014–2016 period in which only consolidated or regional analysis or data sets were available. Some research focused on marketbased finance as such,208 and some focused on investment funds within the shadow banking space but with a regional focus.209 Regional reporting in the matter often focuses on longer-term trends and observes a variety of risks such as the risk of fund outflows and the swift growth of AUM in the OFI sector. An observation common for these regional reports is that their analysis, communication and conclusions often, given a certain variety in terms of facts, are very similar and read like a carbon copy of each other’s reporting. The need to look beyond the known financial investment horizon is structural and, in particular, our understanding of the different layers of a financial system, and how they interact needs to be enhanced so that our understanding of the topics that matter can advance.210

 See in detail: ESMA, (2014), Guidelines for Competent Authorities and UCITS Management Companies, ESMA/2014/937EN, August 1. 208  For example, M. Aquilina and W. Kraus, (2016), Market-Based Finance: Its Contribution and Emerging Issues, FCA Occasional Working Paper Nr. 18, May (via fca.org.uk). 209  N.  Doyle et  al., (2016), Shadow Banking in the Eurozone: Risks and Vulnerabilities in the Investment Fund Sector, Occasional Paper Series Nr. 174, June; G30, (2016), Shadow Banking and Capital Markets. Risks and Opportunities, Group of Thirty Working Paper, November. 210  See, for example, for an interesting exercise: R.  Bookstaber and D.Y.  Kenett, (2016), Looking Deeper, Seeing More: A Multilayer Map of the Financial System, OFR Brief Series 16-6, July 14. They produce a three-layered map representing short-term funding, assets and collateral flows. Risk is transformed and moves from one layer of the map to the next through transactions among large market players. Not only potential vulnerabilities are identified but, more importantly, the different (possible) path of contagion are examined. They indicate that ‘It can help in examining risks that are layer-specific, such as funding liquidity and leverage, collateral behind secured lending, and asset prices and liquidity. A multilayer map exposes new sources of vulnerability from dependency and interconnectivity across layers. Such connections can amplify and transform vulnerabilities into broader, systemic risks. A single-layer map cannot fully capture the array of activities in the financial system, or how different nodes are affected by shocks or disruptions. Risk is transformed as it moves from one layer of the map to the next’ (p. 10). Later on, this was complemented with a model coordinating the flow of information in the economy and how information spreads in networks. That is relevant as people with more and more accurate information tend to remain in the network longer. Highly connected networks where accurate information is readily available to participants can transform in ones with few connection and inaccurate information. Their results show and suggest that the information aggregation function of markets can fail solely because of the dynamics of information flows, irrespective of shocks or news: see P. Monin and R. Bookstaber, (2017), Information Flows, the Accuracy of Opinion, 207

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Often reports also contradict covering similar periods and/or regions or use language and terminology that don’t allow for meaningful interpretation and/or steering.211 The EU from its end concluded this a particular risk; so, beyond the typical maturity, liquidity212 and leverage risk, there is the risk of fund outflows and the possible negative impacts on the wider financial system that might pose a particular financial stability risk against a background of its growing involvement in capital markets, its use of synthetic leverage, and the inherent and growing maturity and liquidity mismatch arising from the demandable nature of fund share investments.213 The same holds true for solvency risk, even in equity funds, where the redeemable nature of fund shares might go well with the leverage-like risks. The callable nature of equity funds is misleading in the face of a leveraged portfolio. Within the EU there is further a concern that the concentration of many AUM with only a few asset managers214 and the fact that there is a concentration of AUM in funds with similar investment strategies across different systemic asset managers might be destabilizing over time.215 It is the combination of size, range of funds managed and the representation in different market segments that through investment, portfolio allocation or rebalancing decisions impact market developments in both normal and stressed conditions.216 And even in redemption, calls can be met, and investment fund managers might be tempted and/or required to sell off assets, either because they want to rebalance portfolios, anticipate future outflows or face constraints related to internal investment

and Crashes in a Dynamic Network, OFR Staff Discussion Paper Nr. 17-01, March 2. Hedge funds among institutional investors seem best equipped to exploit the information acquisition process: N.  Swem, (2017), Information in Financial Markets: Who gets It First?, Finance and Economics Discussion Series Nr. 23, Washington: Board of Governors of the Federal Reserve System, February. 211  Personally, I’m a fan of the Annual Financial Stability Reports produced by the OFR and their communication style: see in recent years, for example, OFR, (2018), Financial Stability Report 2017, (via financialresearch.gov) and in particular: Market Risks Remain Elevated (pp.  32 ff.), Vulnerabilities Remain in Funding and Liquidity (pp. 42 ff.) and Contagion Risk Signals Are Mixed (pp. 44 ff.). See also T. Adrian et al., (2017), Market Liquidity After the Financial Crisis, Annual Review of Financial Economics, Vol. 9, Nr. 1, pp. 43–89; M. Anderson et al., (2017), Is Post-crisis Bond Liquidity Lower?, National Bureau of Economic Research Working Paper Nr. 23,317. 212  The growing liquidity mismatch is clearly a growing concern within the investment fund sector. Open-ended funds tend to create the illusion of stable liquidity by promising daily callable claims to purchase assets. The reality is that many assets may not be very liquid in a period of market repricing or distress. On the contrary, and despite those daily redemption facilities, cash buffers and shares of liquid and short-term assets have been falling (N. Doyle et al., [2016] infra), increasing the risk of an adverse liquidity spiral. 213  N.  Doyle et  al., (2016), Shadow Banking in the Euro Area: Risks and Vulnerabilities in the Investment Fund Sector, ECB Working Paper Nr. 174, June, pp. 23–29. 214  N. Doyle et al., (2016), ibid., pp. 20–22. 215  A similar observation in the insurance industry and associated fire sale risk. See W.  Wu and X.  Zhou, (2017), Investment Commonality Across Insurance Companies: Fire Sale Risk and Corporate Yield Spreads, Finance and Economics Discussion Series Nr. 69, Washington: Board of Governors of the Federal Reserve System. 216  N. Doyle et al., (2016), ibid., p. 4. See for an overview of the material heterogeneity across funds types (pp. 15–16.

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policies or regulatory dynamics that force them to sell assets when their market value is falling. Doyle et  al. conclude: ‘[s]ell-off pressures can thus be aggravated by outflows, although they may not necessarily be caused by them. Herding among fund managers and the unwinding of crowded trades is of particular concern in this context.’217 Doyle et al. also spent time on reflection regarding the questions about the exact nature of the involvement of investment funds in liquidity spirals. The response of investment funds when assets reprice in the market runs as discussed along the line of the solvency or liquidity channel. Although two distinct channels, they often emerge in parallel.218 Liquidity spirals can occur, as indicated above, both in fixed-income as well as equity (open-ended)219 funds. The latter even without the implication of leverage. The nature of the solvency risk might however change. Liquidity spirals can however also occur due to externalities (haircuts or rise in margin requirements) forcing fund to repo, swap or sell assets to meet those externalities, which in turn might lead to forced sales, asset price declines leading to a downward spiral.220 The question regarding the role of investment funds in creating, triggering or facilitating fire sales was already extensively discussed before.221 Chernenko and Sunderam draw four conclusions based on their mutual fund fire-sale analysis: (1) high internalization funds (those that internalize the externality caused by a fire sale) use their cash buffers more aggressively to accommodate flows; (2) when a stock is held by high internalization funds, its realized volatility is lower later on (e.g. the next quarter); (3) flows into high internalization funds exert a smaller spillover effect on the returns of other funds than flows into low internalization funds (relative to other funds that hold the same security)222; and (4) high internalization funds hold larger cash buffers.223

 N. Doyle et al., (2016), ibid., p. 18.  See also: ECB (2010), Towards Macro-Financial Models with Realistic Characterizations of Financial Instability, Special Feature in Financial Stability Review, December, pp. 138–146. 219  Securities and Exchange Commission, (2015), Open-End Fund Liquidity Risk Management Programs; Swing Pricing; Re-Opening of Comment Period for Investment Company Reporting Modernization Release, Release Nr. 33-9922, September 22; C. Weistroffer, and S. Steffen, (2015), The German Open-End Fund Crisis – A Valuation Problem?, Journal of Real Estate Finance and Economics, Vol. 50, Nr. 4, pp. 517–548. 220  See on this specific topic: BIS, (2010), The Role of Margin Requirements and Haircuts in Procyclicality, CGFS Paper Nr. 36, March. 221  See, for example, S. Chernenko and A. Sunderam, (2018), Do Fire Sales Create Externalities, NBER Working Paper Nr. 25,104, September. They conclude that there are meaningful fire sale externalities in the (equity) mutual fund industry. Also see E. Dávila, (2015), Dissecting Fire Sales Externalities, NYU Stern Working Paper, April, mimeo. 222  S. Chernenko and A. Sunderam, (2017), ibid., p. 3: ‘[s]pecifically, we show that when a given fund’s securities are held by other funds that internalize more of their price impact, the relationship between flows into these other funds and returns of the first fund is diminished.’ 223  See for an alternative study on the matter: C. Fricke and D. Fricke, (2017), Vulnerable Asset Management? The Case of Mutual Funds, Deutsche Bundesbank Discussion Paper Nr. 32, October 30. Their main finding is that mutual funds’ aggregate vulnerability to fire sales is relatively small compared to related studies on the banking sector. This suggests that systemic risks among mutual funds are unlikely to be a major concern, at least when looking at this part of the financial system 217 218

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The summary can be that all the protocols that investment funds have in place to ­ itigate liquidity stress might be valid: given there is a sufficient amount of liquidity m available at all times, the portfolio is sufficiently diversified to guarantee such liquidity and the liquidity can be withdrawn from the fund (or through an external credit line) to meet redemption calls in a way that guarantees continuous stable operations. Reality is not necessarily in line with these assumptions. In fact, liquidity buffers have fallen over time, illiquid investing has been on the rise,224 credit lines are not guaranteed during times of distress and this channel might become a channel of contagion in its own right.225 The run risk that normally embodies the asset liquidation cost as well as the cost associated with the inefficient pricing of daily callable fund shares226 now gets extended through external credit lines and price discovery asymmetries.227 Another aspect is that of the interconnectedness between funds and the banking sector. Also, between the banking and fund sector, channels of contagion (of shocks to asset prices) exist. Traditional banks tend to be connected in the money market fund industry through interbank claims. Exogenous liquidity shocks that occur in the MMF sphere easily create a fire sale spiral. Two elements are important in this context: first, rate setting in the interbank market occurs based on tâtonnement process and is therefore endogenously determined. Second, banks are subject to capital and liquidity regulations and see themselves forced to sell assets which impact the endogenously set market price. Declining market prices forces both parties to adjust their balance sheet and then consider further selling (or buying). This process under general market distress easily becomes a fire sale spiral. From that perspective one can argue that capital requirements are contagion intensifiers (in terms of both speed and extent), not only because of the forced buying or selling it triggers but also since the rule incentivizes banks to hold similar assets and portfolio compositions.228 Banks are constrained in their portfolio composition. The model that

in isolation. We explore the determinants of individual funds’ vulnerability to systemic asset liquidations, highlighting the importance of funds’ liquidity transformation. Liquidity transformation should therefore be central in any monitoring efforts. 224  Which creates the issue that a disproportional amount of liquid assets need to be sold to compensate for the illiquid assets held. 225  N.  Doyle et  al., (2016), Shadow Banking in the Euro Area: Risks and Vulnerabilities in the Investment Fund Sector, ECB Working Paper Nr. 174, June, pp. 18–19. ECB (2015), Financial Stability Review, May and November. 226  Consequently, different fund types might trigger a different combination and intensity of risks: real estate funds score high on both, whereas equity funds score low on both. Bond funds as well as hedge funds are a mixed bag and their scoring will typically depend on their investment strategies and internal protocols. 227  See on the individual issues: J.-B. Gossé, et al. (2015), Interconnectedness Between Banks and Market-Based Financing Entities in Luxembourg, Revue de Stabilité financière 2015, Banque centrale du Luxembourg, pp. 127–152; J.-B. Haquin, et al., (2015), Measuring the Shadow Banking System – a Focused Approach, ESMA Report on Trends, Risks and Vulnerabilities Nr. 2, pp. 34–38; X. Jin, et al., (2015), Investment Funds. Vulnerabilities: A Tail-Risk Dynamic CIMDO Approach, Banque Centrale du Luxembourg, Cahier d’études, Working Paper Nr. 95, July; T. Roncalli and G. Weiang, (2015), Asset Managers and Systemic Risk, Working Paper, May 26, mimeo. 228  Those capital and liquidity rules also determine the demand and supply of capital and thereby also impact the rate of return as set by the aforementioned tâtonnement process.

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emerges is one where banks and asset managers hold similar securities and banks ­additionally are linked through the interbanking network.229 Capital requirement for banks might then make bank balance sheets more resilient; they also make bank balance sheets look alike.230 Asset managers from their end absorb very little liquidity shocks (mostly when the shock is originating in the asset management sector) as they do not need to adjust their balance sheets but exacerbate contagion when liquidity buffers are fully utilized.231 Starting 2017, specific research started to emerge dealing with national analysis of asset management activities within the context of shadow banking. One of the first national studies was the Belgian study regarding asset management vulnerabilities.232 That investment fund market is traditional in nature and consists mainly of undertakings for collective investment in transferable securities (UCITS) and open-ended alternative investment funds (AIFs). In terms of vulnerabilities, liquidity risk is limited due to regulation imposing detailed asset eligibility rules which strongly mitigate exposures. Real estate, commodities, unlisted securities, loans and other alternative asset classes are, in principle, excluded as eligible assets for public open-ended investment funds.233 Swing pricing, antidilution levies and redemption gates are all protocols either in place or in the regulatory channel. In general, reports conclude that vulnerabilities within the investment fund

 Banks that hold mixed portfolios are those that engage in bank lending and hold (less liquid and/ or illiquid) securities (like asset managers). They are known as ferry banks as they meander between the bank and nonbank segment of the financial spectrum. They spread contagion to other banks in the interbank markets with similar characteristics (with mixed portfolios). Those that only hold liquid assets will use their liquidity to adjust. These banks are obviously crucial in spreading contagion between both segments of the financial market. When such a bank is faced with declining asset prices, it will start a withdrawal process in the interbank market (as that is where their liquidity buffer sits and is the easiest to adjust on short-term notice) leading to a fire sale in that segment simply to readjust their balance sheet. Asset managers then face less distress as they don’t face the same regulation to readjust their balance sheet when market prices adjust and therefore can use their liquidity buffers in a different (wiser) way. See in detail: S. Callmani et al., (2017), Simulating Fire-Sales in a Banking and Shadow Banking System, ESRB Working Paper Nr. 46, June. 230  Capital requirements force banks to hold less risky assets (i.e. interbank claims). This leads to excess supply of interbanking claims and drives down the risk-free rate of return in that segment, pp. 12, 20. 231  See in detail: S. Callmani et al., (2017), Simulating Fire-Sales in a Banking and Shadow Banking System, ESRB Working Paper Nr. 46, June, pp. 5 ff. See also: S. Morris et al., (2017), Redemption Risk and Cash Hoarding, BIS Working Paper Nr. 608, via bis.org. Cash hoarding seems to be the rule rather than the exception and is more severe when the fund holds a larger amount of the illiquid assets. 232  FSMA, (2017), Report on Asset Management and Shadow Banking, Report, September, via fsma.be 233  FSMA, (2017), ibid., p.  4. Also see: M.  Druant and S.  Cappoen, (2017), Belgian Shadow Banking Sector with a Focus on OFIs. Paper for the IFC-NBB Workshop ‘Data needs and statistics compilation for macroprudential analysis’, May 18–19; E. Wymeersch, (2017), Shadow Banking and Systemic Risk, Working Paper 2017/1, Financial Law Institute, March. 229

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s­ector are growing (but moderate)234 and links to the wider financial system and real economy have strengthened. Data limitations often constrain more detailed conclusions. The latter was also true regarding the question whether portfolio shifts of large institutional cash pools like asset managers respond procyclically to past returns, or countercyclically to valuations? This is an important question, if we can agree on the fact that market stabilization is both a public and a private good. In reality, portfolio changes typically appear procyclical. But we want more of the other (countercyclical and thus stabilizing investments). And thus the question is how long-term return chasing and financial stability should be married. Jones provides a framework build around five criteria: (1) embed governance practices to mitigate ‘multi-year return chasing’, that is, shifting portfolios in response to returns beyond the past 12 months; (2) rebalance to benchmarks with factor exposures best suited to long-term investors; (3) minimize principal-agent frictions; (4) calibrate risk management to minimize long-term shortfall risk (not short-term price volatility); and (5) ensure that regulatory conventions do not amplify procyclicality at the worst possible times.235

7.8 T  he Globalization of Banking and the Impact of the Financial Crisis The element of contagion has been discussed throughout the book. Not surprisingly though, a globalizing world, and an even faster globalizing banking sector, has been ways and levels of connectedness. Although in the early years after the crisis the level and rate of globalization seems to have slowed down and even retrenched for a certain while in terms of cross-border lending, there is only limited retrenchment in terms of foreign bank presence. But it is a bifurcated view: ‘while banks from OECD countries reduced their foreign presence (but still represent 89% of foreign bank assets, 5% less compared to before the financial crisis), those from emerging markets and developing countries expanded abroad and doubled their presence.’ ‘Lending by foreign banks locally grew more than cross-border bank claims did for the same home-host country combination.’236 Recent evidence demonstrates that global banking is not becoming more fragmented but is going through some237 structural transformations leading to a wider variety of players and a more regional focus.

 IMF, (2018), Belgium: Financial System Stability Assessment, IMF Country Report, Nr. 18/67, March 6, p. 10; NBB, (2017), Financial Stability Report, pp. 35–38 (2.4 the shadow banking sector and portfolio management). 235  See in detail: B.A. Jones, (2016), Institutionalizing Countercyclical Investment: A Framework for Long-term Asset Owners, IMF Working paper Nr. 16/38, February. 236  S. Claessens and N. van Horen, (2015), The Impact of the Global Financial Crisis on Banking Globalization’, DNB Working Paper Nr. 459, January. 237  See, for example, S. Adrianova et al., (2015), Why Do African Banks Lend so Little?, Oxford Bulletin of Economics and Statistics, Vol. 77, Issue 3, pp. 339–359. 234

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Claessens and van Horen demonstrate when examining the underlying drivers that ‘­countries hit by a systemic crisis at home are less represented abroad today and host countries growing slower saw their local foreign banks’ assets grow less’. ‘Conversely, entry was greater in host countries that were faster growing and closer to home.’ It stresses the growing importance of foreign banks coming from emerging markets and developing economies: ‘when we compare developments in foreign bank local lending to those in cross-border banking claims, we find that local lending declined less during the crisis than cross-border banking claims did, supportive evidence of the notion that foreign bank presence has been a relative source of stability.’238 The local lending has declined less as foreign emerging market banks stepped in with fairly solid balance sheets. Cross-border lending and foreign bank retrenchment after the crisis should have little correlation. The systematic transformation in advanced economies banking sector points at a further concentration of activities with a smaller number of banks. Capital flows have adjusted after the crisis and trigger and local economies have become more dependent on domestic or regional banking resources. Although foreign banks tend to help diversify risk, when a hot country is hit by a systemic shock, they also seem to be able to introduce instability as banks have the incentive to repatriate liquidity from their foreign affiliates when being in trouble at home. Why this notion on the transformation of the banking sector and the bifurcation between OECD and developing economies? The shadow banking sector is nascent in many emerging economies and even have been welcomed in recent years to supplement the local banking sector that provides limited credit to the local economy.239 However, given the regulatory vacuum these shadow banking institution in emerging economies are operational in (especially outside financial centers as Singapore or Hong Kong), and given the rapidly leveraging balance sheets of both the emerging market banking, corporate and shadow banking sector, caution is required with respect to their future endeavors and behaviors. The reporting on shadow banking in emerging economies and the FSB reports discussed tend to provide a too positive dynamic of shadow banking of these nascent economies. Besides the fact that it takes very little to destabilize their young economies and financial systems, competing in a global or regional market with these global behemoths also implies creating certain similarities to compete efficiently. Leverage is a critical component in this respect. Leverage has risen materially in both the traditional and shadow banking sector in recent years, a process that already started around the turn of the millennium. The only escape from that end is ‘Islamic finance’ that avoids the conventional fixed income dynamics on banks’ balance sheets and is still positively correlated with ‘real ­economic growth and financial inclusion’.240  S. Claessens and N. van Horen, (2015), The Impact of the Global Financial Crisis on Banking Globalization, DNB Working Paper Nr. 459, January, p. 3. 239  And it’s not all bad: there is, for many emerging economies a positive relation identified between credit expansion and real GDP growth in those countries; see: M. Garcia-Escribano and F. Han, (2015), Credit Expansion in Emerging Markets: Propeller of Growth, IMF Working Paper Nr. WP/15/212, September. The type of credit determines to a large degree the impact on GDP and through which channel (investment or consumption). 240  P.A. Imam and K. Kpodar, (2015), Is Islamic Finance Good for Growth, IMF Working Paper Nr. WP/15/81; A. Barajas and A. Massara, (2015), Can Islamic Banking Increase Financial Inclusion?, 238

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The additional leverage in the traditional and shadow banking sector often comes in through the interbanking market, which as we know is very vulnerable and has the potential to try up oversight in times of panic. This led us elsewhere in the manuscript to conclude that the SB market is inherently unstable without a public backstop. The interbanking markets leverages (shadow) bank balance sheets in no time and can blind-eye regulators and supervisors, as data aggregation by nature is backward looking. Acting on the granularity of data sought also means being structurally behind the curve. In case of the interbanking market as a critical element defining connectivity (and home to many shadow banking products and entities as MMFs and repos), once it destabilizes has material impact on the functioning of banks. To be more specific, ‘shocks in the securities and interbank markets have significant effects on loan rates and credit supply, particularly of banks in stressed countries’. ‘Lending to nonfinancial corporations is more sensitive to wholesale funding shocks than lending to households.241 Moreover, bank characteristics matter for monetary transmission: loan growth of large banks that are typically more dependent on wholesale funding and of banks with large exposure to government bonds shows relatively stronger responses to wholesale funding shocks.’ The central bank is then holding the bag242 in the end when banks adjust their balance sheets in various ways. Those banks tend to respond by ‘reducing maturity mismatches, switching to alternative sources of finance and by deleveraging’.243 Admittedly, the Basel III framework forces the liquidity coverage ratio (LCR) and net stable funding ratio (NSFR) on banks, but the framework is, besides being implemented over many years, not always fully implemented in many emerging economies. And there was a reason why Basel III and the liquidity regulation took so long to complete, and was negotiated and adjusted before being reissued. Bonner and Hilbers analyzed the history of liquidity regulation and wonder why it took so long for liquidity regulation to be tabled. They comment: ‘our analysis suggests that regulating capital is associated with declining liquidity buffers. The interaction of liquidity regulation and monetary policy as well as the view that regulating capital also addresses liquidity risks were important factors hampering harmonized liquidity regulation.’244 The question whether capital regulation was sufficient has been asked already long time ago245 and the response took too long. At

IMF Working Paper Nr. WP/15/31; M. Farooq and S. Zaheer, (2015), Are Islamic Banks More Resilient During Financial Panics?, IMF Working Paper Nr. WP/15/41. 241  L. de Haan et al., (2015), Lenders on the Storm of Wholesale Funding Shocks: Saved by the Central Bank?, DNB Working Paper Nr. 456, January. 242  ‘The Eurosystem has reacted to banks’ funding strains by various measures. Refinancing operations have been extended in terms of maturity, size and conditions. This enabled banks to obtain liquidity from the central bank at fixed rate at full allotment.’ Mooney, L. de Haan et al., (2015), ibid., p. 3. 243  L. de Haan et al., (2015), Lenders on the Storm of Wholesale Funding Shocks: Saved by the Central Bank?, DNB Working Paper Nr. 456, January, p. 2. 244  C. Bonner and P. Hilbers, (2015), Global Liquidity Regulation -Why Did It Take So Long?, DNB Working Paper Nr. 455, January. 245  T.F. Hellmann, et al. (2000), ‘Liberalization, Moral Hazard in Banking, and Prudential Regulation: Are Capital Requirements Enough?’ American Economic Review, Vol. 90, Issue 1, pp. 147–165.

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least one crisis too long. And even now that Basel III gradually is in place, questions are being asked whether it is sufficient to hold back on another financial meltdown.246 This question is being asked out loud now that we have entered a protracted period of unconventional monetary policies around the globe247 and the impact of the regulation enacted in recent years.248

7.9 S  hadow Banking and Contemporary Unconventional Monetary Policy 7.9.1  Introduction I have expanded on macroprudential policy on a number of occasions throughout the book and concluded in line with Claessens249hat ‘all-in-­all’ we have very little solid economic models backing those macroprudential policies and lack decent experience. They have been introduced as they were considered the right thing to do given the experiences and symptoms following the financial crisis, but have not been properly stress tested or modeled under a variety of factors. Also their interaction (on a global or a regional level) with fiscal and monetary policy as well as macroeconomic policies is at best ‘shabby’. But also when it comes to ‘efficiency and effectiveness’ of macroprudential policy tools, the literature and ‘knowledge base’ is in its infancy250 and has very little power to guide policymaking. Indeed, progress has been made somewhat in recent years on the ‘empirical side of the effect of some macroprudential tools on a range of target variables, such as quantities and prices of credit, asset prices, and on the amplitude of the financial cycle and financial stability’.251 But as always as things become over-researched in a too short space of time,

 R.  Banerjee and M.  Hio, (2014). The Impact of Liquidity Regulation on Bank Behaviour: Evidence from the UK. Mimeo. 247  U.  Bindseil and J.  Lamoot, (2011), The Basel III Framework for Liquidity Standards and Monetary Policy Implementation, SFB 649 Discussion Paper, 2011-041; C.  Bonner, and S.  Eijffinger, (2013), The Impact of Liquidity Regulation on Financial Intermediation, CEPR Discussion Paper, Nr. 9124. C. Bonner, et al., (2013), Banks’ Liquidity Buffers and the Role of Liquidity Regulation, DNB Working Paper Nr. 393. 248  L. De Haan, et al., (2013), Bank Liquidity, the Maturity Ladder, and Regulation. Journal of Banking and Finance, Vol. 37, Issue 10, pp.  3930–3950. M.  Kowalik, (2013), Basel Liquidity Regulation: Was It Improved with the 2013 Revisions? Economic Review, QII, pp. 65–87. 249  S. Claessens, (2014), An Overview of Macroprudential Policy Tools, IMF Working Papers Nr. WP/14/214, p. 8–11, 21–23. 250  Or to put it more diplomatically: ‘the literature on macroprudential policy has looked at a wide range of possible tools without a primary instrument emerging. It has only recently been converging toward a common understanding of its perimeter and a common taxonomy of instruments’; see G. Galati and R. Moessner, (2014), What Do We Know About the Effects of Macroprudential Policy?, DNB Working Paper Nr. 440, September, p. 3. 251  See for the current state of affairs and summary of the current ‘knowledge base’: G. Galati and R.  Moessner, (2014), What Do We Know About the Effects of Macroprudential Policy?, DNB Working Paper Nr. 440, September. 246

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results point into a variety of directions, creating more confusion than anything else, rather than provide robust guidance within the understanding of the natural limitations of the value economic modeling can bring.252 It is best to spend some time on the analysis and the future of macroprudential instruments.

7.9.2  Macroprudential Instruments and Shadow Banking The first aspect of confusion often deals with the demarcation line between macroprudential instruments (MPIs) and traditional microprudential instruments (MIPI). These groups differ in terms of their objectives regarding the nature of risk.253 The former aims at enhancing the safety and soundness of individual financial institutions. The latter instead focuses on the stability of the financial system as a whole, with a view to limiting macroeconomic costs from financial distress.254 Another aspect is the viewpoint regarding ‘systemic risk’. Or to be precise, ‘risk is taken as exogenous under the microprudential perspective, while the macroprudential perspective emphasizes the endogenous nature of systemic risk. Macroprudential policy therefore focuses on the procyclical behavior of the financial system, and the interconnectedness of individual financial institutions and markets, as well as their common exposure to economic risk factors.’255 MPIs are seen as distinct from monetary tools, macroeconomic tools, fiscal policy and so on, although a blend often is required to address systemic risk in all its complexity. Traditionally and in line with the IMF256

 The question has been asked what the international and global spillovers are and will be of the unconventional monetary policy as we have witnessed in the US in recent years and more recently also in Europe. See: Q. Chen et al., (2015), Financial Crisis, US Unconventional Monetary Policy and International Spillovers, IMF Working Paper Nr. WP/15/85, April. They study the impact of the US quantitative easing (QE) on both the emerging and advanced economies. They focus on the effects of reductions in the US term and corporate spreads. First, US QE measures reducing the US corporate spread appear to be more important than lowering the US term spread. Second, US QE measures might have prevented episodes of prolonged recession and deflation in the advanced economies. Third, the estimated effects on the emerging economies have been diverse but often larger than those recorded in the US and other advanced economies. The heterogeneous effects from US QE measures indicate unevenly distributed benefits and costs. Obviously, although meticulous from an academic perspective, they contribute very little to our ability to apply these macroprudential tools in a more effective and chirurgical precise way. 253  C. Borio, et al., (2001), Procyclicality of the Financial System and Financial Stability: Issues and Policy Options. In Marrying the Macro- and Micro-Prudential Dimensions of Financial Stability. BIS Papers, Nr. 1, March, pp. 1–57. See for a more extensive analysis of the demarcation lines and interactions between the different policy fields: S.  Claessens, (2014), An Overview of Macroprudential Policy Tools, IMF Working Paper Nr. WP/14/214, pp. 8–12. For more in general, see: D. Schoenmaker (ed.), (2014), Macro-prudentialism, VoxEU E-Book, London. 254  A.  Crockett, A. (2000) Marrying the Micro- and Macro-Prudential Dimensions of Financial Stability. Remarks Before the Eleventh International Conference of Banking Supervisors. Bank for International Settlements. Basel, 20–21 September 2000. 255  G. Galati and R. Moessner, (2014), What Do We Know About the Effects of Macroprudential Policy?, DNB Working Paper Nr. 440, September, p. 2. 256  IMF, (2011), Macroprudential Policy: An Organizing Framework. Prepared by the Monetary and Capital Markets Department. 252

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methodology as set out in 2011, there are two types of MPIs: (1) those that mitigate ­systemic risk, for example, countercyclical capital buffers, (2) those instruments adjusted to become macroprudential instruments.257 Nevertheless the demarcation lines stay blurred. Apparently the strict criteria for inclusion are that they should be ‘geared towards systemic risk and are underpinned by strict governance arrangements’.258 Also those elements that one way or the other are geared toward ‘strengthening the resilience of the infrastructure of the financial system’ are now included.259 This creates one list of tools that can be categorized based on the nature of the systemic risk they address.260 The nature of systemic risk can be separated into three large categories: (1) those that focus on the time dimension, for example, credit, leverage and asset price bubbles, (2) those that address liquidity and market risk, and (3) those that (try to) address the vulnerabilities in and derived from the market structure, for example, size, interconnectedness and position. An alternative evaluation of the MPI sphere would be to do so from the perspective of ‘market failures’, as I largely did in the chapter on Pigovian applications in the financial industry. Market failures are then considered to produce ‘systemic risk’.261 Hanson applies this position vis-à-vis macroprudential dynamics of capital regulation which are then seen as an effort to control the cost to society of excessive balance sheet expansion and leverage. In case market failures are the focal point, the categorization will occur, the lines of which externalities are produced.262 De Nicolò et al. produced their chart in 2012, which already at that point in time referred to taxation and Pigovian surcharges as an important feature.263 In 2014, Borchgrevink et al.264 created their own chart of externalities and identify six categories of market failures that give rise to macroprudential concerns: (1) pecuniary externalities, (2) interconnectedness externalities, (3) strategic complementarities, (4) aggregate demand externalities, (5) market for lemons and (6) deviations from full rationality. They conclude that ‘because of the diversity of these categories, policy  Time-varying loan-to-value (LTV), loan-to-income (LTI) or debt-to-income (DTI) ratios belong to this category. 258  IMF, (2011), Macroprudential Policy: An Organizing Framework, Background Paper, Prepared by the Monetary and Capital Markets Department. 259  D. Schoenmaker and P. Wierts, (2011), Macroprudential Policy: The Need for a Coherent Policy Framework. DSF Policy Paper, Nr. 13. 260  See, for example, G. Galati and R. Moessner, (2014), What Do We Know About the Effects of Macroprudential Policy?, DNB Working Paper Nr. 440, September, p.4, Table 1. Other categorizations are possible based on rule versus discretion, quantity versus price and those that are predominantly used in emerging economies. Galati and Moessner, (2014), ibid., p. 3 footnote 1 for literature references. 261  G. De Nicolò, et al., (2012), Externalities and Macroprudential Policy, IMF staff discussion note Nr. WP/12/05. S. Hanson, et al., (2011), A Macroprudential Approach to Financial Regulation, Journal of Economic Perspectives, Vol. 25, Issue 1, pp. 3–28. 262  See for a summary: G. De Nicolò, et al., (2012), ibid., p. 11. 263  That position of more focus on tax instruments and Pigovian instruments in particular can be found back in: S. Claessens, (2014), An Overview of Macroprudential Policy Tools, IMF Working Paper Nr. WP/14/214, pp. 13–15. 264  H. Borchgrevink et al., (2014), Macroprudential Regulation – What, Why and How?, Norges Bank Staff Memo Nr. 13, pp. 4–8. 257

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lessons diverge. There is yet no “workhorse” model for policy analysis’, but also that ­certain lesson can be learned despite the wide variety of theoretical models and externalities identified. ‘First, the intensity of capital and liquidity regulation of banks should also depend on aggregate measures of risk in the financial system. Second, excessive borrowing should be curbed by a time-varying policy inducing borrowers to internalize the increased risk of a costly deleveraging process in the economy.’ Macroprudential tools have regained footage after the financial crisis and have been used and tested in a variety of circumstances outside the microprudential objectives sphere they were historically designed for and often used to influence supply of credit and growth and with an aim to stabilize the global economic and flow of capital.265 Most of these instruments have been redesigned to cater to the objective of strengthening the resilience of the domestic and international financial system. To that effect and on aggregate ‘[t]he most commonly used tools include measures to limit credit supply to specific sectors that are prone to excessive credit growth (e.g. caps on LTV ratios or debt/income ratios aimed at restricting mortgage lending), and limits on net open currency positions and measures to prevent the build-up of domestic imbalances arising from cross-border capital flows (for example via reserve requirements)’.266 The big difference is between preand the post-crisis situation in this context is that macroprudential tools before the crisis have not been used on a ‘system-wide level to banks’ balance sheets. These measures that target the size or the ‘composition of bank balance sheets – e.g. LTD ceilings, institutionspecific capital add-ons or time-varying capital charges – have gained in importance’.267 Although the transmission mechanism through which macroprudential policy (just like monetary policy) works is similar, for example, bank lending and balance sheet channels, and aims to modify the behavior of private agents, the effectiveness of the transmission channel for macroprudential policy is not well understood. They have been introduced post-crisis and therefore there is a lack of agreed modeling framework of the interaction between the financial system and the macroeconomy.268 This is partly due to the fact that macroprudential tools have been used in combination with other policies269  See for a historical review of experiences with macroprudential tools: G. Galati and R. Moessner, (2014), What Do We Know About the Effects of Macroprudential Policy?, DNB Working Paper Nr. 440, September, pp. 6–7. 266  : G. Galati and R. Moessner, (2014), What Do We Know About the Effects of Macroprudential Policy?, DNB Working Paper Nr. 440, September, p. 7. See for an overview of central banking experiences: Committee on the Global Financial System, (2010), Macroprudential instruments and frameworks: a stocktaking of issues and experiences. CGFS Papers Nr. 38, May; IMF, (2011), Macroprudential Policy: An Organizing Framework. Background Paper, Prepared by the Monetary and Capital Markets Department. IMF, (2011), Regional economic outlook Asia and the Pacific, April. 267  G. Galati and R. Moessner, (2014), What Do We Know About the Effects of Macroprudential Policy?, DNB Working Paper Nr. 440, September, p.  8. See also J.W.  Van den End, (2013), A Macroprudential Approach to Address Liquidity Risk with the Loan-to-Deposit Ratio, DNB Working Paper Nr. 372, March. 268  G. Galati, and R. Moessner, (2013), Macroprudential Policy – a Literature Review, Journal of Economic Surveys, Vol. 27, Nr. 5, pp. 846–878. 269  R.  Portes, (2014), Macro-Prudential Policy and Monetary Policy, in Macroprudentialsm (ed. D. Schoenmaker), VoxEU, London, pp. 47–59. 265

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and the fact that the macroprudential tools try to capture a moving target as ‘the transmission mechanism is likely to change over time as the result of changes in financial intermediation practices and in the structure of the financial system. In particular, there is uncertainty about how financial innovation, consolidation in the financial sector and changes in the balance between institution- and market-based credit affect systemic risk over time’, ‘but progress270 has been made in embedding macroprudential policy in different types of theoretical models. There is increasing empirical work on the effect of some macroprudential tools on a range of intermediate target variables, such as quantities and prices of credit, asset prices, output growth, and on the amplitude of the financial cycle.’271 This progress can be summarized as follows: • It helps explaining mechanisms through which real and financial factors interact, and how this interaction can generate systemic crises. • The models developed improved our understanding of the role of regulation in reducing the incidence of financial crises. • State-contingent taxes can play an important role in supporting financial stability. • Externalities that underpin endogenous systemic risk can be addressed by Pigovian taxes. • The credit-to-GDP gap, the debt service ratio, the growth in residential property prices and their gap turn out to have been useful indicators in signaling past crises. • Capital- and liquidity-based macroprudential tools play an important role in increasing the resilience of the financial sector and smoothing the credit cycle. • Raising capital or liquidity requirements enhances the resilience of the banking system through both direct and indirect channels. • Asset-side tools can play an important role in increasing the resilience of the banking system. • The studies highlight the interaction between different macroprudential instruments, and between macroprudential policy and other forms of policy, such as monetary and fiscal policy. But issues remain, regulatory arbitrage being one of them. Lending via foreign branches or direct cross-border lending erodes the effectiveness of macroprudential instruments. This is where the shadow banking sector comes in. The starting point of this is that ‘macroprudential policy could also become less effective if risk taking and exposures move outside the regulated banking sector, while remaining systemically important’.272 A lack of coordination of macroprudential policy with monetary policy could also make the former incrementally

 See for an overview and evaluation of these studies and models: G.  Galati and R.  Moessner, (2014), What Do We Know About the Effects of Macroprudential Policy?, DNB Working Paper Nr. 440, September, pp. 9–17. 271  G. Galati and R. Moessner, (2014), What Do We Know About the Effects of Macroprudential Policy?, DNB Working Paper Nr. 440, September, p. 8. 272  G. Galati and R. Moessner, (2014), What Do We Know About the Effects of Macroprudential Policy?, DNB Working Paper Nr. 440, September, p. 17. 270

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less effective, especially since the understanding on the interaction between ­macroprudential policy and monetary policy is in its infancy.273 The Achilles’ heel will continue to be the inaccurate use given the objectives, the unintended consequences of the use of certain tools or combination of macroprudential tools274 and the fact that the expectation ex post of macroprudential interventions will be too great,275 as Borio concludes, ‘[t]he key to success is to blend ambition with humility – ambition to put in place frameworks that are capable of constraining financial booms and to use the tools vigorously; humility to recognize the limitations in what the frameworks can achieve on their own. The experience so far indicates that it would be imprudent to rely exclusively on these frameworks, or even prudential regulation and supervision more generally, when seeking to tame the financial booms and busts that have caused such huge economic costs. Financial cycles are simply too powerful. And they can cause real damage even if the banking system survives relatively well.’276 This will force a continuous combination of macroprudential tools with monetary and fiscal policies, as ‘macroprudential frameworks must be part of the answer, but they cannot be the whole answer’. It however also continues the observation issues in empirical testing of macroprudential tools and the precise demarcation lines as well as the fact that it leaves room for material side effects as ‘due to the inherently complex nature of systemic policies, the scope for such side effects is much larger than for traditional policies, and may easily come to outweigh the benefits. Policy makers need to step up their efforts in making sure that new macro-prudential policies are incentive-compatible and do not distort the behavior of participants in the financial system.’277 Designing macroprudential stress tests is a work in progress and will continue to be for quite a while. As Demekas278 indicates, while there are tons of models now available to go a long way toward incorporating general equilibrium dimensions into stress tests that are now available and regularly used by central banks, macroprudential authorities, and others, very few stress-testing models focus on—and measure correctly—the resilience of the financial system as a whole and its ability to continue providing financial intermediation services under stress in a way that makes the results readily actionable for individual banks and their supervisors. The real hurdle is often complexity: The traditional approach of starting with wellestablished frameworks—particularly the standard balance sheet-based models used for

 See for a review: P. Kannan, et al., (2012), Monetary and Macroprudential Policy Rules in a Model with House Price Booms. The B.E. Journal of Macroeconomics, Vol. 12, Issue 1, Article 16 and P. Angelini, et al., (2012), Macroprudential, Microprudential and Monetary Policies: Conflicts, Complementarities and Trade-Offs. Bank of Italy Occasional Paper Nr. 140; J.  Boeckx et  al., (2015), Interaction Between Monetary and Macro-Prudential Policies, Economic Review, NBB, September, pp. 7–27. 274   W.  Wagner, (2014), Unintended Consequences of Macro-Prudential Policies, in Macroprudentialism (ed. D. Schoenmaker), VoxEU, London, pp. 105–114. 275  C. Borio, (2014), Macroprudential Frameworks: (Too) Great Expectations, in Macroprudentialism (ed. D. Schoenmaker), VoxEU, London, pp. 29–46. 276  C. Borio, (2014), ibid., p. 40. 277  W. Wagner, (2014), ibid., p. 112. 278  D.G. Demekas, (2015), Designing Effective Macro-Prudential Stress Tests: Progress So Far and the Way Forward, IMF Working Paper Nr. WP/15/146. 273

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microprudential stress testing—and adding features to them, like risk integration, ­behavioral responses or feedback loops, increases quickly the analytical and computational complexity, rendering the resulting frameworks very cumbersome. And moving from that to a proper measurement of systemic risk is fraught with difficulty. Also, market price-based models have their own pitfalls.279 How true is this when being applied to the financial system with its globalization dynamics, rapidly increasing and deepening interconnectedness and linkages. It has been observed post-crisis that ‘measures aimed at borrowers––caps on debt-to-income and loanto-value ratios––and at financial institutions––limits on credit growth and foreign currency lending––are effective in reducing asset growth. Countercyclical buffers are little effective through the cycle, and some measures are even counterproductive during downswings, serving to aggravate declines, consistent with the ex-ante nature of macro-prudential tools.’280 Such policies can therefore reduce the buildup of vulnerabilities and can help mitigate the impact of adverse cycles by encouraging a greater buildup of buffers. In particular, many of these macroprudential tools help to mitigate risk during upswings, while they seem clearly less effective during downswings. This makes sense as ‘many policies are more suited to reducing the buildup of vulnerabilities, while only some are more geared towards building up buffers’.281 Claessens et al. converge with Borio when they acclaim ‘however, even tools which help build buffers in good times generally do not help to provide cushions that alleviate crunches during downswings. As such, macro-prudential tools may be less promising to mitigate adverse events.’282 There also seem to be tools that perform better in certain economies and ‘some policies are somewhat more effective at curbing risks in advanced countries and others in emerging markets. Notably, borrower-based measures seem to work better in advanced countries’. ‘And that a package of macro-prudential policies works better in emerging markets, perhaps as their financial systems are less liberalized, allowing a combination of policies to be used.’283 Claessens et al. also touch upon the specifics of the shadow banking sector from this perspective when discussing the scope for further research when signaling the issue that ‘a major issue is how to account for circumventions and risk transfers to other, possibly less regulated parts of the financial system’.284 They highlight that their research shows that some of these macroprudential tools are effective in reducing bank vulnerabilities, but also that they can be more easily avoided by channeling financing through less regulated parts of the financial system, which forces them to conclude that ‘[a]s such, using macroprudential policies need not be associated with less overall systemic risks or reduced financial cycles’.285 A possible way to avoid circumvention is to use more broader-type tools

 Ibid., p. 21.  S. Claessens et al., (2014), Macro-Prudential Policies to Mitigate Financial System Vulnerabilities, IMF Working Paper Nr. WP/14/155. 281  S. Claessens et al., (2014), ibid., p. 19. 282  S. Claessens et al., (2014), ibid., pp. 19–20. 283  S. Claessens et al., (2014), ibid., p. 20. 284  S. Claessens et al., (2014), ibid., pp. 20, 12–18. 285  S. Claessens et al., (2014), ibid., p. 20. 279 280

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(­‘aggregate financial measures’) but will make analysis more prone to endogeneity which typically occurs in multi-regression models. But even more, some of these macroprudential tools may entail costs; they will affect ‘resource allocations, they may affect economic activity and growth and/or possibly limit (efficient) financial sector development’.286 Some lead this analysis to the conclusion that the shadow banking market should be regulated as if they were banks ‘while in other cases regulation should cover banks’ relationships with them, their procyclical behavior287 in certain markets (such as those for repos), or the ratings process for securitized products’. Some of this can be found back in European reports on the matter that indicates the fact that macroprudential policy should be wider than just the traditional banking sector as vulnerabilities can arise in the nonregulated part of the financial system288 and the danger of potential spillovers and leakages289 from the traditional banking sector to the shadow banking segment and back.290 The asymmetric regulation of traditional and shadow banks can and will lead to shifts to the shadow banking sector, disintermediation and regulatory arbitrage. Macroprudential policy tools should therefore be selected in favor of those that limit the abilities to conduct or engage in regulatory arbitrage.291 The ESRB comments: ‘[t]he availability of such opportunities not only depends on the design of the instrument, but also on the ability of authorities to monitor and address risks in other parts of the financial system. For instance, using macro-prudential instruments that target activities, as opposed to (all or a subset of ) banks, reduces the probability of risky activities migrating to other entities. By way of example, curbing excessive credit growth in real estate by imposing restrictions that apply to all borrowers through activity-based regulation is one potential way to limit leakages to shadow banking.’292 Those choices have a risk-cost trade-off. The more comprehensive it is, the more the cost of intermediation will go up, especially when broadbrush and embedded in system-wide objectives.293 Macroprudential tools that affect

 S. Claessens et al., (2014), ibid., p. 21.  D. Longworth, (2012), Combatting the Dangers Lurking in the Shadows: The Macroprudential Regulation of Shadow Banking, C.D. Howe Institute, Commentary Nr. 361, p. 13. See further p. 19 for an overview of the suggested policies regarding the different shadow banking entities and activities. 288  ESRB, (2014), Flagship Report on Macro-Prudential Policy in the Banking Sector, Frankfurt, p. 5. 289  This leakage may occur, for example, via securitization or the creation of special purpose vehicles. 290  Disruptions in the shadow banking sector are expected to have spillover effects and transmit risk to the banking sector; see also ESRB, (2014), The ESRB Handbook on Operationalising MacroPrudential Policy in the Banking Sector, Frankfurt, pp. 32–33, 84. 291  See for an analysis of the new Basel III requirements and the opportunities for ‘regulatory arbitrage’, M.  Ojo, (2011), Financial Stability, New Macro Prudential Arrangements and Shadow Banking: Regulatory Arbitrage and Stringent Basel III Regulations, MPRA Working Paper Nr. 31,319, Munich. 292  See also ESRB, (2014), The ESRB Handbook on Operationalising Macro-Prudential Policy in the Banking Sector, Frankfurt, p. 167. 293  T. Adrian et al., (2014), Financial Stability Monitoring, NY Federal Reserve Bank of New York, Staff Reports, Nr. 601, pp. 29–31. 286 287

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shadow banking are not only much less well defined, they are also vastly more ­heterogeneous. The designation as a ‘systemically important financial institution’ is a good example. As Adrian et al. lament, ‘designation is a deliberate and lengthy process, and is not well-suited to addressing emerging vulnerabilities that arise from a reduced price of risk by private market participants’.294 Much of the shadow banking risk doesn’t sit with entities or activities but are embedded in the market ‘as such’ and are not covered by a public backstop. Broad-brush macroprudential tools might be costly, expanding the liquidity window to the shadow banking sector as well, and will turn out to be even more costly295 and this despite recent regulatory efforts.296 It can’t be so. I hope that we have to conclude in line with Tarullo that ‘measures to promote the macroprudential objectives associated with the regulation of large financial institutions have already been developed. They need variously to be finalized or implemented. And all will probably need to be adjusted as time passes and circumstances change. But the tools themselves have been identified, selected, and elaborated upon.’297 Let’s hope we will not end up in a regulatory ‘trial-and-error’ momentum. But regulatory overreach will also claim its toll. When shadow banking and traditional banking will complete under similar regulatory terms (and thus traditional banks face competition from public markets as that is what shadow banking is) and thus within a general equilibrium model, optimal bank capital regulation will render ineffective but also that increases in capital requirements cause more banks to engage in value-destroying risk shifting.298 Or to put it differently: when it would be decided to have the shadow banking market be covered by traditional bank regulation, the capital adequacy rules as they are defined

 T. Adrian et al., (2014), ibid., p. 29.  See T. Adrian et al., (2014), ibid., p. 33. They indicate: ‘[f ]irst, an expansion along these lines would require a new regulatory structure to prevent moral hazard, which can be expensive and difficult to implement effectively. Second, an expansion of regulations does not reduce the incentives for regulatory arbitrage, but just pushes it beyond the beyond the existing perimeter. Third, there is a limited understanding of the impact that such a fundamental change would have on the efficiency and dynamism of the financial system. At the same time, it seems clear that policies that promote only greater disclosure would not be sufficient to effectively limit the build-up of systemic risk,’ 296  For example, N. Liang, (2015), Shadow Banking, Low Interest Rates, and Financial Stability, Financial Market Adaptation to Regulation and Monetary Policy, Stanford Graduate School of Business, Presentation March 22. See also A.  Blundell-Wignall and C.  Roulet, (2014), MacroPrudential Policy, Bank Systemic Risk and Capital Controls, OECD Journal: Financial market Trends 2014, Volume 2013/2, Paris, pp. 1–22. 297  D.K. Tarullo, (2015), Advancing Macroprudential Policy Objectives, speech given at the Office of Financial Research and Financial Stability Oversight Council’s 4th Annual Conference on Evaluating Macroprudential Tools: Complementarities and Conflicts, Arlington, Virginia, January 30. See also D.K. Tarullo, (2013), Macroprudential Regulation, speech delivered at the Yale Law School Conference on Challenges in Global Financial Services, New Haven, Connecticut, September 20; D.  Langworth and J.  Weatherall, (2011), Macroprudential Policy and Financial Markets, Paper prepared for ‘The Economics and Econometrics of Recurring Financial Market Crises’, Waterloo, 3–4 October 2011. 298  M. Harris, et al., (2015), Macroprudential Bank Capital Regulation in a Competitive Financial System, Berkeley Working Paper, January 9. 294 295

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might turn out to be suboptimal as multiple variables play out in a competitive financial landscape. There are dependencies between optimal bank capital regulation and the comparative advantages of certain players in the financial field. A similar coverage across the board will therefore most likely trigger anomalies and asymmetries in the total financial infrastructure299 especially in a fragmented and nascent EU capital market and banking union.300 The objective should be to ensure that ‘all components of the financial system can efficiently perform their underlying economic functions, and to ensure the financial system’s ability to itself function as a network within which those components can operate’, realizing that systemic shock cannot be avoided and that regulation should focus (more) on the effectiveness of regulation post-shock rather than ex ante preservation (‘[a]ccordingly, financial regulation should also be designed to work after systemic shocks are triggered, by breaking the transmission of the shocks and limiting their impact’).301 This seems better than trying to address the things we don’t know (‘unknown unknowns’) upfront302 and focus on building robust institutions that allow supervision.303 Because if there is something that needed to be learned from the financial crisis, then it is that the models that try to predict failure failed.304 Taking shadow banking out of the shadow has ultimately many dimensions to it.305 The same is valid for emerging networks and clusters of financial institutions on emerging continents who pose new challenges, and their

 See also but then from a regulatory point of view: K.N.  Johnson, (2013), Macro-Prudential Regulation: A Sustainable Approach to Regulating Financial Markets, University of Illinois Law Review, Vol. 2013, Nr. 3, pp. 881–918. She also pays attention (besides the macroprudential regulation enacted) to the corporate governance mechanisms enacted. See also T. Bennani et al., (2014), Macro-Prudential Framework: Key Questions Applied to the French Case, Banque de France, Occasional Papers Nr. 9, Paris, February; P. Tucker, (2013), Banking Reform and Macroprudential Regulation: Implications for Banks’ Capital Structure and Credit Conditions, Speech given at the SUERF/Bank of Finland Conference, ‘Banking after regulatory reform  – business as usual’, Helsinki, June 13. 300  D.  Liebeg and A.  Trachta, (2013), Macroprudential Policy: A Complementing Pillar in Prudential Supervision  – The EU and Austrian Frameworks, Financial Stability Report Nr. 26, Austrian Central Bank, pp. 56–61. 301  S.L. Schwarcz, (2015), Banking and Financial Regulation, in the Oxford Handbook of Law and Economics, F. Parisi (ed.), Oxford University Press, Oxford. 302  A. Clark and A. large, (2011), Macroprudential Policy: Addressing the Things We Don’t Know, Group of Thirty, Occasional Paper Nr. 30, Washington D.C., pp. 25–28, 47–48. 303  A. Ganioğlu, (2014), Does Effectiveness of Macroprudential Policies on Banking Crisis Depend on Institutional Structure, Central Bank of the Republic of Turkey, Working Paper Nr. 14/19. Particularly important for emerging markets, see: B. Schmitz, (2013), Macroprudential Financial Market Regulation, Aims, Implementation, and Implications for Developing and Emerging Economies, Deutsches Institut für Entwicklungspolitik, Discussion Paper 20/2013, Bonn. 304  ‘Moreover, a statistical default model estimated in a low securitization period breaks down in a high securitization period in a systematic manner: it underpredicts defaults among borrowers for whom soft information is more valuable. Regulations that rely on such models to assess default risk may therefore be undermined by the actions of market participants’; see U. Rajan, et al., (2010), The Failure of Models That Predict Failure: Distance, Incentives and Defaults, University of Michigan Working Paper. 305  M.  Wilson, (2015), Taking the Shadow Banks out of the Shadows, Verbatim C.D.  Howe Institute, The Sylvia Ostry Lecture, Presented to the C.D. Howe Institute, April 9. 299

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design is often different than the shadow banking model as we have seen it emerge in advanced economies.306 But also in advanced economies, traditional and shadow banks both have been experimenting with new models of cooperation to reduce the impact of new regulation, and reduce the credit or operational risk embedded in operations they intend to finance. A lot of these new operational financing models use newer platforms for ‘risk-sharing’. Most of these relations seem to occur along the lines of syndicated relations, which essentially imply that interconnectedness lies no longer in the direct relationship between FIs and between FIs and shadow banking entities through products and transactions, but by engaging in shared lending opportunities. These lending syndications obviously existed for a long time already before the crisis, but their more intense and intentional use has put the focus on the financial stability implications of such dependency on syndicate partners in particular in the presence of shocks to banks’ capital. Or worse, in the case these syndications can or will lead to capital shocks. Nirei et al. indicate, ‘[s]imulations in a network setting show that such shocks can produce rare events in this market when banks have shared loan exposures while also relying on a common risk management tool such as Value at Risk (VaR). This is because a withdrawal of a bank from a syndicate can cause ripple effects through the market, as the loan arranger scrambles to commit more of its own funds by also pulling back from other syndicates or has to dissolve the syndicate it had arranged’307 (see also Box 7.3).

Box 7.3  Concentration Through Syndication Enhances Systemic Contagion Risk Concentration Through Syndicated Lending across Networks: The Next Source of Market or Capital Shocks? Syndicated lending has evolved into a key vehicle through which banks lend to large corporations.308 At the same time, the market is also quite volatile. This leads to rapid contractions in this market, especially under general conditions of market distress. In a way that makes sense. Syndicated projects are generally judged with risk parameters and matrixes different than the loans that banks would provide from their own loan book on a standalone basis. It after all is a joint project with its own (continued)

 See, for example, for Africa: C.  Enoch et  al., (2015), Pan-African Banks, Opportunities and Challenges for Cross-Border Oversight, African Department and Monetary and Capital Markets Department, IMF, April 30. Washington. 307  M. Nirei et al., (2015), Bank Capital Shock Propagation via Syndicated Interconnectedness, BIS Working Paper Nr. 484. 308  See for details on the syndicated market: G. Hale, et al., (2011), Global Banking Network and International Capital Flows, Mimeo, Federal Reserve Bank of San Francisco; V.  Ivanshina and D.  Scharfstein, (2010), Loan Syndication and Credit Cycles, American Economic Review, Vol. 100, Issue 2, pp. 57–61. 306

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Box 7.3  (continued) parameters to satisfy the pool of lenders, each with its own specific position on the balance sheet of the borrower or project company. Under duress, these commitments or capital available for new commitments in the syndicated sphere will dry up to a large degree. Although this happens in many segments of the financial infrastructure, it needs to be realized that many of these commitments are of longer duration, specific or with overall higher risk (triggering the need for syndication to begin with) and that many commitments are done with a view to being refinancing before maturity of the original syndication. The reason for that can be a material reduction of risk in the project after the initial phase (risk reduction will lead to lower interest charges), or can be of a pure financial nature, for example, either sponsors and/or banks had the intention upfront to refinance fairly quick after the activities become operational and so there was no upfront intention to let the initial syndication mature. That is all pretty acceptable and understandable. But it does include an assumption that it is only back-tested and not analyzed ‘ex ante’, and this is a fact that it requires interim liquidity to refinance at all times. But since this is partly a market-based financial model, full guarantees are not available. This becomes more problematic since, through syndication, lenders now become more concentrated in their ‘common exposure’309 and therefore likely to respond in a similar way under duress as they have synchronized their exposures to what was expected the most attractive parts of the market from a ‘risk-return’ point of view.310 Additionally, such ‘rapid contractions in lending can arise when banks’ reliance on a common risk management technology, such as Value at Risk (VaR),311 is combined with their exposure to common borrowers through loan syndication’.312 Nirei et al. analyzed the effects of capital-constrained financial institutions within such a syndicated context. Although banks tend to behave in a linear way as they are exposed to the same markets, same clients, same industries, only on a different level of intensity and a fairly similar level of credit diversification, Nirei et al. conclude that ‘[h]owever, particular market features, such as bank interconnectedness through common syndicates and distinct roles of lead arrangers, produce threshold effects that can lead to significant non-linearities when banks are hit with a shock to their equity capital’.313 They specify that (continued)

 See specifically on the impact of portfolio concentration and the effects of a market or capital shock: A. Pavlova and R. Rigobon, (2008), The Role of Portfolio Constraints in the International Propagation of Shocks, Review of Economic Studies, Vol. 75, Issue 4, pp. 1215–1256. 310  N. Antonakakis, (2012), The Great Synchronization of International Trade Collapse, Economics Letters, Vol. 117, pp. 608–614. 311  See in detail: T. Adrian and H.S. Shin, (2014), Procyclical Leverage and Value-at-Risk, Review of Financial Studies, Vol. 27, Issue 2, pp. 373–403. 312  M. Nirei et al., (2015), Bank Capital Shock Propagation via Syndicated Interconnectedness, BIS Working Paper Nr. 484, p. 28. 313  M. Nirei et al., (2015), ibid., p. 28. 309

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Box 7.3  (continued) ‘there are instances of large numbers of dissolved loans even when the negative common shock is mild. Such tail risk appears strongest in the homogeneousdegree network, where we observe considerable non-­linearity in the aggregate outcome.’314 Often, these syndicated shocks occur when information is available in limited amounts, in particular when the distance between lender and borrower is fairly material, and the risk for asymmetric information distribution is likely.315 The effects of such a shock are often more intense when the credit risk in the syndication is more material. That often is the case in reality as it deals with borrowers and/or projects with enhanced, specific or idiosyncratic risk and often at the riskier components of the cash flow waterfall (leveraged loans or mezzanine tranches).316 That combined with highly levered FIs, or FIs highly dependent on the volatile interbanking market317 (via MMFs), will create contamination and propagate systemic shocks318 and the excess liquidity they generated created massive ‘complacency’319 when allocating capital in particular when syndicated banks have an inclination to keep rolling over lending to the same borrowers.320 (continued)

 M. Nirei et al., (2015), ibid., pp. 28–29.  S. Agarwal, (2010), Distance and Private Information in Lending, Review of Financial Studies, Vol. 23, Issue 7, pp. 2757–2788. J.W. Bos, et al., (2013), The Evolution of the Global Corporate Loan Market: A Network Approach, Mimeo, Maastricht University; F.  Caccioli, et  al., (2014), Stability Analysis of Financial Contagion due to Overlapping Portfolios, Journal of Banking & Finance, Vol. 46, pp. 233–245. 316  L. Allen, et al., (2012), The Impact of Joint Participation on Liquidity in Equity and Syndicated Bank Loan Markets, Journal of Financial Intermediation, Vol. 21, Issue 1, pp. 50–78; S. Battiston, et  al., (2012), Liaisons Dangereuses: Increasing Connectivity, Risk Sharing, and Systemic Risk, Journal of Economic Dynamics and Control, Vol. 36, Issue 8, pp. 1121–1141; J. Cai, et al., (2011), Syndication, Interconnectedness, and Systemic Risk, NYU Working Papers FIN-11-040, NYU; S.A. Dennis and D. J. Mullineaux, (2000), Syndicated Loans, Journal of Financial Intermediation, Vol. 9, Issue 4, pp. 404–426. 317  P.E.  Mistrulli, (2011), Assessing Financial Contagion in the Interbank Market: Maximum Entropy Versus Observed Interbank Lending Patterns, Journal of Banking & Finance, Vol. 35, Issue 5, pp.  1114–1127; E. van Wincoop, (2013), International Contagion Through Leveraged Financial Institutions, American Economic Journal: Macroeconomics, Vol. 5, Issue 3, pp. 152–189. 318  M.B. Devereux, and J. Yetman, (2010), Leverage Constraints and the International Transmission of Shocks, Journal of Money, Credit and Banking, Vol. 42, pp.  71–105; C.H.  Furfine, (2003), Interbank Exposures: Quantifying the Risk of Contagion, Journal of Money, Credit and Banking, Vol. 35, Issue 1, pp. 111–128. 319  B. Gadanecz, (2011), Have Lenders Become Complacent in the Market for Syndicated Loans? Evidence from Covenants, BIS Quarterly Review; R.D. Haas and N. V. Horen, (2012), International Shock Transmission After the Lehman Brothers Collapse: Evidence from Syndicated Lending, American Economic Review, Vol. 102, pp. 231–237. 320  M. Nirei et al., (2015), ibid., p. 2. 314 315

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Box 7.3  (continued) Syndication from a perspective of a trade-off between different types of risks emerges as a knife that cuts both ways: ‘[o]n the one hand, syndicated lending allows banks to diversify their credit risks, while also increasing lending in aggregate. On the other hand, complementarity in bank lending decisions due to dependency on syndicate partners can be a source of contagion.’321 The risk that used to be on the books of individual financial institutions now is spread out over multiple FIs and their balance sheets of which an increasing number is not covered by the traditional banking supervisory regulation and is part of the shadow banking sector sensu structo and sensu lato322 and accounts for an increasingly growing share of the (leveraged) lending market.323 To make things worse, it was demonstrated by Aramonte et al.,324 understandably so, that ‘shadow bank lenders—primarily, investment banks and funds— acquire ex-ante riskier loan portfolios in response to a decline in spot and forward ten-year U.S. Treasury rates, and in response to an increase in the expected severity of the zero lower bound period. We also find that, for a given loan at origination, a higher ex-ante default risk and a lower spot U.S.  Treasury rate are associated with a higher loan spread.’ This makes sense: shadow banking entities and products are developed to a large degree by investors seeking for higher yield while minimizing risk within the fixed-income spectrum. The lower the market interest rates, the more that objective becomes stressed and the shadow banking entities will see themselves entering more riskier products and strategies which, although still qualify as ‘fixed-­income products’ from a legal point of view, absorb material equity risk. Aramonte et al. conclude: ‘[o]ur findings are consistent with lower longer-term interest rates inducing substitution from safer to riskier portfolios in “search for yield” and contributing to a build-up of ex-ante credit risk in the shadow banking system.’ Or put differently, the shadow banking sector then becomes a risk-taking channel of monetary policy. It explains why there has been, except for a small dip after the crisis, very little deleveraging (continued)

 M. Nirei et al., (2015), ibid., p. 2.  See: M. Levine, (2014), Companies Don’t Need Banks for Loans, BloombergView, December 4; C.L. Culp, (2013), Syndicated Leveraged Loans During and After the Crisis and the Role of the Shadow Banking System, Journal of Applied Corporate Finance, Vol. 25, pp. 63–85. The buoyant US leveraged loan market is an example of one of the ‘benefits of shadow markets and securitization namely, the role of non-bank investors in diversifying the risk of credit creation while at the same time improving the price discovery process in different markets. The recent history of the U.S. leveraged loan market demonstrates that shadow banking system participants play a critical role in meeting the total demand for such loans, and that the ebbs and flows from institutional leveraged loan markets are strongly connected with the health and integrity of the underlying leveraged bank loan market.’ 323  N. Harrisson and T. Walsch, (2014), Shadow Banks Taking Market Share in US Loan Market, Reuters, October 16. T.  Braithwaite et  al., (2014), Shadow banks step into the lending Void, Financial Times, June 17. 324  S. Aramonte et al., (2014), Risk Taking and Low Longer-Term Interest Rates: Evidence from the US Syndicated Loan Market, Working Paper December 5. 321 322

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Box 7.3  (continued) going on in the system as a whole and in particular in the shadow banking sector to which many traditional banking activities have been shifted.325 It also became clear that, during the last two decades, syndicated loans have been the most important source of newly originated corporate finance in many areas of the world and that shadow banks (or nonbanks) have progressively become not only increasingly engaged participants but also lead arrangers in these syndicated loan deals. Partly due to the attractive returns that might be banked, their engagement in the syndication sphere can be explained. But it doesn’t explain why they compete with banks for the lead arranger role in these deals. Grupp has been looking into the matter and explains the evidence of shadow banking entities as lead arrangers in syndicated loan deals as follows: ‘[f]irst, some of them benefit from looser regulatory requirements enabling them to compete for loans when banks are constraint.326 Second, nonbanks have specialized expertise in industry niches helping them to succeed with their loans.327 Finally, nonbanks focus on a special group of borrowers that are not asking for cross-selling of other services which is a crucial aspect in lending by bank lead arrangers. These borrowers tend to be more opaque, less experienced but not more risky than borrowers affiliated to bank lead arrangers.’328

 McKinsey Global Institute (MGI), (2015), Debt and (Not Much) Deleveraging, February, pp. 55–74. 326  See also: Y. Altunbaş, et al., (2009), Large Debt Financing: Syndicated Loans Versus Corporate Bonds, The European Journal of Finance, Vol. 16, pp. 437–458; T. Berg, et al., (2014), Mind the Gap… The Syndicated Loan Pricing Puzzle Revisited, Working Paper; M.  Bradley and M.  R. Roberts, (2004), The Structure and Pricing of Debt Covenants, Working Paper; R. Gropp, et al., (2014), The Impact of Public Guarantees on Bank Risk-Taking: Evidence from a Natural Experiment, Review of Finance, Vol. 18, pp.  457–488; V.  Ivashina and D.  Scharfstein, (2010), Loan Syndication and Credit Cycles, American Economic Review, Vol. 100, pp.  57–61; H. Parthasarathy, 2007), Universal Banking Deregulation and Firms’ Choices of Lender and Equity Underwriter, Working Paper. 327  See also: C.  Laux and U.  Walz, (2009), Cross-Selling Lending and Underwriting: Scope Economies and Incentives. Review of Finance, Vol. 13, pp.  341–367; J.  Lim, et  al., (2014), Syndicated Loan Spreads and the Composition of the Syndicate, Journal of Financial Economics, Vol. 111, pp.  45–69; D.  Nandy and Pei Shao, (2010), Institutional Investment in Syndicated Loans, Working Paper. 328  M.  Grupp, (2015), Taking the Lead: When Non-Banks Arrange Syndicated Loans, SAFE Working Paper Nr. 100, Goethe University, Frankfurt am Main, p. 1, 18–21, 26–29. He further concludes: ‘[i]n terms of loan syndicate composition, non-banks syndicate less often than banks (and keep those loan on their books at least when information about the borrower is available (ed.)). If they syndicate, however, they prefer, to a higher degree than banks, participants that help them to reduce information asymmetries. Finally, non-banks charge 105 basis points more than banks, which is a mark-up of around 38% compared to an average bank spread of 274 basis points. This mark-up is a compensation for serving more opaque borrowers, for higher information asymmetries between lead arranger and participants and it is countercyclical as it decreases if lending competition is lower and vice versa.’ 325

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Within the knowledge that macroprudential regulation as we have implemented after the financial crisis is not much more than aggregate microprudential regulation, Wall comments, ‘[a] large fraction of the increase in “macroprudential” supervision since the crisis is really enhanced microprudential supervision of financial firms that are thought to be systemically important. While valuable in reducing the vulnerability of the financial system, such efforts fall short of the systemic reviews of major financial markets that should be a central element of a truly macroprudential supervisory regime. The primary threat to financial stability is widespread financial distress due to important participants in financial markets suffering large losses at the same time, most likely because the firms took correlated exposures. This threat can (only (ed.)) be alleviated by ‘macroprudential policies designed to identify and remedy weaknesses in major markets.’329 This requires a much more comprehensive rethink of our financial infrastructure than what we have witnessed in recent years around the globe and puts the focus on our regulatory and ­macroprudential hamster wheel we currently are operating in.330 The effect of the command-and-control regulation so far has only yielded more leverage and more sources of systemic risk in the global financial system.331 An additional complexity will turn out to be that the organizational model of the (shadow) banking system in itself will be key when trying to tackle the behavior and systemic risk in the (shadow) banking sector. Danisewicz et al. recently documented that ‘there are important differences between the type of regulation and the type of lending’. So the type and nature of the regulation enacted to cover the (shadow) banking sector has a direct impact on the lending (and other transactional) behavior of these institutions. But the behavioral change seems very much dependent on the organizational dynamics of the financial institution and impacts not only the behavior of the FI vis-à-vis its clients but also on their behavior in the interbanking market.332 What is true at the organizational level of a particular FI also seems to be valid at the level of the financial infrastructure as such. The shadow banking market creates ‘private money’ and a competitive banking system seems inconsistent with an optimal level of private money creation. The organizational dynamic then becomes relevant. Certain organizational dynamics will create a positive franchise value for the (shadow) banking institution that will allow and is required to

 L.D. Wall, (2014), Stricter Microprudential Supervision Versus Macroprudential Supervision, Federal Reserve Bank of Atlanta Working Paper, August 14. 330  See for a few examples of that V. Constâncio, (2015), Financial Stability Risks, Monetary Policy and the Need for Macro-Prudential Policy, Speech by Vítor Constâncio, vice president of the ECB, Warwick Economics Summit, 13 February 2015; V. Constâncio, (2015), Financial Integration and Macro-Prudential Policy, Speech by V. Constâncio, vice president of the ECB, at the joint conference organized by the European Commission and the European Central Bank, European Financial Integration and Stability, 27 April 2015. 331  P. Alessandri et al., (2015), Tracking Banks’ Systemic Importance Before and After the Crisis, Bank of Italy Occasional Papers Nr. 259. 332  See in detail: P. Danisewicz et al., (2015), On a Tight Leash: Does Bank Organizational Structure Matter for Macro-Prudential Spillovers, Bank of England Working Paper Nr. 524, February, in particular pp. 11–15. 329

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induce the full convertibility of the bank liabilities, conclude Monnet and Sanches.333 They show how the degree of concentration in the banking system influences its members’ willingness to supply an optimum quantity of money. They initially show that a competitive banking system is unwilling to supply an optimum quantity of money. In addition, they show that a competitive banking system is inherently unstable. This is because the determination of social optimal quantities and prices completely depends on the agents’ beliefs regarding the bankers’ franchise value. Depending on the franchise value of the FI will be a function of the beliefs of the market regarding the future path of the FI. That in itself has undesirable consequences as the quantity of money persistently declines over time and agents reduce their demand for money which will consequently reduce trading and overall ‘real’ economy-level activities. The consequence is that a competitive banking sector as such embeds a self-fulfilling crisis over and over again. Monnet and Sanches further argue that regulation of the (shadow) banking sector is required for the implementation of an efficient allocation as, in a competitive or monopolistic banking sector, there is no ‘voluntarily supply of an optimum quantity of money in the absence of intervention’. Although it seems a logical consequence of their general equilibrium model, I overall reject the notion that regulation should cater to economic (equilibrium) models as they in itself are not a fair notion of reality as such, nor do they often resemble a likely future reality.334 Even if one would consider regulating the supply of liquidity, it would make a lot of sense if this would be done judging the frameworks within which liquidity generation occurs in contemporary terms. Indeed, there is a longtime recognized tension between the benefits of the fractional banking system335 (e.g. the ability to finance more and longer-duration investment opportunities) and, on the other hand, the instability and insolvency it creates for banks and the financial system as such. Sanches illustrates how a joint-liability mechanism ex ante can result in an ex post adequate transfer of liquidity from liquid to illiquid entities in the financial infrastructure. This would generate a ‘socially efficient reserve ratio’.336 Even when risk is heterogeneously generated and leads to financial distress for market agents, it creates material endogenous inefficiencies in network formation, which in turn creates excessive systemic risk. What has been ignored in the regulatory reviews to a large degree is the fact that financial firms in general tend to face forced liquidation costs and which in general are fairly steep.

 C. Monnet and D.R. Sanches, (2015), Private Money and Banking Regulation, Federal Reserve Bank of Philadelphia, Working Paper Nr. 15–19, April. Their central question is: can a private banking system provide a socially efficient quantity of money? 334  I have commented before on the unsatisfying nexus between law and economic models; See: L.  Nijs, (2015), Neoliberalism 2.0: Organizing and Financing Globalizing Markets. A Pigovian Approach to 21st Century Markets, Palgrave Macmillan, London, Chapter 4. 335  A fractional reserve system is a banking system in which only a fraction of bank deposits are backed by actual cash-on-hand and are available for withdrawal. To put it differently, the system allows banks to create more loans to the market than they have deposits and so on to back them. This is done to expand the economy by freeing up capital that can be loaned out to other parties. It also makes the system inherently unstable as a sudden withdrawal of deposits or other funding resources. 336  D.R. Sanches, (2015), On the Welfare Properties of Fractional Reserve Banking, Federal Reserve Bank of Philadelphia Working Paper Nr. 15–20. 333

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As these liquidation costs often relate to strategically relevant assets, the liquidation cost creates links between the distressed firms and its counterparties. Even more, the liquidation cost of the distressed firm will create through these strategically relevant asset links that enhance the system-wide liquidation cost. The higher the cross-sectional dispersion of distress,337 it does not only enhance system-wide liquidation risks but also distorts the network composition in a number of ways: it (‘the network’) features too many links with distressed firms and too few risk-sharing links among non-distressed firms. The reason is that the relatively more liquid firms have incentives to connect with distressed firms for profit while shifting risks away to their direct and indirect counterparties via the network links.338 This inefficiency arises from an externality as bilateral contract terms between parties are not contingent on links faraway in the network. The most recent literature points in that direction, that is, either over- or under-connections, prevail in the financial system.339 The over- or under-connectedness manifests itself as an additional layer or catalyst of systemic risk and systemic distress. This occurs because the inefficient link with the distressed firm not only generates risk of contagion but also crowds out valuable risksharing links in the network, which, in turn, increases systemic risk. This inefficiency seems more severe when institutions are more dispersed in financial distress.340 Wang demonstrates that the non-distressed firms in a network have an incentive to team up with distressed firms for profit, while at the same time they fail to internalize negative spillovers. Such inefficient networks generate as said contagion and loss in risksharing, thereby creating systemic risk. Wang adds the level of heterogeneity in the links within a financial network which generates new dimensions in the understanding of the efficiency of network composition. This understanding has material policy implications, including suggested regulation that prevents the inefficient distress links. The avoidance would generate social welfare. One of the suggestions Wang makes in this respect is the introduction of an acquisition cost.341 Whether it is a market transaction or a bailout, regulation as is doesn’t take into account the externalities of the financial linkage formation. His results indicate that a ‘too-connected-to-fail’ problem arises if the excess acquisition is not prevented on an ex ante basis, that is, liquidating the distressed firm is too costly due to spillovers to its existing counterparties. Ex post there are a number of options that have the potential to generate optimal remedies. Those include the known government bailout, subsidized acquisition or pushed acquisitions.342 But there are many complications: links within a financial network with different levels of distress respond differently to an increase in aggregate dispersion.  J.J.  Wang, (2015), Distress Dispersion and Systemic Risk in Networks, Carnegie Mellon University Working Paper, March 30, pp. 20–24. See also: D. Acemoglu, et al. (2015), Systemic Risk in Endogenous Networks, Working Paper; D. Acemoglu, et al., (2015), Systemic Risk and Stability in Financial Networks, American Economic Review Vol. 105, pp. 564–608. 338  J.J. Wang, (2015), ibid., p. 42. 339  M. Farboodi, (2014), Intermediation and Voluntary Exposure to Counterparty Risk, Working Paper. 340  J.J. Wang, (2015), ibid., p. 42. 341  J.J.  Wang, (2015), Distress Dispersion and Systemic Risk in Networks, Carnegie Mellon University Working Paper, March 30, pp. 25–27. 342  J.J. Wang, (2015), ibid., pp. 28–31. 337

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7.10 S  hadow Banking and Basel III: Do the CostsBenefits of Financial Regulation Still Matter? Basel III does a fair effort, mainly through ex ante regulation to make the financial sector more robust and weathered against the next financial meltdown. However, it does very little to capture the dynamics of the shadow banking industry. Repeatedly, it was argued that the likely outcome of Basel III is an enhanced use of shadow banking products and entities. In the context described, financial intermediation is delivered through longwinded chains and hybrid intermediaries have become the norms in the financial industry that makes sense. The traditional ‘cost-benefit’ analysis still holds valid343 and the debate has recently been revived mainly through two strands of literature.344 The cost and benefits of financial regulation focus on the behavioral and market, general equilibrium and political responses. Although Coates makes a series of claims regarding the valuation difficulties in financial regulation, he under-highlights the importance to reflect the fact that most of the complexity lies in the financial markets. He also does not directly provide an alternative to the fact that financial regulation and the volatility of valuations in the financial markets are embedded.345 Applying this understanding to the Basel III environment, Lee comments, ‘Basel III closes the gap which was caused by the difference in treatment of banking book versus trading book, in relation to capital buffer fund reserves. This new change under Basel III is a step in the right direction, for restraining banks’ abusive use or overuse of shadow bank entities at the risk of creating excessive leverage. Although it is applaudable, for the purpose of preventing financial systemic risks, Basel III may fall short in preventing shadow banking risks because its main target is on banks and traditional banking activities. Banking r­ egulators would be hard pressed to admit that traditional banking activities would inevitably entail some leverage that is accompanied by shadow banking.’346 The Basel III capital requirements could, as a minimum, have taken into account the exposure to shadow banking products and entities, as that exposure is not random nor incidental. The debate rages on between those that are in favor of ex ante corrective or directive (tax) regulation and those that focus on ex post methodologies, bailouts or otherwise. Although I have my personal preferences (for directive ex ante tax regulation complemented with  J.  C. Coates IV, (2015), Cost-Benefit Analysis of Financial Regulation: Case Studies and Implications, Yale Law Journal Vol. 124, Issue 4 pp. 882–1011. 344  The aforementioned Coates and secondly E. A. Posner and E. G. Weyl, (2013), Benefit-Cost Analysis for Financial Regulation, American Economic Review, Vol. 103, Issue 3, pp. 393–397; E.A. Posner et al. (2014), Benefit-Cost Paradigms in Financial Regulation, Journal for Legal Studies, Vol. 43, Issue S2, pp. S1–S34. J.H. Cochrane, (2014), Challenges for Cost-Benefit Analysis of Financial Regulation, Journal of legal Studies, Vol. 42, pp. S63–105. 345  See for a response: E.  A. Posner & E.  G. Weyl, (2015), Cost-Benefit Analysis of Financial Regulations: A Response to Criticisms, Yale Law Journal Forum, Vol. 124, pp. 246–264. 346  E. Lee, (2014), The Shadow Banking System: Why It Will Hamper the Effectiveness of Basel III, University of Hong Kong Working Paper. See also: E. Lee, (2014), Basel III and Its New Capital Requirements, as Distinguished from Basel II, Vol. 131, Issue 1, The Banking Law Journal, pp.  27–69; E.  Lee, (2013), Basel III: Post-Financial Crisis International Financial Regulatory Reform, Journal of International Banking Law and Regulation Vol. 28, Issue 11, pp. 433–447. 343

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c­ ommand and control where needed, if pricing signals are noninstrumental, combined with ex post regulation that ring-fences risk and mitigates contagion), we can reflect with Chang347 when applying the regulation in the repo market. She explored the linkages in the interbank repo market and the banking crisis and the impact on the economy, but through the lens of the effectiveness of the regulation in place. In the case of repos, the exposed regulation is that of liquidity and capital requirements. While capital requirements are to hold a certain proportion of assets in safe assets, liquidity requirements are to hold in liquid assets. When liquid assets are not safe assets, the two requirements might lead to different results. Bank runs would be prevented by only using reverse repos or facilitating reverse. In this context, three factors that determine the repo size are the haircut rate, the market value of the collateral assets and the liquidity shortfall.348 To be more specific, an increase in the haircut rate or a decrease in the market values of the assets would increase the repo size and make it more difficult to reverse the repo and lead to repo runs.349 Central bank intervention to assist cooperation between banks is important after imposing liquidity requirements. Chang argues that the capital requirement which would affect the banks severely would trigger repo runs and bank runs at the following period. Hence, prior to implementing capital requirements, it is important to analyze the impacts on the banks assets and liabilities and provide liquidity facilities. The negative externalities from the repo market can and will then be neutralized through monetary policy and not ex ante regulation.350 The leverage buildup through interfinancial institutional transactions (noncore assets/ liabilities) can increase materially without the level of credit to the economic increasing. In case of ex ante regulation, the ex ante focus should be therefore on noncore assets.351 Reserve requirements as such do not seem to be a promising tool if monetary aggregates and credit to the market are intended to be tamed.352 That leaves the question between ex ante and ex post regulation unanswered. And maybe there is no need for it to receive a precise answer in the context of the financial industry and the shadow banking market in particular. I, as indicated, prefer a combination of ex post and ex ante regulation, the latter with a Pigovian flair. Ex ante should receive most of the attention as it has some ­distinct benefits (see also Box 7.4). In any case, the conditionalities under why ex ante regulation can operate optimally are numerous.

 C-Y Chang, (2015), Interbank Repo, Reverse and Regulations: Roles on the Run, Wellington University Working Paper, in particular pp. 20–22. 348  That seems in line with previous analysis regarding this matter: G. Gorton, (2010), E-Coli, Repo Madness, and the Financial Crisis, Business Economics, Vol. 45 Issue 3, pp. 164–173; G. Gorton and A. Metrick (2012), Who Ran on Repo?, NBER Working Paper Nr. 18,455. 349  C-Y Chang, (2015), ibid., p. 23. 350  C-Y Chang, (2015), ibid., p. 23; See also in detail: J. Stein, (2014), Monetary Policy as Financial Stability Regulations, Quarterly Journal of Economics, Vol. 127, pp. 57–95. 351  H.S. Shin and K. Shin, (2011), Procyclicality and Monetary Aggregates, NBER Working Paper Nr. 16,836 and J.-H. Hahm et al., (2011), Non-Core bank Liabilities and Financial Vulnerabilities, paper presented at the Federal Reserve Board and JMCB Conference on ‘Regulation of Systemic Risk’, Washington, DC. 352  B.-K. Kim, (2013), Central, Traditional and Shadow Banking in the Multiple Deposit Creation Scheme, Bank of Korea, Nr. 2013-10, pp. 22. 347

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Box 7.4  Is Ex Ante Regulation so Much Better than Ex Post Regulation? Ex Ante Regulation: The Holy Grail for the Shadow Banking Industry? This question cannot be answered directly. The effectiveness of regulatory intervention has many dimensions to it: these include timing, dynamics, the market structure, the availability of symmetric and perfect information available to all parties, although often imperfect information and fully rational actors are assumed by the regulator. Gaille argues that ‘[i]n the real world, though, the failure of one or more of these assumptions can change dramatically the impact of a regulatory option’.353 Traditionally, ex ante regulation for the financial sector is preferred, at least if it has the potential to prevent financial failures. There will always be a likelihood of ex ante regulation not being able to prevent failures. In that case, economic damage occurs and the failure might cause, through contagion, widespread contagion. But preventing financial failures is not the only role the regulators are mandated with. Schwarcz indicates that ‘[e]ven an optimal prophylactic regulatory regime cannot anticipate and prevent every failure’.354 He contrasts ex ante and ex post regulation for the financial sector and not surprisingly concludes that ‘ex post approaches can, and arguably should, supplement ex ante approaches as part of a comprehensive financial regulatory framework.’ But how exactly do we regulate a changing financial landscape. Schwarcz depicts the situation and functional approach to financial regulation and the normative hierarchy it would yield as follows: ‘[e]xisting regulatory approaches have two temporal flaws. The obvious flaw, driven by politics and human nature (and addressed in other writings), is that financial regulation is overly reactive to past crises. The other more fundamental flaw is that financial regulation is normally tethered to the financial architecture, including the distinctive design and structure of financial firms and markets, in place when the regulation is promulgated. In order to effectively address future crises, financial regulation must transcend that time-bound architecture. This could be done by regulating the underlying economic functions of the financial system — the provision, allocation, and deployment of financial capital — as well as the financial system’s capacity to serve as a network within which those functions can be conducted.’355 A functional approach to financial regulation would also balance the fact or idea that macroprudential regulation has it own distinct set of readily available tool. (continued)

 B. Gaille, (2015), In Praise of Ex-Ante Regulation, Boston College Law School, Legal Studies Research Paper Series, Nr. 354, March 13, Vanderbilt Law Review, Vol. 68, pp. 354  S.L.  Schwarcz, (2011), Keynote & Chapman Dialogue Address: Ex Ante Versus Ex Post Approaches to Financial Regulation, Chapman Law Review, Vol. 15, pp. 258–269. 355  S.L. Schwarcz, (2015), Regulating Financial Change: A Functional Approach, Minnesota Law Review, Vol. 100, pp.  1441–1494; See also C.  K. Whitehead, (2010), Reframing Financial Regulation, Boston University Law Review, Vol. 100, Issue 1, pp. 1–50. 353

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Box 7.4  (continued) But there is more. Financial regulation operates in a complex interdependent system. That interconnectedness among firms, markets and rules have implications for financial regulatory policy. There is an undeniable trade-off between ‘ex ante regulation aimed at preventing financial failure and ex post regulation aimed at responding to that failure’.356 Very little attention has been given to the distinction between those two types of regulation and their different functionalities. Both are most likely needed as I indicated then expressing my preference within the shadow banking context. When there is pure duty-imposing, ex ante regulation can and will work. But the ex post treatment cannot be neglected as it safeguards the types of interventions aimed at mitigating the systemic consequences of a financial failure. These two components need to be balanced in order to function optimally or deliver optimal results. Ring-fencing risk and containing systemic shocks357 are critical to avoid total meltdowns and a cascade of value destruction events. Ex Ante Versus Ex Post Regulation Ex -ante regulation focuses on prevention and duty enforcement (command and control), and ex post on standards and litigation, and the overall containment of the implications of an event occurring. But should the focus be on deterrence? The law would then primarily be concerned about regulating harmful conduct in a way that mitigates or minimizes net social costs. But it is my understanding that (financial) regulation should not only be concerned with prevention, it should also be focused on avoiding harmful consequences in case the next systemic shock arrives. Obviously, there are limits to ex ante financial regulation,358 otherwise we would have never experienced a financial crisis. This understanding and details of the ex ante regulation will however help to design appropriate ex post regulation359 and ultimately will come up with a balance between types of regulation that regards both the goals of economic efficiency and financial stability. But ex post regulation also has its limits as ‘[e]x post regulation does provide useful additional information when regulated parties are heterogeneous, but also carries significant and sometimes prohibitive social cost, especially when externalities are produced by limited-­ liability firms’.360 Galle demonstrates that the costs of heterogeneity can be sharply reduced with even modest upfront information. He does apply this principle to systemic risk regulation in the (shadow) banking sector. He argues that governing in the twenty-first (continued)

 I.  Anatawi and S.L.  Schwarcz, (2013), Regulating Ex-Post: How Law Can Address the Inevitability of Financial Failure, Texas Law Review, Vol. 92, pp. 75–131. 357  See on the specifics of systemic risk in regulation: S.  L. Schwarcz, (2008), Systemic Risk, Georgetown Law Journal, Vol. 97, Issue 1, pp. 193–249. 358  See for a review: I. Anatawi and S.L. Schwarcz, (2013), ibid., pp. 93–101. 359  See for a review of ex post strategies for financial regulation: I.  Anatawi and S.L.  Schwarcz, (2013), ibid., pp. 102–121. 360  B. Galle, (2015), In Praise of Ex-Ante Regulation, Boston College Law School, Legal Studies Research Paper Nr. 354. 356

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Box 7.4  (continued) century is a problem of incentive design, that is, they know what they want but often not the best way to achieve it.361 One of the consequences of this is that Galle is more pronounced in the choice between ex ante and ex post regulation, which he decides in favor of ex ante regulation.362 Central to his position is the empirical understanding that the problem of ex ante uncertainty is smaller than traditionally appreciated. He also stresses the fact that informational gains that come with ex ante legislation must be traded off against the cost of waiting, a trade-off evaluated positively in many instances. His point is not that ‘ex-ante regulation is always more efficient than ex post, but rather that the case is more nuanced, and depends more on empirical facts that are currently unknown, than others have recognized’.363 He favors ex ante regulation as well in the context of the (shadow) banking sector.364 The optimal balance between ex post and ex ante regulation will be driven by a number of features being ‘the predictability of financial crises, the feasibility of adopting financial regulation, and the ability of regulators to implement their programs without giving rise to substantial market inefficiencies or regulatory arbitrage’.365 But there is more as the trade-off needs to be defined up front, Anatawai and Schwarcz argue: ‘[m]ore specifically, regulators’ reliance on ex ante relative to ex post regulation should be greater, (1) the more confident regulators are in their ability to model the dynamics of the financial system, (2) the more controls exist for regulating systemically significant activities, and (3) the more capable regulators are at implementing their policies without giving rise to substantial market inefficiencies or regulatory arbitrage.’366 The problem will continue to be that the decision where the trade-off is between the two types of components to a certain degree lies in the soundness and transparency of the models used and of the financial market as such. Identifying conditions that can or will lead to a financial crisis is needed but not sufficient. The regulation should embed tools to enforce and make the system robust. In the Pigovian chapter, I expressed my preference for ex ante tax instruments as their pricing signals are picked up swifter and are more pronounced than with command-and-control (C-a-C) regulation. Further, C-a-C regulation is more prone to regulatory arbitrage than tax instruments. We are only just starting to understand the interconnectedness within the financial sector, and the tight coupling between agents through a variety of (opaque) products will make further shocks inevitable.367 (continued)

 Galle, (2015), ibid., p. 2.  See also: T.  Edgar, (2014), Corrective Taxation, Leverage, and Compensation in a Bloated Financial Sector, 33 Virginia Tax Revenue, Vol. 22, Issue 393, pp. 414–422. 363  Galle, (2015), ibid., p. 6. 364  Galle, (2015), ibid., pp. 38–39. 365  I. Anatawi and S.L. Schwarcz, (2013), ibid., p. 128. 366  I. Anatawi and S.L. Schwarcz, (2013), ibid., p. 128. 367  I. Anatawi and S.L. Schwarcz, (2013), ibid., p. 130. 361 362

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Box 7.4  (continued) Besides the fact that most financial regulations are politically misguided or even compromised, they fail to focus on what needs to be safeguarded. They focus on individual FIs or country-specific relevant sectors. But they do not focus on safeguarding the system or the (stability of the) financial market ‘as such’, which is what public law is supposed to engage in. In order to do so, financial regulation368 would have to focus on the dynamics of market failures from a ‘micro’ and ‘macro’ point of view assuming a certain level of chaos theory (assuming complex systems in which shocks are then inevitable). From a micro-point of view, this would focus on the failures in the design of the financial system and the behavioral consequences it triggers at the level of individual market participants. Part of that analysis369 would include (1) the failure of consistent information availability for all participants at the same time, (2) the consistent rationality failure by market participants, (3) the issues relating to any principal-agent relationship given the many fiduciary relations in the financial sector and (4) the wrong incentive structures in the market370 fueling risk taking371 and corporate governance failures. From a macro-point of view, it includes (1) the ring-fencing of risk ex post,372 (2) the ability to build robust firms amid short-termism triggered by the market infrastructure, (3) safeguarding liquidity channels at all times, (4) limiting the triggers of financial risk and (5) limiting the transmission and impact of systemic shocks.373 This can be easily applied to the shadow banking sector as it is prone to many of the same exposures as the FI sector in general but in a new and different context.374 The transformation the shadow banking system has caused also allowed (continued)

 That covers the financial sector but also directly adjacent industry like insurance: See, for example, D. Schwarcz and S.L. Schwarcz, (2014), Regulating Systemic Risk in Insurance, Chicago Law Review, Vol. 81, pp. 1569–1640; also see M. Dungey et al., (2014), The Emergence of SystemicallyImportant Insurers, Working Paper, November 2. 369  See for an extensive evaluation: S.L. Schwarcz, (2014), Systemic Risk and the Financial Crisis: Protecting the Financial System as a ‘System’, Working Paper; see also: S.L.  Schwarcz, (2012), Controlling Financial Chaos: The Power and Limits of Law, Wisconsin Law Review, pp. 815–833, and S.L.  Schwarcz, (2013), On Regulating Shadows: Financial Regulation and Responsibility Failure, Washington and Lee Law Review, Vol. 70, pp.  1781 ff; D.S.  Bieri, (2014), Financial Stability Rearticulated: Institutional Reform, Post-Crisis Governance, and the New Regulatory Landscape in the United States, Working Paper, August. 370  See in detail: N.V.  Okeye, (2015), Behavioural Risks in Corporate Governance: Regulatory Intervention as a Risk Management Mechanism, Routledge, London. 371  S.L.  Schwarcz, (2014), Excessive Corporate Risk-Taking and the Decline of Personal Blame, Emory Law Journal, Vol. 65, Nr. 2 (December). 372  See in detail: S.L. Schwarcz, (2013), Ring-Fencing, Southern California Law Review, Vol. 87, pp. 69–109. 373  See also: T.R. Hurd, (2015), Contagion! The Spread of Systemic Risk in Financial Networks, McMaster University Canada Working Paper, February 2. 374  See for an application of these principles and testing of exposures to the specifics of the shadow banking sector: S.L.  Schwarcz, (2014), Regulating Shadow Banking, Review of Banking and Financial Law, 2011-212, Vol. 31, pp. 619–642. Schwarcz asks the question as to what the role is 368

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Box 7.4  (continued) to observe a number of weaknesses that should be carefully monitored. Two of the fundamental market failures underlying shadow banking—information failure and agency failure—were also prevalent in the bank-­intermediated financial system. By amplifying systemic risk, however, disintermediation greatly increases the importance of what scholars long have viewed as a third market-failure category, that is, the discussed ‘externalities’. Schwarcz comments: ‘[v]iewing externalities as a distinct category of market failure is misleading, though: externalities are fundamentally consequences, not causes, of failures; and all market failures can result in externalities. Focusing on externalities also obscures who should be responsible for causing the externalities.’ He further argues ‘that the third market-failure category should be reconceptualized as a “responsibility failure”: a firm’s ability to externalize a significant portion of the costs of taking a risky action. That not only would more precisely describe the market failure but also would help to illuminate that sometimes the government itself, not merely individual firms, should bear responsibility for causing externalities, and that exercising this responsibility may require the government to enact laws that require firms to internalize those costs.’375 Also the governance dimensions have a prominent role in shadow banking. Schwarcz attempts to rethink the corporate governance assumption that owners of firms should always have their liability limited to the capital they have invested. In the relatively small and decentralized firms that dominate shadow banking, equity investors tend to be active managers. Limited liability gives these investor-managers strong incentives to take risks that could generate outsized personal profits, even if that greatly increases systemic risk. For shadow banking firms subject to this conflict, limited liability should be redesigned to better align investor and societal interests.376 A few of the main exposures in the shadow banking sector are not properly covered at this stage and are the dynamics of ‘local rules in a global game’ and the ‘international spillover channels’. The first refers to the fact that regulator and central banks often see their role in a domestic mandate. Caruana indicates, ‘[m]oreover, the search for a framework that can satisfactorily integrate (continued)

of the lawyers active in the shadow banking sector: L. Schwarcz, (2013), Lawyer in the Shadows: The Transactional Lawyer in a World Of Shadow Banking, American University Law Review, Vol. 63, Issue 1, pp. 157–172: ‘to what extent should transactional lawyers address the potential systemic consequences of their client’s actions? The legal system itself inadvertently enables or requires firms operating as shadow banks to engage in uniquely risky behavior, without protecting against the resulting systemically risky externalities. That finding, in turn, broadens the legal ethics inquiry to two issues: what duty should transactional lawyers have to try to improve the legal system to protect against those externalities, and what duty should transactional lawyers have to try to prevent those externalities, assuming the legal system is not improved.’ 375  S.L.  Schwarz, (2013), Regulating Shadows: Financial Regulation and Responsibility Failure, Washington and Lee Law Review, Vol. 70, Issue 3, pp. 1781–1825. 376  S.L. Schwarcz, (2014), The Governance Structure of Shadow Banking: Rethinking Assumptions about Limited Liability, Notre Dame Law Review, Vol. 90, Issue 1, pp. 1–30.

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Box 7.4  (continued) the links between financial stability and monetary policy is still work in progress with some way to go. The development and adoption of such a framework represent one of the most significant and difficult challenges for the central bank community over the next few years.’377 The same holds true for the international spillover channels which often are responsible for transmitting contagion through the system. These international spillover channels make the life of the regulator and central banker extremely difficult at times. Macroprudential, microprudential, monetary and fiscal policies come together in those channels. Although most of it is domestically regulated, the exposures are often through international dimensions of the financial structure, for example, currencies. The integration of the financial markets allows common factors to dominate domestic-integrated financial systems creating and magnifying systemic risks and uncertainties.378 And then there is the question about the reach, quality and depth of macroprudential legislation and monetary policies to stimulate output, a process that has been ongoing for years now. But questions are asked about whether monetary policy and regulation are effective. One of the problems with monetary policy is that it assumes a certain unicity in the response of market behaviors to monetary policies and related requirements. It however has been demonstrated379 that agents with a different view toward risk, risk taking and leverage will respond differently to uniform monetary policies. To be precise, ‘agents with heterogeneous productivity can increase investment by levering up, but this increases interim liquidity risk. In equilibrium, the more productive agents choose higher leverage, invest more, and take on higher liquidity risk. Therefore, these agents respond less than the agents with lower productivity to monetary policy.’ The consequence is that investment quality deteriorates, which on aggregate will dampen the effect of a monetary stimulus. This creates a feedback loop in the market as ‘worse overall quality leads to lower liquidation values, increasing the cost of liquidity risk. This reduces the demand for loanable funds, further decreasing the interest rate, which then leads to further quality deterioration.’ The implication is that not only monetary policy loses its effectiveness in terms of its ability to stimulate output even if it is able to lead to a significant drop in market interest rates. Choi et  al. illustrated that monetary policy can become less effective than desired in stimulating output due to a feedback between the deterioration of asset quality and the reduction of loan demand elasticity. More productive agents choose to invest more by borrowing, but at the same time they become (continued)

 J. Caruana, (2015), The International Monetary and Financial System: Eliminating the Blind Spot, Panel remarks at the IMF conference ‘Rethinking macro policy III: progress or confusion?’, Washington, DC, 16 April 2015, pp. 1–2. 378  J. Caruana, (2015), ibid., pp. 2–3. 379  D.B. Choi et al., (2015), Watering a Lemon Tree: Heterogeneous Risk Taking and Monetary Policy Transmission, NY FED Staff Reports, Nr. 724, April. 377

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Box 7.4  (continued) exposed to higher liquidity risk due to high leverage. Low interest rates trigger higher amounts of leverage, which means more risk for the less-productive part of the market. The overall quality of the assets in the market drop due to the heterogeneous response to lower interest rates (high-productive agents in the market do not lever up further due to the existing liquidity risk) will decrease asset value, liquidation risk, triggering lower loan demand and therefore even lower interest rates. At market level, it implies that in such a negative spiral the aggregate output of the market becomes less sensitive to monetary policy.380 Having said that, macroprudential regulation does impact banking flows from a context of regulatory arbitrage. Reinhardt and Sowersbutts used a pool of macroprudential policy actions to examine whether macroprudential regulations affect international banking flows. They find evidence that borrowing by the domestic nonbank sector from foreign banks increases after home authorities take a macroprudential capital action. They further find no increase in borrowing from foreign banks after an action which tightens lending standards (such as limits on loan-to-value ratios for house purchase). Evidence on reserve requirements is mixed. Differences in the application of regulation for lending standards and capital regulation for international banks mean that while there is a level playing field for lending standards regulation, this does not always apply for capital regulation, giving foreign branches regulated by their home authorities a competitive advantage.381 They find that foreign banks expand their lending into host countries where regulation is tightened. But this does not occur when regulations apply also to them. Their results suggest that a tightening of capital regulation induces domestic nonbanks to increase their borrowing from abroad while a tightening of lending standards does not have the same effect. The uneven application of regulation may be a driver of international capital flows. This is over and above the effect, which has been documented extensively in the literature, where banks transfer funds to markets with fewer banking regulations. But there is a little add-on here: banks transfer funds to countries which tighten regulatory standards, but transfer these funds when the regulatory tightening does not apply to them, and instead confers upon them a competitive advantage. The openness of a banking system in a country can co-determine the outcome of a macroprudential instrument, but also the choice of which instrument. It points toward an enhanced need for building strong reciprocity frameworks with a high degree of automaticity.382

 D.B. Choi et al., (2015), ibid., pp. 27–28.  D.  Rheinhardt and R.  Sowersbutt, (2015), Regulatory Arbitrage in Action: Evidence from Banking Flows and Macroprudential Policy, Bank of England Staff Working Paper Nr. 546. 382  D. Rheinhardt and R. Sowersbutt, (2015), ibid., pp. 21–22. 380 381

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The endgame for the discussion around financial regulation is not around the corner. The financial crisis has brought around a rethink about the source and scale of ‘systemic risk’. The regulatory framework that has emerged is a multipolar one.383 This is explainable as the crisis brought home the real-world significance, and quantitative importance, of a number of frictions or externalities in the financial system. This will have a distinct impact on the constraints384 it creates in particular in terms of the asset allocation of banks. The implications are layered, complex, to a certain degree unclear and will have a massive impact on analytical models and real-world behavior.385 The complexity of financial network externalities is only starting to be understood and the negative externalities attached.386 The layered counterparty exposure and the network cascades it triggers create ripple effects under duress which we still fail to adequately understand. There is continuously new literature arriving, bringing new elements into the equation that should help us to understand financial intermediation networks and the contagion dynamics and vulnerability aspects.387 We also discussed how policy interventions itself can lead to distortions. Regulation can support risk taking or create moral hazard and make private interest favor or social optimums.388 Regulation also allowed banks to create their own internal risk models: it led to gaming, and some have therefore advocated non-­risk-­weighted capital requirements.389 Haldane explains the multipolar regulatory environment post-crisis as an application of the Tinbergen rule. This rule indicates ‘that there be at least as many regulatory instruments as there are financial frictions’.390 And so the world has moved on with a

 A.G. Haldane, (2015), Multi-Polar Regulation, International Journal of Central Banking, Vol. 11, Nr. 3 (June), pp. 385–401. 384  The most visible constraints post-crisis are (1) liquidity regulation: a core funding ratio (the socalled net stable funding ratio) and a maturity mismatch ratio (the so-called liquidity coverage ratio), (2) the leverage ratio, (3) the capital surcharge to be levied on the world’s largest, most complex, most interconnected banking institutions and (4) the capital conservation and countercyclical capital buffers (pp. 388–391). Their prime intention is to reduce network externalities. 385  A.G. Haldane, (2015), ibid., pp. 391–396. 386  D.  Acemoglu, et  al., (2015), Systemic Risk and Stability in Financial Networks, American Economic Review, Vol. 105, Issue 2, pp. 564–608. 387  For example, due to the cumulative nature of moral hazard problems over the network, small changes in collateral liquidity may result in significant drops in the financial system’s intermediation capacity, which leads to a total credit freeze; M. di Maggio and A. Tahbaz-Salehi, (2015), Financial Intermediation Networks, March. They further demonstrate that the financial system’s intermediation capacity crucially depends not only on the quality of assets used as collateral, but also on how such assets are distributed among different intermediaries. See also: A.  Zawadowski, (2013), Entangled Financial Systems, Review of Financial Studies, Vol. 26, pp. 1291–1323. 388  See on all three counts: G. Alfonso, et al., (2014), Do ‘Too-Big-to-Fail’ Banks Take on More Risk? Economic Policy Review (Federal Reserve Bank of New York), Vol. 20, Issue 2, pp. 41–58; E.  Farhi and F.  Tirole, (2012), Collective Moral Hazard, Maturity Mismatch, and Systemic Bailouts, American Economic Review Vol. 102, issue 1, pp. 60–93. 389  D.  Duffie, (2013), Capital Requirements with Robust Risk Weights, Speech given at the Brookings Institution, Washington, DC, October 31. 390  A.G. Haldane, (2015), ibid., p. 388, and J. Tinbergen, (1952), On the Theory of Economic Policy, Amsterdam, North-Holland; confirmed in a contemporary context: F.  Smets, (2014), Financial Stability and Monetary Policy: How Closely Interlinked? International Journal of Central Banking, Vol. 10, Issue 2, pp. 263–300. 383

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multi-regulatory environment consisting of ex ante capital-, and liquidity regulation and ex post resolution. This should keep us out of trouble and should lead the way to ‘financial stability’. But Cecchetti391 concludes after he overlooked the regulatory field anno 2015 and indicates, ‘I summarize the regulatory changes implemented over the past five years and come to three conclusions. First, as a result of the new Basel III standards, the global financial system is now substantially safer than it was, but probably not yet safe enough. Second, the costs of increasing capital requirements have been much smaller than we originally thought. And third, we are best advised to shy away from time-varying discretionary regulatory policies.’ He advocates materially higher capital requirements than those currently in place, but warns for the unintended consequences, for example, the emergence and further growth of shadow banking activities.

7.11 D  eepening and Growing the Financial Sector: But How Deep and Big Exactly? 7.11.1  Introduction It was reviewed that the shadow banking sector in many emerging economies have an actual role vis-à-vis the real economy. In advanced economies, this is a whole lot less the case, although direct lending by hedge funds and private equity (PE) firms can lead to ‘real economy benefits’. It was also demonstrated before that growing the financial sector only works well up to a certain point after which there is a type of cannibalization emerging vis-à-vis the real economy the financial sectors support. Rent-seeking creates suboptimal rent-seeking results. Overall one can concur with the idea that ‘financial development increases a country’s resilience and boosts economic growth. It mobilizes savings, promotes information sharing, improves resource allocation, and facilitates diversification and management of risk. It also promotes financial stability to the extent that deep and liquid financial systems with diverse instruments help dampen the impact of shocks.’392 But there are limits beyond which costs and damages outpower benefits. We have reached that point in the advanced economies already quite some time ago.393 But now the question is also raised to what degree that tipping point has been reached by in emerging

 S.G.  Cecchetti, (2015), The Road to Financial Stability: Capital Regulation, Liquidity Regulation, and Resolution, International Journal for Central Banking, Vol. 11, Nr. 3 (June), pp. 127–139. 392  R.  Sahay et  al., (2015), Rethinking Financial Deepening: Stability and Growth in Emerging Markets, IMF Staff Discussion Note, SDN/15/08, May, p.  5; J.  De Gregorio, and P.  Guidotti, (1995), Financial Development and Economic Growth, World Development Vol. 23, Issue 3, pp. 433–448; J. Eugster, (2014), Nonlinear Marginal Effects of Finance on Growth, Unpublished, International Monetary Fund. 393  S.G. Cecchetti and E. Kharroubi, (2015), Why Does Financial Sector Growth Crowd Out Real Economic Growth? BIS Working Paper Nr. 490, Bank for International Settlements, Basel; N. Gennaioli, et al., (2012), Neglected Risks, Financial Innovation, and Financial Fragility, Journal of Financial Economics Vol. 104, Issue 3, pp. 452–468. 391

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economies. Where are emerging markets on the stability-growth trade-off slope that financial development entails and what is the room for further improvement and the role for shadow banking in that respect? Recent analysis has been looking into this question and concluded that ‘many benefits in terms of growth and stability can still be reaped from further financial development in most emerging markets. Financial development is defined as a combination of depth (size and liquidity of markets), access (ability of individuals to access financial services), and efficiency (ability of institutions to provide financial services at low cost and with sustainable revenues, and the level of activity of capital markets).’394 But there is something interesting the report also revealed, that is, the effect of financial development on economic growth is bell shaped as it weakens at higher levels. But the IMF concludes that ‘this weakening effect stems from financial deepening, rather than from greater access or higher efficiency’. Also, the pace matters; ‘when it proceeds too fast, deepening financial institutions can lead to economic and financial instability. It encourages greater risk taking and high leverage, if poorly regulated and supervised. In other words, when it comes to financial deepening, there are speed limits.’ This must have to do with the time needed to build robust regulatory and institutional frameworks.395 Another remarkable finding is that there is no intrinsic battle between financial development and financial regulation and supervision as ‘among a large number of regulatory principles, there is a small subset that is critical for financial development as well as for financial stability. In other words, there is very little or no conflict between promoting financial stability and financial development.’396 The report reiterates that bank credit can be misguiding when it comes to assessing the level of credit available in an economy and that shadow banks often play a critical role in complementing bank credit.397 They conclude however that most emerging markets are still in the relatively safe and growth-enhancing region of financial development and have scope to develop further.398 Part of that development will occur through the shadow

 R. Sahay et al., (2015), ibid., p. 5. See also: L. Angeles, (2015), Credit Expansion and the Real Economy, Applied Economics Letters pp. 1– 9; J.-L. Arcand, et al., (2012), Too Much Finance?, IMF Working Paper WP/12/161, International Monetary Fund Washington, DC; A.  Barajas, et  al., (2013), (2013), The Finance and Growth Nexus Re-examined: Do All Countries Benefit Equally?” IMF Working Paper 13/130, International Monetary Fund, Washington. 395  See in detail: R. Sahay et al., (2015), ibid., pp. 15–23. R. Levine, (2005), Finance and Growth: Theory and Evidence, In Handbook of Economic Growth, (eds.) by Ph. Aghion et al., Elsevier, New York, pp. 865–934. R. Levine, et al., (2000), Finance and the Sources of Growth, Journal of Financial Economics, Vol. 58 (1/2), pp. 261–300; N. Loayza, and R. Ranciere, (2006), Financial Development, Financial Fragility, and Growth, Journal of Money, Credit and Banking Vol. 38, Issue 4, pp. 1051–1076. 396  R. Sahay et al., (2015), ibid., pp. 5 and 24–27. 397  R.  Sahay et  al., (2015), ibid., pp.  10–11. See also in depth on shadow banking in emerging economies: IMF, (2014), Shadow Banking around the Globe: How Large and How Risky? In Global Financial Stability Report, Washington, October. 398  R. Sahay et al., (2015), ibid., p. 30; see also: IMF, (2014), How Do Changes in the Investor Base and Financial Deepening Affect Emerging Market Economies? In Global Financial Stability Report, Washington, April; 2013. T. Philippon and A. Reshef, (2013), An International Look at the Growth of Modern Finance, Journal of Economic Perspectives Vol. 27, Issue 2, pp. 73–96. 394

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banking segment. As many emerging economies are still in need in large-scale long-term investment projects, the shadow banking market will penetrate that sphere through the project finance area.

7.11.2  Project Finance and the Role of Leveraged Finance The evidence of a shift in banks’ involvement in project finance is nascent and still preliminary and in need for ongoing evaluation. However, the increasing role is undeniable. Of all the project finance debt outstanding, an increasing amount comes from the shadow banking sector, according to Standard and Poor’s and accounts for more than 12.5% of the total project finance debt outstanding.399 The steep increase in recent years indicates that the source of funding will be critical in the years to come in particular for longer debt with longer maturities. The growing role of shadow banking in project finance can be seen in the recent proliferation of infrastructure debt funds and units established by insurers, hedge funds and other participants in the shadow banking system. This has led to some elevated levels of concern due to the lack of transparency on the side of some shadow banking participants. The concern is built around the potential dynamics of ‘systemic risk’ in the infrastructure sector. There is also the element of lack of infrastructure expertise. It has become clear that Basel III has driven more risk into the project finance sphere. By requiring regulated banks to hold more capital when funding long-­term and often illiquid loans (with associated high costs), it has driven the banking sector400 out of that space of project and infrastructure finance.401 A similar concern can be echoed when it comes to the involvement of shadow banks in the provisioning of ‘levered loans’ predominantly to the private equity and more specific leveraged buyout (LBO) space. Although traditional banking institutions are also active in this space, the shadow banking segment takes in increasingly larger role. This brings in more credit and leverage risk on the books of these entities. But since the space of private equity deals is finite, the number of deals in which banks and shadow banking entities are jointly active (often through syndication) is large, exposing the same business to credit and leverage risk. Given the existing and discussed interconnectedness between the shadow and traditional banking sector, the impact of these dealings on ‘systemic risk’ is material. Grupp402 demonstrates that banks with higher LBO exposure also have a higher level of systemic risk. Other loan purposes do not show this positive relationship, he indicates. Or put differently, banks or shadow banking entities that engage in LBO lending not only have higher credit risk on their books but also pose a high risk to the stability of the public markets. He therefore concludes, ‘LBO loan exposures have a sig-

 Standard and Poor’s, (2013), Out of the Shadows: The Rise of Alternative Financing in Infrastructure, January, pp. 2–4. 400  Mainly through the NSFR, the liquidity standard introduced by Basel III. 401  See also: C. M. McNamara and A. Metrick, (2015), Basel III G: Shadow Banking and Project Finance, Case Study 2014-1G-V1, Yale Program on Financial Stability. 402  M. Grupp, (2015), On the Impact of Leveraged Buyouts on Bank Systemic Risk, SAFE Working Paper Nr. 101, Goethe University, Frankfurt am Main, April. See also: L. Allen, et al., (2012), Does 399

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nificant influence on bank systemic risk with banks having higher levels of systemic risk when financing more LBOs. Second, LBO loans are the only loan purpose that impact systemic risk adversely. Third, several drivers of this impact on systemic risk exist: It increases in the size of the LBO banking network a financial institution is connected to and in the bank size. However, the impact of LBO loan exposure on systemic risk decreases if the bank had a lending relationship with the PE sponsor in the past, more experience in the LBO financing market or a higher credit rating.’403 Grupp has helped to understand that the main drivers influencing this relationship (between LBO financing and systemic risk) positively are the bank’s interconnectedness404 to other LBO financing banks and its size. Lending experience with a specific PE sponsor, experience with leading LBO syndicates or a bank’s credit rating, however, leads to a lower impact of the LBO loan exposure on systemic risk.405

7.11.3  A  s Long as Societies Change, so Do (Shadow) Banking Institutions Most prosperous civilizations have witnessed the existence of banking institutions of some sort. In review, they tended to serve four functions: (1) they enable people to save money safely; (2) they intermediate capital, that is, supply it to those that can productively use it;406 (3) they allocate risk in the economy to those who can bear it; and (4) they

Systemic Risk in the Financial Sector Predict Future Economic Downturns? Review of Financial Studies, Vol. 25, pp. 3000–3036. D. Anginer, (2014), How Does Competition affect Bank Systemic Risk? Journal of Financial Intermediation, Vol. 23, pp. 1–26. U. Axelson, et al., (2013), Borrow Cheap, Buy High? The Determinants of Leverage and Pricing in Buyouts, The Journal of Finance, Vol. 68, pp.  2223–2267; Th. Beck, and O.  De Jonghe, (2013), Lending Concentration, Bank Performance and Systemic Risk: Exploring Cross-Country Variation, World Bank Policy Research Working Paper, WPS6604. 403  M.  Grupp, (2015), pp.  9–13. See also: M.  Billio, et  al., (2012), Econometric Measures of Connectedness and Systemic Risk in the Finance and Insurance Sectors, Journal of Financial Economics, Vol. 104, pp. 535–559; M. Brunnermeier, et al., (2012), Banks’ Non-Interest Income and Systemic Risk, Working Paper; J. Cai, Jian, et al., (2014), Syndication, Interconnectedness, and Systemic Risk, Working Paper; N. Dass, and M. Massa, (2011), The Impact of a Strong Bank-Firm Relationship on the Borrowing Firm. Review of Financial Studies, Vol. 24, pp. 1204–1260. 404  See in detail: J. Lim, et al., (2014), Syndicated Loan Spreads and the Composition of the Syndicate, Journal of Financial Economics, Vol. 111, pp. 45–69; G. López-Espinosa, et al., (2012), Short-Term Wholesale Funding and Systemic Risk: A Global CoVaR Approach, Journal of Banking & Finance, Vol. 36, pp. 3150–3162; T. Tykvová, and M. Borell, (2012), Do Private Equity Owners Increase Risk of Financial Distress and Bankruptcy? Journal of Corporate Finance, Vol. 18, pp. 138–150. 405  See also: Adams, R.F. Zeno, and R. Gropp, (2014), Spillover Effects Among Financial Institutions: A State-Dependent Sensitivity Value-at-Risk Approach, Vol. 49, pp.  575–598; F.  Allen and E.  Carletti, (2013), What Is Systemic Risk? Journal of Money, Credit and Banking, Vol. 45, pp. 121–127; S. Bharath, et al., (2011), Lending Relationships and Loan Contract Terms, Review of Financial Studies, Vol. 24, pp. 1141–1203. 406  See in detail: P. Beaudry and A. Lahiri, (2009), Risk Allocation, Debt Fueled Expansion and Financial Crisis, NBER Working Paper Nr. 15,110, p. 2.

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are a source of objective financial advice that benefits their customers and allows the better ordering of their affairs.407 Many of the objectives are no longer, or only partially, met, although a distinction should often be made between individual institutions and the system as such. This has many implications,408 including the question as to whether as a society we are demanding such financial infrastructure and if we even agreed at some point for such an infrastructure to be developed. Markets are not a natural construct but the consequence of many forces coming together. As markets change, so does the understanding that society needs a better grip on what it wants to have going on in those artificial constructs called ‘markets’.409 The political process, due to many reasons, has been proven noninstrumental in turning the tide. It’s not an easy job though, as Buckley indicates: ‘[t]he analysis of the changes in banking shows that the current architecture of international finance was never planned nor foreseen. The consequence of a series of seemingly innocuous changes has been the creation of vast, complex financial speculators at the very core of the international economy.’410 Another element that a changing society and therefore changing financial landscape brought across is the fact that regulation, as is always the case, is highly imperfect. This is also the case for the financial regulation. The information asymmetry between market players is something that regulation cannot avoid. Nor can it avoid that reality will manifest itself differently than the financial or economic model underlying the regulation predicted or expected. It asks overall, a serious consideration about the relationship of the law and economics sphere and the way they interact. It is my impression that, which I reiterated in early writings, that regulation has not created a solid foothold against the econometric barrage and economic dominance and has failed to stay faithful to its own principles and dynamics. Model-based regulation has been of all times. But its usage has increased, in particular after the financial crisis. It led to the introduction of complex, model-based capital regulation that was meant to promote the adoption of stronger risk management practices by financial intermediaries, and—ultimately—to increase the stability of the banking system. Behn et al. have been examining the use of model-based regulation and in particular the question to what degree it has helped to manage and mitigate credit risk exposure. They comment, ‘[p]rior to the introduction of model-based regulation, the regulatory environment was considered to be too coarse, leading to excessive distortions in lending. In contrast, regulation under Basel II relies on a complex array of risk models, designed and calibrated by banks themselves and subsequently approved by the supervisor. By tying capital charges to actual asset risk, banks are no longer penalized for holding very safe assets on their balance sheets, so that the distortion in the allocation of credit that

 R.P.  Buckley, (2015), The Changing Nature of Banking and Why It Matters, in Rethinking Global Finance and Its Regulation, (eds.) R. Buckley, et al., Cambridge University Press, Cambridge, pp. 14–15. 408  See for a review: R.P. Buckley, (2015), ibid., pp. 16–22. 409  S. Walby, (2013), Finance Versus Democracy? Theorizing Finance in Society, Work Employment and Society, Vol. 27, Nr. 3, pp. 489 ff. 410  R.P. Buckley, (2015), ibid., p. 23. 407

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accompanied the simple flat tax feature of Basel I is eliminated.’411 The wide prevalence of informational and enforcement constraints in the lending process and the effect of sophisticated, model-based regulation on banks’ credit risk remain highly questionable, if not worse. They examined the effect of the Basel II introduction and conclude that the introduction led to the fact that ‘reported probabilities of default (PDs) and risk-weights are significantly lower’, but ‘ex-post actual default and loss rates’ went up materially. They further observed that the interest rates charged (reflecting the perceived riskiness of the loan book) by the banks indicate that they understood the riskiness in their portfolios while benefiting from the lower capital charges. They also find that both the reported probability of default and the risk weights are systematically lower, while the estimation errors (i.e. the difference between a dummy for actual default and the PD) are significantly higher for loans. The overall conclusion is that ‘banks that opted for the introduction of the model-based approach experienced a reduction in capital charges and consequently increased their lending by about nine percent relative to banks that remained under the traditional approach. Thus, this complex, model-based regulation created barriers to entry and subsidized larger banks. This seems rather paradoxical, given the systemic risk associated with larger banks. All in all, our results suggest that complex, model-based regulation has failed to meet its objective of tying capital charges to actual asset risk. Counter to the stated objective of the reform, aggregate credit risk of financial institutions has increased.’

7.11.4  A  Decision-Tree for the Regulator and Oversight Bodies Their conclusions should not be swept under the carpet. Their finding might be particular for the Basel II implementation, and the conclusions to be drawn have material and widespread policy implications. Further increases in complexity are unlikely to increase financial stability. But an even-wider rethink might be necessary. Maybe we should start with the end in mind and create a decision-tree. The end result should be a persistent stable and liquid well-functioning open capital market. This can be endangered by market agents engaging in transactions and market making that can destabilize the market. They can endanger themselves by engaging in transactions involving too much leverage or risk relative to the amount of equity they hold. They can also endanger others with whom they engage in through a variety of transactions and which are often asymmetric in terms of content. This causes ripple effects and will accuse market turmoil and volatility. From that observance, the regulator should decide what type of regulation is most appropriate

 M. Behn et al., (2014), The Limits of Model-Based Regulation, SAFE Working Paper Nr. 75, Goethe University Frankfurt. Keep in mind that following the reform banks were allowed to choose between the model-based approach (referred to as the internal ratings-based approach, shortened to IRB) in which capital charges depend on internal risk estimates of the bank and a more traditional approach that does not rely on internal risk parameters (referred to as the standard approach, shortened to SA). 411

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to tackle the issue: ex ante regulation or ex post regulation (or a combination of both). It should further decide what type of regulatory instrument is most appropriate: a tax instrument, a command-and-control instrument or a quantity instrument (e.g. thresholds on the use of leverage) or a combination. These choices don’t need a whole lot of economic modeling and crossovers between the economic and regulatory field. If the regulator focuses on what he wants to achieve, he can focus on neutralizing those behaviors that do not contribute to that objective or even contradict it. It would allow to create a simpler and transparent model. The enormous compliance burden as is currently created by the avalanche of financial regulation only leads to a financial burden the largest firms in the industry can bear (indirect market manipulation on the side of the regulator) but of which the economic cost ultimately sits with the customer of financial services. That is ‘all of us’, and therefore it is a matter of ‘public interest’. Also the shadow banking system is ultimately a product of how traditional banking has been regulated. Duca412 has been looking a little closer into this. More specifically, he analyzed how capital regulation, risk and other factors (and their change over time) contributed to the emergence and the way of the shadow banking system. His findings include the fact that it was not (only) changing information costs, changing business landscapes and reserve requirements, but mainly the shift in regulation between the bank and nonbank credit sources. He comments: ‘[i]n the short-run, the shadow bank share rose when deposit interest rate ceilings were binding, the economic outlook improved, or risk premia declined, and fell when event risks disrupted financial markets.’ His findings are consistent with the literature strand regarding regulatory arbitrage both for his longand short-term findings.413 That strand denies the role of information costs, but indicates that shadow banks in the short run are impacted ‘when short-run liquidity premia were high, term premia reflected expectations of an improving economy, or event risks occurred in security markets, but also rose when deposit rate ceilings were more binding or short-run regulatory changes favored nonbank relative to bank finance’.414 Those findings supplement existing literature415 that shadow banking is procyclical and vulnerable to liquidity shocks. From

 J.V.  Duca, (2014), How Capital Regulation and Other Factors Drive the Role of Shadow Banking in Funding Short-Term Business Credit, Working Paper, mimeo. 413  Wang suggests to include ‘regulatory arbitrage’ as a risk measurement when determining the levels of regulatory capital required. When a risk measure is applied to calculate regulatory capital requirement, the magnitude of regulatory arbitrage is the amount of possible capital requirement reduction through splitting a financial risk into several fragments. Coherent risk measures by definition are free of regulatory arbitrage; dividing risks will not reduce the total capital requirement under a coherent risk measure. However, risk measures in practical use, such as the Value at Risk (VaR), are often not coherent and the magnitude of their regulatory arbitrage is then of significant importance. Wang developed a coherent mathematical model and illustrates (pp. 21–22) its application under each classification and for all classes of risk measures including distortion risk measures and convex risk measures; see R.  Wang, (2015), Regulatory Arbitrage of Risk Measures, University of Waterloo Working Paper, July 3, mimeo. 414  J.V. Duca, (2014), ibid., 31. 415  See further: T.  Adrian, and H.  S. Shin, (2010), Liquidity and Leverage, Journal of Financial Intermediation, Vol. 19, pp. 418–437; T. Adrian and H. S. Shin, (2009), Money, Liquidity, and 412

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a longer-term perspective, it can be observed that during periods of severe market distress (e.g. Great Depression) ‘the provision of credit shifted towards debt whose funding sources were less vulnerable to liquidity shocks’. The longer-term perspective puts focus on one of the items that is missing in many contemporary regulatory initiatives in recent year, that is, the need to synthesize roles for information costs, financial regulation, innovation and risk.416

7.11.5  A  voiding Ambiguity and Bringing Down the Last Public Puts After the financial crisis, many governments around the world have been stepping in to stabilize markets. By doing so, they helped individual financial institutions to survive and actually provided puts (i.e. bailouts) to those institutions. Singh indicates that these puts came at zero cost to those institutions. Singh indicates, ‘[i]nstitutions in the shadows were provided puts at just the moment they were needed and when no private sector participant would have provided them at any price. This is akin to a homeowner without fire insurance being provided a conventional policy just as the flames from a neighbor’s burning house touch the homeowner’s house.’417 These puts have proven to be much more valuable than initially thought. Singh reviews the current financial landscape, the regulatory interventions so far and concludes that in the (shadow) banking market there is a variety of areas where ‘puts’ are still explicitly and implicitly provided by the government.418 He further acknowledges that in some areas puts will always continue to exist; he uses the collateral market to prove his point. Financial markets (i.e. banks and shadow banks) accepted securities as collateral rather than gold, swapping them for money. When the crisis struck and the next one will arrive, ‘governments will step in, take the bad securities onto its own book, and provide the markets with higher quality collateral or reserves (or money) backed by the full faith and credit of the public sector’.419 ‘Puts’ and the ex ante provisioning of them by governments provide in no way a ‘disciplining tool’ by gov-

Monetary Policy, American Economic Review, Vol. 99, Issue 1, pp. 600–609; T. Adrian and H. S. Shin, (2009), The Shadow Banking System: Implications for Financial Regulation, Banque de France Financial Stability Review Vol. 13, pp. 1–10; S. Claessens, et al., (2012), Shadow Banking: Economics and Policy, IMF Staff Discussion Note Nr. SD/12/12; P.  Jackson, (2013), Shadow Banking and New Lending Channels—Past and Future, in 50 Years of Money and Finance: Lessons and Challenges. Vienna: The European Money and Finance Forum, pp. 377–414; E.S. Rosengren, (2014), Our Financial Structures—Are They Prepared for Financial Stability?, Journal of Money, Credit, and Banking Vol. 46 (s1), pp. 143–56; A. Schleifer and R. W. Vishny, (2010), Unstable Banking, Journal of Financial Economics, Vol. 97, pp. 306–318. 416  J.V. Duca, (2014), ibid., 32. 417  M. Singh, (2012), ‘Puts’ in the Shadow, IMF Working Paper Nr. WP/12/229, p. 5. 418  See Singh, (2012), ibid., pp. 7–14. 419  See Singh, (2012), ibid., pp.  17–19; see also: M.  Singh and P.  Stella, (2012), Money and Collateral, IMF Working Paper Nr. WP/12/95, and M. Ricks, (2011), Regulating Money Creation After the Crisis, Harvard Law School, Working Paper. Singh refers to the creation of CCPs to reduce counterparty risk, the fact that MMFs still can offer NAV par funds and bailing out money-

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ernments. As Singh demonstrates, liquidity can be provided to (shadow) banking institutions, but when the collateral markets come down, only sharp haircuts can help, and that will massively destabilize the market and the respective governments will have no tools to mitigate market failure. He therefore suggests a proper pricing of these ‘puts’ toward the financial market and taking any form of ambiguity in the ‘resolution regimes’ adopted for financial institutions. It will lower moral hazard and will reduce the cost of ex post bailouts.

7.11.6  Financialization and Its Long-Term Implications I discussed the nature and rise of financialization; the good, bad and ugly of financialization; and the implications for the real economy and the financial infrastructure as such. That all happened within a framework where starting in the postwar period the financial sector grew from one in which closely regulated and chartered commercial banks were dominant to one in which financial markets dominate the system. Over this period, the financial system grew rapidly relative to the nonfinancial sector. Mazzucato and Wray comment: ‘[t]o a large degree, this was because finance, instead of financing the capital development of the economy, was financing itself. At the same time, the capital development of the economy suffered perceptibly.’420 The financial development that occurred happened remotely from the real economy and the production sector in particular. The financial sector grew and so did the financial fragility. It was H. Minsky that did not see the banker merely as the metaphor of capitalism, but as its key source of instability. The financialization of the real economy doesn’t merely reflect the ‘picture of runaway finance and an investment-starved real economy’, but one where the real economy itself has ‘retreated from funding investment opportunities and is instead either hoarding cash or using corporate profits for speculative investments such as share buybacks’. Long-term growth in any economy is the result of public and private actors working together in a symbiotic way. This is not going to happen with a financial sector with predatory dynamics and an increasingly financialized private sector that operated under financial matrixes at the expense of long-term investments, R&D and human capital formation. On the other hand, there is the public sector that due to austerity pressures and ideological dynamics feels pressured to keep their debt-GDP ratio in check. But it is growth through long-term investments that increases that denominator. It can’t be so that the shadow banking sector can and will only contribute to financial sector and thus highly privatized gains. The shadow banking sector needs to contribute, in a meaningful and demonstrable way, to the solidification, robustness and the accessibility of finance for strategic long-term investments. For that to turn into a tremendous success, more is needed far beyond the shadow banking sector, in all types of associated policies that allow for those ‘real economy’ innova-

like collateral at subsidized haircuts, thereby referring to the US and European bailout programs that were initiated after the crisis (LTRO, etc.). They all are prone to ‘ambiguity’ if the government will step in and under what conditions. 420  M. Mazzucato and L.R. Wray, (2015), Financing the Capital Development of the Economy: A Keynes Schumpeter-Minsky Synthesis, Levy Economics Institute of Bard College, Working Paper Nr. 837, May.

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tions to be fully deployed, increasing productivity overall in our economies. That asks for an ‘entrepreneurial state’ that is able and willing to tweak the market inconsistencies also in the financial sector and the shadow banking segment in particular. This is going to be more a necessity than a luxury given the enormous amounts of spillovers and externalities the deregulated system can produce in a globalized context. it will require a chirurgical adaptation of monetary, fiscal and macroprudential techniques that regard their interactions. Monetary regimes and financial conditions interact globally and reinforce each other. The strength and relevance of the spillovers and feedbacks tend to be underestimated given the channel through which international spillovers occur. There are four channels in particular421: (1) the conduct of monetary policy: monetary conditions in advanced economies spread to emerging economies and trigger policy responses there; (2) the currency channel: the impact of hard currencies (in particular euro and USD) go well beyond their own territories and jurisdictions. They play a global role in ‘trade invoicing, foreign exchange turnover, official reserves and the denomination of bonds and loans’; (3) the integration of financial markets allows global common factors (uncertainty and risk aversion) to move bond and equity prices; and (4) the availability of external finance in general. Capital flows provide funding that can be good but also have the potential to amplify domestic credit booms and busts. These four channels interact and can ‘amplify domestic imbalances to the point of instability’ and require specific policy actions.422 The story will stay the same over time, and only the details will adjust: ‘[f ]inancial regulation is evolving, as policy makers seek to strengthen the financial system in order to make it more robust and resilient. Changes in the regulatory environment are likely to have an impact on financial system structure and on the behavior of financial intermediaries that central banks will need to take into account in how they implement monetary policy’,423 Bindseil and Nelson conclude. Indeed, as financial regulation tries to influence the banks and other intermediaries to enhance resilience and support financial stability and since the same intermediaries interact with central banks in the context of monetary policy implementations, changes to the regulatory environment will have a distinct effect that central banks will have to deal with. These regulatory changes will have an impact on ‘money markets, monetary operations and monetary transmissions’.424 The impact is judged to be modest and manageable. Although the group chaired by Bindseil and Nelson identify five implication areas, the ones most important from a shadow banking point of view are (1) the shifting asset price relationships and the impact on policy targets (i.e. shifting equilibrium relationships between asset prices and policy rates), (2) regulatory arbitrage and the implementation on policy impact and (3) overall enhanced central bank

 J. Caruana, (2015), The International Monetary and Financial System: Eliminating the Blind Spot, Panel remarks at the IMF conference ‘Rethinking Macro Policy III: Progress or Confusion?’ Washington. DC, 16 April 2015, pp. 2–3. 422  See in detail: J. Caruana, (2015), ibid., pp. 3–4. 423  U. Bindseil and W.R. Nelson (Chair), (2015), Regulatory Change and Monetary Policy, Report submitted by a Working Group established by the Committee on the Global Financial System and the Markets Committee, CGFS Papers Nr. 54, May, p. iii. 424  U. Bindseil and W.R. Nelson (Chair), (2015), ibid., p. 1. 421

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intermediation (also as a lender of last resort).425 Despite this understanding, it was proven that developing heat maps, issue grids and other tools are limited in enhancing our understanding of nascent financial crises. In particular, the tool indicative value at the onset of a crisis is fairly weak.426

7.12 The Neglected Risk Syndrome Investors are human beings and so they behave that way. Behavioral finance has taught us in recent decades a bit about the good, bad and ugly of how the psychology of investors works under a variety of models and scenarios. One of the elements regarding financial crises in recent times is that they occur much more often, and it seems the frequency will only increase.427 Nevertheless, despite the opportunity to learn from previous crisis, the ‘this time is different approach’ implies that investors over and over again are surprised when a crisis kicks in and fail to see the similarities among the different pre-crisis bubbles.428 Also, the regulators seem to go all way with their macroeconomic forecasting during crises.429 Gennaioli et al. indicate in this respect: ‘[e]conomists typically model financial crises as responses to shocks to which investors attach a low probability ex ante, but which nonetheless materialize.’430 Also the 2008 financial crisis provided evidence that investor appreciation of the risks was not entirely rational. Coval et al. illustrate that ‘investors underestimated the probability of mortgage defaults in pricing mortgage backed securities’ (MBS).431 Others provide direct evidence that ‘investors did not even contemplate the magnitude of home price declines that actually materialized’.432 Even more, the risks that were in the system and of which the first signs already showed up in 2007 were not considered unlikely but totally neglected. This makes Greenwood and Schleifer conclude that investor expectations are ‘extrapolative’ rather than ‘rational’.433  See for a distinct and detailed analysis: U.  Bindseil and W.R.  Nelson (Chair), (2015), ibid., pp. 12–21 & 22–32 & 33–39. 426  R. Vermeulen et al., (2015), Financial Stress Indices and Financial Crises, DNB Working Paper Nr. 469, March. 427  See for a complete overview of types and implications of the different crises: S. Claessens and M.A. Kose, (2013), Financial Crises: Explanations, Types and Implications, IMF Working Paper Nr. WP/13/28. 428  See for the literature re financial crises: I. Goldstein, (2013), Empirical Literature on Financial Crises: Fundamentals vs. Panic, Financial Crisis Review, pp. 523–534. 429  See: L.  Alessi, et  al., (2014), Central Bank Macroeconomic Forecasting During the Global Financial Crisis: The European Central Bank and Federal Reserve Bank of New York Experiences, Federal Reserve Bank of New York Staff Reports Nr. 680, July. 430  N. Gennaioli et al., (2014), Neglected Risk: The Psychology of Financial Crises, Working Paper, p. 1, also published as NBER paper Nr. 20875, January 2015. 431  J. Coval, et al., (2009), The Economics of Structured Finance, Journal of Economic Perspectives Vol. 23, pp. 3–26. 432  C. Foote, et al., (2012), Why Did So Many People Make So Many Ex-Post Bad Decisions? The Causes of the Foreclosure Crisis, Working paper, Federal Reserve Bank of Boston. 433  R. Greenwood, and A. Shleifer (2014), Expectations of Returns and Expected Returns, Review of Financial Studies Vol. 27, Issue 3, pp. 714–746. 425

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Gennaioli et al. provide a psychological theory of the neglect of risk. They comment: ‘[t]he theory seeks to explain precisely why the probability estimates of a crisis in the middle of a boom are too low, offering a foundation of “unanticipated” shocks, and of zero probabilities attached to some states of the world by investors.’434 In their model, ‘representativeness (i.e. representativeness maps reality into what investors are thinking about435) induces people436 to over-estimate the probability of outcomes that are relatively more likely in light of recently observed data. Representativeness is intimately related to the idea of similarity: after seeing some data, people concentrate their forecasts on outcomes similar to the data observed, neglecting alternative future paths.’437 It is only when structurally and sufficient amounts of bad news arrive that the representative scenario changes from boom to bust, where previous bad news is remembered leading to an immediate response and associates drop in asset prices. They conclude: ‘[t]he investor now overreacts to the bad news, especially if the true probability of the low state remains low. The possibility of black swans is initially ignored, but ultimately turns into an overstated fear that leads to a self-generating crisis. In contrast to rational expectations, the model yields purely belief-driven boom bust cycles.’438 The bottom line is that their psychologically founded model is different than the rational theory or model regarding ‘unanticipated shocks’. In the psychological model, crises can easily occur on a frequent basis and even likely outcomes may be neglected under such psychological model. Also, the way a crisis unfolds is different under such a psychological model: ‘under representativeness, a few disappointing bits of data intermixed with good news are not enough for neglected risks to become salient. Enough bad news must accumulate for the bad scenario to become representative. As a consequence, investors initially under-react to bad news, but when enough bad news accumulates, investors over-­ react because their representation changes, causing them to overestimate the probability of the low state.’439 This causes the typical ‘boom and bust’ model we can all observe in the markets.

 N. Gennaioli et al., (2014), ibid., p. 2. See also: N. Gennaioli, et al., (2012), Neglected Risks, Financial Innovation and Financial Fragility, Journal of Financial Economics Vol. 104, Issue 3, pp. 452–468. 435  D. Kahneman and A. Tversky, (1972), Subjective Probability: A Judgment of Representativeness, Cognitive Psychology Vol. 3, Issue 3, pp. 430–454: When the investor assesses risk by representativeness, he overreacts to good news; N. Barberis, et al., (1998), A Model of Investor Sentiment, Journal of Financial Economics Vol. 49, Issue 3, pp. 307–343; P. Bordalo, et al., (2014), Stereotypes, NBER Working Paper. 436  See on the gender difference in this matter: F. D’Acunto, (2014), Identity, Overconfidence and Investment Decisions, Working Paper, November. 437  N. Gennaioli et al., (2014), ibid., p. 2. As a financial crisis tends to typically follow economic boom times, ‘the investor then puts too much probability weight on that scenario and neglects the risk of bad outcomes’. The expectations are elicited and they assess things ‘extrapolative’. Even bad news mixed with all the good news doesn’t change investor minds, which explains their ‘numb’ behavior. Bad news is seen as an aberration. 438  Gennaioli et al., (2014), ibid., p. 3. 439  Gennaioli et al., (2014), ibid., p. 7. 434

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But how does this work from a regulatory point of view? Does one anticipate this and create ex ante regulation and prudent oversight? Or does one embrace the implications and create robust ex post frameworks and regulation that can minimize the collateral damage. Or do we need to dig deeper and discuss whether it is preferable to have deregulated globalizing financial markets that ‘even in potential’ can cause these shocks and the typical collateral damage. Much has been said, but very few final (partial) answers are out there. It is clear, however, that in a shadow banking context the psychological model can be seamlessly tested and confirmed given the data sets we inherited from the financial crisis: neglect followed by overcorrection. But the reality of things is that there is no regulation that can tame the ‘psychologically embedded contagion potential’ of public markets. But it does caution against the too-easy acceptance of a pure market-based financial system. And yes, the bottom line might be that in some parts of the world, most likely the advanced part, we have too much finance going on. To that conclusion also came the IMF and the Bank for International Settlements during the last few years. Analyzing their arguments, we can observe the fact that the financial industry in recent years has been accumulating fines for a total amount of about USD 150 billion. Let’s not forget that capitalism, even in its social democratic model, is about rent extraction. That explains the 7% share of the US financial sector in US GDP between 1998 and 2014 and the 29% share in profits during the same period. The invention of services, characterized by its complexity and ambiguities, not only generates excessive returns but also damages the real economy. We discussed how Zingales, a strong advocate of the free market,440 addresses the question of the harm caused. The damage caused occurs either through unsustainable credit-fueled booms or more indirectly through a breakdown in trust in a variety of financial arrangements due to ‘crises, pervasive dumping or both’. Although credit provisioning fuels economic growth initially, once credit levels move beyond 100% of GDP, it starts to stifle innovations and the improvements in the efficiency with which labor and capital are used (‘total factor productivity’). Or put differently, the allocation of capital and the efficacy of corporate control go wrong. Excessive finance and credit negatively impact the functioning of corporate governance. Wolf argues in the context that it is very difficult to police markets that are ‘riddled with conflicts of interest and asymmetric information. Risk-free debt should become risk-sharing debt again.’ Not more but better finance, he argues. And it is very likely that will mean less finance.441 The liquidity creation in shadow banking is vulnerable to self-fulfilling runs, as investors tend to withdraw funding simultaneously. This is not only a problem given the nexus between the traditional and shadow banking sector. The shadow banking segments has another important nexus discussed, that is, that with the (life) insurance business. FoleyFisher et al.442 examined the contractual structure of funding agreement-backed securities offered by life insurers to institutional investors. The variations in investor expectations

 And a professor in finance at the Chicago Booth School of Business.  M. Wolf, (2015), Why Finance Is Too Much of a Good Thing, Financial Times, May 26. 442  N.C.  Foley-Fisher et  al., (2015), Self-Fulfilling Runs: Evidence from the U.S.  Life Insurance Industry, Finance and Economics Discussion Series Nr. 2015-032, Divisions of Research & Statistics and Monetary Affairs Federal Reserve Board, Washington, DC. 440 441

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about the actions taken by other investors are plausibly orthogonal to changes in fundamentals. Their model builds on the discussed theory that goes back as far as Bryant443 and Diamond and Dybig,444 who concluded that liquid liabilities are potentially vulnerable to swift changes in investors’ beliefs about the actions of other investors. Foley-Fischer et al. indicate that ‘[w]hen investors withdraw based on their beliefs and their action leads other investors to withdraw, then the original belief is verified and a self-fulfilling run has occurred. Such a run is in contrast to a fundamental-based run, in which investors decide to withdraw based on, for example, changes in their liquidity demand, risk appetite, regulatory constraints, or information about the liquidity of an issuer.’445 As it is very difficult to provide evidence of these vulnerabilities outside theoretical models and/or lab experiments, it is difficult to empirically separate runs due to changes in fundamentals from changes in expectations about other investors’ expectations. Foley-Fischer et  al. therefore decided, addressing the simultaneity problem, to exploit the contractual structure of a particular type of liquid liability issued by life insurers (‘funding agreement-backed securities’). As these securities and notes are election-date specific, their analysis allows to separate the decisions of investors within each insurer, thereby avoiding the simultaneity problem. Analyzing the withdrawals of investors, they conclude that ‘a statistically and economically significant relationship between the decisions of investors to withdraw and their expectations that other investors might withdraw in the future’.446 They however qualify their analysis and comment that ‘this association could well be driven by fundamental developments, rather than by self-fulfilling expectations’.447 The various instruments issued by a given insurer typically have different election dates, but all information is known in advance to investors. Crucially, the election dates are determined when the security is issued and are therefore plausibly exogenous to recent changes in fundamentals. This exogeneity allows us to construct an instrument for investors’ expectations that gets us closer to identifying the effect of changes in expectations about other investors on the payoff to an individual investor. From that perspective, the results demonstrate that investors were sensitive to changes in their expectations that other investors would withdraw. Vis-à-vis shadow banking, they conclude that ‘evidence of a self-fulfilling run on U.S. life insurers contributes to a deeper understanding of the vulnerability of shadow banking to runs’, and that while the life insurance market and those debt products in specific are much smaller than the repo or asset-backed commercial paper (ABCP) market, it is the same type of investors who invest in both segments and instruments, and their behavior is likely going to be similar across market segments.

 J. Bryant, (1980), A Model of Reserves, Bank Runs, and Deposit Insurance, Journal of Banking & Finance, pp. 335–344. 444  D. W. Diamond and P.H. Dybvig, (1983), Bank Runs, Deposit Insurance, and Liquidity, Journal of Political Economy Vol. 91, Issue 3, 401–419. 445  N.C. Foley-Fisher et al., (2015), ibid., p. 2. 446  N.C. Foley-Fisher et al., (2015), ibid., p. 4. 447  N.C. Foley-Fisher et al., (2015), ibid., p. 5. 443

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7.13 The Limits of Shadow Banking Supervision 7.13.1  Introduction Most of the ex ante suggested regulation involves material amounts of supervision and the aligned compliance. Although there are many critical aspects embedded in supervision, there are also many drawbacks and limitations that make ‘supervision’ qualify more as an enhancer rather than a core element of any potential shadow banking regulation. Supervision should therefore be distinct from the regulatory initiatives taken by regulators around the world. Prudential supervision involves ‘monitoring and oversight of these firms to assess whether they are in compliance with law and regulation and whether they are engaged in unsafe or unsound practices, as well as ensuring that firms are taking corrective actions to address such practices’. Prudential supervision is interlinked with, but distinct from, regulation448 of these firms, which involves the development and promulgation of the rules under which ‘bank holding companies’ (BHCs) and other regulated financial intermediaries operate. The distinction between supervision and regulation is sometimes blurred in the discussions and scope and depth of supervisory activities materially unknown.449 In particular, challenges exist in the supervision model of SIFIs or global financial institutions.450

7.13.2  The Liquidity Fetishism Liquidity is part of modern markets. In fact, it is part of modern financial theory along which modern capital markets have been built. The more liquid the investment, the less of a premium it requires; the more illiquid the investments, the more the illiquidity premium will depress the valuation or will up the required hurdle rate. It all goes back down to the alternative cost of investment theory. When investments are liquid, they allow

 See on the distinction between regulation and supervision: D. Masciandaro and M. Quintyn, (2013), 8. The Evolution of Financial Supervision: The Continuing Search for the Holy Grail, SUERF 50th Anniversary Volume Chapters, pp.  263–318. F.S.  Mishkin, (2001), Prudential Supervision: Why Is It Important and What Are the Issues? In Prudential Supervision: What Works and What Doesn’t, University of Chicago Press, Chicago, pp. 1–30. 449  See, for example, recently: T.  Eisenbach et  al., (2015), Supervising Large, Complex Financial Institutions: What Do Supervisors Do?, Federal Reserve Bank of New York Staff Reports, Nr. 729, May 450  L. H Meyer, (2000), The Challenges of Global Financial Institution Supervision, Speech by Mr. Laurence H. Meyer, Member of the Board of Governors of the US Federal Reserve System, at the Federal Financial Institutions Examination Council, International Banking Conference, held in Arlington, Virginia, on 31 May 2000 and more recently J.L.  Yellen, (2015), Improving the Oversight of Large Financial Institutions, At the Citizens Budget Commission, New York, 3 March 2015. She indicates: ‘[t]o be effective, regulation and supervision must be independent of the entities subject to oversight. You may know or have heard the term “regulatory capture.” Regulatory capture is when a regulatory agency advances the interests of the industry it is supposed to oversee rather than the broader public interest it should represent.’ ‘Regulatory capture’ was first coined and thematically addressed by G. J. Stigler, (1971), The Theory of Economic Regulation, Bell Journal of Economics and Management Science, Vol. 2 (Spring), pp. 3–21; see also E. Dal Bó, (2006), Regulatory Capture: A Review, Oxford Review of Economic Policy, Vol. 22 (Summer), pp. 203–225. 448

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during the intended investment horizon to be redirected and invested in other (more) profitable assets in case they occur. When the initial investment is ‘illiquid’, then that window is closed or it will take too long (or a too steep discount) to liquidate the initial investment to enjoy the benefits of the alternative investment. The alternative cost of investments will push up the required hurdle rate on the initial investment. But over time, that spectrum got a little out of whack in the sense that 100% liquidity became the ‘standard’ and that all other hurdle rates (of all assets who are not 100% liquid) feed off. As worldwide so many different assets got listed, the liquidity of the public financial markets became the standard. But given the vulnerabilities in the system and the deregulated globalizing markets tend to facilitate contagion pretty well, material shocks are to be expected and go ‘hand in hand’ with the dynamics of an unregulated global market underlying a real globalizing economic markets and political landscape with many hurdles and hazards.451 The liquidity has been seen over time as a precondition to a well-functioning real economy. There is however no empirical evidence for that. What we know for sure is that the liquidity works well for the financial sector itself given the many opportunities it can tap into. But the liquidity fetishism also made capital stand at arm’s length from real investments (i.e. real assets rather than financial assets) and tends to shift the risks of financing to the owner of the asset (who already incurs the operational risk). That asymmetry is unwelcome. Many have argued that the volatility of the (global) financial markets only indicates the need for more ‘private market’ as it is more stable, fundamentally more focused on the long term and fundamentals oriented. In contrast, the public markets have become more volatile now that they have become global and deeper and have triggered market participants that have not been in the market before. Those participants see ‘volatility’ as an ‘asset class or investment strategy’.452 This raises questions about the need for constant liquidity at all times and in any market conditions as has become the norm in recent decades. It serves the financial industry, but not necessarily the rest of the economy. Obviously, it has brought down the cost of funding for the rest of the economy, but also that it is the result of a measurement within a framework where liquidity is supposed to be norm at all times. The alternative economic cost will stay in the background as scarcity will be a ‘given’ going forward, although one sometimes wonders if that scarcity is still a structural component of the financial economy after the raft of unconventional monetary policies witnessed in recent years. Nevertheless, for the time being ‘liquidity’ is the norm and the link with a well-functioning economy is assumed.453 And in that context, shadow banking is seen as contributing positively to the economy. However, those investments that the shadow banking made in favor of the real economy were and are often less liquid than their traditional investment pattern (e.g. hedge funds

 Some, given the experiences of the behavior of the global financial markets in 2007/2008, refer to the globalized financial market as a ‘giant slush fund’. 452  See, for example, J. DeLisle, et al., (2014), Volatility as an Asset Class: Holding Vix in a Portfolio, Working Paper, December. 453  See: C.  Wilkins, (2015), Liquid Markets for a Slid Economy, Remarks by Carolyn Wilkins Senior Deputy Governor of the Bank of Canada, Chambre de commerce du Montréal métropolitain, 5 May, Montréal, Quebec. 451

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providing long-term loans rather than investment in public fixed-income securities). The liquidity that shadow banking provides to the rest of the financial infrastructure does not feed through or translates into benefits for the real economy. The regulatory arbitrage executed translates into higher profits and lower capital requirements for financial institutions (the latter leads as well to the former). Any meaningful reform would therefore have to take a broader perspective. It should include the discussion about the size and depth of the financial markets we aspire as a society and which financial activities contribute in which way. The rest is a private market affair excluded from the central bank liquidity window. As simple and meaningful that sounds, reality is harsher and the lawmakers’ keyboard is operated by those that can exercise influence in a persistent and concentrated way. Lobby groups are often better than those (left) that serve the public interest. A simple reinstallment of the ‘Glass-Steagall Act’ that separates commercial from investment banking activities was already too far to be realistic.454 The political reality that those that don’t like to see things happening are structurally willing to bargain harder than those that are in favor of things changing. And what is left then is ‘supervision and compliance’ as next best tools in the toolbox. Lifting the ban on bank secrecy rules was much easier to decide on in the political circuit than some of the other tougher decisions that were and are on the table.

7.13.3  A  Total Reset of the System Is More than Likely Required In recent times, many surveys and analyses have been developed,455 designed and constructed that deal with the shadow banking markets. Suggestions have been made about how and when to regulate and interfere, how and what to monitor and so on. However, each of those takes a practical view, often based on the experiences in recent years. Nevertheless, for any reform to be meaningful vis-à-vis the real economy, a wider perspective is needed than the question whether central clearing will help reduce counterparty risk and NAV funds will make the MMF market more stable as well as what level of haircuts will stabilize the repo market. These are meaningful questions but also imply an intrinsic instability that is now tried to be micro-managed with a view toward neutralizing vulnerability, mitigate contagion and safety mechanisms to regain stability as soon as possible. But it doesn’t ask the question about how a system should look like, where the financial system can flourish but not at the expense of the real economy, and where the real economy can grow without compromising the system that provides capital to them. The nexus between those two needs to be stronger, and more partner-like, but it should also depend on each other’s success. Not a system where the financial sector offloads all types of risks (even funding risks) on the real economy for the financial industry then to flourish. The pace at which we are experiencing financial crises is increasing and there is a reason for it.  J. Brunsdun, (2015), Bank-Separation Talks Hit Snag in EU Parliament, Bloomberg, April 29.  Bankenverband, (2014), Shadow Banking, A Guide by the Association of German banks, January, Berlin; CFA Institute, (2015), Shadow Banking, Policy Frameworks and Investor Perspectives on Markets-Based Finance, April. 454 455

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More comprehensive analyses have been done, and each of them undeniably involves the tackling of the shadow banking sector but equally the paradigm shift from short-term to long-term views on economy, wealth and value creation.456 Letting go of the liquidity requirement under all conditions is likely going to be a critical part in that total overhaul. But until that happens, if it will ever happen, we will continue to focus on supervision and compliance combined with ex ante command-and-control regulation and, more modestly, ex post regulation to mitigate collateral impact. That regulation often works along the following shadow banking lines: (1) interaction of banks with shadow banking entities, (2) money market funds, (3) other shadow banking entities (investment firms, hedge funds, private equity firms, etc.), (4) securitization and (5) securities lending and repos. We all seem to agree that securitization needs to be simpler and transparent, and where skin in the game on the side of the originator seems meaningful but with potentially negative implications. We all seem to agree that not all money market funds should have an NAV denomination, but what variable model should come through and in what timeline is up for debate. We all seem to agree now that securities lending is growing and is executed by large institutional pools that more transparency is needed and more supervision over the amount of leverage used. The list is endless. But what is going to be the upshot of all this? Are we going to have an intrinsically safer system, will pure private money creation be effectively cut off from central banking facilities, and will the nexus between shadow banking and the traditional banking system be better channeled and narrowed down and will leverage be effectively lower across the board? From what we can oversee, none of this is going to be close to reality somewhere soon. Large problems are not fixed through micro-­management. The boldness needed to step away from the Bretton Woods system in 1971 is needed here, but then to make things better. The big picture politician(s), with eye for detail and a decent understanding of the financial system, is still a search that is on. Or, will Ivan Illich get history on his side? He has already in the 1970s/1980s indicated that society is very good at creating institutions and system but every time forgets to build in mechanisms to change it, and since the political channel has very little power left over transnational issues, the odds are against constantly against society. Going from an undertaxed to an overtaxed financial system then seems nothing more than a sideshow.457 The current regulatory avalanche is embedded in the belief that the economy and the financial system can be fixed by simply throwing (more) rules at it. This neoliberal belief has very little ground but is well accepted by economists and media. In fact, we don’t need more rules, we need holistic ideas458 about where we want to take our economies and financial infrastructure in a society with a stag The most notable being: J.E. Stiglitz, (2015), Re-writing the Rules of the American Economy. An Agenda for Growth and Shares Prosperity, pp. 28–32 and 62–67. Its European Counterpart is Ambrosetti Club, (2015), Finance for Growth, The European House, Milan. 457  L. Elliott, (2015), Taxing Times: Banks Are the Golden Goose That Won’t Hiss Too Much, The Guardian, April 5. 458  F.  Boldizzoni, (2013), On History and Policy: Time in the Age of Neoliberalism, MPIfG Discussion Paper, Nr. 13/6. And the comment of Streeck: W. Streeck, (2015), Comment on ‘On History and Policy: Time in the Age of Neoliberalism’, Journal of the Philosophy of History Vol. 9, pp. 33–40. 456

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gering amount of public interest issues and mounting environmental concerns. Out of those holistic ideas, we can carve financial infrastructure models that fit that view. Up till then we can only admit defeat of the financial system over the others.459 In the shadow banking segment, incoming regulation has been driven by three views: (1) shadow banking as the expression of regulatory arbitrage by avoiding capital requirements and the exploitation of implicit guarantees; (2) neglected risk: tail risk being unobserved, concentration of risk, misrepresentation of risk and so on; (3) liquidity transformation: the creation of money-like highly liquid instruments from a broader set of assets. Implicit in each of those perspectives is a certain stance. This stance is that securitization will lead to intermediate funding that will eventually lead to the provision of liquidity to the real economy. This seems to be an illusion when observing the relevant numbers. It is a carefully designed segment that caters to the global demand for risk-free highly liquid assets. More credit creation, we discussed, will lead to larger booms and busts, and therefore the model has an implicit trade-off underlying, that is, between growth and stability. Shadow banking has been meeting the demand for safe money-like claims. But the reality is that shadow banking money is no real money. So also there is a trade-off, that is, between the quantity and fragility of liquidity supply. This has macroeconomic and macroprudential implications, which translates in higher or lower productivity (booms and bust) combined with higher levels of (un)certainty given the level of collateral and leverage in the market. The excess liquidity created by the shadow banking segment can lead to more growth and investments, but not in the real economy. It does however increase the assets underlying the packaged fixed-income liquidity.460 This is because the liquidity supply is excessive relative to the other market conditions. The answers we are looking for lies one or multiple levels deeper than where regulation is currently active. If we don’t get it right at that level, the nature and type of regulation will not matter.

7.14 A  Capital Markets Union for the EU: Meaningless Acronym or Game Changer? 7.14.1  Introduction The tormented EU is looking for growth and jobs and the next acronym in 2015 came from the ambition to create a ‘capital markets union’ (CMU).461 Europe, in contrast to the US, has been more dependent on bank finance and lending. This has implications, especially now that Basel III requires banks to hold more capital against their risk weighted assets. And

 Including society as a system; see: Philip Stephens, (2014), Nothing Can Dent the Divine Right of Bankers, Financial Times, January 16. 460  A. Moreira and A. Savov, (2014), The Macroeconomics of Shadow Banking, Working Paper, mimeo; later on published in The Journal of Finance (2017), Vol 72, Issue 6, pp. 2381–2432. 461  The starting point was the green book issued in February 2015: see: EC, (2015), Green Paper, Building a Capital Markets Union, COM(2015) 63 final, February 18. See for an analysis and 459

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obviously, an integrated European Union will benefit from the depth of a regional capital market.462 The benefit of being close to a 500-million-inhabitant consumer market is that this has the potential to create better and lower funding conditions for many firms across Europe.463 But it is very likely that this will benefit the larger corporate market. The information disadvantage and information opaqueness of the SME market will work against SMEs in a capital market where debt investors, as discussed, are ‘information insensitive’. Access to capital markets is a problem for SMEs also in the US. Volumes too low, information opaque or not readily available and so on.464 But then again, what is high-quality securitization?465 As the center for financial innovation comments: ‘[s]tandardization and improved transparency were held up as necessary steps for improving investor confidence in securitized SME loans. It was noted, however, that the level of transparency is limited by an intrinsic informational asymmetry.466 SME loans involve a large element of judgment on the part of the bank (e.g. assessments about the strength of the business plan, or quality of the management). Investors are unable to access this information, and thus cannot fully assess the strength of each underlying asset in the pool.’467 So therefore the whole idea was to create SME securitization so that banks can offload the SME loans originated on the market. In theory that sounds good but in practice we can observe that in the US also the SME securitization market is also modest in size compared to other segments. The assumed issues and hazards in SME financing will translate into low demand for SME-securitized products, especially given the high-risk aversion of the larger European institutional investors. In those other segments, risks are more synchronic and therefore better to price, manage from a risk perspective and so on. This problem is not solved in the European model. In contrast, it is likely that the spread between the cost of credit for multinational enterprises (MNEs) and SMEs will widen and tilt against the SME market. This is disappointing since the Association for Financial Markets in Europe (AFME) illustrated that ‘securitizations backed by European receivables

evaluation: N. Véron and G. B. Wolff, (2015), Capital Markets Union: A Vision for the Long-term, Bruegel Policy Contribution, Issue 2015/5, April. 462  O. Kaya, (2014), SME financing in the euro area. New solutions to an old problem, Deutsche Bank Research, October 18. 463  Industry-level analysis of the cost of debt funding is structurally lower in the US than in Europe. 464  G20, (2015), SME Debt Financing beyond Bank Lending: The Role of Securitization, Bonds and Private Placements, Working Paper; see also: I. K. Nassr and G. Wehinger, (2014), Non-Bank Debt Financing for SMEs: The Role of Securitisation, Private Placements and Bonds, OECD Journal: Financial Market Trends Vol. 2014/1, pp. 139–159. 465  W. Perraudin, (2014), High Quality Securitisation: An Empirical Analysis of the PCS Definition, Risk Control Limited, July 1. 466  Nevertheless, it seems that informational rent extraction is positively associated with collateral holdings by banks; see B.  Xu et  al., (2015), Do Banks Extract Informational Rents Through Collateral, BIS Working Paper Nr. 522, October. 467  Center for the Study of Financial Innovation, (2014), Securitisation and SME lending. A CSFI roundtable discussion with Richard Hopkin (AFME), Ramnik Ahuja (Bank of England), Hugh Savill (ABI), Monique Ebell (NIESR) and Andy Davis (Prospect), Held on Monday, 13 October 2014, p. 2.

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have performed well during the crisis, from both a credit and price perspective’.468 Dannreuther rephrases the problem and therefore the solution correctly when indicating that SMEs would be better served through public facilities that reflect more socially regulated forms of finance rather than market-based finance. Most SMEs need a predictable supply of credit, better price administration and other publicly administered forms of credit. This is in sharp contrast with the current EU trend.469 From the initial reactions, it is clear that it will mainly be the MNC market that will benefit from a deeper and more liquid European capital market.470 In a Europe-wide capital market, the role of the shadow banking segment should not stay undiscussed. The evolution of the shadow banking segment has been discussed in the European chapter and is closely monitored. But how should this work in an enlarged borderless capital market Union in the EU? Despite the ongoing monitoring and enhanced regulation in many fields, the ECB471 recently qualified that the shadow banking sector is and ‘remains a risk to financial stability in the Eurozone due to increased size and remaining opaqueness’. In its recent financial stability report, the ECB indicates that ‘the greater the leverage, liquidity mismatch and size of certain intermediaries, the more likely they are to amplify shocks’, and ‘the sector’s risk exposure could be higher than widely assumed, due to the use of derivatives’. With a shadow banking segment of about EUR 23.5 trillion (more than doubled in a decade), the vulnerabilities increased as well. This would be particularly the case in case of an aggregate sharp fall in asset prices. This could trigger investors to pull their money from investment funds, forcing the funds to sell their holdings, in turn pushing asset prices even lower. And so the ECB concluded that ‘[l]arge-scale outflows cannot be ruled out in the event of adverse economic or policy surprises over the medium term’.472 The implications and potential spillover risks of the shadow banking to other domains are different from country to country in the eurozone.473 The potential stabilities have however been addressed474 from a monetary or regulatory point of view and which included the following actions475: (1) bank balance sheet cleanup, (2) consolidation of the financial sector, (3) recapitalization of those banks that needed it and (4) regulatory reform. Although European banks now all adhere to the European banking framework,

 AFME, (2014), High-Quality Securitisation for Europe. The Market at a Crossroads, June.  See in detail: C. Dannreuther, (2015), We Need a Democracy of Credit for SMEs. After the Lack of Demand in the EU Economy, the Key Problem Facing SMEs Is a Lack of Access to Finance, April. 470  G.  Jackson, (2015), Europe’s Corporate Borrowers Look to Capital Market Union, Financial Times, May 27. 471  J. Shotter and C. Jones, (2015), ECB Warns of Risks Posed by Shadow Banking Sector, Financial Times, May 28. 472  ECB, (2015), Financial Stability Review, May, Frankfurt, pp. 12–14, 87–88, 98–100, 103–106, 126, 132. 473  See for an overview: ECB, (2015), ibid., p. 132. 474  Or ‘attempted to address’ is likely the better qualification. 475  F. Restoy, (2015), The Financial Sector and the Banking Union, Speech by Fernando Restoy, Deputy Governor of the Bank of Spain, at the Círculo Financiero, organized by La Caixa, Barcelona, 18 May 2015. 468 469

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it remains highly uncertain if that will suffice. Besides material concerns regarding content and compliance aspects of the framework, the layered fabric of the framework raises questions about the timely and effectiveness of the answers and actions taken under the framework in case of distress. And even if that would turn into a positive reality, vulnerabilities are also caused by monetary interventions, the ECB indicated. Monetary interventions also bring on the radar the involvement of the sovereigns in this matter. Unconventional monetary policies can potentially increase systemic risk in the system. But can monetary policies also reduce the risk of a sovereign crisis? We know that the real cost of debt can be reduced through lower real interest rates. On the other hand, deflation of long-term debt is less effective and requires higher inflation rates. In general, Bacchetta et al.476 show that a sovereign crisis momentum can only be avoided ‘with steep inflation rates for a sustained period of time’, the ‘cost of which is likely to be much larger than government default’.477 Anderson et al.478 have been looking into the propositions of the green book regarding the Capital Markets Union and conclude that given the overarching objective of greater financial diversification and integration for financial stability, proposals will need to be targeted at both savers and borrowers and that economic and financial stability will be better served if funds are directed toward investments less prone to capital flight during stress, including equities. Indeed, the better matching of savers and borrowers leads to greater allocative efficiency and thereby supports economic growth. Increased privatesector risk sharing reduces volatility and typically occurs through the channels of (1) improving access to funding by borrowers, (2) better matching of investors to financial risk and (3) more flows of investments across borders.479 But the case for securitization in Europe is dismal. The European tradition for using covered bonds is long and sticky. That it also creates a cheap source of funding for banks is an add-on bonus. Covered bonds however have traditionally been limited to mortgages and have not been branched out into other asset classes. As Hale describes ‘covered bonds work

 Ph. Baccetta et  al., (2015), Self-Fulfilling Debt Crises: Can Monetary Policy Really Help, Working Paper January 19. 477  See also: M.  Aguiar, et  al., (2013), Crisis and Commitment: Inflation Credibility and the Vulnerability to Sovereign Debt Crisis, Working Paper, Harvard University; A.  Camous, and R.  Cooper, (2014), Monetary Policy and Debt Fragility, NBER Working Paper Nr. 20,650; D. Cohen, and S. Villemot, (2011), Endogenous Debt Crises, CEPR Discussion Paper Nr. 8270; G. Corsetti and L. Dedola, (2014), The Mystery of the Printing Press: Monetary Policy and SelfFulfilling Debt Crises, Working Paper, Cambridge University; P. de Grauwe, (2011), The Governance of a Fragile Eurozone, CEPS Working Documents, CEPS, Brussels; P. de Grauwe and Juemei Ji, (2013), Self-Fulfilling Crises in the Eurozone: An Empirical Test, Journal of International Money and Finance Vol. 34, pp. 15–36; J. Hilscher, et al., (2014), Inflating Away the Public Debt? An Empirical Assessment, NBER Working Paper Nr. 20,339; G.  Lorenzoni, and I.  Werning, (2014), Slow Moving Debt Crises, Working Paper, Northwestern University; K. Sheedy, (2014), Debt and Incomplete Financial Markets: A Case for Nominal GDP Targeting, Brookings Papers on Economic Activity, Spring 2014. 478  N. Anderson et al., (2015), A European Capital Market Union: Implications for Growth and Stability, Financial Stability Paper, February 2015, London. 479  N. Anderson et al., (2015), ibid., p. 18. 476

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similarly, except that the underlying assets are kept on the bank’s balance sheet, meaning that the borrower has “dual recourse” to both the assets and the bank itself ’.480 On top of this, the recent regulatory barrage affecting securitization makes the prospects of any revival of the securitization market in Europe highly unlikely, as a level playing field between covered bonds and asset-backed securities is further away than ever.481 This level playing field would include requiring buyers of both products to hold equal amounts of capital despite the product choice. Also, currently, this tilts toward favoring covered bonds. But there is more going on. Currency unions like the eurozone limit the ability of the central bank to use interest rate policy to accommodate asymmetric shocks. On the other hand, collateral policies can serve ‘to dampen asymmetric shocks in a currency area when these shocks also affect the collateral held by banks and when collateral portfolios of banks differ systematically across countries’. Cassola and Koulisher illustrate that ‘the lack of collateral of distressed banks constrains their access to market funding because of moral hazard’. The central bank then faces a trade-off. ‘Relaxing collateral policy reduces the interest rate in the distressed economy but that increases the credit risk it bears.’482 Knot483 is however convinced that a Capital Markets Union can bolster a Monetary Union. This would lead to the reduction and mitigation of asymmetric shocks caused by structural differences between national economies. He argues that ‘[a] successful Capital Markets Union will open up entirely new channels for the transmission of monetary policy to the real economy, making central bankers much less dependent on a single sector for the transmission of its policy decisions’.

7.14.2  Bank-Biased or Market-Biased Financial System? It was argued before that typically nascent economic markets are more bank focused and that economies then diversify into more and increasing market-based activities. The more those capital markets deepen and become more liquid, the cost of funding typically tends to come down in contrast to a ban-biased model where the cost of funding typically stays higher. An interesting question then becomes whether those models differ in their vulnerability toward systemic risk and their impact on growth. Europe is a bit of an exception to that general trend. Europe, despite its mature economy, is still heavily bank-biased. Langfield and Pagano used Europe and a test-ground for these questions. They conclude

 T. Hale, (2015), Eurozone Securitisation Prospects Remain Slim, Financial Times, June 11.  T. Hale, (2015), New Regulatory Measures Anger European Securitisation Industry, Financial Times, May 17. 482  N. Cassolo and F. Koulisher, (2013), The Collateral Channel of Monetary Policy: Evidence from the European Central Bank, Working Paper, December. See also: V.V.  Acharya and S.  Steffen, (2013), The Greatest Carry Trade Ever? Understanding Eurozone Bank Risks, National Bureau of Economic Research Working Paper Series, Nr. 19,039; E. Farhi and J. Tirole, (2012), Collective Moral Hazard, Maturity Mismatch, and Systemic Bailouts, The American Economic Review, Vol. 102, pp. 60–93. 483  K. Knot, (2015), How Capital Markets Union Can Bolster Monetary Union, Speech by Mr. Klaas Knot, President of the Netherlands Bank, at the 47th International Capital Markets Association meeting and conference, Amsterdam, 4 June 2015, p. 2. 480 481

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that an increase in the size of the banking system relative to equity and private bond markets is associated with more systemic risk and lower economic growth, particularly during housing market crises. Those effects are amplified during housing market crises. Banks function as an amplification mechanism by which banks overextend and misallocate credit when asset prices rise and ration it when they drop. They therefore argue in favor of reducing regulatory favoritism toward banks, while simultaneously supporting the development of securities markets.484 Indeed, the European banking sector has expanded since the early 1990s much faster than Europe’s economic output and wealth and much faster than other banking systems.485 During that same period Europe’s capital markets have barely grown. Given the tight connection between financial systems and macroeconomic performance, it is natural to question whether Europe’s increasing dependence on banks has affected the stability and growth of its economy.486 So being bank dependent comes at a cost: ‘being highly leveraged, banks respond disproportionately to changes in collateral values: balance sheets expand when asset prices rise, and contract when prices drop.’487 This amplification leads to the above-­indicated consequences, that is, systemic risk tends to be higher in bankbased financial structures.488 Or to be precise, ‘[w]hen asset prices rise, banks’ expansion occurs at the expense of credit quality. Banks’ additional risk-taking is uncovered once asset prices drop.’489 Also economic growth tends to be lower in bank-based financial structures, particularly during times of large drops in asset prices.490 There is a mechanism behind it: ‘banks’ excessive credit creation in the upswing of the financial cycle results in more funding being directed to bad projects with low productivity, while insufficient credit creation in downswings means that good opportunities are forgone.’ This empirical analysis highlights the social costs of excessive reliance on banks, which we refer to as a ‘bank bias’, they conclude. Capping the growth and size of large banks,491 which account

 S. Langfield and M. Pagano, (2015), Bank Bias in Europe: Effects on Systemic Risk and Growth, ECB Working Paper Nr. 1797, Frankfurt, May. 485  S. Langfield and M. Pagano, (2015), ibid., pp. 3–4. 486  See for a weighting of the argument regarding bank-versus market-based financial systems, see: S. Langfield and M. Pagano, (2015), ibid., pp. 5–8. 487  S. Langfield and M. Pagano, (2015), ibid., p. 2. 488  The buildup of risk before financial crises and the sensitivity of economic activity to financial shocks is therefore expected to be larger in bank-based than in market-based structures. 489  See for details regarding these two core principles: S. Langfield and M. Pagano, (2015), ibid., pp. 8–14 (principle 1) and pp. 14–18 (principle 2). 490  The increase in systemic risk is particularly strong when real house prices drop by more than 10%, reflecting the importance of housing as collateral (p. 2). 491  The bank dominance in Europe is not an industry-wide problem but mostly one of large bank dominating the industry. See for an evaluation: S. Langfield and M. Pagano, (2015), ibid., pp. 18 ff. including the arguments why the industry has developed as such. Regulatory support is a dominant argument (see also: F.J. Lambert, et al., [2014}, ‘How Big Is the Implicit Subsidy for Banks Considered too Important to Fail?’ Chapter 3 in Global Financial Stability Report, International Monetary Fund, April). Other arguments for the specific bank dominance in Europe (since regulatory support is common around the world and therefore cannot account for the European dominance specifically) are the 484

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for most of Europe’s ‘bank bias’ is one of their recommendations. Their second recommendation points toward the previous topic, that is, that of a Union-wide and more liquid capital market.492 Given their conclusions, these recommendations493 make sense. The absence of an alternative funding channel increased economic risk when the bank lending channel got clogged. A plurality of lending channels is better. No one really disagrees. But under which conditions and are we willing to accept the implications of a broader market-based financing model? Are we willing to tolerate maturity transformation to occur outside the realm of the tight financial regulation? And are we prepared to pick up the tag if the next wave of vulnerability comes through? Both the fractional banking model within the traditional banking sector and maturity transformation occurring outside the regulated banking model have tremendously contributed to the creation of vulnerable financial markets and banking institutions. Given their critical role, this vulnerability has spread to the real economy. Is it time to end the fractional banking system494 and end the notion of maturity transformation? In a mainstream way of thinking, this sounds pretty much unrealistic. But the contemporary banking problems require materially different solutions.

7.15 A  World without Maturity Transformation: Is It Possible? Is It Desirable? What a crazy idea at first sight. But if we scratch behind the surface, there is a lot that works in favor of a world without maturity transformation and/or without a fractional banking system.495 One can create liquidity through a central banking system without maturity transformation. Even in a system where incoming and outgoing flows have the fact that more than elsewhere the ‘universal bank concept’ is dominant in Europe as well as the understanding that banks have played a more than critical role in the European integration efforts that occurred in recent decades and on the back of which they have grown disproportionately large. See for details on these arguments: M. Pagano, et al., (2014), Is Europe Overbanked?, Report Nr. 4 of the European Systemic Risk Board’s Advisory Scientific Committee; P. R. Lane, (2013), Capital Flows in the Euro Area, EU Commission Economic Papers Nr. 497; P. R. Lane, and P. McQuade, (2014), Domestic Credit Growth and International Capital Flows, Scandinavian Journal of Economics, Vol. 116, Issue 1, pp.  218–252. Banks have grown so large because they were politically endorsed as ‘national champions’ (N.  Véron, (2013), Banking Nationalism and the European Crisis, Bruegel Policy Paper, Brussels). The national sovereign for a long time was dependent on them for financing and the board was considerably politically dominated. 492  Specifically they indicate ‘[u]seful steps towards this capital markets union would include the integration of stock trading platforms in Europe; a reduction of the fixed costs faced by small and medium firms in accessing capital markets; greater standardization of corporate bond issues and private placement transactions; and measures to improve the depth and quality of asset-backed securities markets’ (p. 2). 493  See in detail: S. Langfield and M. Pagano, (2015), ibid., pp. 22–28. 494  See: S. Alifanov, (2015), On the Dangers Inherent in a Fractional Reserve Banking System, The Student Economic Review Vol. XXIX, pp. 117–124. 495  A contrario, see: V.V.  Chari and C.  Phelan, (2014), On the Social Usefulness of Fractional Reserve Banking, Journal of Monetary Economics, Vol. 65, pp. 1–13.

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same duration and maturity, liquidity can be provided through a central banking facility for those deposit-holders/investors that during the interim want to withdraw deposits. The credit risk stays with the intermediary but the liquidity facility is provided by the central bank. It is anyway a major anomaly (through deposit insurance) in the financial system, and which was politically induced, to make societies believe that they can generate truly risk-free investment income. In order to generate returns, one needs to accept some type and level of risk, either operational or financial nature. In a deposit insurance mechanism, that risk has not gone away but is offloaded on the taxpayer. So, risk is removed at the front door but creeps back in through the backdoor. This regulatory intervention makes financial systems unstable. So is it then technically possible to abolish maturity transformation without compromising on economic growth? Most would answer no as they see it as a conditional mechanism for the functioning of twenty-first-century markets.496 I feel somewhat different about it. Technically, it is perfectly possible to create a model where there is maturity transformation, but a liquidity facility available, but without deposit insurance attached to it. In an unlevered way, this would reduce however the return of credit intermediaries to 3–5% depending on market circumstances and the spread achievable. However, one would need a much lower capital base, so financial industry returns would still be reasonable but not as high as they once were. Would that turn it into state bank system? Not exactly, the competitive advantage of banks would then come down to allocating credit in the most efficient way given the opportunities it can source. That was what a private banking system was all about I guess. Nonbanks can play equally important role as traditional banks but under equal market and regulatory conditions, that is, without deposit insurance and a liquidity window for exiting investors but where the credit risk stays with the intermediary. If not, maturity transformation will continue to be the Achilles’ heel of the (shadow) banking sector and we would do nothing more but repeat what we already know.497 And as long as maturity transformation is around, we will struggle to make macroprudential work properly498 and question our ability to regulate the systemic risk

 P.  Lowe, (2015), The Transformation in Maturity Transformation, Address by Philip Lowe, Deputy Governor of the Reserve Bank of Australia, to Thomson Reuters’ 3rd Australian Regulatory Summit, Sydney, 27 May 2015. He reports: ‘[t]he transformation of claims over fundamentally illiquid assets into claims that are highly liquid is one of the critical functions that the financial sector provides for the community. Without such transformation, it is difficult to see how modern economies would work. This transformation has been critical to the accumulation of physical capital in our societies as well as the operation of our modern payment systems’ (p. 1). 497  S. Fischer, (2015), The Importance of the Nonbank Financial Sector, Remarks by Stanley Fischer Vice Chairman Board of Governors of the Federal Reserve System at a conference on ‘Debt and Financial Stability—Regulatory Challenges’ sponsored by the Bundesbank and the German Ministry of Finance, Frankfurt, Germany, March 27. 498  See f.e. also S. Schwarcz, (2015), Banking and Financial Regulation, in The Oxford Handbook of Law and Economics, Francesco Parisi, (ed.), Oxford University Press, Oxford, pp. 19–21. 496

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and subsequent shocks it causes.499 The maturity transformation in shadow banking markets severely limits the ability of regulators to impose macroprudential restrictions like loan-to-value limits.500 This shadow cost is currently not properly reflected in macroprudential regulation. The current regulatory initiatives are all primitive in a certain way and ‘should there be a need for policy intervention measures to be admittedly intrusive, they should go well beyond the new capital and liquidity regulatory framework’.501 And I would take it a step further. If the credit intermediation function would be all about allocate savings to profitable and save investments, the maturity transformation model would not impact the real economy as badly as it did in recent years. In a model where banks were intermediaries of loanable funds, banks accept deposits of preexisting real resources from savers and then lend them to borrowers. In the real world however, banks provide financing through money creation.502 That is, they create deposits of new money through lending, and in doing so are mainly constrained by profitability and solvency considerations. Jakab and Kumhof503 contrast simple intermediation and financing models of banking. They conclude that compared to otherwise identical intermediation models, and following identical shocks, financing models predict changes in bank lending that are far larger, happen much faster, and have much greater effects on the real economy, while the adjustment process depends far less on changes in lending spreads, the dominant adjustment channel in loan intermediation models. They explain these differences which are critical in understanding,

 See, for example, A.  Penalver, (2013) Managing Maturity Transformation Under Aggregate Uncertainty, Paris School of Economics Working Paper; A. Segura and J. Suarez (2013), Recursive Maturity Transformation, Working Paper September; S.  Krieger, (2011), Shadow Maturity Transformation and Systemic Risk, Federal Reserve Bank of NY, March 8; T.  Paligorova and J.A.C. Santos, (2014), Rollover Risk and the Maturity Transformation Function of Banks, Bank of Canada/Banque de Canada Working paper Nr. 2014/8; A.  Segura and J.  Suarez, (2014), How Excessive Is Bank’s Maturity Transformation, Working paper, November. 500  J.C. Williams, (2015), Macro-Prudential Policy in a Microprudential World, FRBSF Economic Letter Nr. 2015-18, June 1, pp. 4–5. 501  V. Constâncio, (2015), Monetary Policy and the European Recovery, Speech by Vítor Constâncio, Vice President of the European Central Bank, at the XXXI Reunión Círculo de Economía, Barcelona, 30 May 2015, p. 4. 502  See in detail on money creation: M. McLeay, et al. (2014), Money in the Modern Economy: An Introduction, Bank of England Quarterly Bulletin, Vol. 54, Issue 1, pp. 4–13, and M. McLeay, et al., (2014), Money Creation in the Modern Economy, Bank of England Quarterly Bulletin, Vol. 54, Issue 1, pp. 14–27; R. Werner, (2014), Can Banks Individually Create Money Out of Nothing? The Theories and the Empirical Evidence, International Review of Financial Analysis, Vol. 36, pp. 1–19; R. Werner, (2014), How Do Banks Create Money, and Why Can Other Firms Not Do the Same?, International Review of Financial Analysis, Vol. 36, pp. 71–77. 503  Z. Jakab and M. Kumhof, (2015), Banks Are Not Intermediaries of Loanable Funds—and Why This Matters, Bank of England Working Paper Nr, 529, May, revised in 2018. In the loan intermediation model, bank loans represent the intermediation of real savings, or loanable funds, between nonbank savers and nonbank borrowers. But in the real world, the key function of banks is the provision of financing, or the creation of new monetary purchasing power through loans, for a single agent that is both borrower and depositor. The bank therefore creates its own funding, deposits, in the act of lending, in a transaction that involves no intermediation whatsoever (p. ii). 499

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why the current regulation will prove to be largely noninstrumental: ‘[t]he fundamental reason for these differences is that savings in the loan intermediation model of banking need to be accumulated through a process of either producing additional goods or foregoing consumption of existing goods, a physical process that by its very nature is slow and continuous. On the other hand, money creating banks that create purchasing power can technically do so instantaneously and discontinuously, because the process does not involve physical goods, but rather the creation of money through the simultaneous expansion of both sides of banks’ balance sheets. While money is essential to facilitating purchases and sales of real resources outside the banking system, it is not itself a physical resource, and can be created at near zero cost. In other words, the loan intermediation model is fundamentally a model of banks as barter institutions, while the monetary creating model is fundamentally a model of banks as monetary institutions.’504 That bank risk spills over to the sovereign but not just in an ad-random fashion. Although within the eurozone risk transmitted from the bank system to the sovereign,505 there was no risk transmission from domestic banks to their respective sovereign in stressed countries. Instead, non-stressed countries bear the risk by providing guarantees to banks in stressed countries. This implies that the well-known bank-sovereign nexus506 has an important cross-border component, conclude Breckenfelder and Schwaab.507 Questions are being asked about the behavior of that nexus under unconventional monetary conditions as experienced in recent years.508

 Z.  Jakab and M.  Kumhof, (2015), ibid., pp. ii–iii. See also: T.  Adrian and N.  Boyarchenko, (2013), Intermediary Leverage Cycles and Financial Stability, Federal Reserve Bank of New York Staff Reports, Nr. 567; T. Adrian, et al., (2013), Which Financial Frictions? Parsing the Evidence from the Financial Crisis of 2007 to 2009, NBER Macroeconomics Annual, Vol. 27, pp. 159–214; L. Christiano, et al., (2014), Risk Shocks, American Economic Review, Vol. 104, Issue 1, pp. 27–65; E.  Chrétien and V.  Lyonnet, (2014), Fire Sales and the Banking System, Working Paper, École Polytechnique, Paris; F. Lindner, (2013), Does Saving Increase the Supply of Credit? A Critique of Loanable Funds Theory, Working Paper, IMK; A.  Martin and J.  Ventura, (2012), Economic Growth with Bubbles, American Economic Review, Vol. 102, Issue 6, pp. 3033–3058. 505  R. Cooper and K. Nikolov, (2014), Government Debt and Banking Fragility: The Spreading of Strategic Uncertainty, Unpublished Working Paper; E. Farhi and J. Tirole, (2014), Deadly Embrace: Sovereign and Financial Balance Sheets Doom Loops, Unpublished Working Paper, Harvard University. 506  See: V.V.  Acharya and S.  Steffen, (2015), The Greatest Carry Trade Ever? Understanding Eurozone Bank Risks, Journal of Financial Economics Vol. 115, Issue 2, pp. 215–236; P. Augustin, et  al., (2015), Corporate to Sovereign Risk Spillover. Unpublished Working Paper; L.  Benzoni, et al., (2015), Modeling Credit Contagion via the Updating of Fragile Beliefs: An Investigation of the European Sovereign Crisis, Federal Reserve bank of Chicago Working Paper Nr. WP/2012-04 (also in The Review of Financial Studies, Vol. 28, Issue 7, pp. 1960–2008). 507  H.-Johannes Breckenfelder and Bernd Schwaab, (2015), The Bank-Sovereign Nexus Across Borders, Working Paper, May 21. 508  F.  Eser and B.  Schwaab, (2015), Evaluating the Impact of Unconventional Monetary Policy Measures: Empirical Evidence from the ECB’s Securities Markets Programme. Journal of Financial Economics, Elsevier, Vol. 119, Issue 1, pp. 147–167; M. Fratzscher and M. Rieth, (2015), Monetary Policy, Bank Bailouts and the Sovereign-Bank Risk Nexus in the Euro Area, DIW Discussion Paper Nr. 1448; A. Krishnamurthy, et al., (2014), ECB Policies Involving Government Bond Purchases: Impact and Channels, Working Paper; A. Leonello, (2014), Government Guarantees and the Two504

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The maturity transformation (and accompanying liquidity transformation) leads to a variety of results in the shadow banking sector. The SB system liquefies partially illiquid investment projects (e.g. mortgages) and manufactures shadow collateral (e.g. MBS). The design of that shadow collateral has been studied by di Iaso and Pozsar.509 They distinguish510 between ‘simple shadow banking’, where shadow collateral is illiquid on a continuous basis, and ‘complex shadow banking’, where shadow collateral is designed to be extremely liquid in states without aggregate shocks, thereby boosting bankers’ leverage, but illiquid in a crisis.511 The economy is prone to massive deleveraging in the case of aggregate shocks.512 They indicate that from a policy perspective the root cause was ‘to let shadow collateral get into the plumbing of the system’ and yes ignoring ‘the risks of aggressive maturity transformation’.513 Basel III has, for the traditional banking sector limited the most aggressive maturity transformation (repos) which didn’t miss its effect in terms of declining volumes. But that decline has been offset by the fact that nonbank counterparties became common in many sovereign and reserve bank transactions. The implications of that have ‘increased the supply of public parking space available to cash pools, the shortage of which, by compressing the cost of leverage in the shadow banking system, elicited the creation of shadow collateral with poor liquidity properties in adverse market scenarios (complex shadow banking)’.514 That was one of the causes of the 2008 crisis. Absorbing liquidity of those institutional cash pools in a meaningful way can be effective in reducing demand for shadow banking collateral and the growth of the segment in general.

Way Feedback Between Banking and Sovereign Debt Crises, Working Paper; A. Lucas, et al., (2014), Conditional Euro Area Sovereign Default Risk, Journal of Business and Economics Statistics Vol. 32, Issue 2, pp. 271–284. 509  G. di Iaso and Z.  Pozsar, (2015), A Model of Shadow Banking: Crises, Central Banks and Regulation, Working Paper, May 18. They indicate that within the current financial infrastructure the ‘complex shadow banking model provides the equilibrium (when the demand for parking space from cash pools – as compared to the supply of sovereign bonds – and the demand for returns from entities with ALMs are high)’. This is caused by two structural dynamics: (1) the increasing demand of institutional cash pools for risk-free assets (sovereign bonds and shadow collateral) and (2) the proliferation of balance sheets with asset-liability mismatches (ALMs), like those of insurance companies and pension funds; these entities have liabilities in fixed nominal amount and, in a low-yield environment, seek to allocate funds to bankers which deliver leverage-enhanced returns. 510  G. di Iaso and Z. Pozsar, (2015), ibid., pp. 6–10. 511  G. di Iaso and Z. Pozsar, (2015), ibid., pp. 10–20. 512  That has material policy implications in particular for capital and liquidity regulation: G. di Iaso and Z. Pozsar, (2015), ibid., pp. 20–24. They indicate ‘a central bank focused on financial stability can fulfill that mandate actively managing its balance sheet by absorbing via reverse repo programs some of the demand for parking space from institutional cash pools. In the model, this type of policy intervention drives up the banks’ cost of the leverage sourced from institutional cash pools, and reduces incentives in pursing strategies which deliver high-leverage-enhanced returns in good times at the cost of massive deleveraging in the case of aggregate shocks’ (pp. 25–26). 513  G. di Iaso and Z. Pozsar, (2015), ibid., p. 25. See also: G. Di Iasio and F. Pierobon, (2013), Shadow Banking, Sovereign Risk and Bailout Moral Hazard, Bank of Italy (February). 514  G. di Iaso and Z. Pozsar, (2015), ibid., p. 25.

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7.16 T  he Regulatory Rat Race Can’t Go on Forever: Equity as the Only Real Backstop in a Private Market The level and origin of future vulnerabilities are uncertain and so the chase is on for a continuous model that can ‘ad hoc’ stem risk from market-based finance. Market-based finance is now a good thing, as it provides for multiple channels of funding toward the real economy. But there is always the undertone in the way new regulation is defended and qualified. Capital and liquidity regulation is good, but probably not good enough, money market fund regulation is tighter and will mitigate potential valuation shocks, but only a little, central clearing of OTC derivatives and securities financing transactions has been an improvement, but CCPs now are a new potential systemic risk to the financial system and we have, in the meantime, no real good idea of what on a ‘net’ basis the clearing absorbs in terms of asymmetric and counterparty risk. Asset managers in their own right can be a source of systemic risk, but the dynamics are so fragmented that regulation is and will be overinclusive. Securitization was the root cause of the financial crisis; it leads to concentration of uncertainty and a redistribution of risk in a nonoptimal way. But we need it to unlock credit markets and policy makers’ claims. It all sounds very unconvincing, the benefits unproven, the real economic cost largely unknown and so we power on. The beauty of not knowing where you want to arrive is that it doesn’t matter how you get there. And so we measure more granular every day, we monitor every day, we report excessively, we make it sound academically astute and hope that the next crisis is far away.515 We bother less about proportionality and disregard the state the economy is in for years now. We lament on the fact that we need to better integrate financial regulation with macroeconomic, monetary and macroprudential policies,516 but forget that none of these vulnerabilities really go away unless there is an externality and convincing equity backstop in the private system. We fail to see the difference between the material market plunge in 1999–2001 due to the tech bubble and the fact that the system cleaned itself out in no time. That happened because shareholders took their losses and moved on. The information-insensitive debt market cannot and will never properly function over time without an adequate backing of a solid equity backbone. The lender of last concept by making the liquidity window available for as many market participants as possible seems like a risky strategy. The theoretical ability of central banks to control the money supply should not be confused with the idea that this would come at no or limited cost, especially now that we still seem to lack a proper understanding of what we exactly are securing when we provide a liquidity backstop to a market-based financial system as the shadow banking market. It is also something that cannot be repeated into perpetuity (although theoretically it can).

 FSB, To G20 Finance Ministers and Central Bank Governors Financial Reforms – Progress on the Work Plan for the Antalya Summit, Basel, pp. 2–4. 516  Ø. Olsen, (2015), Integrating Financial Stability and Monetary Policy Analysis, Speech by Mr. Øystein Olsen, Governor of Norges Bank (Central Bank of Norway), at the Systemic Risk Centre, London School of Economics, London, 27 April 2015. 515

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A market-based financial system implies that the right to ‘succeed’ is matched by the right to ‘fail’. No backstop is needed in that equilibrium. The natural debt market insensitivity and the silhouette of a public backstop imply that debt markets have become risk intolerant. Debt as a monetary instrument was never meant that way: not then, not now not ever. The risk rating of debt has become a vague notion that should translate into expected compensation but doesn’t translate anymore into an effective understanding that debt could potentially not be repaid when risk effectively materializes. Credit risk and liquidity risk are notions that seem to be implicitly covered not that many institutions are covered by a web of financial regulation. Bringing that back to the forefront would help, also because then the real market dynamics in the financial industry would be back about finding the best risk-return opportunities in the market and not playing the system many times over. Would an equity system produce lower growth? Not necessarily proves the Islamic banking model, where debt and interest in its pure conventional doesn’t exist. The Islamic banking model is inherently more stable than the conventional one517 and this despite the many variations in analysis. The embedded stability seems to be pronounced in most literature.518 It should be observed that the many shenanigans it has endured during the financial crisis were mainly due to the fact that the financial packages in the Middle East were a blend of conventional and Islamic finance (in fact more conventional than Islamic finance).519 The contribution of Islamic finance to stable and consistent economic growth is (almost520) beyond dispute.521

 M. Čihák and H. Hesse, (2008), Islamic Banks and Financial Stability: An Empirical Analysis, IMF Working paper nr. WP/08/18. Specifically they conclude that ‘(i) small Islamic banks tend to be financially stronger than small commercial banks; (ii) large commercial banks tend to be financially stronger than large Islamic banks; and (iii) small Islamic banks tend to be financially stronger than large Islamic banks’. A contrario: A. López Mejía, et al., (2014), Regulation and Supervision of Islamic Banks, IMF Working Paper, WP/14/219. Their focus is more on the specific Islamic risk embedded in Islamic contracts: (1) shariah compliance risk, (2) equity investment risk, (3) rate of return risk, (4) displaced commercial risk and the fact that common risk seems to be more pronounced in Islamic banks—(1) credit risk, (2) operational risk, (3) liquidity risk and (4) transparency risk. Given the above, it doesn’t really nullify the benefits of Islamic banking as a system over the conventional model. Most of the argumentation has been done through the lens of a conventional banking model which implied their results. See H. Askari et al., (2010), The Stability of Islamic Finance: Creating a Resilient Financial Environment for a Secure Future, Wiley & Sons (Asia) Pte. Ltd. 518  M.I. Tabash and R.S. Dhankar, (2014), The Impact of Global Financial Crisis on the Stability of Islamic Banks: An Empirical Evidence, Journal of Islamic Banking and Finance, Vol. 2, Nr. 1 (March), pp. 367–388. 519  A.  Kammer, et  al., (2015), Islamic Finance: Opportunities, Challenges, and Policy Options, IMF Staff Discussion Note Nr. SDN/15/05, April. 520  A contrario: K.  Johnson, (2013), The Role of Islamic Banking in Economic Growth, CMC Senior Theses, Paper Nr. 642. 521  M.I. Tabash and R.S. Dhankar, (2014), Islamic Finance and Economic Growth: An Empirical Evidence from United Arab Emirates (UAE), Journal of Emerging Issues in Economics, Finance and Banking, Vol. 3, Issue 2, pp. 1069–1085; H. Furqani and R. Mulyany, (2009), Islamic Banking and Economic Growth: Empirical Evidence from Malaysia, Journal of Economic Cooperation and development, Vol. 30 Issue 2, pp. 59–74. 517

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The leverage in the financial system is, although subject to many additional sets of regulations, not targeted directly, but only managed. One of the things that are often overlooked is not only that leverage and the level of leverage can contribute to systemic risk but also that the magnitude of that vulnerability is directly linked to other macroeconomic elements and in particular the stock of total debt and the flow of gross savings. Although the cash flow measurement is well known from the corporate finance field, in order to measure the corporations’ ability to service its debt, the ratio is less used on a macro-level. Ramey and Sarlin522 have been examining the usefulness of the conventional debt to cash flow from savings ratio and performed a quantitative evaluation of debt/cash flow (D/CF) as a determinant of financial crises, particularly banking, debt and currency crises. They showed that the D/CF ratio performs better or on par with more conventional measures, such as public debt to GDP and the credit-to-GDP gap. They also relate the debt/cash flow ration to four conceptual zones of escalating financial instability: (1) inefficient, (2) stable, (3) warning and (4) crisis zones. Their conclusions on all fronts support the use of the ratio in monitoring, stratification and reporting of financial vulnerability.523 Ultimately, we have to conclude that the public liquidity support historically has grown out of a joint venture between the state and the deposit holders. Depository entities are subject to risk-based fees, strict portfolio limitations and capital requirements— the key terms of the joint venture.524 Central bank reserves function as tradable permits for deposit issuance, placing the upper bound of the money supply. Shadow banking is not part of this. Rick argues: ‘[t]hey issue money-like instruments, but this activity per se has no legal or regulatory status. Indeed, very short-term IOUs,525 as such, are not a cognizable legal category. Shadow banking entities pay no risk-based fees to the state. Many of them are unencumbered by meaningful portfolio restrictions or capital requirements. There are no legal limits on the quantity of money-like instruments that they are permitted to issue. Thus the basic terms of the joint venture are absent.’526 I have detailed before in this chapter why I believe creating a private money-creating system cannot be done in a sustainable way527 over time. And that most of the incoming regulation during the last few years make certain technical vulnerabilities less likely to occur going forward, but that creating a stable market-based financial system is impossible. Even more, argues Rick, ‘these regulatory approaches all have one thing in common:  B.A. Ramsey and P. Sarlin, (2015), Ending Over-Lending: Assessing Systemic Risk with Debt to Cash Flow, ECB Working Paper Serie Nr. 1769, Frankfurt, March. 523  See also: M. Drehmann and K. Tsatsaronis, (2014), The Credit-to-GDP Gap and Countercyclical Capital Buffers: Questions and Answers, BIS Quarterly Review, March 2014; G. Farrell, (2013), Countercyclical Capital Buffers and Real-Time Credit-to-GDP Gap Estimates: a South African Perspective, Mimeo; F.  Betz, et  al., (2014), Predicting Distress in European Banks, Journal of Banking & Finance, Vol. 45, August, pp. 225–241. 524  M. Rick, (2012), Money and (Shadow) Banking: A Thought Experiment, Review of Banking and Financial Law, Vol. 31, p. 744. 525  These ‘private’ IOUs essentially became public obligations during the 2008 financial crisis. 526  M. Rick, (2012), ibid., p. 744. 527  See in how far sustainable contracting can help: B. Lomfeld, (2016), Sustainable Contracting: How Standard Terms Could Govern Markets, Reshaping Markets. Economic Governance, the Global Financial Crisis and Liberal Utopia, (eds. B. Lomfeld, A. Somma and P. Zumbansen) in Cambridge University Press, Cambridge, pp. 257–282. 522

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They take the existing “private money” system as a given.528 It is not obvious why this should be the case. The private money market need not be taken as a fixed and immutable feature of the financial landscape.’529 If private money creation would be covered by the sovereign liquidity window, it could not be done based on market. It would have to occur within the boundaries of a widened joint venture where next to deposits certain types of money creation would be covered (i.e. it would become sovereign money).530 This in itself would already come with many implementation challenges.531 Rick evaluates the recent regulatory proposals covering the shadow banking segment and concludes: ‘[t]he monetary aspects of the shadow banking problem have been relatively neglected in the ongoing debates over financial regulatory reform. This may have been a mistake. Shadow banking is a monetary phenomenon, and monetary institutions, like all legal institutions, stand in need of design.’532 The idea that market-based finance can be instrumental in stabilizing the financial markets provides other channels of funding so that the economy is not reliant on the banking channel only and that market-based finance contributes to economic growth is driven by the naïve impression that the market-based system envisaged is there to provide liquidity when others don’t. Bank distress and financial markets distress often go hand in hand. And yes, there are parts of the world where the nonbanking financial sector is instrumental in fostering growth, but this is because the banking sector is maturing or is not yet fully deep and liquid in its terms of functioning. A market-based financial system in on top of a mature but not-so-well-functioning banking system, will not lead to growth, will not lead to deeper markets and cheaper cost of funding but will alternatively lead to redistribution of wealth, liquidity for the financial sector but not for the real economy, and will synthetically inflate asset prices and make the wealth buildup for many in society vulnerable and unstable. The idea that ‘[n]on-bank and market-based finance widen participation and enhance diversity in the financial system – in the forms of funding available to companies (to complement bank lending) and in the distribution of risk exposures amongst counterparties’533 is somewhat limiting the reality of things and limits the debate to what is theoretically possible. Especially, if later on she indicates that the vulnerabilities of such a system are embedded in the following aspects: (1) information asymmetry regarding SMEs, (2) liquidity fragility in some market including securities financing markets and (3) implications following incoming regulation that might increase demand for collateral or destabilize the collateral markets altogether.534

 See also S. Nagel, (2014), The Liquidity Premium of Near-Money Assets, Working Paper, September; see also: J. Bianchi and S. Bigio, (2013), Liquidity Management and Monetary Policy, Working Paper, University of Wisconsin and Columbia University; R. Robatto, (2013), Financial Crises and Systemic Bank Runs in a Dynamic Model of Banking, Working Paper, University of Chicago. 529  M. Rick, (2012), ibid., p. 746. 530  And the entities that issue those instruments would have to be subject to portfolio restrictions and capital requirements. 531  M. Rick, (2012), ibid., p. 747. 532  M. Rick, (2012), ibid., p. 748. 533  D. C. Furse, (2014), Taking the Long View: How Market-Based Finance can Support Stability, speech given by External Member of the Financial Policy Committee, Bank of England, March 28, p. 4. 534  D.C. Furse, (2014), ibid., p. 5. 528

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The reality of things is that banks, especially those of the size as we know them in the West, are not interested in financing SMEs and other more vulnerable parts of our economies. The asymmetric risks, the lower volumes, the information asymmetry, the illiquidity, the compliance and headcount cost to administer, all of them make these markets not particularly interesting for the banking, nor for any market-based system. It is therefore unfortunate that the debate often is restricted to the fact that buoyant securitization markets, private placements and bond markets would be the headway to a well-financed SME segment in our markets.535 The regulatory environment in which the financial sector operates in contemporary terms is characterized by easy manipulative rules. Sometimes they were intended that way as the effectiveness was eroded by the constant lobbying process, something due to illdesign and sometimes because the regulator got confused about what was the cause and what were the symptoms of the problems that led us to the 2008 events. It has also led to costly bank failures. Bulow and Klemperer get fairly close to the truth when they indicate that such a regulatory system cannot properly manage a market-based financial infrastructure. Any robust regulatory system that would claim to do so would be characterized by the following: ‘(i) bank losses are credibly borne by the private sector (ii) systemically important institutions cannot collapse suddenly; (iii) bank investment is counter-cyclical; and (iv) regulatory actions depend upon market signals (because the simplicity and clarity of such rules prevents gaming by firms, and forbearance by regulators, as well as because of the efficiency role of prices).’536 Their market-based solutions offered are driven by the same dynamics that led me to conclude that ex ante market-based tax instruments are the most adequate around to manage a market-based financial system. It is the dynamics of the markets and pricing signal of the market that will drive liquidity, availability of credit and countercyclical behavior.537 But their true message is in the end. They indicate that our financial infrastructure and regulation is prone to market error. Markets are an artificial construct and therefore can become unstable. This cannot be avoided. There is ex ante regulation that can put down that claim. But that is okay, they say. The whole idea should be that there is symmetry between upside and downside, between risk and return. This implies that markets aren’t required to be right all the time, or even ‘right on average as the models of regulators and bankers. What matters is that the risks of error are allocated to private investors’.538 Levine, already in 2002, indicated that the debate about bank-based versus market-based financial systems has relative merits and is little fruitful. This is especially true since his analysis demonstrates that although overall financial development is robustly linked with

 I. K. Nasr and G. Wehinger, (2014), Unlocking SME Finance Through Market-Based Debt: Securitisation, Private Placements and Bonds, OECD Journal, Vol. 2014/2, pp.  89–190; R. Wardrop et al., (2015), Moving Mainstream. The European Alternative Finance Benchmarking Report, London, February; IOSCO, (2014), Market-Based Long-Term Financing Solutions for SMEs Infrastructure, September. 536  J. Boluw and P. Klemperer, (2013), Market-Based Bank Capital Regulation, Economics papers 2013-W12, University of Oxford. 537  J. Boluw and P. Klemperer, (2013), ibid., pp. 41–43. 538  J. Boluw and P. Klemperer, (2013), ibid., p. 43. 535

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economic growth, there is no support for either the bank-based or market-based view.539 In such a contrasting view, bank-based systems are preferred or characterized by the fact that banks (1) acquire information about firms and managers and thereby improve capital allocation and corporate governance, (2) manage cross-sectional, inter-temporal and liquidity risk and thereby enhance investment efficiency and economic growth, (3) mobilize capital to exploit economies of scale, (4) cause well-developed markets to quickly and publicly reveal information, which reduces the incentives for individual investors to acquire information. Market-based systems are characterized by (1) fostering greater incentives to research firms since it is easier to profit from this information, (2) enhancing corporate governance by easing takeovers and making it easier to tie managerial compensation to firm performance and (3) facilitating risk management.540 Levine’s work explores the relationship between economic performance and financial structure. And his findings evidence what we by and large know as being the mainstream line of thinking about market models, that is, ‘[t]he bank-based view holds that bank-­based systems – particularly at early stages of economic development and in weak institutional settings – do a better job than market-based financial system at mobilizing savings, allocating capital and exerting corporate control. In contrast, the market-based view emphasizes that markets provide key financial services that stimulate innovation and long-run growth. Alternatively, the financial services view stresses the role of bank and markets in researching firms, exerting corporate control, creating risk management devices, and mobilizing society’s savings for the most productive endeavors.’541 But his analysis doesn’t allow to favor one model over the other and questions whether the distinction is useful to begin with: ‘[t]he data provide no evidence for the bank-based or market based views. Distinguishing countries by financial structure does not help in explaining cross-country differences in long-run economic performance.’542 Or to put it differently: although there are differences between countries in terms of their weighting of one system over the other and the observation that more mature economies tend to overweigh marketbased financial infrastructure, none of the findings help explaining cross-country differences in long-run economic performance. Only one thing is clear, that is, economic growth requires financial development not in terms of size and volumes (or product catalogue available) but in terms of legal rights of investors and the efficiency of the legal system in enforcing those rights. That dynamic is strongly linked with long-term growth.543 But what has been the role of shadow banking in Western markets that would allow us to conclude that they materially contributed to strengthening the financial infrastructure and delivering a more robust economic fabric in the different economies. When we consider the two possible types of financial intermediation, traditional and shadow banking, which differ in the level of diversification across projects, the following observations can be concluded: shadow banks, by pooling different loans, improve on the diversification of

 R. Levine, (2002), Bank-Based or Market-Based Financial Systems: Which Is Better?, NBER Working Paper Nr. 9138, also published in Journal of Financial Intermediation, Vol. 11, Issue 4, pp. 398–428. 540  R. Levine, (2002), ibid., pp. 2–3. 541  R. Levine, (2002), ibid., p. 23. 542  R. Levine, (2002), ibid., p. 23. 543  R. Levine, (2002), ibid., pp. 23–24. 539

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their idiosyncratic risks and increase the marketability of the assets. They will have a higher endogenous level of leverage that the traditional banking counterpart, and this due to their ability to pledge a larger share of the return on their projects. The implication is that by introducing a shadow banking system a higher amount of capital is being intermediated. This makes the economy more vulnerable through three different channels, concludes Ferrante.544 She details that this will be so because ‘[f ]irst, by being highly leveraged and more exposed to risky projects, shadow banks will amplify exogenous negative shocks.545 Second, during a recession, the quality of projects intermediated by shadow banks will endogenously deteriorate even further, causing a slower recovery of the financial sector. A final source of instability is that the shadow banking system will be vulnerable to runs.546 When a risk occurs, shadow banks will have to sell their assets to traditional banks, and this fire sale, because of the limited leverage capacity of the traditional banking system, will depress asset prices, making the run self-fulfilling and negatively affecting investments.’ So far, our response has been one of command-and-control regulation and large amounts of compliance and supervision as has become clear throughout the book.547 The naivety that ‘more measurement’ will lead to a better understanding and that a better understanding will lead to better management of market fallouts disregards the fact that this shadow banking market has not emerged naturally but is the consequences of regulatory implications, monetary policy, regulatory arbitrage, reckless use of leverage and a total neglect of tail risk.548 A central database or a trade repository for repo and securities lending transactions, monthly monitoring of MMF and their movements, CCP reporting, SIFI check lists, repo-lending and securitization disclosures and so on will provide jobs but none them will matter in the end. The massive ‘on load’ of information will blur the view of what really matters in this context. And regulation is not used for what it serves. It is the instrument that allows regulators to design markets and ultimately society as seen fit by their constituents. The responses post-crisis demonstrate that politics has become about bureaucracy and no longer is about statesmanship. So, the quest to solve statistics in this matter rages on.549 So, as long as we don’t have the larger picture right in terms of what kind of financial system we want, the concerns will pile up. Central banks and their policies reside in the same boat.  F.  Ferrante, (2015), A Model of Endogenous Loan Quality and the Collapse of the Shadow Banking System, FED Working Paper, March, later on published in American Economic Journal: Macroeconomics, Vol. 10 (2018), Issue 4, pp. 152–201. 545  L.J.  Christiano, et  al., (2014), Risk Shocks, American Economic Review, Vol. 104, Issue 1, pp. 27–65. 546  T.R.T.  Ferreira, (2014), Financial Volatility and Economic Activity, Northwestern University Working Paper; M.  Gertler and N.  Kiyotaki, (2013), Banking, Liquidity and Bank Runs in an Infinite Horizon Economy, mimeo 547  ECB. (2013), Enhancing the Monitoring of Shadow Banking, ECB Monthly Bulletin, Frankfurt, February, pp. 89–99. 548  See about the relationship between monetary policy, financial conditions and financial stability: T. Adrian and N. Liang, (2014), Monetary Policy, Financial Conditions, and Financial Stability, FRB New York Staff Report, Nr. 690, September. 549  A.  Agresti et  al., (2013), Non-Bank Financial Intermediation in the Euro Area: Current Challenges for Harmonized Statistics, Bank and Bank Systems, Vol. 8, issue 4, pp. 62–66. 544

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To illustrate, ‘[o]ur concern is not so much with possible risks of losses to the Fed but rather with deviation from well-established precedent and with adverse incentive created by validating risky bank relations with shadow banking’, Wray indicated recently.550 In their view, the financial crisis ‘was not simply a liquidity crisis but rather a solvency crisis brought on by risky and, in many cases, fraudulent or other unsustainable practices’. And that requires different responses: ‘[g]overnment response to a failing, insolvent bank is supposed to be very different from its response to a liquidity crisis: In traditional banking practice, government is supposed to step in, seize the institution, fire the management, and begin a resolution.’ ‘However, rather than resolve institutions that probably were insolvent, the Fed, working with the Treasury, tried to save them during the GFC—by purchasing troubled assets, recapitalizing the banks, and providing low-interest-rate loans for long periods.’551 That private money is not cash and that all IOUs are not equal should not come as a surprise, Moe indicates.552 There is less agreement about the way forward and how central banks should conduct their liquidity policies in the future. Some favor that central banks become the lender of last resort (LOLR) and others are wary of extending the role of the public safety net and see more cloud in reigning in the expansion of the shadow financial system with stricter regulation.553 Moe goes to the core of the issue rapidly and indicates that ‘[o]ur intuition is that there must be some limit to how far central banks should go in supporting the broader financial market in a crisis, especially when much of the ongoing expansion is based on a “liquidity illusion” that markets are deep and safe and will be supported by central banks—almost for free. This has led to underpricing of the true risk embedded in shadow banking instruments, and made them an artificially cheap source of funding.’554 Even if central banks can create abundant amounts of official liquidity, there should be limits to their support of the private financial sector. An unlimited accommodative monetary policy will enhance the financial fragility rather than reduce it. If the shadow banking sector wants to provide superior liquidity through securitized products and so on, it can best do so on its own terms without a public backstop. This endogenous nature of private credit (and liquidity) was not sufficiently appreciated before the crisis, Moe argues.555 There is a limit to what central banks can and should do in a market that assumes that inside money (bank money) is convertible to outside money (currency or central banking reserves) given the size of some markets (derivatives etc.). A market-based financial system is characterized by ‘excess credit elasticity’.556 Privately created money can  L.R. Wray, et al., (2015), Reforming the Fed’s Policy Response in the Era of Shadow Banking, April 2015, Levy Economics Institute of Bard College, p. 7. 551  L.R. Wray, et al., (2015), ibid., pp. 16–17. 552  T.G.  Moe, (2015), Shadow Banking and the Policy Challenges Facing Central Banks, in Reforming the Fed’s Policy Response in the Era of Shadow Banking, Working Paper, April 2015, p. 103, also published in Journal of Financial Perspectives, Vol. 3, Nr. 2, pp. 31–42. 553  T.G. Moe, (2015), ibid., p. 100. 554  T.G. Moe, (2015), ibid., p. 100. 555  Moe, (2015), ibid., p. 104. 556  The concept was introduced in: C. Borio and P. Disyatat, (2011), Global Imbalances and the Financial Crisis: Link or No Link? BIS Working Papers Nr. 346, Bank for International Settlements. May. 550

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disappear as well just as liquidity can dry up (most likely when you need it most). It is not reallocated elsewhere. The illusion of consistent liquidity of private money leads to aberrant risk taking, which is not properly assessed and appreciated557 even though it is quite clear that private liquidity has become highly endogenous to the conditions in the global financial system. That way, the financial system and the shadow banking segment have become instrumental and the engine in the boom-bust cycle. Reducing the abilities of the shadow banking market actually implies reducing the ability of the banking sector to create credit, overleverage and chase short-term profits. Moe also puts serious question marks on whether the current reforms will be sufficient to dampen the endogenous cycles of finance as the expansion of the shadow banking market is still preferred through regulation in many different ways558 and has created other hurdles that might destabilize the system, for example, through collateral requirements.559 It was already mentioned that economic model as a basis for regulation has its distinctive drawbacks and imports the economic fallacies into the regulatory domain. The fallacies exist and have been demonstrated; in fact, they are embedded in the economic science altogether. Nevertheless, this has not refrained economist from developing a superior view about themselves and their science relative to other that in their way contribute to the ‘good life’. Economists’ objective supremacy is intimately linked with their subjective sense of authority and entitlement.560 There is no evidence that an expert-advised (or is it export-led) democracy yields better results. Fourcade et al. observe that ‘[h]uman life is messy, never to be grasped in its full complexity or shaped according to a plan: people act in unanticipated ways, politics makes its own demands, cultures (which economists do not understand well) resist’.561 Besides the already discussed fact that economic models do not predict reality as such, but provide indications of how in a welfare maximizing environment focused on an equilibrium a potential outcome might look like taking into account the many assumptions underlying thee models. Combining these two elements lead to the conclusion that ‘the very real success of economists in establishing their professional dominion also inevitably throws them into the rough and tumble of democratic politics, forcing them to try to manage a hazardous intimacy with economic, political, and administrative power. It takes a lot of self-confidence to put forward decisive expert claims in that context. That confidence is perhaps the greatest achievement of the economics profession – but it is also its most vulnerable trait.’562 Nevertheless, the ordoliberal

 This ‘self-reinforcing interaction between risk appetite and liquidity is not yet sufficiently appreciated’; B. Coeuré, (2012), Global Liquidity and Risk Appetite: A Re-interpretation of the Recent Crises, Speech at the BIS-ECB Workshop ‘Global Liquidity and Its International Repercussions’, Frankfurt am Main, February 6. 558  See Moe, (2015), ibid., p. 106. 559  See Moe, (2015), ibid., pp. 106–112. 560  M. Fourcade et al., (2014), The Superiority of Economists, Maxpo Discussion Paper Nr. 14/3. 561  M. Fourcade et al., (2014), ibid., p. 23. 562  M. Fourcade et al., (2014), ibid., p. 23. See also: J. Jung and F. Dobbin, (2012), Finance and Institutional Investors, In K. K. Cetina and A. Preda (eds.), The Oxford Handbook of the Sociology of Finance, Oxford University Press, Oxford, pp. 52–74. 557

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way of thinking embedded in economics has spread silently and off the radar into regulation and has become the standard. Rather than convince the world, they used the most powerful jack they could find to leverage their ideas and turn them into real world policies. It points at the role of ‘embedded liberalism’ and ‘ordo-liberalism’563 in the process of the changing state-society interaction.564 Some get very nervous about that idea: ‘[l]ate capitalist and postmodern trade law today takes the form of a transnational regulatory order that is hegemonic in facilitating the transnational expansion of capitalism and privatized regimes of accumulation, which secure the interests of an increasingly transnational capitalist class’, writes Cutler.565 Others are more relaxed as they indicate that this ‘changing role of international (economic) law does not mean that the freedom and power of states are broken down with the help of law in order to create a neoliberal private law society. Public law plays an important “ordering” role in some of the dominant ideas about the organization of (the international) society.’566 It is therefore with utmost suspicion that I observed the shenanigans of the regulatory and supervisory bodies in recent years, which shifted from a control and monitor state to a ‘let’s see the opportunity in shadow banking’ flower power happy mode that credits shadow banking with the ability to become a stable market-based financial system with sufficient ‘tender love and care’ and preferably not too much regulation.567 The assumptions and blurred realities Carney starts from resemble in no way the intrinsic vulnerabilities of these institutions and activities and ignore the fact that regulation doesn’t make shadow banking institutions more resilient. It is not designed to do that and should not be wrongfully credited for being able to do that. In particular not the regulation that we have seen arrive in recent years. They, at best, create the illusion of more resilience. It seems to go wrong in the understanding how much regulation can effectively achieve in such a context. Ex ante regulation can reduce the probability, but not the economic damage in case that probability works against us.568 The argument that things are now better supervised and that systemic risk is now better monitored and understood fails to honor the academic state of affairs in terms of the research on the matter. We indeed have a lot of models, and a lot of different models, available. But our true understanding of systemic risk is still nascent on many different counts. And so is our understanding of contagion

  See for an excellent overview on the origins of ordoliberalism: D.J.  Gerber, (1994), Constitutionalizing the Economy: German Neo-Liberalism, Competition Law and the ‘New’ Europe, American Journal of Comparative Law, 1994, Vol. 42, pp. 25–84. 564  D. Marsh, et al., (2006), Globalization and the State, in C. Hay, M. Lister and D. Marsh (eds.), The State. Theories and Issues, Palgrave Macmillan, Hampshire and New York, p. 177. 565  C.  Cutler, (2008), Toward a Radical Political Economy Critique of Transnational Economic Law, in: S. Marks (ed.), International Law on the Left: Re-examining Marxist Legacies, Cambridge University Press, Cambridge, p. 201. 566  C. Peters, (2014), On the Legitimacy of International Tax Law, IBFD Doctoral Series Nr. 31, Amsterdam, p. 44. 567  M. Carney, (2014), Taking Shadow banking Out of the Shadows to Create Sustainable MarketBased Finance, Financial Times, June 16. 568  Smaller probabilities don’t say anything about the damage that occurs when that reduced probability, despite everything, manifests itself. 563

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and the impact of interconnectedness in the different financial networks. It is highly reckless, at least, to support the view that such a model that has been known for creating the largest carnage of the last century is now put back on a pedestal, glorified with additional but not undebated regulation and credited with potential that is unproven but that doesn’t directly benefit the real economy but only extends the financial infrastructure in a predatory way. There is no lobby-free regulator or supervisor569 in this world that can claim to be confident when making such statements or even be under the illusion that he is protection the public interest this way. I never would have thought that this was what Ackerman and Sands meant when they wrote in 2012 that they, representing the Institute of International Finance, ‘welcome in particular the work of the Financial Stability Board and European Commission on greater international coordination and consistency of policy across jurisdictions, and we are keen to contribute to this work’.570 In the US, it seems that things are moving in the same direction. In the notes of the Federal Advisory Council and Board of Governors of February 2015, it is indicated that ‘in order to increase the accessibility of credit supporting small business growth and to prevent the business from moving to alternative lenders in the shadow banking system that could ultimately cause systemic risk, banks may need some small-business-­lending-specific relief from regulations to create a level playing field’.571 But at least they are honest when indicating that ‘with the passage of time, the introduction of new people, and the probability of growing scale, complexity, innovation, technology dependence, and interconnectedness, the likelihood increases for a market emergency that could precipitate panics and runs on financial intermediaries’.572

7.17 T  ransforming Shadow Banking into Resilient Market-Based Finance: An Illusion? Also the FSB has moved into a higher gear and sees its mandate now as being the ‘transformation of shadow banking in market-based finance’. This is new since 2014,573 and their attempts will be stillborn. If we roll back time to 2010, this was when the FSB was mandated by the G20/G7 to develop policy measures in the next five areas: • Mitigating risks in banks’ interactions with shadow banking entities; • Reducing the susceptibility of MMFs to ‘runs’; • Improving transparency and aligning incentives in securitization;

 My apologies for the intentional oxymoron.  IIF, (2012), Shadow Banking: A Forward Looking Framework for Effective Policy, Preface, June. 571  Record of Meeting, (2015), Federal Advisory Council and Board of Governors, February 6, p. 7. 572  Record of Meeting, (2015), Federal Advisory Council and Board of Governors, February 6, p. 17. 573  FSB, (2014), Transforming Shadow Banking into Resilient Market-Based Financing. An Overview of Progress and a Roadmap for 2015, Basel, November 14. 569 570

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• Dampening procyclicality and other financial stability risks in securities financing transactions such as repos and securities lending; and • Assessing and mitigating financial stability risks posed by other shadow banking entities and activities. This was with a view toward reducing excessive buildup of leverage, as well as maturity and liquidity mismatching in the system. As discussed, a comprehensive framework of monitoring mechanisms was developed (with data aggregation and collection) and considered the crown jewel of the FSBs work, and covers now about 90% of global GDP.574 Additionally, the attempt was to mitigate the risk caused potentially by the interactions between banks and shadow banking institutions (both ways). To that effect, rules were developed as discussed before encompassing (1) risk-sensitive capital requirements for banks’ investments in the equity of funds and (2) the supervisory framework for measuring and controlling banks’ large exposures. Banks will also be subject to a hard limit on large exposures of 25% of Tier 1 capital (15% for global systemically important banks), which is more prudent than the 25% of total capital currently applied in most jurisdictions. The framework has been fully implemented by 1 January 2019. With respect to the run on MMF new legislation was introduced and, although useful, questions are being asked about the policy choices made.575 Only the next crisis will teach us how robust the variable MMFs were or whether the options to have MMFs hold more capital would have been the better option. Ultimately, the illusion of risk-free is kept alive to a large degree in the segment, despite the introduction of the variable MMF option (or at least the illusion of a bailout when needed). The capital buffers as included in the European proposal is minimal and will likely make no meaningful difference when needed. The inconsistency of the regulatory vis-à-vis a certain policy object across different regulatory initiatives has unfortunately been a well-known and well-documented problem.576 The same is true for the enhanced securitization disclosure requirements as implemented (more in Europe than in the US though). Good in itself, they will make no real difference in duress, given the information insensitivity embedded in debt markets (so also the MMF segment) and the true issues as identified by the Basel Committee on Banking Supervision (BCBS).577 The real dynamics of securitization is all about increas-

 FSB, (2014), ibid., p. 2.  See, for example, J.N. Gordon and C.M. Gandia, (2014), Money Market Funds Run Risks: Will Floating Net Asset Value Fix the Problem?, Columbia Business Law Review, Nr. 2, pp. 313–371. They find that ‘the stable/accumulating distinction explains none of the cross-sectional variation in the run rate among these funds (i.e. between a fixed NAV and a Variable NAV (ed.)). Instead, two other variables are explanatory: ‘yield which we take as a proxy for the fund’s portfolio risk, and whether the fund’s sponsor is an investment bank, which we take as proxy for sponsor capacity to support the fund’. 576  S. Agarwal et al., (2014), Inconsistent Regulators: Evidence from Banking, Quarterly Journal of Economics, pp. 889–938. They claim that is ‘due to differences in their institutional design and incentives’. 577  BCBS, (2011), The Joint Forum Report on Asset Securitisation Incentives, Basel, July. 574 575

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ing leverage at the lowest cost possible or beyond the point that would make it unrealistic under normal market and contractual conditions.578 Securitized products exploit the weakness of the debt markets, that is, their information insensitivity. It explains why in case of, for example, receivable securitization, ‘although the same set of bank lenders are active in both traditional bank loan market and the receivables securitization market, firms often do not borrow from their relationship banks’.579 This is because the value of a securitized loan is less sensitive to private information about the firm. This can under no condition be fostered. Reducing the procyclicality through haircuts of some sort was introduced. Well intended, they have triggered issues of creating systemically important central clearing parties, create uncertainty about the real benefits of netting exposures and the potential disruption of pricing of collateral assets and markets given the higher demand they trigger. The same judgment can be developed given the proposed application of numerical haircut floors to nonbank-tononbank transactions, a consultation that started in October 2014.580 They also looked at the current regulatory approaches on rehypothecation of client assets and examine their possible harmonization, which is a work in progress as discussed. But then again, in many circumstances, the regulatory field is instrumental in keeping certain shadow banking segments alive or even endorsed.581 And the moral hazard is left out in the open. Although we created massive frameworks for identifying all sorts of systemically important institutions in the banking, nonbanking, insurance and noninsurance sector, and have hit them with all sorts of tax surcharges, the momentum of big universal banks from a regulatory point of view has tilted toward them. The understanding that large or complex banks tend to take on greater risk and have a

 For example, Kumar demonstrates that ‘firms use securitization facilities to access the commercial paper market at a time when they find direct access to investment grade debt prohibitive’ and that ‘firms using securitization are larger, have more account receivables, have fewer growth opportunities and have a credit rating along the investment grade/speculative grade boundary’; see in detail: N. Kumar, (2013), The Role of Lender Relationship in Receivable Securitization, University of Chicago, Booth School of Business Working Paper, May 2. 579  Kumar, (2013), ibid. 580  FSB, (2014), Strengthening Oversight and Regulation of Shadow Banking Regulatory framework for haircuts on non-centrally cleared securities financing transactions, Basel, October 14, Annex 4, pp. 27–29. 581  A poster child example is the exemption of derivatives and repos from the normal insolvency/ bankruptcy cash flow waterfall distribution of claims under US regulation. These repos, ‘which are equivalent to very short-term (often one-day) secured loans, are exempt from core bankruptcy rules such as the automatic stay that enjoins debt collection, rules against pre-bankruptcy fraudulent transfers, and rules against eve-of-bankruptcy preferential payment to favored creditors over other creditors’; see E. Morrison et al., (2014), Rolling Back the Repo Safe Harbors, John M. Olin Center for Law, Economics and Business, Harvard Business Lawyer Discussion Paper Nr. 793, August 18, also published in Business Lawyer, Vol. 69, Issue 4, pp. 1015–1047. They advance and indicate that ‘While these exemptions can be justified for United States Treasury securities and similarly liquid obligations backed by the full faith and credit of the United States government, they are not justified for mortgage-backed securities and other securities that could prove illiquid or unable to fetch their expected long-run value in a panic. The exemptions from baseline bankruptcy rules facilitate this kind of panic selling and, according to many expert observers, characterized and exacerbated the financial crisis.’ 578

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bigger appetite for risk lies in their anticipation for further rescue. It also works both ways. Riskier (i.e. larger) banks take on more risk, and when they do, they are more likely to take advantage of potential government support.582 The SIFI designation has become a brand designation583 that warrants a ‘subsidy value’.584 What should not be forgotten in the end is that every regulatory intervention has its distinct impact on the functioning and business models in the financial sector. These can be individual or cumulative in nature and often have contradictory effects, and can cause unintended consequences caused by the collective implementation of new regulation. The market responses should be part of the regulatory ex ante assessment, for example, the consequences of the search for higher yield and so on, the impact of the growth of the shadow banking sector and the rise of the asset encumbrance. And last but not least, regulatory interventions might lead to deleveraging pressures and a reduced flow of credit to the real economy.585 So the quest for identifying simple, transparent and comparable securitizations might simply be the wrong question. It has no proven track record of lowering the cost of funding, except for the banks who don’t put that element forward to their clients, does not channel liquidity to the most vulnerable parts of the real economy, and does not deepen materially financial markets. It has been known for many other elements, which need no repetition here, but the search for safe securitization criteria is simply the wrong one, in an environment where assessing risk is continuously difficult, it is proven that it inflates synthetically asset prices and that it concentrates idiosyncratic risk. The quest for simple, transparent and comparable securitization criteria is built around: (1) generic criteria relating to the underlying asset pool (asset risk), (2) transparency around the securitization structure (structural risk) and (3) governance of key parties to the securitization process (fiduciary and servicer risk),586 and the criteria seem to lack real substance and deep understanding of the real issues at hand. This sounds like a manager who tells his team that they are in the wrong street of town, whereas they are actually in the wrong part

 G. Afonso, et al., (2014), Do ‘Too-Big-to-Fail’ Banks Take On More Risk, Federal Reserve Bank of NY, Economic Policy Review, December, pp. 41–58; see also: M. Brandão Marques, et al., (2013), International Evidence on Government Support and Risk Taking in the Banking Sector, Mimeo. 583  E. Brewer and J. Jagtiani, (2007), How Much Would Banks Be Willing to Pay to Become ‘TooBig-to-Fail’ and to Capture Other Benefits?, Mimeo. 584  D. Baker and T. McArthur, (2009), The Value of the ‘Too Big to Fail’ Big Bank Subsidy, CEPR Reports and Issue Briefs Nr. 36; Z. Li, et al., (2011), Quantifying the Value of Implicit Government Guarantees for Large Financial Institutions, Moody’s Analytics Quantitative Research Group, January; J. Santos, (2014), Evidence from the Bond Market on Banks’ ‘Too-Big-To-Fail’ Subsidy, Federal Reserve Bank of New York Economic Policy Review 20. Nr. 3 (December), pp. 29–39; K. Ueda and B. Weder di Mauro, (2012), Quantifying Structural Subsidy Values for Systemically Important Financial Institutions, Mimeo. 585  See in detail: EBA, (2015), Overview of the Potential Implications of Regulatory Measures for Banks’ Business Models, EBA Report, London, February 9. 586  BCBS, (2014), Criteria for Identifying Simple, Transparent and Comparable Securitisations, Consultative Document, December 11, pp. 8–9 and annex pp. 12–19; see also: EBA, (2014), EBA Discussion Paper on Simple Standard and Transparent Securitisations. Response to the Commission’s call for advice of December 2013 related to the merits of, and the potential ways of, promoting a safe and stable securitization market, EBA/DP/2014/02, October 14. 582

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of town or possibly the wrong town altogether. Advocating a free market doesn’t mean allowing just anything to happen in that free market. The regulator always has to balance public interest with free-market activities. When the downside is clear and the upside highly uncertain and clearly skewed, that proportionality dynamic is no longer met and simple restrictions on activities should be facilitated. Especially when the shadow banking market is to a large degree the making of regulatory work throughout the years and decades. Some refer to it as the shadow banking charade and suggest the regulatory view takes ‘a more introspective look at shadow banking as an invention of their own making within the regulated banking system’ as ‘banking regulators deceived themselves as to the true nature of the forces that destabilized the financial system and misinformed policy makers’.587 Fein points at some remarkable features: (1) shadow banking is seen as credit intermediation and transformations that occur outside the traditional banking sector. She comments: ‘[t]hese statements reflect a delusion among banking regulators that the shadow banking system is something other than the regulated banking system. This supposition contradicts reality and suggests that regulators lack a sound grasp of the forces that destabilized the financial system and caused the financial crisis’588; (2) runs in the markets for repurchase agreements (‘repos’) and asset-backed commercial paper were mistakenly not seen as runs on the traditional banks: ‘what is surprising is that banking regulators failed to recognize these runs as runs on the banking system. Banks were—and are—key players in the repo and ABCP markets.’589 Banks are ultimately part of the shadow banking market and thus part of the shadow banking system and a source of systemic risk. That has led to what Fein calls the shadow banking deception by regulators, supervisors and academia likewise. She argues ‘[t]heir failure to properly understand the runs that occurred has led to specious explanations’ and quotes Gorton,590 who highlights: ‘[t]he fact that the run was not observed by regulators, politicians, the media, or ordinary Americans has made the events particularly hard to591 understand. It has opened the door to spurious, superficial, and politically expedient “explanations” and demagoguery.’592 Fein’s message is clear: there is no shadow banking segment outside the traditional banking sector. The traditional banks are the largest and most dominant players in each of the shadow banking segments. Regulators therefore ‘fail to account for the extensive involvement of banking organizations in shadow banking activities and lay disproportionate blame for the financial crisis on entities outside the regulated banking system. These statements are troubling because they suggest that banking regulators are operating under false premises in their pursuit of financial reforms.’593 Rather than regulate a paral M.L. Fein, (2013), The Shadow Banking Charade, Working Paper, February 13, in particular pp. 5–11. 588  M.L. Fein, (2013), ibid., p. 6. 589  M.L. Fein, (2013), ibid., p. 7. 590  G.  Gorton, (2010), Questions and Answers About the Financial Crisis, prepared for the US Financial Crisis Inquiry Commission, Feb. 20, 2010, p. 2. 591  S.  Ben Hadj, (2014), Financial Institutions Externalities and Systemic Risk: Tales of Tails Symmetry, Working paper, November, mimeo. 592  Op. cit. at M.L. Fein, (2013), ibid., p. 9. 593  M.L. Fein, (2013), ibid., p. 11. 587

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lel banking universe that doesn’t exist, it might be better to accept the shadow banking reality as it is, that is, as an integral part of the traditional banking sector and largely a creation of banking regulators. Any potential attempt to regulate is captured by this flawed concept of what ‘shadow banking’ really entails.594 It is clear that when discussing the role of culture in the financial industry, any potential in doing so cannot be limited to discussion, herding and wrong-side incentives, but will have to involve the dynamics of regulatory culture and the dynamics of their decision-making power.595 Indeed, the externality creation dynamics of a financial institution don’t differ, only the mechanisms through which these externalities occur when comparing the traditional and shadow banking sector. The non-internalization of these externalities leads to systemic risk. Although academia here and there have been hammering on the issues regarding the noninternalization of externalities, less focus has been on the mechanism that facilitates that happening. The central concept is tail risk, on both ends of the loss distribution curve. The basic idea is that a bank should create as much risk as it undertakes. Any imbalance in the distribution of profit and losses is a sign of the bank’s failure to internalize its externalities or the social costs associated to its activities, describes Hadj. The central thesis is the ‘importance of tail symmetry on the sustainability of the financial system’. The role of the regulator than becomes to ‘to act as the referee and make sure that the individual decision taken by any financial institution in order to increase its own welfare has limited negative effects or externalities on the overall system’.596 His contribution is that his model ‘accounts for all the internal decisions of the bank and then considers their net effect on the system. Notably, both sides of the profit and loss distribution’ are examined. It is Ben Hadj’s position that a financial activity with no negative externality on the financial system should not alter the symmetry of the tails regarding the profit and loss distribution of the banking activity.597 The current regulation makes very little effort to take a holistic approach toward managing these externalities and all the collateral implications it brings along. It doesn’t even make a proper start with untangling the most problematic issue in the externalities framework, that is, that of the global financial network that is still little understood in terms of the contagion effect on asset prices, the creation and enlargement effect of the network and the intrinsic dynamics of the contagion effect. Bisias et al. have reviewed the nearly 30 models598 that have emerged over the last couple of years in the Pigovian chapter. The balance sheet linkages created by the network effects clearly facilitate contagion effects (i.e. transmitting systemic risk), but also facilitate price contagion. Capponia and Larsson599 examined this

 M.L. Fein, (2013), ibid., p. 12–19 & 23–24.  A.W.  Lo, (2015), The Gordon Gekko Effect: The Role of Culture in the Financial Industry, Working Paper, June 7. 596  S. Ben Hadj, (2014), ibid., p. 2. 597  S. Ben Hadj, (2014), ibid., p. 3. 598  D. Bisias, et al., (2012), A Survey of Systemic Risk Analytics, Office of Financial Research, US Department of Treasury, January. 599  A. Capponi and M. Larsson, (2014), Price Contagion Through Balance Sheet Linkages, Working Paper, March 1; see also C. Chen, et al., (2014), Asset Price-Based Contagion Models for Systemic Risk, Working Paper, mimeo. 594 595

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effect in the presence of both a banking and a nonbanking sector. Firms in the banking sector actively manage their leverage ratios to conform with prespecified target levels. Their analysis suggests that ‘regulatory policies aimed at stabilizing the system by imposing capital constraints on banks may have unintended consequences: banks’ deleveraging activities may amplify asset return shocks and lead to large fluctuations in realized returns’. That very same mechanism can cause spillover effects, where assets held by leverage targeting banks can experience hikes or drops caused by shocks to otherwise unrelated assets held by the same banks. Such fire sale externalities are produced if leverage targeting banks become too large relative to the nonbanking sector, as measured by elasticity-weighted assets, they conclude. So it is the fabric of the financial system itself that is at least part of the problem regulation should be trying to tackle. Since financial markets are a creation, a synthetic concept, they can and should be altered if they don’t function properly and don’t deliver what they’re supposed to deliver. Chinazzi et al.600 have been looking deeper into this question and assessed which structure of the financial system is more resilient to exogenous shocks, and which conditions, in terms of balance sheet compositions, capital requirements and asset prices, guarantee the higher degree of stability. The interesting thing about their study is that they, drawing on the theory of complex networks, show how contagion can propagate under different scenarios when the topology of the financial system, the characteristics of the financial institutions and the regulations on capital are let vary. They build on the contagion model discussed by Gai and Kapadia601, and they demonstrate that and how connectivity, the topology of the markets and the characteristics of the financial institutions interact in determining the stability of the system. In more detail,602 Chinazzi et al. conclude: • Connectivity is not only a driver of contagion, as it provides the channel for shocks to propagate, but also a hedge against contagion, via diversification. • Heterogeneity has an ambiguous role: when only considering the links in the financial network, the main effect is a widening of the interval of connectivity levels in which contagion is possible. This is due to the fact that diversification cannot, in this case, prevent contagious links to exist, which are a necessary condition for contagion to arise. • When size of the links is brought in (size heterogeneity), large financial institutions seem to act as shock absorber, making contagion a less likely phenomenon. Heterogeneity in connectivity provides additional stabilization when the initial default  M. Chinazzi et al., (2015), Defuse the Bomb: Rewiring Interbank Networks, Working Paper, June 3; see also: M. Chinazzi and G. Fagiolo, (2015), Systemic Risk, Contagion, and Financial Networks: A Survey, Working Paper, June 4. 601  P.  Gai, and S.  Kapadia, (2010), Contagion in Financial Networks, Proceedings of the Royal Society A: Mathematical, Physical and Engineering Science, Vol. 466, pp. 2401–2423. And later on: P.  Gai, et  al., (2011), Complexity, Concentration and Contagion, Journal of Monetary Economics, Vol. 58, pp. 453–470. 602  See extensively: M. Chinazzi et al., (2015), ibid., pp. 19–25. The findings are in line and build upon: M. Elliott, et al., (2014), Financial Networks and Contagion, American Economic Review, Vol. 104, pp.  3115–3153; F.  Caccioli, et  al., (2012), Heterogeneity, Correlations and Financial Contagion, Advances in Complex Systems, Vol. 15; F. Caccioli, et al., (2014), Stability Analysis of Financial Contagion due to Overlapping Portfolios, Journal of Banking & Finance, Vol. 46, pp. 233–245; T. Roukny, (2013), Default Cascades in Complex Networks: Topology and Systemic Risk, Scientific Reports. 600

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is random. However, this comes with the cost of an extremely high contagion risk when the most connected or the largest institution is initially distressed. Too-connected-to-fail banks are more dangerous than the too-big-to-fail ones: the total amount of distressed loans matters less than the number of creditors being initially hit by the default.603 Complex interactions between network structure and balance sheet composition: larger capital requirements are effectively able to stabilize the system, while larger liquid reserves, despite providing a buffer in case of liquidity run, induce banks to keep a smaller amount of capital, thus making them vulnerable to contagion. Short-term exposures are a channel for liquidity shocks, but they can also be easily removed, preventing shock to propagate. Capital requirements should also be rethought in the light of the trade-offs between microand macroprudential regulation: conditions that are extremely desirable from a microprudential point of view (e.g. larger liquid reserves and no fire sale losses) may induce, at a macro-level, systemic fragility.

They conclude that a better understanding of the causal links between network structure and the likelihood of systemic risk is required.604 This implies the increasing use of the empirical knowledge about real-world financial-network structures to calibrate theoretical models.605 And what is true for the shadow banking market is ‘mutatis mutandis’ for the ‘shadow insurance’ business. Liquidity creation is vulnerable to self-fulfilling runs in the shadow banking sector. The contractual structure of funding agreement-backed securities as applied in the insurance sector seems to contain the same triggers.606 And so both create money-like claims.607 The question that emerges is in what way regulation

 J.M. Conley and C.A. Williams, (2016), Fixing Finance 2.0 in Reshaping Markets. Economic Governance, the Global Financial Crisis and Liberal Utopia, (eds. B. Lomfeld, A. Somma and P. Zumbansen) in Cambridge University Press, Cambridge, 208–228. 604  See for a Europe-specific view on the topic: P. Abbassi et al., (2014), Cross-Border Liquidity, Relationships and Monetary Policy: Evidence from the Euro Area Interbank Crisis, Bundesbank Discussion Paper Nr. 45/2014 Frankfurt. 605  See also in more detail: D.  Acemoglu, et  al. (2013), Systemic Risk and Stability in Financial Networks, NBER Working Paper Nr. 18,727; H. Amini, et al., (2012), Stress Testing the Resilience of Financial Networks, International Journal of Theoretical and Applied Finance, 15; F. Blasques, et al., (2015), A Dynamic Network Model of the Unsecured Interbank Lending Market, BIS Working Paper Nr. 491, Basel; R. Cont, et al., (2013), Network Structure and Systemic Risk in Banking Systems, in Handbook on Systemic Risk, (eds.) by J.-P. Fouque, and J.A. Langsam, Cambridge University Press, Cambridge; M. Elliott, et al., (2014), Financial Networks and Contagion, American Economic Review, Vol. 104, pp.  3115–3153; P.  Glasserman and H.  P. Young, (2015), How Likely Is Contagion in Financial Networks? Journal of Banking & Finance, Vol. 50, pp. 383–399. 606  See in detail: N.C. Foley-Fisher, et al., (2015), Self-Fulfilling Runs: Evidence from the U.S. Life Insurance Industry, Finance and Economics Discussion Series 2015-032, Board of Governors of the Federal Reserve System, Washington; see also: D. Alberts et al., (2013), The Use of Captives and Special Purpose Vehicles Shadow Insurance or Legitimate Financing? De-Mystifying the Life Reserve Financing Debate. 607  See on the concept of shadow banking creating ‘claims’ seen by investor as ‘money-like claims’: A. Sunderam, (2015), Shadow Banking and Money-Like Claims, Review of Financial Studies, Vol. 28, Issue 4, pp. 939–977. 603

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should anticipate. And yes, in most cases the answer is ‘more equity’. Equity ensures the right to fail as is mainstream in any capitalist model. Debt instruments of all sorts without equity backing equals contagion, enhanced vulnerability and systemic risk. Debt instruments without equity backing require a public backstop as argued before in the book. Even for basic risks in the banking as interest rate risk, more and better quality equity to absorb that risk has recently been suggested.608 But there is the wider question about the functionality of financial legislation. And what does it mean that Fein, in my opinion, correctly assessed above that shadow banking is not a parallel universe, but merely a predictable extension of (traditional) banking business models shaped by layers of incoming regulations through the years. Trőger argues: ‘at least some of the financial stability concerns associated with shadow banking can be addressed by an approach to financial regulation that imports its functional foundations more vigorously into the interpretation and implementation of existing rules’ since ‘the general policy goals of prudential banking regulation remain constant over time despite dramatic transformations in the financial and technological landscape. Moreover, these overarching policy goals also legitimize intervention in the shadow banking sector.’609 He advocates a more normative construction of available rules that have the potential to limit both the scope for regulatory arbitrage and the need for evermore rapid interventions and a constant increase in the complexity of the regulatory framework. The regulatory treatment of financial innovation should be intimately linked to existing prudential rules and their underlying policy rationales. That approach also ends the ‘socially wasteful race between hare and tortoise’, which signifies the relation between regulators and a highly dynamic industry. The focus should then be only on weeding out rent-seeking circumventions of existing rules and standards without hampering market party and market efficiency in general. That seems close to Schwarcz,610 who was discussed earlier in this chapter and who favors a functional approach to financial legislation. Trőger reiterates, ‘the envisioned recourse to functionally described objectives of regulation is mainly supposed to facilitate a swifter, more accurate amendment of existing rules by expert bodies whose operations could escape the political quagmire of the legislative process’.611 Where Schwarcz argues in favor of ongoing monitoring and updating of financial legislation by technocratic experts, there are those that would take it far beyond that and champion ‘principle-based financial regulation’.612 Schwarcz argues against principle-based financial r­ egulation, given the downside risks and unintended consequences of principle-based regulatory frame BCBS, (2015), Interest Rate Risk in the Banking Book, Consultative Document, Basel, June.  T.H. Trőger, (2014), How Special Are They? – Targeting Systemic Risk by Regulating Shadow Banking, Working Paper, Goethe University, Frankfurt am Main, House of Finance, Frankfurt am Main, October 5. Later on published in: Reshaping Markets. Economic Governance, the Global Financial Crisis and Liberal Utopia, (eds. B. Lomfeld, A. Somma and P. Zumbansen) in Cambridge University Press, 2016, Cambridge, pp. 185–207. 610  S.L. Schwarcz, (2016), Regulating Financial Change: A Functional Approach, Minnesota Law Review, Vol. 100, Issue 4, pp. 1441–1494. 611  T.H. Trőger, (2014), ibid., p. 3. 612  See, for example, J. Black, et al., (2007), Making a Success of Principles-Based Regulation, Law and Financial Markets Review, Vol. 1, Issue 3, pp. 191–206, J. Black, (2011), The Rise, Fall and Fate of Principles Based Regulation, Law Reform and Financial Markets, Vol. 3, pp. 26–32. 608 609

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works.613 From that end, the functional dynamics and rationale between traditional and shadow banking credit intermediation is in close connection. Trőger identifies that ‘the view that existing regulation—at least in its substance—attempts to address the key concerns that reverberate in the debate on new rules to adequately cover shadow banking’.614 The main drawback of the existing narrow rule-based formalistic interpretation and design of laws is the widely discussed issue of regulatory arbitrage.615 The fundamental idea of all financial regulation is to safeguard liquidity and stability in public markets. Since private agents in our model create that liquidity through credit intermediation, they are often on the radar of financial regulation. Trőger indicates that ‘[y]et still, it is the structure of private sector money creation that precipitates the hazard of a sudden and massive destruction of liquidity’.616 Given the fact that money creation is with private commercial agents, it is fair to point at the fact that equity holders who benefit from limited liability benefit from enhancing leverage (which translates into ex post risk enhancement of debt holders). In plain terms: ‘the fact, that residual claimants benefit without limits from higher profits riskier projects may yield, while typical creditors with fixed interest and redemption claims do not participate in the increased upside of more volatile investment opportunities but are confronted with a higher probability of default and a higher loss ratio. Without adjustment, and realizing they can only protect themselves only so much through covenants, they provide inadequately cheap funding for the actual risks taken with investment decisions.’617 The overall cause of financial regulation then becomes ‘to safeguard the essential macro-economic function of private sector liquidity supply (credit intermediation), because risk-insensitive funding by investors—broadly understood—leads to excessive risk taking and leverage and thus potentially creates systemic risk’.618 Financial regulation should become more normative to reduce the scope for regulatory arbitrage. Trőger demonstrates the implications of the narrow-based regulatory model as it is applied in recent years and uses the MMF and the securitization market as illustrations.619 The short story is that the way the shadow banking aspects were tackled will be answered by the industry with all sorts of techniques to reduce or neutralize the effectiveness and ultimately will reduce the amount of capital they will have to hold, to reduce the risk retention required by banking institutions and the effective equity risk they will run. The permanently rolling over waves of financial regulation have become meaningless, or at least only marginally meaningful. The idea is to create an internal momentum that reduces the need for constant regulatory cementing of the financial building. More normative and less literalist views on financial regulation are required, Trőger argues, because

 S. L. Schwarcz, (2009), The ‘Principles’ Paradox, European Business Organization Law Review, Vol. 10, June, pp. 175–184. 614  T.H. Trőger, (2014), ibid., p. 5. 615  T.H. Trőger, (2014), ibid., pp. 14–15. 616  T.H. Trőger, (2014), ibid., p. 9. 617  T.H. Trőger, (2014), ibid., p. 11. 618  T.H. Trőger, (2014), ibid., p. 11. 619  T.H. Trőger, (2014), ibid., pp. 15–17. 613

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it ‘is apt to prevent regulatory arbitrage more vigorously because it bases the supervisory treatment of specific transactions first and foremost on their substantive risk structure’.620 It doesn’t require actual risk assessments, but a parallel treatment of the transactions covered by traditional banking regulation. There are more alleged than actual limits to such a regulatory model and the real limits come down to the modus operandi of the supervisors and mitigating the moral hazards they might be potentially captured by.621 All credit intermediation activities are then, for example, captured by an open normative regulatory window. The compliance and structuring issues then reside with the market parties and not with the regulator and supervisors. It would constitute a form of regulatory capture across the industry, and not on a narrow reading of transaction-based regulation. Given our earlier discussion that credit intermediation is now a process that takes place over long-winded credit intermediation chains, covered multiple entities and balance sheets, in different jurisdictions, this could clearly help to creating effective regulatory capture. As indicated before, I still ask the question as to whether certain activities should not be outright prohibited if the basic purpose of the liquid, stable and functioning markets are not guaranteed. Because, normative regulation solves the arbitrage issue, but not the macro-, microprudential issues following these activities and the role of the central bank as LOLR. The idea that ‘shrinking transaction costs may well open the opportunity to perform the tasks of private sector liquidity supply more efficiently in a market-based system of credit intermediation than within an integrated entity/group (hierarchy) that is at the center of the regulated banking-sector’622 might theoretically be true, it finds no ground in reality, and will undeniably lead to ex post interventions that will once again burden the sovereign. Also Turner623 concludes that regarding the current reforms ‘these changes do not go far enough’. He makes explicit the weakness in the current line of thinking ‘for they still tend to define financial stability in terms of reduced probability of failure within the financial system rather than in terms of the macroeconomic instability which financial system developments can induce’.624 The focus is not sufficiently on the fundamental role that the creation of credit and purchasing power plays within our financial infrastructure

 T.H.  Trőger, (2014), ibid., p.  17; see also: E.  Posner and E.  G. Weyl, (2013), An FDA for Financial Innovation: Applying the Insurable Interest Doctrine to 21st Century Financial Markets, Northwestern Law Review, Vol. 107, pp. 1307–1358. Regulatory-capital arbitrage is defined by the Basel Committee as ‘the ability of banks to arbitrage their regulatory capital requirement and exploit divergences between true economic risk and risk measured under the [Basel Capital] Accord’. See how regulatory arbitrage contributed to commercial real estate bubbles and CMBS issuance boom and busts: J. Duca and D. C. Ling, (2015) The Other (Commercial) Real Estate Boom and Bust: The Effects of Risk Premia and Regulatory Capital Arbitrage, Federal Reserve Bank of Dallas, Working Paper Nr. 1504. 621  T.H. Trőger, (2014), ibid., pp. 18–19. 622  T.H. Trőger, (2014), ibid., p. 19. 623  A. Turner, (2013), Credit, Money and Leverage: What Wicksell, Hayek and Fisher Knew and Modern Macroeconomics Forgot, Stockholm School of Economics Conference on: ‘Towards a Sustainable Financial System’, Stockholm, September 12. 624  A. Turner, (2013), ibid., pp. 32–33. 620

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and our economies and the risks it creates. Turner claims that the focus should be more on the level and evolution of real economy leverage, the changing mix for which credit is extended (and the implications for systemic risk and value creation) and the self-­ reinforcing relationship between credit supply, investment, consumption levels and asset prices. It would create a stronger buffer against procyclical behavior, bank credit growth and would directly constrain credit flowing to bubble sensitive areas (such as real estate). Overall, Turner indicates that a ‘new approach needs to be based on a return to fundamental analysis of the role which credit creation and resulting debt contracts play in our economies’.625

7.18 P  olicy, Supervision and Regulation: Tackling Structural Developments It was indicated before that the emergence of a shadow banking market to a large degree was driven by a higher demand for safe assets than the natural supply of it. This forces the following two positions as described by Di Iasio and Poszar.626 When the banking sector has access to the shadow banking technology, which allows them to liquefy partially illiquid investments (e.g. mortgages) and to manufacture shadow collateral (e.g. MBS), the design of shadow collateral will occur as follows. In a simple shadow banking environment, bankers design shadow collateral, which is liquid in all states of nature; in this case, the technology also provides liquidity insurance against aggregate shocks (crisis). Conversely, with complex shadow banking, shadow collateral is designed to be extremely liquid in states without aggregate shocks, thereby boosting bankers’ leverage, but illiquid in a crisis. So there is an intrinsic choice in this leverage-­insurance paradigm. This framework is characterized by two structural developments they highlight: first, the rise of institutional cash pools which manage large cash balances. Their demand for parking space is accommodated by sovereign bonds and shadow collateral. Second, the proliferation of balance sheets with ALMs, like those of insurance companies and pension funds; these entities have liabilities in fixed nominal amount and, in a low-yield environment, seek to allocate funds to bankers which deliver leverage-enhanced returns.627 They show  A.  Turner, (2013), ibid., p.  34. We are very remote from that position. Turner points in the analysis at the fact that many, if not all, economics textbooks still are deeply embedded in a number of financial economic myths: (1) first, that banks in sequence ‘raise deposits’ from savers and then ‘make loan’ to borrowers, ignoring their potential to create purchasing power ex nihilo, (2) that banks primarily lend money to firms/entrepreneurs to fund investment projects, allocating funds between alternative uses, largely ignoring the other potential functions and impacts of bank lending, (3) third, that the ‘demand for money’ (i.e. ‘for transactions money’) is a crucial issue. These books are often also silent on the role of banks as creators of money and the important impact they have on aggregate balance sheets and the leverage embedded (p. 31). 626  G.  Di Iasio and Z.  Poszar, (2015), A Model of Shadow Banking: Crisis, Central Banks and Regulation, Working Paper, May 18, mimeo. 627  To be precise: ‘[w]holesale funding is not only something that dealers/banks use to fund their own securities inventories/portfolios, but it is largely passed on through banks’ matched repo books 625

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that when the demand for parking space from cash pools—as compared to the supply of sovereign bonds—and the demand for returns from entities with ALMs are high, complex shadow banking is the competitive equilibrium outcome628 and the economy is prone to massive deleveraging in the case of aggregate shocks. Since the 2007 financial crisis, Basel III has been limiting in various ways the ability of banks to issue short-term instruments (repos) and run large matched books. In the meantime, the sovereign increased its supply of Treasury bills and short-term Treasury coupons, and the Federal Reserve started a Reverse Repo Program (RRP), opened to a wide set of nonbank counterparties, to lend out a fraction of its large post-quantitative easing (QE) holdings of safe assets. These responses have increased the supply of public parking space available to cash pools, the shortage of which, by compressing the cost of leverage in the shadow banking system, elicited the creation of shadow collateral with poor liquidity properties in adverse market scenarios (complex shadow banking) and was one of the roots of the crisis.629 Their key message therefore is that ‘a central bank focused on financial stability can fulfil that mandate actively managing its balance sheet by absorbing via reverse repo programs some of the demand for parking space from institutional cash pools. In the model, this type of policy intervention drives up the banks’ cost of the leverage sourced from institutional cash pools, and reduces incentives in pursing strategies which deliver high-leverage-enhanced returns in good times at the cost of massive deleveraging in the case of aggregate shocks.’630 The consequence is that economic agents have access to less leverage as the liquidity is now absorbed by the central bank to fund its asset portfolio. But, they indicate that, on the other side of the spectrum, asset-liability mismatches that levered bond portfolio managers are

to less regulated/supervised portfolio managers, such as leveraged hedge and bond funds. Leveraged funds use securities financing transactions and other cash-absorbing investment strategies to generate excess (leverage-enhanced) returns over a benchmark. The returns of these so-called alternative investment strategies satisfy the reach for yield of entities, like pension funds and insurance companies, which have accumulated asset-liability mismatches (ALMs). These entities have liabilities in fixed nominal amount and the returns of their traditional asset portfolios, dominated by sovereign bonds and other safe assets, have been suffering in a low yield environment. As a response, they increase allocations (i.e. funds to be managed) to leveraged funds: the greater the reach for yield from entities with ALMs, the greater the need for leverage from leveraged funds, the higher the demand for dealers’ balance sheet capacity, the greater the demand of dealers to raise funding for their matched books, the larger the volume of repos (and derivatives) absorbing the cash provided by institutional cash pools. In a nutshell, this is the modern financial ecosystem’ (pp. 24–25). 628  They assume that the liquidity properties of the shadow collateral in different states of the world are a banker’s’ choice. This choice characterizes the type of shadow banking system that emerges in equilibrium. In the terminology of our model, bankers’ decision is between (i) high leverage/output at the cost of large exposure to aggregate shocks (complex shadow banking) versus (ii) lower leverage/output and insurance against aggregate shocks (simple shadow banking). They show that the choice is largely affected by the financial ecosystem: when the demand for parking space from cash pools and the reach for yield from entities with liabilities in fixed, nominal amount (asset-liability mismatches) are high, complex shadow banking is the competitive equilibrium outcome and the economy is prone to massive deleveraging in the case of aggregate shocks (p. 25). 629  Di Iasio and Z. Poszar, (2015), ibid., p. 25. 630  Di Iasio and Z. Poszar, (2015), ibid., pp. 25–26.

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trying to bridge, still and will firmly remain and notably so in a prolonged low-yield environment. Risk taking therefore occurs in different corners of the system, in new ways and forms. None of the regulators, supervisors and policy makers have drilled down to the level that it comprehensively tackles those structural and fundamental macro developments to which the shadow banking sector responds. Financial stability risks are inherent in income and wealth inequality, global imbalances and other macro factors that give rise to growing institutional cash pools. Redistributive policies and tax reforms could well play into mitigating those systemic risks. In a world with multiple inefficiencies, the single policy tool the central bank has control over will not undo all inefficiencies. The world is better characterized by multiple inefficiencies and multiple policy makers with various objectives. Asking the policy question only in terms of optimal monetary policy effectively turns the central bank into the residual claimant of all policy and gives the other policy makers a free hand in pursuing their own goals. This further worsens the trade-offs faced by the central bank.631 By what with monetary policy in a globalized world where trust is hard to build and even more difficult to sustain. Does it really make sense then to develop standards for all types of shadow banking activities? Schembri argues: ‘[f ]or example, standards exist for securitization, specifically risk retention and disclosure; money market funds, including liquidity and valuation; and repo and securities-lending transactions, chiefly minimum haircuts. Several other types of shadow banking entities, such as broker-dealers, investment funds and finance companies, have been categorized by their economic function within a principles-­based regulatory framework. Policy tool kits have been developed for each.’632 Too big to fail and OTC derivatives are still on the list, and most governments struggle with those aspects. How exactly do you build trust if we don’t have the faintest clue (okay only a little bit) regarding some of the most fundamental questions which have been keeping us busy since the 2007 crisis: the nature and emergence of systemic risk, the building and sensitivities of financial networks, the nature and impact of contagion and the transmission effects, and let’s not forget the limited understanding of the macroprudential toolbox that we have thrown ad hoc at the problem in recent years. This includes by the way the sensitivities surrounding the interface between the federal and private fund market in times of distress,633 and let’s not forget the 800-pound gorilla still left in the room, the identification and measurement of tail risk in the banking sector.634

 T. Davig and R.S. Gürkaynak, (2015), Is Optimal Policy Always Optimal, International Journal of Central Banking, September, Vol. 11S1, pp. 353–384, and see the discussion: A. Orphanides, (2015), Discussion of ‘Is Optimal Monetary Policy Always Optimal?’, International Journal of Central Banking, September, Vol. 11S1, pp. 385–393. 632  Lawrence Schembri, (2015), Building trust, not walls – the case for cross-border financial integration, Remarks by Lawrence Schembri, Deputy Governor of the Bank of Canada, to the Windsor–Essex Regional Chamber of Commerce, Windsor, Ontario, 25 June 2015, p. 2. 633  D.O. Beltram et al., (2015), Un-Networking: The Evolution of Networks in the Federal Fund Market, Finance and Economics Discussion Series 2015-055, Washington, Board of Governors of the Federal Reserve System. 634  See in detail: A. Lucas et al., (2015), Modeling Financial Sector Joint Tail Rik in the Euro Area, ECB Working Paper Series, Nr. 1837, August 2015, Frankfurt. 631

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Rules and regulations may have different impacts on risk taking by individual banks and on banks’ systemic risk levels. That is why implementing prudential rules and policies requires careful consideration of their impact on bank risk and systemic risk. An interesting question then is whether market-based measures of systemic risk and recent regulatory indicators provide similar rankings on the systemically importance of, for example, large European banks. Van Oordt and Zhou find evidence that regulatory indicators of systemic importance are positively related to systemic risk. In particular, banks with higher scores on regulatory indicators have a stronger link to the system in the event of financial stress, rather than having a higher level of bank risk. They reiterate that ‘[n]ot all operations of banks that have an impact on the level of risk are similarly related to systemic risk. A single policy measure may have opposing effects on individual risk and systemic risk. That is why policy measures emanating from the micro-prudential objective of regulation – focusing on the risk of individual banks – may differ in scope and direction from policy measures that emanate from the macroprudential objective of regulation, and focus on systemic risk.’ ‘Our study provides some evidence supporting the regulators’ choice of systemic importance indicators. In particular, we evaluate the relation between G-SIB categories and indicators, on the one hand, and market-based (systemic) risk measures on the other, for a sample of large banks in the EEA. The results support all G-SIB categories and most G-SIB indicators used to measure banks’ systemic importance.’635 In a world where loan issuance is traditionally understood as one of the core functions of the banking sector, but also where the shadow banking sector is growing, it needs to be understood that the monetary transmission channels operate differently for shadow banks relative to commercial banks. Already in 2010 Woodford636 indicated that a comprehensive framework needs to include the understanding that a big chunk of the financial intermediation runs through a market-based system. Although the financial sector has been incorporated in recent models, it is still largely treated as a relatively homogeneous entity. However, empirical studies indicate that banks and shadow banks react to shocks in different ways. The bottom line is this: while banks reduce the amount of loans on their balance sheets following monetary policy tightening, shadow banks increase lending.637 This suggests that the share of credit intermediation via the shadow banking sector is an important determinant of the effectiveness of monetary policy on aggregate lending and the economy.638 As a consequence,

 M. van Oordt and C. Zhou, (2015), Systemic Risk of European Banks: Regulators and Markets, DNB Working Paper Nr. 478, July, p. 17. 636  M.  Woodford, (2010), Financial Intermediation and Macroeconomic Analysis, Journal of Economic Perspectives, Vol. 24, Issue 4, pp. 29. 637  B. Nelson, G. Pinter and K. Theodoridis, (2015), Do Contractionary Monetary Policy Shocks Expand Shadow Banking? Bank of England Working Paper Nr. 521, Bank of England, January. 638  F. Mazelis, (2015), The Role of Shadow Banking in the Monetary Transmission Mechanism and the Business Cycle, Humboldt University Berlin Working Paper, July, mimeo. Since banks create credit endogenously, funding supply is not a constraint on bank lending. Instead, their choice of lending depends on the productivity in the economy. Banks’ response to shocks therefore more readily resembles the balance sheet channel of monetary policy transmission. Shadow banks have to raise funds in the form of deposits first to act as intermediaries. Their behavior is therefore dependent on the supply of funding and corresponds more accurately to the lending channel (p. 20). 635

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shadow banks can significantly reduce the real effects of monetary policy shocks. At the same time, they amplify the reaction of key variables to real shocks.639

7.19 P  rivate Money Creation and Financial Regulation The fact that the banking sector as such is private with an at least partial public mandate can be considered problematic. The fact that the banking sector ultimately can create ‘private money’ with a fair and large degree of discretion is then even more reason for concern. The fact that this is a private market affair means that the banking sector is prone to competition. A competitive banking system is inconsistent with an optimum quantity of private money (creation). Taking into account the maturity and liquidity transformation they engage into (in that way they resemble the shadow banking market), the banking sector requires a positive franchise value to induce the full convertibility of bank liabilities. This is one-on-one true for the shadow banking sector as well. Monnett and Sanches640 indicate that such a positive franchise value, under conditions of perfect competition, can be obtained only if the return on bank liabilities is sufficiently low, which imposes a cost on those who hold these liabilities for transaction purposes. If the banking system is monopolistic, then an efficient allocation is incentive-feasible. In this case, the members of the banking system obtain a higher return on assets, making it feasible to pay a sufficiently high return on bank liabilities. Financial regulation is required to obtain a certain level of efficiency. I do refer here to the discussion in the Pigovian chapter and my viewpoint about the preference from a regulatory efficiency point of view of Pigovian taxes and instruments relative to command-and-control legislation.641 Monnet and Sanches indicate: ‘a primary concern of monetary economists should be to know whether a private banking system is capable of creating enough of this kind of liquidity to allow society to achieve an efficient allocation. In other words, can a private banking system provide a socially efficient quantity of money? And if so, what are the characteristics of such a system? Is it stable?’642 They demonstrate that a competitive banking system is unwilling to supply an optimum quantity of money and therefore is inherently unstable. For this reason, any equilibrium allocation under perfect competition is necessarily inefficient. Under conditions of a monopolistic banking system, an optimum quantity of money requires bankers to earn a sufficiently high return on assets to ensure a

 Mazelis, (2015), ibid., p. 17. He raises the question: whether central bank policy reacts optimally to real and nominal shocks if it does not take the presence of shadow banks into account? 640  C. Monnett and D.R. Sanches, (2015), Private Money and Banking Regulation, Federal Reserve Bank of Philadelphia, Working Paper Nr. 15-19, April, also published in Journal of Money, Credit and banking, Vol. 47, Issue 6, pp. 1031–1062. 641  See also L.  Nijs, (2015), Neoliberalism 2.0, Regulating and Financing Globalizing Markets, Palgrave, Basingstoke, chapters 4 ff. 642  Monnett and Sanchez, (2015), ibid., p. 2. 639

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properly large franchise value consistent with the voluntary convertibility of bank liabilities. If the members of the banking system have market power, then they can extract a larger surplus from borrowers while holding the total gains from trade constant. As a result, an allocation with the property that the banking system supplies an optimum quantity of money is incentive-feasible because a monopolistic banking system allows its members to sufficiently raise the return on assets. The regulation of the banking sector, they argue, is necessary for the implementation of an efficient allocation because a monopolistic banking sector would not choose to voluntarily pay the optimum return on money in the absence of intervention.643 They further indicate that the fact that banks, when engaging in liquidity and maturity transformation, will impact the optimal provision of liquidity but will also enhance the inherent stability of the system. Sanches had already lamented before about the fact that a primary concern in monetary economics is whether a purely private monetary regime is consistent with macroeconomic stability. He argued that a competitive regime is inherently unstable due to the properties of endogenously determined limits on private money creation. To be precise, he indicates that ‘there is a continuum of equilibria characterized by a self-fulfilling collapse of the value of private money and a persistent decline in the demand for money. I associate these equilibrium allocations with self-fulfilling banking crises.’644 He characterized the properties of a purely private monetary system. The key frictions in the environment are agents’ inability to commit to their promises and to verify the amount of collateral pledged as reserves to secure privately issued claims that circulate as a medium of exchange. As a result, agents distrust those who have the ability to issue these claims, giving rise to endogenous limits on money creation.645 It ultimately all comes down to understanding the counterparties you deal with.646 In the aftermath of the financial crisis, and as consolidated in the Basel III, higher capital thresholds have been implemented. This higher level of equity is likely to increase financial stability, but could also imply detrimental effects on liquidity creation. Although there seems to be no direct trade-off between liquidity provision and financial stability as run-prone provisions are not necessary for the efficient provision of liquidity. For example, mutual funds are, when subject to appropriate liquidity requirements, constrained efficient and run-proof. Kucinskas647 therefore concludes correctly in my understanding, that is, if bank runs happen with a nonzero probability, mutual funds are strictly superior to deposit-taking banks from a welfare perspective. This understanding needs to be positioned within the context of a trend in literature that emerged since 2010 where more narrow forms of banking have been advocated, which would eliminate maturity and

 Monnett and Sanchez, (2015), ibid., pp. 33–34.  D.R. Sanches, (2015), On the Inherent Instability of Private Money, Federal Reserve Bank of Philadelphia, Working Paper Nr. 15-18, April. 645  D.R. Sanches, (2015), ibid., p. 32. 646  See for an analysis of the counterparty risk as a key vulnerability in a complex and global financial infrastructure: BIS, (2015), BIS Quarterly Review: International Banking and Financial Market Developments, September, p. 61. 647  S. Kucinskas, (2015), Liquidity Creation Without Banks, DNB Working Paper, Nr. 482, August 17, p. 23. 643 644

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liquidity mismatches altogether. This sounds quite a bit like full reserve banking648 but has been redressed by a number of prominent economists in recent years,649 who invariably started from the Diamond and Dybvig model of 1983.650 But capital regulation should and is triggered by the liability side of a bank. Capital levels are regulated, usually because of market failures attributable to some combination of information problems, moral hazard, collective action problems and systemic risk. But macroprudential reasons should be injected in that analysis in order to reduce contagion in the financial network and avoid costly and imperfect wind-ups of banks or resolution protocols in case of insolvency. Liquidity and liability are related but not fully overlap and the integration of capital and liquidity regulation seems unattainable for the foreseeable future. The structure of the liability side reveals some of the liquidity constraints that might occur. Duration and ‘runnability’ of liabilities create or magnify stability risks and only equity can stave of counterparty concern. Tarullo comments threefold in this respect on the matter of higher capital ratios: ‘[f ]irst, a run that cuts off funding to widely held assets is a greater risk to the system than a conventional bank run in the absence of deposit insurance. A bank’s whole loans would not usually be sold in great number even under stressed circumstances and, even to the degree they were, other banks’ portfolios of loans are generally not marked down because of the stressed bank’s sales. Second, the possible availability of central bank liquidity support does not obviate the need for higher capital for intermediaries reliant on short-term wholesale funding.’ ‘Third, because these risks to the firm and the financial system arise from of the composition of the liability side of the balance sheet, the concerns expressed here apply – though perhaps in somewhat different degrees  – regardless of the particular form of intermediation in which the firm is engaged.’651 Tarullo therefore advocates tailored capital regulation across all types of financial intermediaries, in contrast to the fairly uniform approach these days. He indicates that ‘the fact that so many intermediaries have moved well beyond their traditional practices, products, and scope may warrant some qualification of conventional practice’.652 In the wake of the crisis, however, Basel III strengthened capital quality and levels across the board. Neither the generally applicable Basel III changes nor the G-SIB surcharges were specifically tied to the stability of a bank’s debt structure. However, the  R. Horváth et al., (2012), Bank Capital and Liquidity Creation. Granger-Causality Evidence, Working Paper Nr. 1497, November. 649  A. Admati, and M. Hellwig, (2014), The Bankers’ New Clothes: What’s Wrong with Banking and What to Do About It, Princeton University Press, Princeton, NJ; L.J. Kotlikoff, (2010), Jimmy Stewart Is Dead: Ending the World’s Ongoing Financial Plague with Limited Purpose Banking, John Wiley & Sons New Jersey; J.H. Cochrane, (2013), Stopping Bank Crises Before They Start. The Wall Street Journal, 23 June and (2014), Toward a Run-Free Financial System, Working Paper, University of Chicago. M.  Wolf, (2014), Strip Private Banks of Their Power to Create Money, Financial Times, 24 April. 650  D.W. Diamond and P.H. Dybvig, (1983), Bank Runs, Deposit Insurance, and Liquidity, Journal of Political Economy, Vol. 91, Issue 3, pp. 401–419. 651  D. K. Tarullo, (2015), Capital Regulation Across Financial Intermediaries, Speech by Mr. Daniel K Tarullo, Member of the Board of Governors of the Federal Reserve System, at the Bank of France Conference ‘Financial Regulation  – Stability Versus Uniformity; A Focus on Non-bank Actors’, Paris, 28 September 2015, pp. 3–4. 652  Ibid., p. 4. 648

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cleanest approach might have been to integrate capital and liquidity requirements in a single regulatory framework, which would establish minimum levels of capital and liquidity and then increase the capital requirement for intermediaries with more vulnerable funding structures.653 But as said, a full convergence seems not be on the books for quite a while to come. And maybe for now that is more of a good than a bad thing. As I indicated in the Pigovian chapter, our understanding of liquidity regulation is very limited and Tarullo connects the dots further ‘without a more complete understanding of the precise relationship between liquidity and capital needs, placing so much weight on one form of regulation would be ill-advised’.654 But consistency of capital regulation across different intermediaries with different activities and liabilities structures is paramount to tackle regulatory arbitrage655 and create a level playing field, that is, a similar asset being held, or a business activity conducted, by financial firms with different regulatory structures. Attention must be paid to the liability structure of the different firms before deciding whether the asymmetric regulatory treatment is prudent or an invitation to the propagation of new financial risks.656 To that effect, Basel III wouldn’t need to be extended to nonbanks but capital regulation should be shaped in line with the liability structure and the liquidity dynamics that balance sheet brings. Market liquidity is part of the public good called ‘stable and well-functioning public markets’. Nevertheless, it has many angles and faces, which I tried to bring together in Box 7.5.

Box 7.5  The Different Faces of Market Liquidity Market liquidity657 can be described as the ability to rapidly buy or sell a sizable volume of securities at a low cost and with a limited price impact, which is important to the efficient transfer of funds from savers to borrowers and hence to economic growth.658 Highly resilient market liquidity is critical to financial stability659 because it is less prone to sharp declines in response to shocks. Market liquidity that is low is also likely to be fragile, but seemingly ample market liquidity can also suddenly drop.660 (continued)

 Ibid., p. 5.  Ibid., p. 5. 655  See, for example, B. Munyan, (2015), Regulatory Arbitrage in Repo Markets, OFR Working Paper, October 29. 656  Ibid., p. 8. 657  D.J.  Elliott, (2015), Market Liquidity: A Primer, Economic Studies at Brookings Paper, The Brookings Institution, Washington. 658  See extensively: IMF, (2015), Global Financial Stability Report, Chapter Two: Market LiquidityResilient or Fleeting, October, pp. 53–56. 659  F. Duarte and T. M. Eisenbach, (2015), Fire-Sale Spillovers and Systemic Risk, FRB of New York Staff Report Nr. 645, Federal Reserve Bank of New York. R. Bookstaber and M. Paddrik, (2015), An Agent-Based Model for Crisis Liquidity Dynamics, OFR Working Paper Nr. 15-18, September 16. 660  IMF, (2015), ibid., pp. 49–114. 653 654

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Box 7.5  (continued) But to be precise, it needs to be pointed out that there are three concepts of liquidity: monetary liquidity, funding liquidity and market or asset liquidity. Monetary liquidity captures the looseness of monetary conditions—it is underpinned by the stance of the monetary policy authority. Funding liquidity is the ease with which banks and other nonbank financial intermediaries can raise funding. And market liquidity refers to the ease with which one asset can be traded for another. All three concepts are tightly related.661 There is no direct link between market liquidity and central banking liquidity provided to the market. The link between those two is the product of the (optimal) functioning of (1) the bank funding model and (2) the functioning of the market channel. A third element is the overall risk appetite in the market and the composition of the investor base. Many factors determine the level and nature of market liquidity662 like cyclical factors as monetary policy, but also changes to the market infrastructure,663 and there is a direct link observed with increased vulnerability. As the IMF indicated: ‘[l]arger holdings of corporate bonds by mutual funds, and a higher concentration of holdings among mutual funds, pension funds, and insurance companies, are associated with less resilient liquidity.’664 Cyclical factors are one of the most important drivers of market liquidity. Investor risk appetite and composition of the investor base,665 funding and market making,666 technology and regulation, as well as macroeconomic667 and monetary policy conditions668 are among the most common. But it is a knife that cuts both ways: monetary policy has had a positive impact on market liquidity in recent years but may have increased liquidity risk. Regulatory changes can have adverse impacts on market liquidity. For example, reductions in market making appear to have harmed market liquidity, but conclusive evidence is still not available on the impact of regulatory changes overall. But there are areas that are very elusive in terms of their impact on market liquidity. The concept of ‘safe assets’ was discussed before, and safe assets are used as a medium for exchange for risky assets. The availability of ‘safe assets’ is (continued)

 J.  Cunliffe, (2015), Market Liquidity and Market-Based Financing, Speech given by Sir Jon Cunliffe, Deputy Governor, Deputy Governor Financial Stability, Member of the Monetary Policy Committee, Member of the Financial Policy Committee and Member of the Prudential Regulation Authority Board British Bankers’ Association International Banking Conference, London, Thursday 22 October 2015, p. 5. 662  See extensively with literature references: IMF, (2015), ibid., p. 55. 663  See IMF, (2015), ibid., pp. 58–60. 664  IMF, (2015), ibid., p. 49. 665  IMF, (2015), ibid., pp. 66–67. 666  IMF, (2015), ibid., pp. 60–64; also see: D. Duffie, (2012), Market Making Under the Proposed Volcker Rule, Working Paper Nr. 106, Rock Center for Corporate Governance at Stanford University, Palo Alto, California. 667  J.  Christensen, and J.  Gillan, (2015), Does Quantitative Easing Affect Market Liquidity?, Federal Reserve Bank of San Francisco Working Paper Nr. 26, San Francisco. 668  IMF, (2015), ibid., p. 65. 661

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Box 7.5  (continued) prone, due to its use, to non-neutrality and overproduction and therefore can have materially destabilizing effects.669 Nothing in life is free, and this is most certainly true in financial markets. Liquidity comes at a price. And that price is not at all the same for all financial assets. It should reflect the underlying liquidity characteristics of the asset itself and how it is traded. Financial assets cannot escape entirely their underlying risk characteristics. Financial intermediation and financial engineering can reduce the costs of those risks by enabling them to be held by those who can best bear them. The more its liquidity depends on intermediaries being able and willing to put their capital at risk, the higher the price should be. Assets with standard terms and structures increase price transparency and the ease of price discovery, thereby attracting a larger pool of buyers and sellers. Similarly, assets that are designated benchmark instruments and those included in indices tend to attract a larger pool of buyers and sellers. And assets that can be posted as collateral against security financing and derivative transactions experience greater demand. On the other hand, while some characteristics make assets more liquid, some make them more illiquid. Assets that tend to be traded primarily by ‘buy-­and-­hold’ investors may require greater warehousing of risk to facilitate the matching of trades at or close to prevailing market prices. Assets exposed to tail risks tend to exhibit larger price falls and become less liquid in times of stress. Complex and/or opaque assets are less well understood and the risks can be more difficult to manage, so reducing the pool of potential buyers. Finally, assets with relatively news-insensitive cash flows like investment-grade corporate bonds may be less attractive to more active investors seeking to profit from information, but more attractive to buy-and-hold investors seeking predictable long-dated cash flows.670 Cunliffe has two further observations in this respect: (1) funding and monetary liquidity can exacerbate the illusion of market liquidity financial intermediaries and (2) financial engineering can make a very important contribution to liquidity—but they cannot turn lead into gold. He clarifies, ‘[t]he underlying risk characteristics of an asset cannot be changed. They can be separated out, combined with other risks, repackaged. And that is important. Because although the liquidity risks generated by the underlying characteristics of an asset cannot be changed, they can be structured to enable the risk to be held by those most able to bear it. This doesn’t change the underlying risks but it does change the impact if they crystallize. However, if the effect of financial intermediation and financial engineering to increase liquidity is not to distribute liquidity risk to those most willing and able to bear it but rather to obscure it, then it contributes only to the illusion of liquidity that can evaporate very quickly and painfully.’671 (continued)

 M. Eden and B. Kay, (2015), Safe Assets as Commodity Money, OFR Working Paper Nr. 15-23, November 25. 670  See extensively: J.  Cunliffe, (2015), Market Liquidity and Market-Based Financing, Speech given by Sir Jon Cunliffe, Deputy Governor, Deputy Governor Financial Stability, Member of the Monetary Policy Committee, Member of the Financial Policy Committee and Member of the Prudential Regulation Authority Board British Bankers’ Association International Banking Conference, London, Thursday 22 October 2015, pp. 4–6. 671  J. Cunliffe, (2015), ibid., p. 6. See for a number of examples and applications pp. 6–7. 669

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Box 7.5  (continued) Without regulating, capital will not be allocated optimally; but when regulated, the story is not done. Shadow banking provides an outside option for banks, which adds a new constraint in the mechanism design problem that determines the optimal allocation. A tax on illiquid assets and a subsidy to the liquid asset similar to the payment of interest on reserves (IOR) constitute an optimal liquidity regulation policy in this economy, Grchulski and Zhang propose.672 They seem to build their liquidity proposal based on the pecuniary-externality-based theory of optimal liquidity regulation of FIs in a similar fashion I designed my comprehensive FI-externality tax model in our Pigovian chapter. Both seem to be meeting at the hip. Financial markets have been affected by a number of structural changes over the past few years. Innovation has generated a broad trend toward fast, electronic trading. And necessary regulation implemented in response to the global financial crisis to ensure the safety and soundness of core intermediaries has discouraged them from market making as principal—though this may also reflect greater risk aversion on their part. These developments, alongside occasional bursts of volatility associated with short-term illiquidity, have led to concerns that market liquidity may have become more fragile. Although episodes of heightened volatility and short-term illiquidity are not necessarily in themselves threats to financial stability, they could become so if they were to persist, amplify or spill over.673 Overall, the ‘normal’ level of liquidity in markets that are less reliant on core intermediaries appears to have increased—but in some cases, to the detriment of resilience. In contrast, the ‘normal’ level of liquidity in markets that are more reliant on core intermediaries appears to have fallen—but with a likely increase in the resilience of those markets via the resilience of the core intermediaries themselves. Anderson et al. made the following interesting observations: • Weaknesses in trading infrastructure that become exposed in stressed circumstances can impede market access, exaggerate market moves and undermine confidence among investors. • Consensus views among investors can jeopardize market liquidity if there is a rush to exit commonly held positions. The reliability of nonbank market makers in such circumstances can be uncertain. • Investor behavior that distorts prices in one market can be rapidly transmitted to others via arbitrage activity. In other circumstances, the absence of arbitrage activity can lead to large pricing anomalies, reinforcing uncertainty among inves(continued)

 B. Groschulski and Y. Zhang, (2015), Optimal Liquidity Regulation with Shadow Banking, The Federal Reserve Bank of Richmond, Working paper Nr. 15-12. They indicate: ‘[d]uring expansions, i.e., when the return on illiquid assets is high, the threat of investors flocking out to shadow banking pins down optimal policy rates. These rates do not respond to business cycle fluctuations as long as the economy stays out of recession. In recessions, when the return on illiquid assets is low, optimal liquidity regulation policy becomes sensitive to the business cycle: both policy rates are reduced, with deeper discounts given in deeper recessions. In addition, when high aggregate demand for liquidity is anticipated, the IOR rate is reduced and, unless the shadow banking constraint binds, the tax rate on illiquid assets is increased.’ 673  N.  Anderson et  al., (2015), The Resilience of Financial Market Liquidity, Bank of England Financial Stability Paper Nr. 34, October 2015, p. 3. 672

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Box 7.5  (continued) tors. And while the use of circuit breakers can forestall disruption in the market to which they are applied, they can have adverse knock-on consequences. • Bank and nonbank companies’ ability and willingness to put capital at risk as principal has changed. Market participants should factor these changes into their investment decisions. So far, none of the post-crisis episodes of heightened volatility and short-term illiquidity have originated in predominantly dealer-intermediated markets. Further investigation is warranted as market structure evolves. The 2008 crisis and its aftermath have both evidenced the importance that liquidity has for investors and underlined the need to understand the linkages between credit markets and liquidity. Contrary to the common belief that illiquidity leads to a credit risk deterioration in financial markets, it is found that credit risk is more likely to be weakly endogenous for liquidity risk than vice versa. The results suggest that a negative credit shock typically leads to a subsequent liquidity shortage in the credit default swap market.674

But while the nexus between capital regulation and liquidity675 is a very important node in the financial network, the 800-pound gorilla still is ‘leverage’. The banking model cannot exist, not perform without it and that will continue to create problems over time despite the leverage ratio requirement (LRR) embedded in the Basel III package.676 The claims that the LRR would contribute to financial and bank stability have not been proven to the full degree yet and stress testing seems to point at a higher LRR than the current one required to deliver on that promise.677 What it does seem to trigger is enhanced risk taking by banks: for example, ‘we show that the LRR might induce banks with low-risk lending strategies to diversify their portfolios into high-risk loans until the LRR is no longer the binding capital constraint on them’,678 although the leverage ratio of FIs worldwide has only reduced from about 32% to just above 20%. As Haldane indicated during the 2014 INET meeting in Toronto, only a 5% drop in asset prices would still cause material turmoil and destruction.

 M. Hertrich, (2015), Does Credit Risk Impact Liquidity Risk? Evidence from Credit Default Swap Markets, International Journal of Applied Economics, Vol. 12, Issue 2, September, pp. 1–46. 675  Liquidity regulation (through the implementation of the LCR) has led to a repricing of liabilities to reflect their new treatment under LCR and on the asset side it has led to an increase of T-bonds by banks; see: G.  Debelle, (2015), Some Effects of the New Liquidity Regime, Speech by Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, at the 28th Australasian Finance and Banking Conference, Sydney, 16 December 2015, p. 8. 676  See in detail: BCBS, (2014), Basel III Leverage Ratio Framework and Disclosure Requirements, Working Paper, January. There are some fine differences between the definition of the leverage ratio between the Basel III framework and the capital regulation in the US; see EBA, (2014), Report on Impact of Differences in Leverage Ratio Definitions, Leverage Ratio Exposure Measure Under Basel III and the CRR, March 4. 677  I. Kiema and E. Jokivuolle, (2014), Does a Leverage Ratio Requirement Increase Bank Stability?, ECB Working Paper Nr. 1676, May. 678  Ibid., p. 1. Also see ECB, (2015), Financial Stability Review, November, pp. 1–13. 674

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No reason to cheer or take the eye of the ball, especially not since the largest problem is, besides the fact that our private partial reserve banking model doesn’t properly work without leverage for private economic agents, the drivers of the banking model trigger a procyclical leverage behavior679 and that despite the fact that the LRR has been proven to be more countercyclical than it regulatory capital counterpart.680 Every mild shock in the market will therefore not only need sufficient liquidity regulation to offset these leverage dynamics but also the intervention of the lender of last resort as we argued before and in line with Carlson et al.681 It was argued that LOLR lending and liquidity regulations are complementary tools. Liquidity shortfalls can arise for two very different reasons: first, sound institutions can face runs or a deterioration in the liquidity of markets they depend on for funding; second, solvency concerns can cause creditors to pull away from troubled institutions. Using the recent crisis as a playground, it turns out that central bank lending is the best response in the former situation, while orderly resolution (by the institution as it gets through the problem on its own or via a controlled failure) is the best response in the second situation. Liquidity regulation will be required as well, however, as it helps to ensure that the authorities will have time to assess the nature of the shortfall and arrange the appropriate response, and they provide an incentive for banks to internalize the externalities associated with any liquidity risks. The fact that nonbank financial institutions pose many challenges for central banks going forward,682 also in emerging markets but ultimately globally, was reiterated in the fist-thick report of the Bank for International Settlement covering all regions of the world. But the trend is already initiated that we start feeling comfortable with all the regulatory and supervisory changes produced in recent years. A very good example of that are the conclusions of a recent Bank of England Stability Paper,683 which concluded that, after they reported Basel III Tier 1 standards were met or exceeded across the board in the UK,

 T. Adrian et al., (2015), The Cyclicality of Leverage, Federal Reserve Bank of New York Staff Reports, Nr. 743, October. They conclude: ‘[b]anking organizations manage payout and leverage in order to achieve a scale of operation that is best captured by its book equity. The long-run leverage of the bank is then built on the trend book equity. In the short-run, however, the bank’s total assets can fluctuate considerably depending on market conditions, especially on those same forces that determine the book-to-market ratio of the bank’ (pp. 13–14). 680  M. Brei and L. Gambacorta, (2014), The Leverage Ratio Over the Cycle, BIS Working Paper Nr. 471, November. See regarding the leverage issue on novel lending platforms in emerging markets: CGAP, (2015), Inclusive Finance and Shadow Banking: Worlds Apart or Worlds Converging, Washington, September. 681  M. Carlson et al., (2015), Why Do We Need Both Liquidity Regulations and a Lender of Last Resort? A Perspective from Federal Reserve Lending During the 2007–09 U.S. Financial Crisis, Finance and Economics Discussion Series Nr. 2015-011, Board of Governors of the Federal Reserve System, Washington. 682  BCBS, (2015), What Do New Form of Finance Mean for EM Central Banks, BIS Paper Nr. 83, November. 683  M. Brooke et al., (2015), Measuring the Macro-Economic Costs and Benefits of Higher UK Bank Capital Requirements, Bank of England Financial Stability Paper Nr. 35, December. This paper uses a framework that measures and compares the macroeconomic costs and benefits of higher bank capital requirements. The economic benefits derive from the reduction in the likeli679

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‘(1) once resolution requirements and standards for additional loss-absorbing capacity that can be used in resolution are in place, the appropriate level of capital in the banking system is significantly lower than these earlier estimates, at 10–14% of risk-weighted assets; (2) The appropriate level of bank capital varies significantly with the risk environment in which the banking system operates. Our main conclusions relate to typical risk environments. But we also find that in periods where economic risks are elevated – such as after credit booms – the appropriate level of capital would be much higher; (3) It would be inefficient to capitalize the banking system for these elevated risk environments at all times, based on our analysis of the economic costs of higher bank capital levels. This motivates the use of time-­varying macroprudential tools, such as the countercyclical capital buffer.’

7.20 ( Shadow) Banking, Financial Regulation, Stability and Liquidity: Let the Puzzling Begin… 7.20.1  Introduction Even the most stringent financial regulation doesn’t secure financial stability when shadow banking is part of the larger picture. Regular banks pursue regulatory arbitrage to neutralize legislation and create off-balance sheet financing by extending their business model outside the normal perimeters via shadow banking. Shadow banking adds to financial instability because tightening market discipline in economic downturns forces shadow banks to sell assets at fire sale prices to regular banks. As Huang demonstrated, financial instability as a function of financial regulation is U-shaped rather than monotonically decreasing as conventional wisdom predicts or assumes. He further proposes a framework that can comprehensively evaluate the impact of different regulatory regimes on both the regulated and the shadow banking market.684 I already highlighted before in this chapter that apply in a broad-brush way, the regulation applicable to the regulated banking sector to the shadow banking sector comes with many drawbacks, overinclusiveness, liquidity drains also in the regulated segments and much more. So a quick solution that goes to the root cause of the problem is not around the corner unless it comes with much collateral damage. Since the 2008 crisis, there have been scholars and supervisors who, in contrast to existing mainstream opinions, argued that the relationship between regulation and financial stability is not linear and monotonic upward sloping. Huang argued effectively that when financial regulation is sufficiently lenient, financial migration is negligible and in those hood and costs of financial crises. The economic costs are mainly related to the possibility that they might lead to higher bank lending rates which dampen investment activity and, in turn, potential output. 684  J. Huang, (2016), Banking and Shadow Banking, Princeton University Working Paper, December 1, mimeo (also published in Journal of Economic Theory, Elsevier, Vol. 178(C), pp. 124–152).

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circumstances tightening financial regulation lowers financial instability and improves social welfare. But when financial regulation becomes too stringent, the volume of financial migration increases and financial instability increases and worsens social welfare. The borrowing capacity of shadow banks relies on market discipline and the level of financial regulation that regular banks face. So, if the channel connecting the borrowing capacity of shadow banking to financial regulation is turned off, tightening regulation can always lower financial instability because the contraction of the regulated banking sector caused by strict regulation dominates the expansion of the shadow banking sector.685 Within a context of regulatory arbitrage, tighter financial regulation causes larger borrowing capacity of shadow banks, that is, the higher leverage that a regular bank can obtain via shadow banking. But defaulting on shadow banking obligations by the regular bank implies less leverage in the future as creditors will stop lending to the SB segment. So, then there is no opportunity left for regulatory arbitrage in this space. The cost for the regular bank then is the net present value (NPV) of future regulatory benefits. With tighter financial regulation, greater opportunity for regulatory opportunity emerges. Tighter and inflexible regulation leads to larger costs of default and higher levels of leverage. Please note the feedback loop between the cost of default and the amount of leverage. A lower cost of default leads to a greater incentive to default and a narrower SB channel. That narrower channel offers less benefits to regulated banks and which implies a lower cost of default. But when financial regulation is sufficiently loose, the cost for regular banks to default is small. The feedback loop amplifies the effect of the small cost of default so profoundly as to rule out shadow banking completely.686 But that is not what Basel III has in mind; bank leverage ratios are primarily seen as a microprudential measure that intends to increase bank resilience.687 Yet in today’s environment of excessive liquidity due to very low interest rates and quantitative easing, bank leverage ratios should also be viewed as a key part of the macroprudential framework.688 Avgouleas comments: ‘leverage ratios can prove an effective macroprudential measure

 J. Huang, (2016), ibid., p. 2.  J. Huang, (2016), ibid., p. 3. Huang’s model is based on M. Brunnermeier and Y. Sannikov, (2014), A Macroeconomic Model with a Financial Sector, The American Economic Review, Vol. 104, pp. 379–421. 687  To make it even more complicated, there are three types of leverage: (1) ‘balance sheet’, (2) economic leverage and (3) embedded, respectively, based on balance sheet concepts, market-dependent future cash flows, and market risk. Avgouleas argues, ‘[b]alance sheet leverage is the most recognized form as it is the most visible. It measures the ratio at which the value of a firm’s assets exceeds its equity base. Banks typically leverage themselves by borrowing to acquire more assets, with the aim of increasing their return on equity. Economic leverage means that a bank is exposed to a change in the value of a position by an amount that exceeds what the bank paid for it. Finally, embedded leverage refers to holding a position that is itself leveraged. There is no single measure that can capture all three dimensions of leverage simultaneously’; see E. Avgouleas, (2015), Bank leverage Ratios and Financial Stability: A Micro- and Macroprudential Perspective, Levy Economics Institute Working Paper Nr. 849, October, p. 2. 688  See for a discussion of the different leverage concepts within the context of new financial regulation: E. Avgouleas, (2015), ibid., pp. 30–34. 685 686

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aimed at stabilizing the financial system as a whole. They cannot, however, replace monetary policy, when they are used in a backdrop of excessive liquidity, due to very loose monetary policy or the reinvestment of trade surpluses, in the case of attractive (and open) host markets. Therefore, the financial stability dilemmas surrounding loose monetary policies will remain an intractable economic policy and intellectual problem, even in the face of a new spate of well-thought-out and well-calibrated leverage ratios like those being implemented in key financial centers.’689 Admati et  al.,690 however, illustrate remaining issues. They, for example, point at the implications of a ‘leverage ratchet effect’ (i.e. an agency cost of debt) whereby conflicts of interest with creditors lead shareholders to resist all forms of leverage reduction even when reducing leverage would increase firm value while generally favoring an increase in leverage even if it destroys firm value. And what about the relationship between bank leverage and their incentives to manage liquidity? Vo provides evidence that banks become less prudent managing their liquidity when leverage on their balance sheet is higher.691 But if we take a step back and ponder on the many aspects discussed in this chapter, the question can be asked whether the SB battle can be won given all items in the mix. Liquidity, private money creation ex ante and ex post regulatory options, leverage, regulatory arbitrage, micro- and macroprudential perspectives and the macro-dynamics of institutional asset pools. And then there is financial regulation, layer after layer, until it now has largely become unreadable, making it even more prone to regulatory arbitrage, which I’m sure has played a role when the FI industry pondered on how to organize its massive lobbying industry. Making statements about technicalities of specific pieces of legislation, but taking step back and judging the holistic direction of our regulatory body covering the FI industry is another. Stellinga took on that challenge and concludes that on an EU, but valid across the board, the following observations can be made: (1) financial regulation post-2008 crisis is tougher and more stringent (i.e. more detailed), but has stayed largely within the framework and mindset as it was present pre-2008 crisis (status-quocrisis); (2) despite the fact that financial regulation goes through the political grinder, a lot of the ‘material part’ of financial regulation sees the light on public-private expert platforms where financial MNCs are dominant; and (3) there is a lot more attention for the macroprudential dynamics of financial regulation and oversight, but there is a total lack of consensus of holistic approach across the different pieces of regulation that interact at the level of the industry (monetary policy, micro- and macroprudential policy, tax law, financial law, contract law, Basel III, etc.) how the potential of the FI can be geared toward creating value and growth for the real economy rather than FI rent-seeking at the expense of the real economy.692 The status-quo-crisis is reflected by the FI comparison

 E. Avgouleas, (2015), ibid., p. 35.  A.R. Admati et al., (2015), The Leverage Ratchet Effect, Princeton University Working Paper, mimeo, March 19. 691  Q.-A.  Vo, (2015), Liquidity Management in Banking: What Is the Role of Leverage?, Swiss Finance Institute, Research Paper Nr. 15-51. 692  B. Stellinga, (2015), Europese Financiële Regulering Voor en Na de Crisis, WRR Paper Nr. 15; conclusions pp. 83–86. 689 690

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pre- and post-crisis: still systemically important and large institutions, lots of leverage (even more than before) and complexity of transactions and products. And even the political agenda hasn’t changed a lot. Despite all efforts to de-risk and capitalize banks, the UK as prime financial hub in Europe indicates its ambition to become the fintech capital of the world. Now realizing that fintech is mainly the business of regulatory arbitrage, low capital cost operation, data capture, outsourcing human labor to algorithms, streamlining back-office for margin improvement purposes and transferring risk-management to customers, you appreciate that there’s a certain cognitive dissonance in calling both for more fintech and more prudent business models in banking at the same time, argues Kaminska.693 Mazzucato adds to this that ‘[t]he first thing is, there’s never been a lack of finance. There’s never even been a credit crunch. There’s plenty of finance out there, it’s just been the wrong type for of finance for innovation in the real economy.’694 The short-termism that comes with innovative finance will take its toll by creating less fundamental innovations and only applied and over time irrelevant advances. She argues, ‘[p]atient long-term committed strategic finance. What we know is that innovation in the real economy takes 20–30 years, and what the VC industry has done…given that the narrative of what actually creates wealth has been so biased, this has caused great dysfunctions and it’s made the venture capital industry more short-termist, exit driven. They want the exit to happen in three-to-five years, which is fine for gadgets but it’s not going to get us the next big thing after the internet. And in biotechnology and clean technology this is causing lots of PLIPOs, Product-­less IPOs.’ In other words, we need to limit rent-seeking not increase it by making it more accessible to new entrants.695 And that raises the question about a possible ex ante or ex post approach, that is, should the focus be on the birth or burst of financial bubbles. Demos et al.696 demonstrate that the beginning of bubbles is much better constrained than their end and one could logically conclude that ex ante regulation would be better placed to contain exposures across the bubble cycles. This viewpoint also seems in line with Schwarcz as discussed before in this chapter.

 I. Kaminska, (2015), Fintech and Banking Risk; Cognitive Dissonance de Semaine, Financial Times, FT Alphaville, November 12. 694  Quoted in I. Kaminska, (2015), ibid. 695  Quoted in I. Kaminska, (2015), ibid. A beautiful narrative of Mazzucato in the article reflects the current conundrum: ‘[n]ational income and product accounting up until the 1960s treated the whole financial sector almost like it treated social security payments, as transfer of existing wealth. For good reasons finance started to be counted into GDP measures and the net interest payments was the way to do it because otherwise the fees had already been included, and you would think that given this massive amount of financial innovation in financial intermediation the percentage of GDP of these net interest payments would have reduced, right? Because the reason why commercial banks were all of a sudden included in GDP was due to their service of financial intermediation. That percentage has not decreased.’ A good example of that is the involvement of (shadow) banking in real estate finance; see extensively: A. Antoniades, (2015), Commercial Bank Failures During the Great Recession: The Real (Estate) Story, BIS Working Paper Nr. 530, November 23. 696  G. Demos et al., (2015), Birth or Burst of Financial Bubbles: Which Is Easier to Diagnose?, Swiss Finance Institute Research Paper Nr. 15-57. 693

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But let’s look back and see what has been done so far to mitigate vulnerabilities in the system. Fisher lists them for us: (1) requirements for more and higher-­quality capital and other lossabsorbing capacity at banks; (2) new requirements for liquidity buffers at banks; (3) more stringent capital and liquidity requirements at the largest, most systemically important firms; (4) stress testing of the largest banks; (5) the shift of the clearing of some derivatives to central counterparties (CCPs); (6) new margin requirements for uncleared derivatives transactions; (7) the designation of systemically important nonbank financial institutions by the Financial Stability Oversight Council; and (8) enhanced sharing of information among regulators and monitoring of risks to financial stability.697 Most, if not all, of these measures contribute to make the system more robust in a countercyclical fashion. They therefore cater to combat the cyclically induced vulnerabilities which can be summarized as being ‘(1) high debt burdens at households and firms; (2) elevated leverage and maturity transformation within the financial sector; (3) complexity and interconnectedness in intermediation chains; (4) low risk premiums on assets, especially assets funded with debt; and (5) complacency on the part of investors, supervisors and decision-makers in the private sector of the financial system’.698 But even in 2019, it is clear for the regulator and supervisor that the picture for shadow banking is far from complete. And although securitization as well as repo levels and AUM by MMFs are far below their precrisis peaks, structural changes also have played a role in, for example, the largest broker-dealers being now part of bank holding companies and therefore subject to consolidated supervision by the Federal Reserve, which includes regular stress testing and tighter capital and liquidity requirements. The reduction in leverage and maturity transformation in itself is a good thing especially since it has come at a limited cost in terms of market liquidity.699 Fisher acknowledges in line with Rumsfeld that the ‘unknown unknowns’ are the ones that can hurt most and that the continued lack of data in some areas might impede the design of regulation. Areas that would qualify are ‘securities lending, bilateral repos, and derivatives trading’ as well as ‘the activities of important nonbank market participants, such as asset managers, and the interconnections across institutions remain more opaque’.700 Better data leads and should lead to better regulation.701 But data don’t reveal the interconnectedness and its many complexities. In the chapter on Pigovian taxes, I discussed this topic at length.  S. Fisher, (2015), Financial Stability and Shadow Banks – what we don’t know could hurt us, Speech by Stanley Fischer, Vice Chair of the Board of Governors of the Federal Reserve System, at the ‘Financial Stability: Policy Analysis and Data Needs’ 2015 Financial Stability Conference, sponsored by the Federal Reserve Bank of Cleveland and the Office of Financial Research, Washington, DC, 3 December 2015, pp. 1–2. 698  Ibid., p. 2. 699  Although there is some concern about certain parts of the market, for example, lower brokerdealer activity and the impact on bond market liquidity. 700  S. Fisher, (2015), ibid., p. 4. Also: S. Fischer, (2015), ‘The Importance of the Nonbank Financial Sector’, speech delivered at the Bundesbank conference ‘Debt and Financial Stability–Regulatory Challenges’, Frankfurt, Germany, March 27, and S.  Fisher, (2015), ‘Nonbank Financial Intermediation, Financial Stability, and the Road Forward’, speech delivered at ‘Central Banking in the Shadows: Monetary Policy and Financial Stability Postcrisis’, 20th Annual Financial Markets Conference sponsored by the Federal Reserve Bank of Atlanta, Stone Mountain, Ga., March 30. 701  Fisher provides a nice example, ‘[a]n illustration of the possible interaction between better data and better policies is the potential role of margins in securities financing transactions. The more 697

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And so data sets have a number of problems: (1) they are either incomplete, overinclusive or too complex to be useful; (2) converting them into legislation makes it all either impossible (to cover the many hypotheses) or too quantitative; (3) when problems show up in data sets, it generally is too late (and therefore not useful as a basis for regulation); and (4) they fail to appreciate that only good theory can be a basis for regulation. That theoretical framework is only in development and has many blind spots, including the aforementioned ‘interconnectedness’.702 In addition to direct connections, common exposures and contagion are important sources of interconnectedness and fragility. But the connections observed in literature between economic agents are often too small to explain the systemic exposure we observed in reality. So, it is really the triangular dynamics between interconnectedness, contagion and complexity that needs unwiring. And when doing so, we might untangle between banks and nonbanks, as existing (differential) regulation is a factor in the mix of the three-abovementioned components.703 And bottom line, in line with Turner I’m prepared to challenge the belief that we need credit growth to fuel economic growth, and that rising debt is okay as long as inflation remains low. In fact, most credit is not needed for economic growth—but it drives real estate booms and busts and leads to financial crisis and depression.704 It did and will constantly drive us away from any type of welfare optimum and into the hands of large monopolistic behemoth-driven tail end of the industry.705

stringent regulation of the banking sector may push short-term financing activities to less regulated entities. To limit such regulatory arbitrage, the Federal Reserve will be developing regulations that would establish minimum margins for securities financing transactions on a market-wide basis. The margins would apply to all market participants, thereby mitigating the risks associated with regulation along institutional lines’ (p. 5). 702  See for a good overview: D. Bisias, et al., (2012), A Survey of Systemic Risk Analytics, OFR Working Paper Nr 1, Washington: US Department of the Treasury, Office of Financial Research, January; G.  Kara, et  al., (2015), Taxonomy of Studies on Interconnectedness, FEDS Notes. Washington: Board of Governors of the Federal Reserve System, July 31. 703  Reference has already been made to the relevant literature in the Pigovian chapter and wider throughout the book. Here it can be limitedly referred to: (1) D. Acemoglu, (2015), Systemic Risk and Stability in Financial Networks, American Economic Review, vol. 105 (February), pp. 564–608; (2) F.  Allen, et  al., (2012), Asset Commonality, Debt Maturity and Systemic Risk, Journal of Financial Economics, Vol. 104 (June), pp. 519–534; (3) R. Caballero, et al., (2013), Fire Sales in a Model of Complexity, Journal of Finance, Vol. 68 (December), pp. 2549–2587; (4) F. Duarte, and T. Eisenbach, (2015), Fire-Sale Spillovers and Systemic Risk, Federal Reserve Bank of New York Staff Reports Nr. 645, Federal Reserve Bank of New York, February; (5) G. Hale, et al., (2014), Crisis Transmission in the Global Banking Network, Working Paper, December, mimeo; and (6) G. Kara, et al., (2015), Taxonomy of Studies on Interconnectedness, FEDS Notes, Washington: Board of Governors of the Federal Reserve System, July 31. 704  A.  Turner, (2015), Between Debt and the Devil: Money, Credit, and Fixing Global Finance, Princeton University Press, Princeton, NJ. See for a full evaluation that come with the rise of financialization of the economy and society at large: The Rise of Finance: Causes and Consequences of Financialization, Socio-Economic Review, Vol. 13, Issue, July 2015. 705  D.  Fiashi et  al., (2014), The Interrupted Power Law and the Size of Shadow Banking, PLoS ONE 9(4): e94237. doi:https://doi.org/10.1371/journal.pone.0094237

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7.20.2  The Limits of Regulation Policy makers around the world have concentrated their efforts on designing a regulatory framework that increases the safety of individual institutions as well as the stability of the financial system as a whole.706 In this context, an important innovation has been the introduction of complex, model-based capital regulation that was meant to promote the adoption of stronger risk management practices by financial intermediaries and, ultimately, to increase the stability of the banking system. Behn et al.707 investigate how the introduction of sophisticated, model-based capital regulation affected the measurement of credit risk by financial institutions. Prior to the crisis, regulation was seen too coarse, thereby leading to distortions. Now Basel II, which was at the time of the financial crisis in places, relies on a set of risk models, designed and calibrated by banks themselves and subsequently approved by the supervisor. By tying capital charges to actual asset risk, banks are no longer penalized for holding very safe assets on their balance sheets. But when regulation relies on internal risk models, informational and incentive problems occur. In particular, they measured ‘the effects of model-based regulation on the measurement of credit risk’.708 They conclude that ‘reported probabilities of default (PDs) and risk weights are significantly lower for portfolios that were already shifted to the IRB approach compared with SA portfolios still waiting for approval.  However, there are more aspects defining the shape of shadow banking: regulatory arbitrage, technology lowering barriers to entry, demographics and a favorable macro environment. See: High Meadow Institute, (2016), The Shadow Banking Sector & Alternative Financing Driven by Technology, Industry Snapshot and Forecast, Working Paper, February; G. Buchak et al., (2018), Fintech, Regulatory Arbitrage, and the Rise of Shadow Banks, Journal of Financial Economics, Vol. 130, Issue 3, pp. 453–483. Fintech firms accounted for more than a third of shadow bank loan originations by 2019. Fintech firms have advantages in corresponding interest rates. To isolate the role of technology, in the decline of traditional banking, Buchak et al. ‘focus on technology differences between shadow banks, holding the regulatory differences between different lenders fixed. More importantly, the online origination technology appears to allow fintech lenders to originate loans with greater convenience for their borrowers.’ How much of shadow banking and fintech growth is regulation driven and how much is due to better technology? Answer: 70/30. Regulatory arbitrage seems to be the dominant force with shadow banks now controlling the riskiest lending segment and are the largest issuer of guarantees in lightly regulated markets. Technology plays a role but doesn’t democratize credit access nor does it reduce the cost of credit. It merely focuses on refinancing already creditworthy borrowers at a high price. See also: J. Frost et al. (2019), BigTech and the Changing Structure of Financial Intermediation, BIS Working Papers Nr. 779, April 8. To be published in 2020 in Economic Policy. They conclude that differences in the development of FinTech credit reflect differences in income and financial market structure. The higher a country’s income and the less competitive its banking system, the larger is the FinTech credit volume. BigTech credit benefits even more from these factors. Looking at credit scoring shows that credit models using machine learning and data from the e-commerce platform are better at predicting losses than traditional credit bureau ratings. BigTech lenders have an information advantage in credit assessment relative to a traditional credit bureau. A. Fuster et al., (2018), The Role of Technology in Mortgage Lending, FRB of NY Staff Report nr. 836, February, also published in The Review of Financial Studies, Vol. 32 (2019), Issue 5, pp. 1854–1899. 707  M. Behn et al., (2016), The Limits of Model-Based Regulation, ECB Working Paper Series Nr. 1928, July. 708  They did so by comparing following positions. Since Basel II banks can choose between the model-based approach (known as IRB ‘internal-ratings-based approach’) in which capital charges depend on internal risk estimates of the bank and a more traditional approach that does not rely on 706

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However, ex-post default and loss rates go in the opposite direction and actual default rates and loan losses are significantly higher in the IRB pool compared with the SA pool.’709 With shadow banking evolving in nature through time and many aspects of systemic risk, network contagion still under review, the question needs to be asked if ‘financial stability’710 in itself might also be a dynamic concept of if you want a ‘dynamic stability’.711 This would mean that financial stability in itself is not something to work on after a crisis but that it should be embedded as discipline by itself. That it is a continuum rather than an ad hoc thing to deal with was already clear since Minsky’s ‘stability creates its own instability’.712 A model that excessively relies on a ‘lender of last resort’ concept will face its limitations at some point. Governments and their central banking arms can’t operate continuously beyond their institutional capacity to ensure ‘stable public markets’ as a public good by providing emergency liquidity support including

internal risk parameters (referred to as the standard approach, known as SA) (p. 2 & pp. 16 ff.). S. Tuuli, (2019), Model-Based Regulation and Firms’ Access to Finance, Bank of Finland Research Discussion Paper Nr. 4, Helsinki. Rule discusses insurance models and the growing importance of model risk management. He describes some recent findings from the Prudential Regulation Authority (PRA)’s work to guard against weakening over time of capital requirements calculated from internal models—the so-called model drift. D. Rule, (2019), Model use and misuse—speech by David Rule, given at the Association for British Insurer’s Prudential Regulation Seminar 2019, May 14. 709  They conclude that ‘the introduction of Basel II-type, model-based capital regulation affected the validity of banks’ internal risk estimates. We find that for the same firm in the same year, both reported PDs and risk-weights are significantly lower, while estimation biases and loan losses are significantly higher for loans under the new regulatory approach’ (p. 32). 710  M.  Rubio, (2018), Shadow Banking, Macroprudential Regulation and Financial Stability, in Shadow Banking: Financial Intermediation beyond Banks (Ed. Esa Jokivuolle), SUERF Conference Proceedings 2018/1, Larcier, pp. 112–118. 711  It remains to be seen if and how ‘regulatory sandboxes’ can help in tackling this problem. Sandbox is a mechanism for developing regulation that keeps up with the fast pace of innovation. A regulatory sandbox is a regulatory approach, typically summarized in writing and publishing, which allows live, time-bound testing of innovations under a regulator’s oversight. Novel financial products, technologies and business models can be tested under a set of rules, supervision requirements and appropriate safeguards. A sandbox creates a conducive and contained space where incumbents and challengers experiment with innovations at the edge or even outside of the existing regulatory framework. A regulatory sandbox brings the cost of innovation down, reduces barriers to entry and allows regulators to collect important insights before deciding if further regulatory action is necessary. A successful test may result in several outcomes, including full-fledged or tailored authorization of the innovation, changes in regulation or a cease-and-desist order. See: UNGSA, (2018), Briefing on Regulatory Sandboxes, via ungsa.org 712  See R. Ghandi, (2016), Financial Stability – Issues and Concerns: Are We Barking up All Right Trees, Inaugural speech at the 6th Annual Great Lakes – Union Bank Financial Conference, Great Lakes Institute of Management, Chennai, February 5 (via bis.org). D. Kohn, (2017), Regulating for Financial Stability: the Essentials, Speech given by Donald Kohn, Robert S Kerr Senior Fellow, Brookings and External Member of the Financial Policy Committee, Bank of England at the Wharton School of the University of Pennsylvania April 7. Kohn argues, in my understanding correctly, to extend the toolkit to create stability with tools that allow to counter strong procyclicality in real estate and mortgage markets (pp. 6 ff.) and back-up liquidity facilities adapted to the diverse intermediation channels of the twenty-first century (pp. 7 ff.).

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the different (operational) strategies regarding how to bring them to market713 as well as the issue of idiosyncratic support.714 Their size has grown (of both governments and central banks),715 and one can wonder whether the statement ‘small is beautiful but big is necessary’ stands in this context.716 Recently, Haldane suggested to rethink the concept of financial stability thereby acknowledging the multifaceted nature of the problems, market failures and market frictions exposed within the financial system during the crisis, the severity of the hit to balance sheets, risk appetite and economic activity that the crisis has inflicted and continues to inflict. Haldane reviews a wide set of issues within the context of a financial system which is dynamic and adaptive: the calibration of regulatory standards, balancing the costs and benefits of tighter regulation; the overall system of financial regulation, balancing underlaps and overlaps, simplicity and complexity, discretion and rules; the impact of reforms on incentives in the financial system, in particular incentives to avoid regulation; and the evolving role of macroprudential regulation in safeguarding stability of the financial system. So any financial regulatory regime will itself need to be adaptive if it is to contain risk within this system.717 That rethink needs to go hand in hand with a fundamental rethink of corporate

 See P. Praet, (2016), The European Central Bank and Its Role as Lender of Last Resort During the Crisis, Speech by Peter Praet, (2016), Member of the Executive Board of the European Central Bank, at ‘The Lender of Last Resort: An International Perspective’, a conference sponsored by the Committee on Capital Markets Regulation, Washington, DC, February 10; M.  Dobbler et  al., (2016), The Lender of Last Resort Function After the Global Financial Crisis, IMF Working Paper Nr. WP/16/10, January, pp. 11–25 (pp. 26–35 for a garden variety of operational challenges and outstanding issues). Also see M. Anson et al., (2017), The Bank of England as Lender of Last Resort: New Historical Evidence from Daily Transactional Data, Bank of England Working Staff Working Paper Nr. 691, November 10. And in more general terms: FCA, (2016), Market-Based Finance: Its Contribution and Emerging Issues, Occasional Paper Nr. 18, May. Regarding the impact of principle versus rule-based mechanism in monetary policy, see: J.A. Dorn, (2017), Monetary Policy in an Uncertain World: The case for Rules, CATO Working Paper Nr. 47, August 16. 714  Idiosyncratic support refers to the uncertainty about whether the central bank will provide support, by the imposition of punitive financial and nonfinancial penalties on management and shareholders and by strictly enforced frameworks for enhanced regulatory oversight and prompt corrective action; ibid., p. 7. 715  See in the implications of collateral quality and credit quality under growing balance sheet conditions: D. Gatarek and J. Jablecki, (2014), Estimating the Risk of Joint Defaults: An Application to Collateralized Lending Operations, NBP Working Paper Nr. 181. 716  M.  Shafik, (2016), Small Is Beautiful but Big Is Necessary, Speech given at the Bloomberg Markets Most Influential Summit, September 28, who argues in favor. 717  A.  Haldane et  al., (2017), Rethinking Financial Stability, Speech given at the ‘Rethinking Macroeconomic Policy IV’ Conference, Washington, DC, Peterson Institute for International Economics, 12 October, p. 3. In extensor: D. Aikman et al., (2018), Rethinking Financial Stability, Bank of England Staff Working Paper Nr. 712, February 28. They find that additional insights gained since the start of the reforms paint an ambiguous picture on whether the current level of bank capital should be higher or lower. Additionally, they present new evidence that a combination of different regulatory metrics can achieve better outcomes in terms of financial stability than reliance on individual constraints in isolation. They further discuss in depth several recurring themes of the regulatory framework, such as the appropriate degree of discretion versus rules, the setting of macroprudential objectives and the choice of policy instruments. 713

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governance, where the interest of shareholders is no longer put in front of that of society and the economy at large.718 Judging shadow banking cannot be done judging individual pieces of legislation or policies. Actions taken in the official banking space on a regulatory level impact the functioning and shape of the SB sector and vice versa.719 Ten years down the road from the financial crisis, many questions have been asked about what we have achieved, what we think we have achieved, what we should have achieved and if there is anything we learned (at all) during the last decade. Has the system overall become more resilient?720 Many opinions have been floating around a full decade after the start of the financial crisis and remarkably enough everybody is very careful expressing thoughts that would be considered too convincing that we are out of the woods. Indeed, the avalanche of regulation and policies during the last ten years has only provided a tiny blanket of ‘good feeling’ about what we have achieved. Or as Klaus Schwab put it, ‘the global financial crisis has inspired little meaningful reform’ and ‘we haven’t learned too much’.721 Most  D. Strauss, (2018), Andy Haldane Calls for Corporate Governance reform, FT, September 28. The FSB has also been concerned with the issues which it coins ‘misconduct in financial institutions’. See in extensor: FSB, (2018), Strengthening Governance Frameworks to Mitigate Misconduct Risk: A Toolkit for Firms and Supervisors, April. After industry and shareholder concerns, the idea has now been pushed out to 2020. J.  Heltman, (2018), FED to Delay New Big-Bank Capital Measure Until 2020, American Banker, November 9, americanbanker.com 719  Also A.  Gerety, (2017), Clarifying the Shadow Banking Debate: Application and Policy Implications, Institute for International Economic Law Issue Brief 01/2017. One of the conclusions is that the analysis of shadow banking is a necessary part, but only a part, of the work required to understand and monitor the risks and frailties in an evolving financial system. 720  Did capital regulation do its work, and what about Basel III, how did we handle the too-big-tofail aspect. Many options drift around but nobody is a very convinced about their opinions on this matter. See, for example, D. Nouy, (2017), Safer than Ever Before? An Assessment of the Impact of Regulation on Banks’ Resilience Eight Years On, Banque de France Financial Stability Review Nr. 12, April, pp. 23–32; D.J. Elliott and E. Balta, (2017), Measuring the Impact of Basel III, Banque de France Financial Stability Review Nr. 12, April, pp. 33–44; S.J.A. de-Ramon et al., (2017), An Overview of the UK Banking Sector Since the Basel Accords: Insights from a New Regulatory Database, Bank of England Working Paper Nr. 652, March. Greenwood et al. provide some perspective on the essential qualities of capital regulation: (1) first, whenever possible, multiple constraints on the minimum level of equity capital should be consolidated into a single constraint; (2) second, the best way to deal with the inevitable gaming of any set of ex ante capital rules is not to propose further rules, but rather to allow the regulator sufficient flexibility to address unforeseen contingencies ex post; (3) third, though a regulatory framework that relies primarily on minimum capital ratios is appropriate for normal times, such a framework is inadequate in the wake of a large negative shock to the system. See: R. Greenwood et al., (2017), Strengthening and Streamlining Bank Capital Regulation, Brookings Paper on Economic Activity, Fall 2017, pp.  479–565; L.B. Boulifa and D.R. Khouaja, (2016), Could Basel III Capital and Liquidity Requirements Avoid Bank Failure, The International Journal of Business and Finance Research, Vol. 10, Nr. 4, pp. 63–71. The latter focus on the newly introduced LCR and NSFR. Their results show a mixed bag and small banks and off-balance sheet activities continue to be a concern. 721  S. Meredith, (2018), The Global Financial Crisis Has Inspired Little Meaningful Reform, says WEF founder, September 14, cnbc.com. He also refers to the global debt levels when indicating ‘[w]e should not forget that the global debt today is substantially higher than it [was] at the beginning of the financial crisis’. 718

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scholars and policy makers seem to have that sixth sense telling them that we have done a lot but not necessarily the things we should have done.722 And then there is the staggering amount of debt in the world that has been growing at serious rates even after the financial crisis.723 It has put a question mark on not only the deleveraging ambitions724 but also the fact that the incoming regulation will be canceled by the unmanageable and unstable levels of debt725 in case a next crisis comes around.726 Others point at the private equity sphere that has stepped in, where the banks receded.727 And has the culture in the banking sector underlying the financial changed?728 The feedback is ultimately very mixed and unconvincing. The financial systems seem very vulnerable,729 and some even point at shadow banking as the place where the next crisis is looming.730 Others are willing to go that far that capitalism itself is at stake731 or refer to the cost of the (in)action of

 Martin Wolf looks at the rent-extracting economy and the vested interest: M. Wolf, (2018), Why So Little Has Changed Since the Financial Crash, Financial Times, September 3; Mario Draghi, despite all efforts so far, urges harder policing of the USD 49 trillion shadow banking market. Regulators have forced banks to become more resilient in the last decade, but the ‘next step will be to ensure that equally strong regulation and supervision’ is applied to shadow banking: N. Comfort, (2018), ECB’s Draghi Seeks Tougher Policing of $49 Trillion Shadow Banks, Bloomberg September 13 (bloomberg.com). This should be read in conjunction with the analysis which can be found in ECB, (2017), Report on Financial Structures, October, in particular pp. 59 ff. 723  See the BIS data sets (bis.org) for updates on outstanding debt, but as it stands the level of global debt is well above 250% of global GDP. For some analysis and reflection on the current state of affairs regarding (both public and private) debt management and their role of financial crises: IMF, (2016), Debt: Use It Wisely, Fiscal Monitor, October, Washington, DC. 724  McKinsey Global Institute, (2015), Debt and (Not Much), Deleveraging, February. H.S. Shin, (2017), Leverage in the Small and in the Large, Panel remarks at IMF Annual Meeting seminar on systemic risk and macroprudential stress testing, Washington, DC, October 10. 725  Every financial stability report issued in recent years regardless of the country reports house price dynamics and global debt levels as the most dominant themes in terms of stability issues. 726  A. Turner, (2018), After the Crisis, the Banks Are Safer, But Debt Is a Danger, Financial Times, September 11. 727  M. Vandevelde et al., (2018), The Story of a House: How Private Equity Swooped in After the Subprime Crisis, Financial Times, September 5. 728  G. Tett, (2018), Has the Banking Culture Really Changed, Financial Times, September 3. 729  H. Ellyatt, (2018), The Financial System Still Looks Vulnerable Despite Post-Lehman Banking Rules, Experts Say, CNBC, September 10, cnbc.com 730  James Bullard, president of the Federal Reserve Bank of St. Louis in C. Jeffery, (2018), Next Financial Crisis ‘Will Be Brewing’ in Shadow Banking, August 17, centralbanking.com; R. Miller, (2018), Bernanke, Geithner, Paulson Voice Some Concern About Next Crisis, July 18, bloomberg. com. Others feel very concerned about the outcome of ten years of new regulation and policies: G. Tett, (2018), Five Surprising Outcomes of the 2008 Financial Crisis: (1) debt has increased; (2) banks have become bigger, (3) US banks rule; (4) shadow banking has increased; (5) no banker has been jailed; (6) the left has lost. 731  Because of the need for a climate change-fueled switch: N. Ahmed, (2018), Scientists Warn the UN of Capitalism’s Imminent Demise, motherboard.vice.com, August 27. Also P. Collier, (2018), The Future of Capitalism, Allen Lane, Bristol. The question of what has gone wrong centers on the disappearing ‘reciprocal obligation’, the mutual obligation on which fruitful social arrangement depends. This besides the economic factors at work such as globalization, urbanization and tax erosion. 722

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central banks732 during the last decade.733 And ultimately there are those that question the expert strategies in designing the regulation and policies during the last decade.734 The bottom line is, (1) first, ‘instead of stasis, the crisis ignited an extensive recalibration of pre-crisis policy knowledge and ideas about how to regulate finance. Overall, the direction of this recalibration has been towards an uneasy reformism that straddles the post-­Lehman appetite for interventionism and the pro-market orthodoxy so familiar to the pre-Lehman world’; (2) ‘second, there is overwhelming evidence that the thinking of the emerging global regulatory regime on this issue is shaped most extensively by international organizations staff that sit at the core. With the exception of the Fed, ‘all other actors (academic economists, legal scholars, private sector experts) have been allowed to join the debate on a very selective basis (most often to boost their (IO experts ed.)) own claims to expertise’; (3) ‘such an environment calls upon IO staff to then differentiate themselves from their peers and adopt different strategies. We have described how the IO staff studied used measurement, mandate, and status to treat shadow banking with greater flexibility and authority.’735  See regarding the topic of legal protection of central banks (for their (in)actions) and their balancing act between independence and accountability: A. Khan, (2018), Legal Protection: Liability and Immunity Arrangements of Central Banks and Financial Supervisors, IMF Working Paper Nr. WP/18/176, August. Also earlier: A.  Khan, (2017), Central Bank Legal Frameworks in the Aftermath of the Global Financial Crisis, IMF Working Paper Nr. WP/17/101 and A.  Khan, (2016), Central Bank Governance and the Role of Nonfinancial Risk Management, IMF Working Paper Nr. WP/16/34. 733  M. Sandbu, (2018), The Devastating Cost of Central Banks’ Caution, Financial Times, August 7. Monetary trust and the politics of central bank legitimacy are intrinsically related but that relationship is also full of paradoxes: ‘while a central bank’s legitimacy hinges on it being perceived as acting in line with the dominant folk theory of money, this theory accords poorly with how money actually works. How central banks cope with this ambiguity depends on the monetary situation.’ See in detail: B. Braun, (2016), Speaking to the People? Money, Trust, and Central Bank Legitimacy in the Age of Quantitative Easing, MPIfG Discussion Paper 16/12, Max-Planck-Institut für Gesellschaftsforschung, Köln, October; also see: C.  Borio, (2019), On Money, Debt, Trust and Central Banking, BIS Working Paper Nr. 763, January 11, via bis.org. Borio highlights that trust is the foundation of a well-functioning monetary system. The distinction between money and credit, both underpinned by trust, is overdone. He further indicates that a demand-determined, elastic supply of credit is essential for the system to operate at all and to set interest rates. But in the longer run, too elastic a supply can undermine monetary and financial stability. The notion that the monetary base, rather than the interest rate, is the system’s ultimate anchor is incorrect. 734  C. Ban et al., (2016), Grey Matter in Shadow Banking: International Organizations and Expert Strategies in Global Financial Governance, Review of International Political Economy, Vol. 23, Nr. 6, pp.  1001–1033. Experts secured control over how issues in shadow banking regulation are treated is the baseline in their message. To be precise, ‘The evidence suggests that IO (international organizations ed.) experts embedded a bland reformism opposed to both strong and “light touch” regulation at the core of the emerging regulatory regime. Technocrats reinforced each other’s expertise, excluded some potential competitors (legal scholars), coopted others (select Fed and elite academic economists), and deployed measurement, mandate, and status strategies to assert issue control.’ When it comes to shadow banking, they add ‘academic economists’ influence came from their credibility as arbitrageurs between several professional fields rather than their intellectual output’. Please observe the very interesting literature list pp. 1028 ff. 735  C. Ban et al., (2016), ibid., pp. 1025–1026. 732

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And then there is the evolving landscape of the financial industry and shadow banking in particular. Some look at the technology field to see the impact and involvement of shadow banking, while others see the workings of the shadow banking market in new phenomena such as litigation funding.736 Often commonly appreciated positions need to be debunked before progressing to adequate regulatory interventions or even just plain analysis.737 The limitations of regulation need to be better understood. Economics for Effective Regulation (EFER) is one of these initiatives to get a better grip on that understanding. EFER is a market-based approach to the design of regulation. It takes stock of all the issues regulators face when designing market regulation: ‘information asymmetries, externalities, market power, and behavioral distortions,738 as well as any unintended consequences of previous interventions that arose from market responses to changes in

 T. Lou, (2014), Into the Shadows: Banking and the Prudential Regulation of Litigation Funders, Macquarie Law Journal, Vol. 14, pp. 73–96. Lou argues that litigation funding is a form of shadow banking. 737  The fact that European banks have been the main providers of capital during the melt-up toward the financial crisis starting in 2007 has often been neglected or assumed it were the savings-heavy Asian economies. It is however well understood that aging societies tend to always develop an excess supply of capital. See, for example, B. Noeth and R. Sengupta, (2012), Global European Banks and the Financial Crisis, Federal Reserve Bank of St. Louis Review, November/December 2012, Vol. 94, Issue 6, pp. 457–479. They argue ‘that the role of funding costs and a “liberal” regulatory regime that allowed for an unprecedented expansion of the balance sheets of European banks was no less important’ in deciphering the elements that led to the financial crisis. In a broader context this has now been reconfirmed for both individuals and corporates, that is, a broad-based trend in rising gross saving and net lending of nonfinancial corporates across major industrialized countries (though most pronounced in countries with persistent current account surpluses). Dao and Maggi confirm that ‘this trend holds consistently across major industries, and is concentrated among large firms, driven by rising profitability, lower financing costs, and reduced tax rates. At the same time, higher gross corporate saving have not supported a commensurate increase in fixed capital investment, but instead led to a build-up of liquid financial assets (cash). The determinants of corporate cash holding and saving are also broad-based across countries, with the growth in assets of large firms, R&D intensity, and lower effective tax rates accounting for most of the increase.’ See in detail: M.C. Dao and C. Maggi, (2018), The Rise in Corporate Saving and Cash Holding in Advanced Economies: Aggregate and Firm Level Trends, IMF Working Paper Nr. WP/18/262, November. 738  In recent times, it was resurfaced that behavioral elements are more relevant to financial supervision and regulation. Khan distinguishes three categories in that space: (1) behavioral effects of norms (social, legal and market), (2) behavior of others (internalization, identification and compliance) and (3) psychological biases. Both individual and group behaviors are relevant. See A. Khan, (2018), A Behavioral Approach to Financial Supervision, Regulation, and Central Banking, IMF Working Paper Nr. 18/178, August, in particular pp. 29 ff. Innovation can escape any rule provided there is sufficient time, but a banker is always looking for the boundaries in which the law loses focus and no longer is trustworthy. Khan signals, ‘More comprehensive financial regulation and supervision could consider the different norm contexts, how individual behavior is shaped by behavior of others, and behavioral biases. This could allow regulation and supervision to more comprehensively address individual decision-making and its risks to the financial sector’ (p. 29). Further analysis and deep thinking are required into the following fields: (1) incorporating behavioral expertise into the selection and application of supervisory interventions; (2) examining the behavioral impact of supervision itself; and (3) the links between behavioral elements and systemic risk (p. 51). This topic deserves way more attention than I (can) provide it with here. See Khan’s literature list (pp. 52–56) for inspiration. Reflexivity is the idea that investors’ biased beliefs affect 736

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the regulatory environment.’739 Some countries have taken the stance that mostly following the principle of same-business rules or ‘bank-­equivalent regulation’, that through a wide and consistent regulatory perimeter, based on the principle of ‘bank-equivalent regulation’, it is possible to set up a well-balanced prudential framework.740 But that would also require a level playing field on a tax level. This seems to be a lot more complicated as it impacts the sovereignty of countries directly. (Offshore) financial centers have turned tax legislation in a business model and that is not going to change somewhere soon.741 One last word about the effectiveness of the introduced legislation in recent years. In June 2015, a group of Federal Reserve Bank presidents participated in a tabletop exercise designed to assess the value of prudential policy tools in averting or easing financial crises. Presented with a hypothetical scenario of overheating financial markets, the participants were asked to consider how effectively various capital-based, liquidity-based and credit-based tools, as well as stress testing and supervisory guidance, could address the risks inherent in the scenario. The group concluded that many prudential tools had limited applicability and could only be implemented with a lag.742 To balance the argument, some scholars see the benefits of shadow banking. In particular they argue in favor of the argument that SB improves welfare ‘because it provides a channel to escape excessive regulation that is asymmetrically more valuable for banks with market outcomes and that market outcomes in turn affect investors’ beliefs. Investors form beliefs about firms’ creditworthiness, in part, by extrapolating past default rates. Investor beliefs influence firms’ actual creditworthiness because firms that can refinance maturing debt on favorable terms are less likely to default in the short run—even if fundamentals do not justify investors’ generosity. Greenwood et al.’s model is able to match many features of credit booms and busts, including the imperfect synchronization of credit cycles with the real economy, the negative relationship between past credit growth and the future return on risky bonds, and ‘calm before the storm’ periods in which firm fundamentals have deteriorated but the credit market has not yet turned. See in detail: R. Greenwood et al., (2019), Reflexivity in Credit Markets, NBER Working Paper Nr. 25,747, April. Regarding the relationship between publicly available information (to be precise data that is open to interpretation and exhibits randomness, as this gives the persuader ‘wiggle room’ to highlight false patterns and persuasion): J. Schwarzstein and A. Sunderam, (2019), Using Models to Persuade, HBS Working Paper, May 16, mimeo. 739  Z. Iscenko et al., (2016), Economics for Effective Regulation, FCA Occasional Paper Nr. 13, March. 740  That is the case, for example, in Italy where shadow banks and traditional banks are subject to mirroring rules. See in detail: C. Gola et al., (2017), Shadow Banking out of the Shadows: Non-Bank Intermediation and the Italian Regulatory Framework, Bank of Italy Occasional Papers Series Nr. 372, February. What stays undiscussed is the impact of our earlier discussion that creating a level playing field in regulatory terms comes with unnecessary and disproportionate economic consequences. Regulatory drifting has its impact on economic parameters. You might contain shadow banking risk quite efficiently (p. 38). Marginal cost and benefits of additional regulation should be balanced to avoid suboptimal functioning of the market. Containing demand in Italia could also be the consequence of the preference of firms to use banks loan rather than market-based instruments. 741  The whole issue of tax competition, offshore-onshore deserves its own (set of ) monograph(s). See: J. Garcia-Bernardo et al., (2017), Uncovering Offshore Financial Centers: Conduits and Sinks in the Global Corporate Ownership Network, Scientific Reports, nature.com, July 24, pp. 1–10. 742  See for a write-up: T.  Adrian et  al., (2017), Macroprudential Policy: A Case Study from a Tabletop Exercise, FRBNY Economic Policy Review, February, pp. 1–30. See for a schematic overview of the findings table 3 p. 20.

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access to efficient investment opportunities’.743 Ultimately, and as long as we leave the organization of credit intermediation to the free market, the dimensions and shape of that market will be a function of demand- and supply-side factors.744 Following that position, it has been observed that the composition and drivers of international bank lending and international bond issuance, the two main components of global liquidity, have seen considerable shifts in the post-crisis era.745 Avdjiev et al. argue that the sensitivity of both types of flows to US monetary policy rose substantially in the immediate aftermath of the global financial crisis. That position was then later reversed. Further, the responsiveness of international bank lending to global risk conditions declined considerably after the crisis and became similar to that of international debt securities. Global liquidity fluctuations have largely been driven by policy initiatives in creditor countries. Policies and prudential instruments that reinforced lending banks’ capitalization and stable funding levels reduced the volatility of international lending flows.746 Given the discussed myriad of credit intermediation chains, a material part of shadow banking activities will one way or the other become covered by the traditional banking regulation, but also the implied guarantee provided to this sector. This in itself has become a business model.747 Or as Cordella et  al.748 argue: ‘[l]evered banks take excessive risk, as their actions are not fully priced at the margin by debt holders. The impact of government guarantees on bank risk taking depends critically on the portion of bank investors that can observe bank behavior and hence price debt at the margin.’ Thus, greater guarantees increase risk taking at least when informed investors hold a sufficiently large fraction of bank liabilities. But they also reduce risk taking by increasing the profits of banks. Their model also shows that when bank capital is endogenous,  G. Ordoñez, (2018), Sustainable Shadow Banking, American Economic Journal: Macroeconomics, Vol. 10, Issue 1, pp. 33–56. 744  Analysis of those demand and supply relations teaches us that ‘[d]uring non-crisis years, bank flows are well explained by a common global factor and a local demand factor. But during times of crisis flows are affected by idiosyncratic supply shocks to a borrower country’s creditor banks.’ See: M. Amiti et al., (2017), Supply- and Demand-Side Factors in Global Banking, Federal Reserve Bank of New York Staff Reports, Nr. 818, June. 745  S.  Avdjiev et  al., (2017), The Shifting Drivers of Global Liquidity, Federal Reserve Bank of New York Staff Reports, Nr. 819, June, also published as NBER Working Paper Nr. 23565, and revised in October 2019. 746  See also: E. Cerutti, et al., (2017), Global Liquidity and Drivers of Cross-Border Bank Flows, Economic Policy, Vol. 32, Issue 89, pp. 81–125. 747  There are many different ways in which banks can be categorized. The EBA, not too long ago, proposed a standardized classification of business models of the EU banks. The proposed approach to classification combines both a qualitative and a quantitative component. The qualitative component is based on an expert knowledge of the supervisory authority, which is confirmed or challenged by quantitative indicators. Their findings are that banks’ classification through this mixed approach allows better and more granular identification of banks’ business models than the clustering methodology. They maintain the four traditional models: universal, retail-oriented, corporateoriented and other specialized business models. See in detail: M. Cernov and T. Urbano, (2018), Identification of EU Bank Business Models. A Novel Approach to Classifying Banks in the EU Regulatory Framework, EBA Staff Paper report, Nr, 2, June, via eba.europe.org 748  T. Cordella et al., (2017), Government Guarantees, Transparency and Bank Risk-Taking, World Bank Policy Research Working Paper Nr. 7971, February. 743

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public guarantees lead unequivocally to an increase in bank leverage and an associated increase in risk taking.749 The leverage of financial institutions affects the demand for assets and the value of transaction between financial institutions. There is a positive relationship identified between buyer capital on the one hand and the likelihood of buying assets and the value of the deal.750 As one could expect, the institutions that are the least constrained in their ability to raise funds are those that demand assets most and are consequently willing to pay the most.751 Ultimately, the financial system remains vulnerable to financial crisis. A possible resolution will always start with grasping the idea that ‘it is banks’ economic function rather than legal form that demands a special regulatory response. That economic function—funding long-term investments with large amounts of short-term debt—is valuable but can impose appalling costs on the real economy when left solely to the discipline of market forces.’752 The way to get there is either by suppressing shadow banking or getting them included by the banking regulation. Reality has chosen for the misty middle-of-the-road model. And there is no proof in reality that this strategy has ever been successful. So questions can be asked about the effectiveness of recent regulatory adjustments and whether it will help at a point in time that it really matters. That question is not limited to banking or macroprudential regulation.753 Also insolvency regulation is prone to that assessment. In particular, the repo and derivatives sphere in the context of insolvency still is an area full of questions. And the tension is clear: repos and derivatives are a good thing because ‘they provide for levels of market liquidity that would be unimaginable without them. But on the other hand there is continued concern because both types of transactions are somehow regarded as being unstable and volatile in their nature, potentially exacerbating and accelerating crisis situations.’ Paech correctly argues that repos and derivatives are treated somewhat ambiguously in insolvency situations. He argues, ‘[i]nsolvency law and relevant regulation seem to support and protect repo and

 This leads alternatively to banks rescuing their SIVs (in the financial crisis), although they had no contractual obligation to do so. This is known as step-in risk. Segura clarifies that behavior: ‘I show that this outcome may arise as the equilibrium of a signaling game between banks and their debt investors when a negative shock affects the correlated asset returns of a fraction of banks and their sponsored vehicles. A rescue is interpreted as a good signal and reduces the refinancing costs of the sponsoring bank. If banks leverage is high or the negative shock is sizeable enough, the equilibrium is a pooling one in which all banks rescue.’ See: A. Segura, (2017), Why Did Sponsor Banks Rescue Their SIVs, Bank of Italy Working Paper Nr. 1100, February, Milan. 750  How the capital position of potential buyers of assets affects the decision to purchase and the value of the transaction themselves breaks down in two questions. This relates to the amount of funding available as a function of their equity capital and the demand for assets is a function of the total funds available to financial intermediaries. 751  See: S. Das, (2017), The Effect of Leverage on Asset Sales Between Financial Institutions, IMF Working Paper Nr. WP/17/200, August. 752  J. Crawford, (2017), Lesson Unlearned? Regulatory Reform and Financial Stability in the Trump Administration, Columbia Law Review, Vol. 117, Issue 4, pp. 127–143. 753  Also see D. Żochowski et al., (2019), Cross-Border Effects of Prudential Regulation: Evidence from the Euro Area, ECB Working Paper Nr. 2285, May 23. 749

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derivatives transactions, while at the same time imposing limits on them, trying to balance liquidity arguments with those relating to stability…. [R]egulation is better placed than insolvency law to address systemic stability concerns, whereas relevant insolvency 'rules guarantee high levels of liquidity while they are ineffective in terms of stability.’754 This needs to be judged against the background that monetary policy shocks are effective to ease stressed financial conditions, but have limited ability to fully contain the buildup of vulnerabilities.755

7.20.3  D  o Shadow Banks Undermine Market Discipline of Traditional Banks? Financial intermediation by nonbank entities based on a business model that combines highly leveraged short-term funding with risky long-term investments such as subprime mortgage lending has been around for some time now. These shadow banks, while not being subject to bank regulation, experienced a dry-up of funding in the 2008 financial crisis. They were forced to liquidate their assets and the price shock created contamination across the global marketplace. Commercial banks responded by reducing their credit to the private sector. Two questions follow naturally out of that story: (1) the first we already discussed at various points throughout the book and we will only summarize our findings here, which takes us back to the fundamental point about why something called the shadow banking market exists to begin with, and (2) more importantly, it raises the question about in what way and to what degree the existence of shadow banks affects the portfolio composition and funding strategies of traditional banks.

 P. Paech, (2017), Repo and Derivative Portfolios. Between Insolvency Law and Regulation, LSE Working Paper Nr. 13/2017. What is particularly nice is the comparison that peach draws between the US and European regulatory model. Also see: P. Paech, (2016), The Value of Insolvency Safe Harbours, Oxford Journal of Legal Studies, Vol. 36, Issue 4, pp. 855–884; S.L. Schwarcz, (2018), Securitization Ten Years After the Financial Crisis: An Overview, Review of Banking and Financial Law, Vol. 37, pp. 757–769. 755  See in detail: M.  Saldías, (2017), The Non-Linear Interaction Between Monetary Policy and Financial Stress, IMF Working Paper Nr. WP/17/184, August. The paper observes that ‘monetary policy and stressed financial conditions have a nonlinear relationship. The findings suggest that the effects of monetary policy shocks on output are stronger when the financial system is sound.’ A stressed financial sector impairs the transmission mechanism which casts serious doubt about the effect of an expansionary monetary policy under those regimes and that it could very well be that the effect would be not too effective to stabilize output. It forces to rethink conceptually countercyclical policies under different scenarios of financial conditions and all types of ‘lean against the wind’ policies to address financial vulnerabilities. Saldías highlights that ‘direct effect of a monetary policy shock on financial conditions is considerably larger when the financial system is under stress. This suggests that expansionary monetary policy can really “get into the cracks” and help rebuild resilience of the financial system when it is needed. However, a tightening of monetary of the same magnitude is less effective in containing vulnerabilities in normal times.’ 754

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But before answering them, a quick word about the fact that the banking sector and infrastructure has evolved in a variety of ways since the financial crisis. The following are the main aspects of that evolution756: • Changes in banking market capacity and structure. Capacity has been shrinking relative to economic activity in several countries (mainly those affected by the financial crisis) directly impacted by the crisis. This adjustment has occurred mainly through a reduction in business volumes rather than the exit of firms from the market. • A shift in banking business models was observed. Advanced economy banks have tended to reorient their business away from trading and more complex activities, toward less capital-intensive activities, including commercial banking. This pattern is evident in the changes in banks’ asset portfolios, revenue mix and increased reliance on customer deposit funding. • Bank performance is impacted. Bank profitability (return on equity) has declined (often due to deleveraging) across countries and business model types from the historically high rates seen before the crisis.757 • Bank resilience and risk taking.758 Banks globally have enhanced their resilience to future risks by substantially building up capital and liquidity buffers. Advanced economy banks have shifted to more stable funding sources and invested in safer and less complex assets. • Market sentiment and future bank profitability. Equity investors remain skeptical toward some banks with low profitability.

 See in detail: CGFS, (2018), Structural Changes in Banking after the Crisis, CGFS Papers Nr. 60, January. The CGFS draws four major conclusions from the shifts and changes identified: (1) post-crisis, a stronger banking sector has resumed the supply of intermediation services to the real economy, albeit with some changes in the balance of activities; (2) longer-term profitability challenges require the attention of banks and supervisors, as they may signal risk-taking incentives and over-capacity; (3) consolidation and preservation of gains in bank resilience require ongoing surveillance, risk management and a systemic perspective; and (4) enhanced surveillance of systemic risk is required by developing more granular data sets and using and sharing data more intensely and wisely. 757  Although they haven’t suffered from negative interest rates as banks experience losses in interest income (due to negative interest rates) that are almost exactly offset by savings on deposit expenses and gains in non-interest income, including capital gains on securities and fees. In detail: J.A. Lopez et  al., (2018), Why Have Negative Nominal Interest Rates Had Such a Small Effect on Bank Performance? Cross Country Evidence, NBER Working Paper Nr. 25,004, September. 758  The risk-taking channel has moved to the shadow banking sector. Wischnewsky and Neuenkirch document a risk-taking channel of monetary policy transmission in the euro area that works through an increase in shadow banks’ total asset growth and their risk asset ratio. Conventional monetary policy shocks create a portfolio reallocation effect toward riskier assets which is pronounced, whereas for unconventional monetary policy shocks they detect stronger evidence for a general expansion of assets. See: A. Wischnewsky and M. Neuenkirch, (2018), Shadow Banks and the Risk-Taking Channel of Monetary Policy Transmission in the Euro Area, CESifo Working Paper Nr. 7118, June 26. 756

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• System-wide effects. Banks appear to have become more focused geographically in their international strategy and tend to intermediate more of their international claims locally. Direct connections between banks through lending and derivatives exposures have declined. Some European banking systems with relatively high capacity have made progress with consolidation. A shift toward more stable funding sources (such as deposits) has been observed. • Provision of bank lending to the real economy. Trends in bank-intermediated credit have been uneven over time and across countries, reflecting differences in their crisis experience and related overhang of credit. But the adjustment is still ongoing in others, reflecting in part a legacy of problem bank assets that continues to hamper the growth of fresh loans.759 • International banking was one of the areas most affected by the crisis. Aggregate foreign bank claims have seen a significant decline since the crisis, driven particularly by banks from the advanced economies most affected by the crisis. When a crisis occurs depositors may withdraw their deposits early on. You could see and qualify these withdrawals as a source of market discipline. A crisis changes the solvency outlook of a bank and that changed outlook triggers a behavioral response. Traditional banks try to counter those behaviors by sticking to safe investments and portfolio strategies. But that commitment comes at a cost, for example, you have to forego returns during normal times. Shadow banking can be seen in that context as an alternative banking strategy that combines a (more) risky portfolio strategy while maintaining the possibility of early withdrawals in time of crisis. Even if we make abstraction of the impact of the fact that banks are subject to capital regulation and shadow banks are not and making abstraction of possible regulatory arbitrage,760 it is still fair to state that

 A. Mika and T. Zumer, (2017), Indebtedness in the EU: A Drag or a Catalyst for Growth? ECB Working Paper Nr. 2118, December 21. They find evidence of a positive long-run relationship between private sector indebtedness and economic growth, and a negative relationship between public debt and long-run growth across EU countries. However, the more immediate impact of private sector debt on growth is found to be negative, and positive for the public sector debt. They find no conclusive evidence for a common debt threshold within EU countries, neither for the private nor for the public sector. 760  Discussed and well documented. See recently: M.  Harris et  al., (2014), Higher Capital Requirements, Safer Banks? Macroprudential Regulation in a Competitive Financial System, Working Paper University of Chicago, mimeo; G. Ordoñez, (2018), Sustainable Shadow Banking, American Economic Journal: Macroeconomics, Vol. 10, Issue 1, pp. 33–56; G. Plantin, (2015), Shadow Banking and Bank Capital Regulation, Review of Financial Studies, Vol. 28, Issue 1, pp. 146–175. For example, see the supplementary leverage ratio (SLR). The SLR rule may present their latest arbitrage opportunity. Enacted after the crisis to prevent another leverage buildup, the rule caps leverage at the very largest US banks. While the leverage rule is simpler than risk-based capital requirements because it requires equal capital against assets with unequal risk, bankers can arbitrage by shedding safer assets and/or adding riskier ones. An earlier leverage rule imposed in 1981 invited the same arbitrage. D.B. Choi et al. find more compelling evidence of leverage rule arbitrage around the new rule. They find higher-risk (risk-weighted) asset shares and security yields at SLR banks relative to the control (the next largest set of banks) after the SLR was finalized in 759

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shadow and traditional banks coexist and interact. Now we learned from the 2008 ­financial crisis that shadow banks faced during the crisis a steep contraction of funding which triggered a fire sale when assets had to be liquidated. Traditional banks did not—in general—suffer from the mentioned withdrawals but experienced a sharp rise in their funding costs and reallocated their ­portfolios toward safe and liquid assets. Now within an economy, there is a sort of circularity going on.761 In such an economy, banks collect deposits from households and choose to invest in safe, risky and liquid assets. Households provide that funding based on the solvency and liquidity outlook of a bank (ignored the possible availability of an insurance deposit mechanism for a moment). If the outlook regarding liquidity and solvency changes762 based on incoming news or signals, the debt market moves from being information-insensitive to being information-sensitive. Households then decide whether or not to withdraw deposits, and, if so, banks will trade their assets in a secondary market at marked-to-­market pricing. The strategy of the bank going forward is defined by the secondary market pricing outlook. When households withdraw deposits, shadow banks liquidate their assets to meet redemptions by depositors. Those fire sale externalities trigger a bank to pursue a shadow banking strategy. But as more banks do so, the shadow banking market does not only grow, its liquidation efforts in a crisis also yield deeper fire sale dimensions, which reduces the benefits of the shadow banking model relative to a traditional banking model. There is an equilibrium, if you want, in that trade-off. Going forward this is going to be key. Depositors have little reason to stay invested with such low interest rates763 and don’t forego much in terms of accrued interest income. Under such conditions, market discipline–driven bank strategy is safe and low risk and so the risk for fire sales is limited. The increased prospect of a fire sale will need to be met with higher interest rates. But the higher interest rates reduce withdrawal incentives and allow or facilitate traditional banks to pursue (more) risky portfolios and increased default risk.764 The bottom line is that the

2014. The effects tend to be larger at more leverage rule–constrained banks. While this arbitrage might have, perversely, increased overall bank risk, they find no evidence that it did. In detail: D.B.  Choi et  al., (2018), Bank Leverage Limits and Regulatory Arbitrage: New Evidence on a Recurring Question, FRB of NY Staff Report, Nr. 856, November. 761  I ignore the international dimensions here for a moment. 762  Solvency and liquidity risk can be understood in a very similar fashion. But here the distinction is that ‘solvency risk’ is the risk of fundamental insolvency after holding assets to maturity, and ‘liquidity risk’, which refers to the prospect of bankruptcy due to withdrawals before assets reach maturity. 763  The story regarding interest rates deserves two volumes itself. Many elements have contributed to the changes in the natural interest rate as we observed it (i.e. the interest rate consistent with output at its potential and constant inflation). In general terms, globalization and the associated change in market power in the goods and labor markets can be a significant driver of global real interest rates. See: J.M. Natal and N. Stoffels, (2019), Globalization, Market Power and the Natural Interest Rate, IMF Working Paper Nr. WP/19/95, May. Also and in a broader context: IMF, (2019), Chapter 2: The Rise of Corporate Market Power and Its Macroeconomics effects, in World Economic Outlook April 2019, Washington, DC. 764  Liquidating (often) illiquid assets will lead to expected losses for depositors. Illiquid banks (holding lots of illiquid assets) are vulnerable to self-fulfilling runs.

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shadow banking sector will expand to a size where the liquidation efforts cause a fire sale and undermine market discipline.765 This insight is not only relevant for policy design but also supports the idea that taxation of shadow banking entities is absolutely key to financial stability. These tax-related interventions deter banks from pursuing shadow banking strategies and in equilibrium can lead to a situation where the shadow banking market doesn’t become large enough to trigger fire sale. Ari et al. show that policy interventions yield different results when facing different sizes of the shadow banking market. The liquidation of assets in the secondary market can be met with purchases, thereby alleviating a fire sale but only below a certain size of the shadow banking sector. But there is a problem, a timing issue to be precise. The interventions in the secondary market where assets are purchased ex ante to offset necessary liquidations of assets will likely fuel the growth of the shadow banking sector and make the intervention obsolete. So once a fire sale is underway, the policy maker is keen to intervene, but by doing so in an ex ante format (which yields the better result), (s)he aggravates the long-term outlook in that secondary market. Possible alternatives to this model could be that policy design intervenes at the level of traditional banks. It would help grow the shadow banking sector but contribute to long-term stability through ‘collateralized liquidity provisions’.766 It secures traditional banks from liquidity risk and restores market discipline.767 It was already well documented that shadow banking creates money-like assets that become illiquid under high levels of uncertainty.768 The contribution of Ari et al. is that shadow banking can thrive beyond the conditions of safe assets, regulatory arbitrage and liquidity transformation or in general absent the benefits of intermediation techniques. Banks can (endogenously) engage in shadow banking strategies straddled769 with their traditional banking activities. The cost of doing so for traditional banks is limited and includes ‘any costly action undertaken by banks to resolve asymmetric information issues with their depositors, such as providing detailed balance sheet reports, eschewing opaque intermediation processes like securitization, or issuing

 See in extenso the excellent work of A. Ari et al., (2017), Shadow Banking and Market Discipline on Traditional Banks, IMF Working Paper Nr. WP/17/285, December, pp. 5–6. I will refer this paragraph extensively to this work to facilitate research efforts. 766  V. Asriyan et al. (2019), Collateral Booms and Information Depletion, ECB Working Paper Nr. 226, April 16. 767  The aforementioned but in this context neglected deposit insurance mechanism does exactly that. It also eliminates liquidity risk but replaces bank discipline by bank regulation. A combination of the two items could work: it would stabilize the traditional banking sector, diminish the fire sale risk but would grow the shadow banking sector, whereby the positives outweigh the negatives (growth of the SB market), yielding a positive financial stability outlook (ibid. pp. 5–6). 768  Or migrates from information-insensitive to information-sensitive. See recently: A. Moreira and A. Savov, (2017), The Macro-Economics of Shadow Banking, The Journal of Finance, Vol. 72, Issue 6, pp. 2381–2432. 769  The exchange point or zone between shadow banks and traditional banks has become an area of interest. See, for example, L.A.  Gornicka, (2016), Banks and Shadow Banks: Competitors or Complements? Journal of Financial Intermediation, Vol. 27, pp. 118–131. Within that exchange zone, traditional banks provide implicit guarantees to shadow banks in order to gain access to offbalance sheet exposure, or share a pool of liquidity among them (traditional banks can hold more illiquid, higher-yielding assets with higher returns without all the downsides, especially when they also enjoy insurance despot guarantees). 765

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costly equity with voting rights’.770 But Ari et al. make it clear that straddling traditional and shadow banks exist beyond regulatory arbitrage771 and implicit or explicit (contractual) links. Shadow banks affect market discipline of traditional banks. Their underlying understanding about the functioning of the shadow banking market is condensed into their four stylized statements: • the shadow banking sector expanded rapidly until its collapse in 2007. The traditional banking sector grew at a slower rate but did not suffer from a collapse; • at the onset of the financial crisis, shadow banks experienced a sudden dry-up of funding and liquidated their assets; • spreads between private debt securities and Treasury bonds increased sharply during the crisis. Securities with higher perceived risk experienced greater increases in spreads; and • traditional banks reallocated their portfolios toward safe and liquid assets and were able to increase their liabilities. At the same time, they faced a rise in their funding costs.772 The shadow banking market can grow beyond the benefits of credit intermediation, and regulatory arbitrage exists and grows up till and beyond the point that it becomes systemically relevant (i.e. both the aforementioned solvency and liquidity risk are the consequence, and expose traditional banks). Now we could cut this short to liquidity support, deposit insurance guarantees and macroprudential and capital regulation to work its magic. But it was mentioned that the government could get involved in the secondary market by purchasing illiquid assets to offset a possible avalanche of liquidations and consecutive fire sale. The net benefits could be positive but leave policy design behind with the moral hazard of ex ante anticipation of the government stepping in.773 Reducing the liquidity and solvency risk would then have a trade-off, that is, the shadow banking market it needs to cover in terms of possible secondary market purchases just became bigger. A direct alternative would be to step in and focus on securing the traditional banking scene, which is what the US Federal Reserve Bank (Fed) largely has done during the crisis through a combination of enlarging deposit protection. It does have the benefit of ring-fencing the traditional banking scene but still generates an enlarged shadow banking market even if the effort is combined with capital regulation.774 The above analysis points exactly at why I’m struggling for years to convince myself that things are looking better post-crisis and post-regulatory avalanche hitting those

 Ibid. Ari et al. p. 7.  R. Palan and D. Wigan, (2017), The Economy of Deferral and Displacement: Finance, Shadow Banking and Fiscal Arbitrage, in (eds. A.  Nesvetailova), Shadow Banking: Scope, Origins and Theories, Routledge, Abingdon UK, pp. 202–216. 772  Ibid. Ari et al., pp. 8–12. 773  Bailouts could be efficient not only ex post (after the debt has been issued) but also ex ante (before the issuance of the debt). Although anticipated bailouts create the typical moral hazard problem leading countries to issue more debt, this may be correct for the under issuance of public debt that would result from the lack of cross-country policy coordination. See in detail: M. Azzimonti and V. Quadrini, (2018), International Spillovers and ‘Ex-ante’ Efficient Bailout, NBER Working Paper Nr. 25,011, September. 774  Ibid. Ari et al., pp. 37–40 770 771

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places in the system where the pain came from. Regulators have responded by putting more model-based regulation in place with many layers or regulatory complexity,775 leading to ambiguity and market manipulation. Like the political scene of financial spectrum became somewhat polarized. The newly introduced regulation, which left ample room for mispricing risk and arbitrage opportunities, fueled and provided incentives for certain activities to move more (concentrated) toward the regulated entities and for other activities to move into the new areas in the shadow banking system. Solving that puzzle requires forward-looking regulation and thus a different kind of regulation that we have puts our hopes on.776 So taxation as remediation is key.777 Rightly so. I was glad to be among the first, if not the first, in the period 2012–2013 to suggest a Pigovian tax model as an adequate alternative to

 Market agents respond to complexity regardless of whether that is regulatory complexity, market complexity or the complexity of the corporate structure of large multinational corporations. See regarding the nature of international financial integration and the role of complexity: P.R. Lane and G.  Milesi-Ferretti, (2017), International Financial Integration in the Aftermath of the Global Financial Crisis, IMF Working Paper Nr. WP/17/115, May. Regulatory complexity stems from both demand and supply side assets: supply-side factors include developments in the financial system and crisis-generated policymaking, which may increase regulatory complexity, including through the institutional architecture underpinning it. Demand-side factors include the self-interest of regulated entities (p. 2). See in detail G. Prasanna et al., (2019), Regulatory Complexity and the Quest for Robust Regulation, ESRB Report of the Advisory Scientific Committee, Nr. 8, June. They produce seven principles to design robust legislation (pp. 3–4, 32–40). They report that excessively complex regulations contribute to increased systemic risk in several ways: the illusion of well-designed systems that can be played; it misses contingencies; an over-fitted model misses the ‘unknown unknowns’; complexity makes responses convoluted; and it fosters regulatory arbitrage. Too simple regulation misses the mark and fails to address misaligned incentives, informational asymmetries and externalities. Financial regulation is robust when it stands even when confronted with hard-to-predict developments and innovations. The expert panels detail the aforementioned seven principles around the concept of system robustness and regulatory robustness: ‘[s]ystem robustness refers to the capacity of a system to maintain its core functions in the face of unexpected perturbations or disturbances. Regulatory robustness entails being able to cope with a variety of failure-inducing circumstances and behaviors, while not trying to offer the best-tailored response to each specific phenomenon’ (p. 3). 776  F.  Allen et  al., (2018), The Interplay Among Financial Regulations, Resilience, and Growth, Federal Reserve Bank of Philadelphia, Working Paper Nr. 18-09, February. 777  It was argued before that the lowering of corporate taxes (combined with higher profitability and lower funding costs) has led to more corporate cash savings and hoarding behavior but not to the well-anticipated capital and R&D investments. Dao and Maggi reported recently and extensively that higher gross corporate savings have not supported a commensurate increase in fixed capital investment, but instead led to a buildup of liquid financial assets (cash). See: M.C.  Dao and C.  Maggi, (2018), The Rise in Corporate Saving and Cash Holding in Advanced Economies: Aggregate and Firm Level Trends, IMF Working Paper Nr. WP/18/262, November. Also see: K. Adler et al., (2019), Corporate Cash Holding and Innovation in the Era of Globalization, IMF Working Paper, WP/19/17; R. Armenter and V. Hnatkovska, (2017), Taxes and Capital Structure: Understanding Firms Savings, Journal of Monetary Economics, Vol. 87, pp. 13–33; J. Azar, et al., (2016), Can Changes in the Cost of Carry Explain the Dynamics of Corporate Cash Holdings? Review of Financial Studies, Vol. 29, Issue 8, pp. 2194–2240; P. Bacchetta and K. Benhima, (2015), The Demand for Liquid Assets, Corporate Saving, and International Capital Flows. Journal of the European Economic Association, Vol., 13, Issue 6, pp. 1101–1135; P. Chen, et al., (2017), The 775

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the ailing corporate tax and leverage-discouraging mechanisms currently in vogue. Ari et al. model a tax on shadow banking also as a Pigovian tax as shadow banking imposes a negative externality on the remainder of the financial sector and indirectly on society through its contribution to fire sales.778 A Pigovian tax modeled to combat that specific negative externality is a tax that shifts down the expected payoff schedule for shadow banking and is optimal as it realizes a situation without no fire sales on safe assets. It eliminates the liquidity tax and strengthens market discipline. They however suggest to model it as a tax on profits and is therefore not anchored on the externality directly but as a proxy taxes the profits. This is not without complications of all sorts including regulatory arbitrage and so on. It does however reduce the willingness to engage in the shadow banking sector by traditional banks and reduces the ‘commitment costs’. They also leave open if the Pigovian tax should be levied from the shadow bank or whether it could also be levied from the traditional bank. Their alternative model, that is, taxing the liabilities of the shadow banking entity, looks more promising and without a number of complications. Also, this would reduce the SB profits but the levying mechanism is anchored on the externality-generating feature, that is, the funding side of the SB entity. We’re going to make the above discussion even a bit worse than it already is. It was argued that shadow banking can make the wheels come off market discipline at traditional banks. Gissler and Narajabad779 add to that momentum by highlighting that ‘the creation of private safe assets by shadow banks can crowd out traditional banks’ supply of safe assets’. They focus on the effect that the discussed money market reform had on the (increased) demand for government and government-like safe assets. Shadow banks responded and issued increased levels of short-term debt as well as their lending to banks.780 Traditional banks responded differently to that situation. This differential is

Global Rise of Corporate Saving, Journal of Monetary Economics, Elsevier, Vol. 89(C), pp. 20–24; M. Dao, et al., (2019), The Granularity of Corporate Saving, IMF Working Paper WP/; J. Graham and M.T.  Leary, (2017), The Evolution of Corporate Cash, NBER Working Paper Nr. 23,767; J. Gruber and S.B. Kamin, (2016), The Corporate Saving Glut and Falloff of Investment Spending in OECD Economies. IMF Economic Review, Vol. 64, Issue 4, pp. 777–799. G. Gutiérrez and T. Philippon, (2017), Investment-Less Growth: An Empirical Investigation, Brookings Papers on Economic Activity Nr. 22,897; E. Lyandres and B. Palazzo, (2016), Cash Holdings, Competition, and Innovation, Journal of Financial and Quantitative Analysis, Vol. 51, Issue 6, pp. 1823–1861. 778  Ibid. Ari et al., pp. 40–41. 779  S.  Gissler and B.  Narajabad, (2019), Supply of Private Safe Assets: Interplay of Shadow and Traditional Banks, Working Paper, December, mimeo. 780  To manage their interest rate risk, they changed the terms of their lending: the new loans had a shorter maturity and reset the interest rate at a high frequency, that is, they decreased the frequency of interest rate resets of their loans to depository institutions. Also see: I. Drechsler, et al., (2018), Banking on Deposits: Maturity Transformation Without Interest Rate Risk, NBER Working Papers Nr. 24,582, National Bureau of Economic Research, Inc. and P. Hoffmann et al., (2018), Who Bears Interest Rate Risk?, ECB Working Paper Nr. 2176, September. The latter find limited interest rate risk—on aggregate—in the European banking sector. Interesting however is the different (three) measurements of interest rate risk: ‘[f ]irst, a net-worth sensitivity measures the effects of a hypothetical increase in interest rates of one basis point on the net present value of assets minus that of liabilities. Second, we compute the projected change in the net interest margin at a one-year

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used to study the effect of increased supply of safe assets by shadow banks. Gissler and Narajabad evidence that banks use shadow banks’ borrowing as a perfect substitute for deposit financing, at least those that could afford the increased interest rate sensitivity. The substitution of safe debt with SB borrowing ‘does not go along with an overall increase in the balance sheet and therefore has no lending effect’. The findings go upstream the traditional way of thinking that ‘the rise of the shadow banking system as a response to banks’ decreased or stagnating supply of deposits in a world with growing demand for safe assets’.781 Or in other words, shadow bank debt and traditional bank debt may not only be complements, but also substitutes. That has material implications: ‘[i]f shadow banks create safe assets at the expense of traditional banks’ deposits, then there will be a minimal effect on the total funding available for households and firms from banks and shadow banks.’ Unfortunately, the interplay of that trade-off is not so well understood yet and often embedded on artificial models and/or stylized facts.

7.20.4  Financial Stability and Regulation782 Each time a financial crisis comes by, an avalanche of new incoming regulation tends to follow. These financial crises tend to be preceded by protracted periods of financial stability and investor optimism. When designing regulation, regulators tend to focus on what happened during the crisis, try to manage the symptoms, marginally assess how regulation will impact the activities and industries it tries to manage and convince itself of the countercyclicality aspects as well as the optimal relation with other policy domains that evolve

horizon resulting from the same increase in interest rates. Finally, we use time-series information on banks’ net interest margin to compute its sensitivity with respect to changes in short-term interest rates (3-month Euribor)’ (p. 2). But the critical point here is that their findings somewhat deviate from other reported analysis including the one by Drechsler et al. (pp. 4, 7, 11–12, 15), although some differences exist in the way the studies are set up and which might help to explain some of the differential in the findings. They comment: ‘[w]hile some theoretical models highlight the redistributive effects of monetary policy between banks and the non-financial sector, our results show that these effects may be quantitatively less important than previously thought. Instead, our results highlight potential re-distributive effects within the banking sector. We estimate these to be 40% larger than those between banks and the non-financial sector’ (p. 2). Also: M.K. Brunnermeier, and Y.  Koby, (2018), The “Reversal Interest Rate”: An Effective Lower Bound on Monetary Policy, March 29, Mimeo; S. Di Tella and P. Kurlat, (2018), Why Are Banks Exposed to Monetary Policy, NBER Working Paper Nr. 24,076, November; I. Drechsler et al., (2017), The Deposit Channel of Monetary Policy, Quarterly Journal of Economics, Vol. 132, pp. 1819–1876; W.B. English et al., (2018), Interest Rate Risk and Bank Equity Valuations, Journal of Monetary Economics, Elsevier, Vol. 98(C), pp. 80–97; F. Ippolito et al., (2018), The Transmission of Monetary Policy Through Bank Lending: The Floating Rate Channel, Journal of Monetary Economics, Vol. 95, pp. 49–71; D. Kirti, (2017), Why Do Bank-Dependent Firms Bear Interest-rate Risk, Working Paper, mimeo. 781  S. Gissler and B. Narajabad, (2018), Ibid. p. 18. 782  An interesting question was asked whether financial stability is a matter of macroprudential or monetary policy. See: D. Aikman et al., (2018), Targeting Financial Stability: Macroprudential or

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­ ost-crisis. Very often cyclical indicators (like, for instance, credit growth) are at the center p of attention for policy makers, although they tend to be masking deeper asymmetries in the system. That’s where regulation directly interacts with macroprudential policy. That explains why I treated both in parallel in the Pigovian chapter. It is only when these aspects are all aligned that one can attempt to achieve a deeper level of resilience in the system. And even then. There is an element of learning in every crisis and there is an externality to face. That externality will always be different, just like the nature of complexity783 will change as time progresses.784 Market agents learn from each crisis and so do regulators. Longer periods of tranquility however tend to go hand in hand with a higher c­ oncentration

Monetary Policy? Bank of England Staff Working Paper Nr. 734, June 8. Deploying the countercyclical capital buffer (CCyB) improves outcomes significantly relative to  when interest rates are the  only instrument. The  instruments are typically substitutes, with  monetary policy loosening when the  CCyB tightens. Also A.  Ferrero et  al., (2018), Concerted Efforts? Monetary Policy and Macro-Prudential Tools, Bank of England Staff Working Papers Nr. 727, May 25. 783  Markets have a short memory, and reengage with products that were at the root cause of previous crises. See, for example, J. Rennison, (2019), Investors Flock Back to Credit Product Blamed in Financial Crisis, Financial Times May 2. In this case synthetic CDOs. Also: C.  M. Reinhart, (2018), The Biggest Emerging Market Debt Problem in America, December 20, via project-syndicate.org. She points out the intrinsic risks that exist in the corporate collateralized loan obligations. See also: K. Haunss, (2018), European CLO Market Hits Post-Crisis High, Reuters, November 21, via reuters.com. It has led the FSB to open a formal inquiry into leveraged loans indicating that the segment could pose a threat to financial stability. See in detail: S.  Flemming, (2019), Global Regulators Launch Inquiry into Leveraged Loans, FT, March 7. See also the FSB, (2019), Global Monitoring Report on Non-Bank Financial Intermediation 2018, February 4, Case study 2: Recent developments in leveraged loan markets and the role of NBFIs, pp. 73–78. Leveraged loans are loans provided to nonfinancial corporates that typically have high levels of indebtedness, belowinvestment grade credit ratings or a spread at issuance higher than a certain threshold. The market is estimated to be around USD 1.4 trillion, but is very likely larger due to syndication projects, and the fact that most contracts are private. While restrictions on the use of collateral, issuance of new debt, payments to shareholders, asset sales and affiliate transactions is widespread, clauses that weaken these restrictions are almost as common and economically large. In detail: V. Ivanshina and B. Vallee, (2018), Weak Credit Covenant, Working Paper, May 28, mimeo. Securitizations are also on their way up both in the US and, according to the latest charts, in Europe. For example, DNB, (2019), Uitstaande Nederlandse securitisaties nemen voor het eerst sinds 2007 weer toe, Statistisch Nieuwsbericht, March 15, via dnb.nl. Or what about the first ‘reverse mortgage securitization’ created by Waterfall Asset Management. M.  Adams, (2018), Hedge Fund Claims First Reverse Mortgage Securitization, October 31, via globalcapital.com. In a reverse mortgage, a homeowner borrows against a portion of the equity value in their home. These borrowers make no repayments until a repayment event occurs (the sale of the property after the last surviving borrower died). The loan doesn’t amortize and the interests accrue. Probability of default is focusing here on the borrower mortality or morbidity rather than the repayment capacity. Or a landmark securitization by landinvest, a company which makes property loans over the internet. See: T. Hale, (2019), What a Debut Securitisation Tells Us About Fintech, FT Alphaville, June 10. 784  For example, Goldberg and Meehl document that comparing 2007 with 2017 large US bank holding companies (BHCs) remain very complex, with some declines along organizational and geographical complexity dimensions. The numbers of legal entities within some large BHCs have fallen. By contrast, the multiple industries spanned by legal entities within the BHCs have shifted

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of investing in risky assets. The aggregate riskiness increases and a systemic event is ­imminent, leading to an externality the individual investor cannot internalize. Since the learning process post-event is neither fully efficient nor effective, excessive risk taking reemerges at some point modeling the externality of the next systemic event. The longer the intermittent tranquility period, the more migrated the externality will be. Focusing on symptomatic analysis and treatment is therefore idle. The same holds true for macroprudential policy. The difficulty for measuring the efficiency and optimal level of such policies before the next crisis comes along remains a challenge. It could however be possible to say something meaningful about the ‘necessary and sufficient’ condition of optimal regulation, for example, in relation to its countercyclicality. Or maybe there is value beyond countercyclical measures. Ultimately, whether countercyclical measures are best or not in any given situation depends on the balance and relationship between the resilience and risk-taking effect those measures ignite. The dynamics of the industrial and financial complex (and how industries within an economy relate to each other) should therefore be taken into account to evaluate the correctness of the variables one aims to target through regulation and policy. Basak and Zhao785 have been looking into this. They created a set of portfolio choices that policy makers and regulators can choose from each time a crisis occurs. The only constant is that externalities that market agents cannot or will not internalize constrained risk-taking measuring (which are often countercyclical) are warranted. This is even the case when it is uncertain (which in practice is always the case) what the size and nature of the externality will be, or when it is unclear how investors will respond to any given externality. A further variable is the transmission channel through which contagion will unfold. The bottom line of this is that it is ex ante impossible to determine to what extent or degree policies should be stringent during periods of protracted tranquility. Basak and Zhao conclude: ‘[t]he answer depends on the relative magnitudes of the two effects just described: the increase in investor risk-taking and the improvement in the regulator’s perception of the resilience of the financial system.’786 To understand that relationship, we need to first understand the relationship between the learning curve investors go through in a crisis and the level

more than they have declined, especially within the financial sector. Nonfinancial entities within US BHCs still tilt heavily toward real estate–related businesses and span numerous other industries. Fewer large BHCs have global affiliates, and the geographic span of the most complex has declined. Favorable tax treatment locations still attract a significant share of the foreign bank and nonbank entities, while fewer legal entities are present in informationally opaque locations. In detail, see: L. Goldberg and A. Meehl, (2019), Complexity in U.S. Banks, FRB of NY Staff Report Nr. 880, February. For other examples how the nature, sources and perception of systemic risk changes over time: S. Antill and A. Sarkar, (2018), Is Size Everything, FRB of NY Staff Reports Nr. 864, August. Also: M.D.  Flood et  al., (2017), The Complexity of Bank Holding Companies: A Topological Approach, NBER Working Paper Nr. 23,755, August. 785  D. Basak and Y. Zhao, (2018), Does Financial Tranquility Call for Stringent Regulation, IMF Working Paper Nr. WP/18/123, May. 786  Ibid., p. 5. Their model allows investors to choose between a safe or risky asset. They are aware of the fact that a systemic risk crisis might occur. The investors do not know the extent to which the risky asset exposes the financial sector to this systemic crisis risk, but they can learn about it from

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of inefficiency of financial markets.787 This inefficiency holds true in the context of a financial crisis, that is, each agent contributes to the emerging externality through his or her position in risky assets. Excessive risk taking and excessive financial instability go hand in hand. The learning question than relates to how investors modify their position as they go along learning about the intrinsic riskiness associated with the externality. The findings show us that the learning curve is slow and only accelerates once the crisis has arrived. To that point the intensity of the systemic nature of the externality builds up (i.e. all the way into the start of the crisis). Basak and Zhao reflect on the tax to be set as macroprudential efforts to reestablish (denominated as a Pigovian tax) efficiency.788 The optimal tax will rise as investor confidence rises. I think we get it right when we conclude that longer periods of financial stability provide a belief among market agents that the link between investment behavior and stability is weak, that is, the transmission channel doesn’t pass on contagion. The externality then no longer has to be seen as an issue or a reason to reposition risk premiums. During this period, the externality builds up and thus contributes to later higher levels of market inefficiency. The multivariable position is exactly the reason why it is so hard to get macroprudential policy right: the relative sizes of the learning curve and associated risk taking on the one hand and the evolving dimensions of resilience in the financial market at any given point in time during the process.789 But the point this conclusion makes is that optimal policies and regulation do not always require to be countercyclical in nature. The trade-off lies in the dynamic between resilience and risk taking. Any attempt to answer that question should involve more than just an assessment along the lines of countercyclical matrixes but should involve as mentioned the underlying dimensions of the economy and level of diversification of the industry. It also explains why a number of credit booms are not followed by economic underperformance. Credit booms can effectively be labeled good or bad relative to the lending standards applied.790 Resilience becomes a fluid

the financial system’s history of performance. The longer the period of tranquility, the higher the level of risk taking is. The complacency trap means to risk buildup and is inherent to confidence associated with stable financial markets. A revision of that position only occurs once the crisis kicks in. This adjustment only occurs in the first phase of a crisis. In the following phases of a crisis, investors rebuild risk and invest even in assets that lead to the ongoing crisis. Despite the simplicity of the model designed by Basak and Zhao, it shows remarkable resemblance with reality where investors were willing to return to toxic products relative short after the first phase of the 2007 crisis (2007–2009). For example, subprime became bespoke and the show continued. 787  See for details: Ibid., pp. 11–18. 788  Ibid., 18–22. Also: S. Poledna and S. Thurner, (2016), Elimination of Systemic Risk in Financial Networks by Means of a Systemic Risk Transaction Tax, Quantitative Finance, Vol. 16, Issue 10, pp. 1599–1613. 789  More complete models of a crisis mode exist, but struggle to untangle the individual dynamics of the highlighted multivariable dynamics. See, for example, B. Biais et al., (2015), Dynamics of Innovation and Risk, Review of Financial Studies, Vol. 28, Issue 5, pp. 1353–1380; M. Gertler and N.  Kiyotaki, (2015), Banking, Liquidity, and Bank Runs in An Infinite Horizon Economy, American Economic Review, Vol. 105, Issue 7, pp. 2011–2043. 790  D. Kirti, (2018), Lending Standards and Output Growth, IMF Working Paper Nr. WP/18/23.

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c­ oncept when facing the trade-off; hence the near certainty of inefficient and ineffective regulation following a crisis. Over- or underestimation of resilience when designing policy is a given. Overestimating resilience will allow for structural buildup of systemic risk791 under incoming laws; underestimation will lead to unnecessary repression of financial activities and economic activities in general and value destruction as a consequence. When assessing this trade-off the right way, an additional complication emerges and that is the question regarding the information asymmetry that might exist between market agents and policy makers when it comes to understanding resilience. Assuming that policy makers have full information on resilience might be true (given conditions) but that doesn’t equate full understanding. Any model developed or to be developed will have to simplify this understanding to the level that in relation to market agents policy makers have full information and thus asymmetry exists with market agents who do (by definition and on aggregate) or do not. Because if they would, their investment behavior would act as a proxy.792 Financial innovation or, by extension, financial engineering has brought a number of things to this world: lower cost of funding and flexible products that grasp better the intricacies of a typical business environment or a particular industry. But there are downsides to this story. We already concluded that an overly financial sector relative to its economy is harmful in many ways. But there is also the question regarding whether and how financial development triggers the occurrence of banking crises. It appears that financial development, from an institutional dimension and to a lesser extent from a market dimension, triggers financial instability within a short time frame (one to two years).793 Naceur et  al. also concluded that whereas financial access is destabilizing for

 In terms of systemic risk, much of the undefined risk sits in the rest category ‘investment funds’, which is a potpourri of vehicles not meeting formal regulatory qualifications but therefore also stay largely unsupervised. See also: E.  Bengtsson, (2017), Investment Funds, Shadow Banking and Systemic Risk, in (eds. A. Nesvetailova) Shadow Banking: Scope, Origins and Theories, Routledge, Abingdon UK, pp.  163–178. Also in a broader context, see: A.  Bouveret, (2017), The Shadow Banking System During the Financial Crisis of 2007–08: A Comparison of the US and the EU, in (eds. A. Nesvetailova), Shadow Banking: Scope, Origins and Theories, Routledge, Abingdon UK, pp. 107–121. 792  The inability for now to properly bring those dynamics together shows up in the fact that literature on countercyclical macroprudential policy and regulation, learning and moral hazard and ineffective risk taking from an externalities point of view tend to evolve in silos. See for an overview D.  Basak and Y.  Zhao, (2018), Does Financial Tranquility Call for Stringent Regulation, IMF Working Paper Nr. WP/18/123, May, pp.  8–11. P.  Bolton et  al., (2016), Cream-Skimming in Financial Markets. Journal of Finance, Vol. 71, Issue 2, pp. 709–736; J. Danielsson et al., (2016), Learning from History: Volatility and Financial Crises, Federal Reserve Board Finance and Economics Discussion Series Nr. 2016-093, October; M.  Basurto and R.  Espinoza, (2017), Consistent Measures of Systemic Risk, SRC Discussion Paper Nr. 74, October; G. Jiménez et al., (2017), Macroprudential Policy, Countercyclical Bank Capital Buffers and Credit Supply: Evidence from the Spanish Dynamic Provisioning Experiments, Journal of Political Economy, Vol. 125, Issue 6, pp. 2126–2177; M.E. Kahou and A. Lehar, (2017), Macroprudential Policy: A Review, Journal of Financial Stability, Vol. 29, pp. 92–105; A.R. Ghosh et al., (2017), Taming the Tide of Capital Flows—A Policy Guide, MIT Press, Cambridge, MA. 793  S. Naceur et al., (2019), Taming Financial Development to Reduce Crises, IMF Working Paper Nr. WP/19/94, April. 791

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advanced countries, it is stabilizing for emerging and low-income ones. Their results ­confirm and extend existing literature on the matter. There is now overwhelming evidence that provides food for regulators. Their results first confirm the potential destabilizing effect of financial development leading to systemic banking crises. The findings hence support the implementation of regulatory measures, such as capital requirements794 and access control to loans and deposits for financial institutions, in order to stabilize the system. Second, the results show that regulation should not be unique but that it should take into account the degree of development of the country. As indicated, access to financial institutions is destabilizing for advanced countries, it is stabilizing for other countries. Regulators should thus impose strict access control for financial intermediaries in advanced countries and should enhance its access, supporting, for example, fintech industry795 and its financial innovations796 (mobile application payments,797 mezzanine and

 The question will always be asked how far should capital requirements be raised in order to ensure a strong and resilient banking system without imposing undue costs on the real economy. Capital requirement increases make banks safer and are beneficial in the long run but also entail transition costs because their imposition reduces credit supply and aggregate demand on impact. For example, see in detail: C. Mendicino et al., (2019), Bank Capital in the Short and the Long Run, ECB Working Paper Nr. 2286, May 24. 795  See the recommendations and analysis of the IMF, (2018), Bali Fintech Agenda, IMF Policy Paper, October, pp. 4–5; G. Buchak, et al. (2017), Fintech, Regulatory Arbitrage, and the Rise of Shadow Banks, Chicago Booth Working Paper, May, mimeo. See regarding the impact of online platform providing or facilitating credit (USD 284 billion in 2017) and the implications it brings: FSB, (2019), Global Monitoring Report on Non-Bank Financial Intermediation 2018, February 4, Case study 1: FinTech Credit: Data, classification and policies, pp. 68–72. Some points of attention are as follows: (1) business models vary materially across jurisdictions (P2P, matching, notarized platforms, crowdfunding, marketplace lending, etc.); (2) data collection stays opaque despite licensing; (3) categorization remains difficult and can vary from deposit-taking corporations, OFIs or auxiliary financial activities and (4) prudent regulation is variably applicable often based on domestic technical criteria. Also see BCBS, (2018), Sound Practices: Implications of Fintech Developments for Banks and Bank Supervisors, February. S.  Claessens, et  al. (2018), FinTech Credit Markets Around the World: Size, Drivers and Policy Issues, BIS Quarterly Review, September, pp.  29–49; CGFS/FSB, (2017), FinTech credit: Market Structure, Business Models and Financial Stability Implications, May; T. Philippon, (2017), The FinTech Opportunity, BIS Working Paper Nr. 655, August 7, via bis.org; A.  Meyer et  al., (2017), Fintech: Is This Time Different? A Framework for Assessing Risks and Opportunities for Central Banks, Bank of Canada Staff Discussion Paper Nr. 10, July. 796  Also, the dynamics of regulatory arbitrage change with fintech, crowdfunding, and so on. See in detail: D.M. Ahern, (2018), Regulatory Arbitrage in a FinTech World: Devising an Optimal EU Regulatory Response to Crowdlending European Banking Institute Working Paper Series Nr. 24, March. Also see: Y. Googoolye, (2019), The Need to Adapt Regulatory and Supervisory Structures to Changing Technologies and Business Models, Speech at the 15th Meeting of the FSB Regional Consultative Group for Sub-Saharan Africa, Port Louis, 2 May 2019, via bis.org. The operative word when it comes to online platforms is ‘trust’. There is a wide variety of papers dealing with the issue. For example, C. van der Cruijsen et al., (2018), Trust in Other People and the Usage of Peer Platform Markets, DNB Working Paper Nr. 608, October 1. 797  See also the FSB report that considers the financial stability, regulatory and governance implications of the use of decentralized financial technologies such as those involving distributed ledgers and online peer-to-peer, or user-matching, platforms. The report focuses on technologies that may reduce or 794

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high-yield finance, cryptocurrency798 and even offshore banking) in low-income ­countries.799 The impact of financial development on stability is not homogeneous800; rather, it varies with its component and the country under consideration. Financial stability assessments should include variables associated with the financial development (access, depth and efficiency) of a country under review. The same holds true for capital requirements and should therefore not be applied in a homogeneous way as is currently the case.801 As one observes the most recent working program of the European Banking Authority (EBA),802 one cannot but observe that financial innovation remains of strategic concern to regulators and supervisors and in particular understanding the risks embedded in new products, structures and technology. In line with that concern, another strategic priority of the EBA, ten years after the crisis, is the increase and enhancement of loss-absorbing capacity in the EU banking system. It wasn’t without a reason that the loss absorption capacity still runs through the Basel III criteria, and does not cover the wider spectrum of

eliminate the need for intermediaries or centralized processes that have traditionally been involved in the provision of financial services. Such decentralization generally takes one of three broad forms: the decentralization of decision-making, risk taking and record-keeping. There are already examples emerging of decentralization in payments and settlement, capital markets, trade finance and lending. The report notes that the application of decentralized financial technologies—and the more decentralized financial system to which they may give rise—could benefit financial stability in some ways. At the same time, the use of decentralized technologies may entail risks to financial stability. These include the emergence of concentrations in the ownership and operation of key infrastructure and technology, as well as a possible greater degree of procyclicality in decentralized risk taking. A more decentralized financial system may reinforce the importance of an activity-based approach to regulation, particularly where it delivers financial services that are difficult to link to specific entities and/or jurisdictions. Certain technologies may also challenge the technology-neutral approach to regulation taken by some authorities. See in extenso: FSB, (2019), Decentralized Financial Technologies, June 6. 798  FSB, (2019), Report on Crypto-Assets, Work Underway, Regulatory Approaches and Potential Gaps, May 31. Also see: R. Auer and S. Claessens, (2018), Regulating Cryptocurrencies: Assessing Market Reactions, in BIS Quarterly Review Q3, September, pp. 51–65; R. Auer, (2019), Beyond the Doomsday Economics of ‘Proof-of-Work’ in Cryptocurrencies, BIS Working Paper Nr. 765, January 21. Also: ECB, (2019), Crypto-Assets: Implications for Financial Stability, Monetary Policy, and Payments and Market Infrastructures, ECB Crypto-Asset Task Force, ECB Occasional Paper Nr. 223, May 17. Also: J. Danielsson, (2018), Cryptocurrencies: Financial Stability and Fairness, LSE Systemic Risk Centre Discussion Paper Nr. 87, November and J. Danielsson, (2018), Cryptocurrencies: Policy, Economics and Fairness, LSE Systemic Risk Centre Discussion Paper Nr. 86, November. 799  S. Naceur et al., (2019), ibid., pp. 3,19. 800  See also: E. Cerutti et al., (2018), The Growing Footprint of EME Banks in the International Banking System, in BIS Quarterly Review pp. 27–38. 801  Also see: C. Mathonnat and A. Minea, (2018), Financial Development and the Occurrence of Banking Crises, Journal of Banking & Finance, Vol. 96, pp. 344–354. 802  EBA, (2019), The EBA 2019 Work Programme, via eba.europe.org. It also deserved special attention in the latest EBA annual report. See EBA, (2019), EBA Annual Report 2018, May, pp. 86–90. However, it wasn’t linked (directly) to the functioning and operations of shadow banking which in itself is remarkable.

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financially engaged entities.803 Nevertheless, the financial industry found sufficient confidence to reframe the shadow banking segment into ‘market-based’ or ‘non-bank’ finance. Some commentators see that as a result of regained confidence in what has been produced post-crisis in terms of rules and oversight, with a persistent focus in contemporary terms on the effectiveness of regulation and are concentrating on identifying persistent areas of risk as well as emerging risks. I’m not sure if that level of confidence is justified based on an untested set of rules introduced in a variety of shadow banking segments.804 With global debt having almost doubled during the last decade, one can wonder if the proclaimed paradigm shift has effectively occurred and, if so, whether the shift has moved in the right direction. Capital buffers and liquidity conditions as well as regulatory constraints have provided a cushion of safety but the market still dictates what products to design and how risk is managed.805 One of these ‘new’ domains of potential financial stability risks comes from the crypto-asset markets.806 However, this market is currently worth only a few hundred billion US dollars, and crypto-assets are not yet widely used for financial transactions. The growth of crypto-asset trading platforms (often misleadingly called ‘exchanges’) and the introduction of new financial products (such as crypto-asset

 EBA, (2019), ibid., pp. 9–10.  R.  Ophèle and J.  D’Hoir, (2018), Moving Beyond the Shadow Banking Concept, Banque de France, Financial Stability Review Nr. 22 April, pp. 145–154, and D. Domanski, (2018), Achieving the G20 Goal of Resilient Market-Based Finance, Banque de France, Financial Stability Review Nr. 22 April, pp. 155–165. For those who would like to explore and ponder a bit further regarding the road traveled in terms of regulation and supervision, trends in market-based finance, new forms of credit intermediation, and so on, I can recommend the full report of the Banque de France on NonBank Finance: Trends and Challenges, Financial Stability Review, Nr. 22 April, via banque-france.fr 805  In fact, and increasingly, financial regulation has adopted processes that are inconsistent with adherence to the rule of law. Relying on flawed regulatory processes—especially those related to the use of ‘guidance’, which avoids transparency, accountability and predictability, and thereby increases regulatory risk—has resulted in poor execution of regulatory responsibilities, unnecessary regulatory costs and opportunities for politicized mischief, claims Calomiris. He analysis a number of positions where this allegedly is the case. See C. Calomiris, (2017), Restoring the Rule of Law in Financial Regulation, CATO Working Paper Nr. 48, September 13. 806  See also FSB, (2018), Crypto-Asset Markets: Potential Channels for Future Financial Stability Implications, October 10, via fsb.org. This report sets out the analysis behind the FSB’s proactive assessment of the potential implications of crypto-assets for financial stability. The FSB’s report includes an assessment of the primary risks present in crypto-assets and their markets, such as low liquidity, the use of leverage, market risks from volatility and operational risks. Based on these features, crypto-assets lack the key attributes of sovereign currencies and do not serve as a common means of payment, a stable store of value or a mainstream unit of account. No direct material risk is identified coming from crypto-assets, but potential emerging risks need to be followed accurately. The FSB lays the framework as to how it will monitor crypto-asset markets. See: FSB, (2018), Crypto-Assets: Report to the G20 on work by the FSB and standard-setting bodies, July 16. The IOSCO also opens a consulting on the matter: IOSCO, (2019), Issues, Risks and Regulatory Considerations Relating to Crypto-Asset Trading Platforms, Consultation Report, CR2/1019, May. The first demonstrates the current relevant frameworks (pp.  6–9), to whom are provided considerations in the following areas: access to trading platforms; safeguarding traded assets; support of platform operations; internal conflicts of interest; operational platform issues; detecting and dealing with market abuse; price discovery; safeguarding the resilience; integrity and reliability of critical systems; cybersecurity; clearing and settlement. 803 804

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funds and trusts and exchange-traded products) as well as the growing interest by retail investors raise questions about what potential risks are embedded in this developing market segment. The FSB807 has been reporting on the issue in recent times and beyond the fact that cryptocurrencies are currently not in a position to do what they were designed to do, that is, to facilitate the transfer of value without the need for a trusted third-party intermediary (they do not reliably provide the standard functions of money and are often unsafe to rely on as a medium of exchange or store of value), the FSB has identified five areas of concern808: • Market liquidity risks: due to concentrated ownership of crypto-assets among few market participants. Also the only partly regulated nature (at best) of these cryptoplatforms can cause liquidity issues in case of operational platform issues. • Volatility risks: prices have been very volatile and can largely be traced back to the fact that these assets are backed by any contractual claim, since their value is not derived from the value of such underlying claim but is rather subject to speculation. Knowing that many platforms have no circuit breakers, flash crashes or unorderly unwinding of the market could cause devastating effects and many investors might not be prepared for serious boom/bust dynamics. • Leverage risks: leverage poses greater risks to holders and their creditors and may magnify volatility and transmission of risks. Actual leverage levels in those markets stay unreported and it is unclear where financing comes from. • Technological and operational risks: most crypto-assets operate decentralized and with limited or no formal governance structure809; security and privacy issues are a concern. Technological limitations and network governance issues tend to occur frequently. Those issues include: (1) concerns about the long-­term viability of ‘mining’-based systems; (2) returns to scale in mining can lead to the creation of concentrated mining pools that have substantial control over a crypto-asset; (3) many crypto-asset networks have limited bandwidth, or lack the ability to quickly process large numbers of transactions at the same time; (4) decentralization and lack of or inadequate governance make it difficult to resolve technological limitations or errors (fraud, hacking and other cyber incidents810).

 FSB, (2018), Potential Channels for Future Stability Implications, October 10, via fsb.org  See in detail: FSB, (2018), ibid., pp. 5–8. 809  And if there is, it is a sort of financialized corporate governance. See in detail for that discussion: A.R.  Admati, (2017), A Skeptical View of Financialized Corporate Governance, Journal of Economic Perspectives, Vol. 31, Issue 3, pp. 131–150. See also: D. Domanski, (2019), Corporate Governance: A Building Block for Financial Resilience, Remarks at the G20/OECD Seminar on Corporate Governance: Corporate Governance in Today’s Capital Markets on 8 June in Fukuoka, via fsb.org. The EBA concluded that crypto-asset activities do not fall within the scope of EU banking, payments and electronic money law, and risks exist for consumers that are not addressed at the EU level. Crypto-asset activities may also give rise to other risks, including money laundering. EBA, (2019), Report with Advice for the European Commission on Crypto-Assets, EBA Report, January 9, via eba.europe.eu 810  D.  Domanski, (2019), Cyber Security: Finding Responses to Global Threats, G7 2019 Conference: Cybersecurity: Coordinating efforts to protect the financial sector in the global 807 808

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Given these concerns, destabilizing effects can feed into the wider market through a number of transmission channels811: (1) confidence effects (with subsequent contagion effect); (2) financial institutions’ exposures to crypto-assets, related financial products and entities that are financially impacted by crypto-­assets; (3) the level of market capitalization of crypto-assets; and (4) the extent of their use for payments and settlements. Regulatory action so far has been limited to some banking institutions refusing to accept credit card transactions involving the purchase of cryptocurrencies, regulating or increasing regulatory oversight of crypto-asset trading platforms, hosted wallets, registration or licensing regimes; clarification of the legal status of crypto-assets for tax purposes, regulatory sandboxes that permit pilot initiatives under close regulatory supervision, up till and including complete bans of crypto-assets for payment purposes.812 Every regulatory reform needs to look as much forward as it looks back. But Basel III combined with regulatory action in the different shadow banking segments and a variety of macroprudential instruments have been implemented. This includes recovery and resolution planning,813 although some work needs to be done in that space as some serious open questions remain. And obviously, looking forward tends to focus on other low-hanging fruit such as asset management,814 fintech,815 crypto-asset blockchain (financial ­networks),816

e­ conomy Banque de France, Paris, 10 May 2019. Also see: IOSCO, (2019), Cyber Task Force, Final Report, IOSCO Report FR09/2019, June 18. 811  See in detail: FSB, (2018), ibid., pp. 8–12. 812  See in detail: FSB, (2018), ibid., pp. 12–16. 813  For an evaluation of what happened in the last decade. E. Avgouleas and C. Goodhart, (2019), Bank Resolution 10 Years from the Global Financial Crisis: A Systematic Reappraisal School of European Political Economy, LUISS 7/2019, May 31. 814  For example, S. Morris, et al. (2017), Redemption Risk and Cash Hoarding by Asset Managers, Journal of Monetary Economics, Vol. 89, pp. 71–87. 815  See in detail: EBA, (2018), EBA Report on the Prudential Risks and Opportunities Arising for Institutions from Fintech, July 3. The analysis includes positions such as biometric authentication, robo-advisory, big data and machine learning implications, DLT and smart contract aspects, outsourcing to public cloud and the use of mobile wallets. Also see: G. Buchak, et al. (2017), Fintech, Regulatory Arbitrage, and the Rise of Shadow Banks, Chicago Booth Working Paper, mimeo. S. Gu et al. conclude that the machine learning repertoire, including generalized linear models, dimension reduction, boosted regression trees, random forests and neural networks, offers an improved description of expected return behavior relative to traditional forecasting methods (measuring asset risk premia). In detail: S. Gu et al., (2018), Empirical Asset Pricing via Machine Learning, NBER Working Paper Nr. 25,398, December; C. Chakraborty and A. Joseph, (2017), Machine Learning at Central Banks, Bank of England Staff Working Papers Nr. 674, September 1; J. Proudman, (2019), Managing Machines: The Governance of Artificial Intelligence, Given at FCA Conference on Governance in Banking, London, June 4; P.R.  Milgrom and S.  Tadelis, (2018), How Artificial Intelligence and Machine Learning Can Impact Market Design, NBER Working Paper Nr. 24,282, February. Shin is somewhat more positive about the potential for big tech to create financial inclusion. They do create a challenge in terms of trade-offs between financial stability, competition and data protection. H.S. Shin, (2019), Big Tech in Finance: Opportunities and Risks, chapter three, BIS Annual Economic Report, June 30, via bis.org; IMF/WBG, (2019), Fintech; The Experience so far, June 27; A. Fatás (eds.), (2019), The Economics of Fintech and Digital Currencies, CEPR Press, March 5, via voxeu.org 816  See in detail: Ph. Paech, (2017), The Governance of Blockchain Financial Networks, Modern Law Review, Vol. 80 Issue 6, pp. 1073–1110. Blockchain can then be defined as a new I­ nternet-based

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index investing,817 data-driven finance,818 market fragmentation819 and cybersecurity.820 Or what about ‘mini-BOTs’821? These are possibly explicit risks that might emerge. More concern and attention should be offered to what I want to call ‘implicit risks’, that is, risks that way of recording entitlements and enforcing rights (smart contracts). Paech constructs a vision of how financial regulation and private law should set the boundaries of this new technology in order to protect market participants and societies at large. Also see: E. Avgouleas and A. Kiayias, (2019), The Promise of Blockchain Technology for Global Securities and Derivatives Markets: The New Financial Ecosystem and the ‘Holy Grail’ of Systemic Risk Containment, European Business Organization Law Review, Vol. 10, Issue 1, March, pp.  81–110. It took only a few hours after Libra, the Facebook-initiated stablecoin was communicated mid-June 2019 before parallels were drawn between the Libra and the construction of a new shadow banking market. It was German EP member Markus Ferber who tabled the idea (without further details), via blockcrypto.com, 18 June 2019. See also M.  Casey et  al., (2018), The Impact of Blockchain Technology on Finance: A Catalyst for Change, CEPR Press, July 16, via voxeu.org 817  Also see: V.  Sushko and G.  Turner, (2018), The Implications of Passive Investing for Securities Markets, BIS Quarterly Review, March, pp. 113–131; V. Sushko and G. Turner, (2018), What Risks Do Exchange-Traded Funds Pose?, Bank of France, Financial Stability Review Nr. 22, April, pp. 133–144; Z. Da and S. Shive (2018), Exchange Traded Funds and Asset Return Correlations, European Financial Management, Vol. 24, Nr. 1, pp. 136–168. Also see K. Anadu, (2018), The Shift from Active to Passive Investing: Potential Risks to Financial Stability?, Finance and Economics Discussion Series 2018-060. Washington: Board of Governors of the Federal Reserve System, https:// doi.org/10.17016/FEDS.2018.060. The latter ask themselves four questions: (1) effects on investment funds’ liquidity transformation and redemption risks; (2) passive strategies that amplify market volatility; (3) increases in asset management industry concentration; and (4) the effects on valuations, volatility and co-movement of assets that are included in indexes. They conclude that overall the shift from active to passive investment strategies appears to be increasing some types of risk while diminishing others: The shift has probably reduced liquidity transformation risks, although some passive strategies amplify market volatility, and passive-fund growth is increasing asset-management industry concentration. We find mixed evidence that passive investing is contributing to the co-movement of assets. 818  D. Zetzsche et al., (2019), The Future of Data-Driven Finance and RegTech: Lessons from EU Big Bang II, IBA Working Paper Nr. 35, April. Markets move based on news and narratives. In recent times, big data and algorithms determine sentiment and the narrative in financial markets. Nyman et al. wondered what that means for systemic risk assessments. They conclude that changes in the emotional content in market narratives are highly correlated across data sources. They show clearly the formation (and subsequent collapse) of very high levels of sentiment—high excitement relative to anxiety—prior to the global financial crisis. Their model and approach can lead to some intuitive and useful representations of financial market sentiment. A novel methodology was developed to measure consensus in the distribution of narratives. This metric can potentially be used to measure homogenization in the financial system. See R. Nyman et al., (2018), News and Narratives in Financial Systems: Exploiting Big Data for Systemic Risk Assessment, Bank of England Staff Working Paper Nr. 704, January. The idea is to get closer to gauging ex ante financial stability and systemic risks and events. Also see: S. Chassang et al. (2019), Data Driven Regulation: Theory and Application to Missing Bids, NBER Working Paper Nr. 25,654, March. Fraiberger et al. conclude that media sentiment robustly predicts daily returns in both advanced and emerging markets, even after controlling for known determinants of stock prices. But not all news sentiment is alike. A local (country-specific) increase in news optimism (pessimism) predicts a small and transitory increase (decrease) in local returns. By contrast, changes in global news sentiment have a larger impact on equity returns around the world, which does not reverse in the short run. Media sentiment affects mainly foreign—rather than local—investors: although local news optimism attracts international equity flows for a few days, global news optimism generates a permanent foreign equity inflow. See in detail: S.P.  Fraiberger et  al., (2018), Media Sentiment and International Asset Prices, NBER Working Paper Nr. 25,353, December; B. Broadbent, (2019), Investment and Uncertainty: The Value of Waiting for News, Speech given by Ben Broadbent,

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emerge from existing and traditionally stable segments of the financial market, but where asymmetric conditions can emerge (due to a variety of reasons) and which tend to trigger shocks and material contagion particular in information-insensitive markets like the debt market, still being the mother of all financial markets. Segments where the stewardship that is intrinsic to investing is replaced by industrialized mechanics, such risks are ‘unknown unknowns’. Safer then becomes a very relative concept, and the question ‘are we safer a decade after the crisis?’ is a question on which the jury is still out. The level of comfort that is echoed in recent times through literature, speeches and policy documents I cannot share. Unless it would come with a complex set of conditionalities822 and even then I would argue against the motion, and that despite the many good efforts that have gone in redesigning the regulatory landscape of a wide variety of shadow banking segments. A balanced development of nonbank finance doesn’t really exist. When the market is the prime driver, the role of

Deputy Governor Monetary Policy, Imperial College Business School, London, 20 May; M.J. Lee, (2018), Uncertain Booms and Fragility, FRB of NY Staff Reports Nr. 861, July. 819  FSB, (2019), FSB Report on Market Fragmentation, June 4, via fsb.org. There is no commonly agreed definition of ‘market fragmentation’ (see IOSCO report infra in this note pp. 6 ff. for a variety of definitions). The term is generally used to refer to markets that fragment either geographically or by type of product or participant. This paper only discusses fragmentation along geographical lines. Market fragmentation can manifest itself in a number of ways. One symptom may be a limited presence of foreign providers of financial services within a given jurisdiction. Another may be a reduction in cross-border capital flows and/or the existence of multiple prices for the same or economically similar financial assets across different jurisdictions or markets. A further symptom may be the segregation of levels of capital and liquidity within local markets that go beyond those commensurate with local risks, or a reduction in the availability of financial services for end-users (p. 4). See also the extensive literature list: pp. 20–26 and a number of interesting case studies: Annexes C & D: pp.  37–44. The supervisory and regulatory restrictions of extra-jurisdictional application exist and are known (pp. 5–13). The suggested solutions are still in terms of its constituting arguments, operational mechanics and broadband applicability: developing international standards, intensified cross-border sharing of information, and comparability and mutual recognition of regulatory regimes (pp.  14–18). Also to be read in conjunction with IOSCO, (2019), Market Fragmentation & Cross-Border Regulation, Report, Nr. FR07/2019, June. See for a set of interesting case studies, appendix A, pp. 28–52. There is also the concern of regulatory arbitrage working through the analysis. 820  See, for example, IMF, (2018), Global Financial Stability Report, October, Chapter 2, Regulatory Reform 10 Years after the Global Financial Crisis: Looking Back, Looking Forward, pp. 55–81. See also the FSB’s Cyberlexicon with a handy overview of the most important cyber-area-related concepts. See FSB, (2018), Cyber Lexicon, November 12, via fsb.org 821  A new type of Treasury bill that Italy wants to introduce in its drama to fight off the EC’s neoliberal agenda when it comes to budget management and sovereign debt. Mini-BOT (mini Bill of Treasury) small denomination bonds issued to help speed up its settling of debts. In essence, however, it is nothing more than an accounting trick. Giugliano explains, ‘the government simply pays its obligations through another form of debt. The innocent argument for their introduction is that they should make it easier for companies to cash in their arrears, providing a liquidity boost for Italian business.’ See: F.  Giugliano, (2019), Italy Scary Parallel Currency Threat, June, via Bloomberg.com 822  See, for example, IMF, (2018), Global Financial Stability Report, October, Chapter 1, A Decade After the Global Financial Crisis: Are We Safer, pp. 1–53.

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r­egulation and oversight is to ex ante and ex post cage the market in a way that avoids ­financial instability. Stringing together monitoring, testing, regulating and supervision in a way that would leave the impression that the market is sufficiently managed to avoid a crisis is an illusion. We have accepted the fact that all the efforts undertaken will not prevent a crisis; we only have put lifeboats and so on in place. It would have however been more convincing when the most opaque, highly concentrated and troubled parts of the financial market would have been barred from engaging with other parts of the economy and traditionally regulated markets. We missed that opportunity as our basic modus operandi hasn’t changed (the dominance of the free-market model) and so hasn’t the likelihood of future systemic shocks.823 We created, through our avalanche of legislation, new avenues for shadow banking to emerge and step in. It was, for example, extensively documented that nonbanks step into the credit markets as less-capitalized banks reduce loan retention, particularly among loans with higher capital requirements and at times when capital is scarce. That leads to spillovers—loans funded by nonbanks with fragile liabilities experience greater sales and price volatility during the 2008 crisis.824

7.20.5  The Regulation of Private Money Private money (which mainly is short-term debt) is inherently vulnerable to runs and that is the case in all its forms (and not just in demand deposits). A financial crisis ultimately embodies a bank run of some sort. A financial crisis is an event in which households and firms no longer believe that bank debt (private money) is worth par; instead, they collectively want cash. But given the fractional banking system, as well as for other reasons, banks do not have the cash, so they go insolvent in case of a run on banks. So by ­definition, we are working under the reality of an insolvent banking system.

 See a contrario: F. Villeroy de Galhau, (2018), Between ‘Shadow’ Banking and an Angelic Vision of the Market: Towards a Balanced Development of Non-Bank Finance, Banque de France, Financial Stability Review, Nr. 22, April, pp. 7–10. 824  R. Irani et al., (2018), The Rise of Shadow Banking: Evidence from Capital Regulation, ‘The Rise of Shadow Banking: Evidence from Capital Regulation, Finance and Economics’ Discussion Series Nr. 2018-039. Washington: Board of Governors of the Federal Reserve System, https://doi. org/10.17016/FEDS.2018.039, who demonstrate the association between bank regulatory capital and credit reallocation toward nonbanks in the US market for syndicated corporate loans. Their research sits in a wider net of literature documenting the implication of recent banking regulation. They show how undercapitalized banks reallocate credit to nonbanks, and these effects are pronounced among loans with higher capital requirements and at times when bank capital is scarce. This is achieved by secondary market trading activity, that is, by selling loan shares in the years following origination. Low-capital banks are also most likely to sell distressed loans, which have higher-risk weights for capital requirements (pp.  2–4). There is limited empirical evidence on the relation between bank capital and shadow banking, and precisely how a greater presence of shadow banks might exacerbate or propagate risks in the financial system. See also: M.  Bruche, et  al. (2018), Pipeline Risk in Leveraged Loan Syndication, Working Paper, Federal Reserve Board; D. MartinezMiera and R.  Repullo, (2018), Markets, Banks and Shadow Banks. Working Paper, CEMFI; J.  Toporowski, (2017), Why Overcapitalization Drives Banks into the Shadows, in (eds. A. Nesvetailova), Shadow Banking: Scope, Origins and Theories, Routledge, Abingdon UK, pp. 181. 823

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Therefore, this bank regulation aims at preventing bank runs. This is necessary as ‘bank runs’ are not as occasional as one tends to think. They occur in all market economies throughout history, in advanced and emerging markets, in economies with or without a central bank, in economies with and without deposit insurance, and also with different forms of bank debt. Looking back at history, we can identify two approaches to bank regulation: the use of high-­quality collateral825 to back banks’ short-term debt and government insurance for the short-term debt.826 Bank runs have been of all times, but modern crises appear to be idiosyncratic, where market participants expect to wait for government or central bank intervention, and behave accordingly. Now, most bank debt produced is short-term but is also like the entire debt market information-insensitive. So there is no real price discovery system operational.827 And when doubt emerges in the market and the system becomes information-sensitive, the price system doesn’t work. Holstrom already in 2015 recommended to stop treating debt like equity. Because where stock markets are focused on price discovery and risk sharing, transparency, exchange traded and works with varying volumes, it operates in an information-sensitive way. Debt markets on the other hand are information-insensitive, opaque, not focused on price discovery, work with constant volumes and bilateral trading creating cheap, stable and liquid markets. Equity markets are expensive, risky and with varying degrees of liquidity. Banks’ assets tend to be opaque and hard to value, triggering a high cost to produce information on.828 As said, in terms of regulation, focus has been on two strategies: the use of high-quality collateral to back banks’ short-term debt (but ignore it factually) and government insurance for the short-term debt (and in essence ignore the collateral). Both come with detriments: focus on collateral uses up long-term safe debt. Focusing on deposit insurance did not only demonstrably increase the probability of a crisis, although it was also documented that the probability of a crisis is not predicted by the presence of insurance. Also, explicit or implicit limitations on entry into banking can create charter value (an intangible asset equal to the present value of monopoly rents; charter is necessary to be active in banking) that is lost if the bank fails. Entry restrictions can create an incentive for the bank to abide by the regulations and not take too much risk. But nonbanks would then have to be prevented from issuing short-term debt. If nonbanks increase the issuance of short-term debt, issuance that migrates from the traditional banking sector, it implies that regulation is constraining issuance and costly. Now the regulator can only identify

 D. Gabor, (2017), Shadow Connections: On Hierarchies of Collateral in Shadow Banking, in (eds. A. Nesvetailova), Shadow Banking: Scope, Origins and Theories, Routledge, Abingdon UK, pp. 143–162. 826  G. B. Gorton, (2019), The Regulation of Private Money, NBER Working Paper Nr. 25,891, May. 827  The concept of ‘information insensitivity’ in debt markets has earlier been discussed at large; Bengt Holstrom, (2015), Understanding the Role of Debt in the Financial System, BIS Working Paper Nr. 479, January, and T.V. Dang et al., (2015), The Information Sensitivity of a Security, Working Paper, March, mimeo. 828  See in extenso: T.V. Dang et al., (2017), Banks as Secret Keepers, American Economic Review, Vol. 107, Issue 4, pp. 1005–1029. Also: T. Jackson and L.J. Kotlikoff, (2018), Banks as Potentially Crooked Secret-Keepers, NBER Working Paper Nr. 24,751, July, Revised. 825

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where banking activities occur, but in case banking regulation reduces profits, new bank will enter the lending sphere, including the issuance of private money (short-term debt). Gorton therefore concludes that the 2007 crisis did not only show how a debt market that goes from information-insensitive to information-sensitive freezes and is dysfunctional, and this was over a much longer period than historically experienced. The real pain, according to Gorton and I fully underwrite, is the fact that we have applied stock market policies to debt markets thereby ignoring the fundamental differences. All in all, Gorton sits very close to Martinez-Miera and Repullo,829 who documented a little while before that capital regulation leads to more shadow banking. Depending on the conditions, they trigger shadow banks to finance medium- to high-risk firms (depending on whether the too-tight current banking regulation imposes flat or VaR-related conditions on banks). Banks can decide who they lend to as they know how much capital they have to hold against each type and level of risk. Banks who screen their clients830 lower their cost of funding, at least if that is what they want. Equity in general terms is more costly for shadow banks, but they do not have to hold a minimum amount of equity for any given level of risk. When traditional banks are faced with a flat (so risk-ignorant and consequently does not vary with the bank’s risk—mainly Basel I based) criteria,831 regulated banks tend to have to hold quite some capital and medium risk type of clients are crowded out to shadow banking entities as they face no such rule.832 Their amount of equity and the cost of it depend not on who they lend to and there screen very little. If the criteria that regulated banks face are risk-related, banks are crowding out riskier borrowers. Martinez-Miera and Repullo analyzed the effect of bank capital requirements on the structure and risk of a financial system where markets, regulated banks and shadow banks coexist. Banks are regulated and certified, shadow banks are privately certified (more expensive equity). Under both risk-insensitive and risk-sensitive requirements, safer entrepreneurs borrow from the market (because it is cheaper) and riskier entrepreneurs borrow from banks. But risk-insensitive (sensitive) requirements are especially costly for relatively safe (risky) entrepreneurs, which may shift from regulated to shadow banks. In short, this would imply that not only risky clients migrate to shadow banks (because the bank has to hold too much capital reducing their profitability), but also medium risk and relatively safe clients will shift to shadow banks from traditional banks.

 D. Martinez-Miera and R. Repullo, (2019), Markets, Banks and Shadow Banks, ECB Working Paper Nr. 2234, February. Also see: J. Beguenau and T. Landvoigt, (2017), Financial Regulation in a Quantitative Model of the Modern Banking System, mimeo; E.  Fahri and J.  Tirole, (2017), Shadow Banking and the Four Pillars of Traditional Financial Intermediation, NBER Working Paper Nr. 23,920. 830  V. Vanasco, (2017), The Downside of Asset Screening for Market Liquidity, Journal of Finance, Vol. 72, pp. 1937–1981. 831  Risk-based requirements can be found mainly in Basel II and Basel III standards. See for the modeling dynamics: D.  Martinez-Miera and R.  Repullo, (2019), ibid., pp.  18–21 (flat) and pp. 21–24 (risk sensitive). 832  D. Martinez-Miera and R. Repullo, (2019), ibid., pp. 5–7, on how the regulation is structured and affects the financial infrastructure. 829

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This is the conclusion of their analysis which has contributed to this debate by proposing an analytical framework to assess the effects of bank capital requirements on the structure and risk of the financial system. In particular, they address issues such as (1) what is the difference between regulated and shadow banks, and how do they differ from direct market finance, (2) what type of borrowers are funded by them, (3) how does bank capital regulation affect lending through these channels and (4) how does the existence of shadow banks affect the effectiveness of this regulation. The shifting of medium- to highrisk clients to the shadow banking sphere due to capital requirements results in an increase in the default probability of entrepreneurs that shift, and therefore is an unintended consequence of capital regulation that can lead to a riskier financial system. Maybe in contrast to first-line sentiment, optimal capital regulation833 has to take into account the existence of unregulated finance, whose presence imposes a constraint on the regulator that leads to lower optimal capital requirements. Clients have three avenues they can walk to raise the necessary funds: the market directly, a regulated bank and the unregulated shadow bank. Market finance differs from intermediated finance in that clients are not screened, but only safer projects or clients survive. Investors in shadow banks do not screen bank clients and so a moral hazard issue emerges. Private certification of shadow banks is more expensive than the certification of regulated banks. But cheaper traditional bank certification has implications: certain client profiles will see a limited likelihood of being financed as the capital requirement costs outweigh the interest marge to be gained above the cost of funding. And more importantly, there is trade-off between the cost (in terms of higher cost of capital) and benefits (in terms of lower certification costs) of being subject to capital regulation. Martinez-Miera and Repullo also identified another trade-off and one that is complementary to the one just mentioned. This trade-off derives from the assumption of underpriced deposit insurance for regulated banks. They show that replacing lower certification costs by underpriced deposit insurance yields essentially the same results in terms of the equilibrium structure of the financial system.834 In summary, with flat capital requirements the equilibrium market structure is such that regulated banks always fund the riskiest projects, while if shadow banks operate, they fund projects that are safer than those of the regulated banks.835 With VaR capital requirements the equilibrium market structure is such that regulated banks always fund the intermediate risk projects, while if shadow banks operate, they fund the riskiest projects. Thus, the type of capital requirements leads to very different structures of the financial sector. They argue ‘[w]ith flat requirements the equilibrium market structure is such that regulated banks always fund the riskiest projects, while if shadow banks operate they fund projects that are safer than those of the regulated banks. With Value-at-Risk requirements the equilibrium market structure is such that regulated banks always fund the intermediate risk projects, while if shadow banks operate they fund the riskiest projects.’836

 D. Martinez-Miera and R. Repullo, (2019), ibid., pp. 24–33.  In detail on deposit insurance: D.  Martinez-Miera and R.  Repullo, (2019), ibid., pp.  36–38 Appendix A. 835  D. Martinez-Miera and R. Repullo, (2019), ibid., pp. 11–18 in detail for the model and results. 836  D. Martinez-Miera and R. Repullo, (2019), ibid., p. 34. 833 834

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Their results illustrate how the possibility of unregulated finance affects the effectiveness of the different types of regulation.837 But there is also implication to this analysis: tightening flat capital requirements838 increases the screening incentives of banks given the mandatory nature of the regulation leading to the fact that they drive some safer (riskier) entrepreneurs to the shadow banking system, where they will have lower or no screening and higher default risk. Consequently, a tightening of capital requirements can potentially lead to a reduction in the risk of loans to clients that stay with the regulated banks, but at the same time lead to an increase in the risk of loans to those that shift out of the regulated banks, which may result (if the second effect is large enough) in an increase in the overall risk of the financial system. Sounds like Gorton all over again. And the company doesn’t end there. Fahri and Tirole built their argument that prudential regulation must adjust to the emergence of shadow banking around the idea that traditional banking is built around four pillars, that is, SME lending,839 access to public liquidity, deposit insurance and prudential supervision.840 They studied the same optimal taxation

 One can wonder if a paradigm shift isn’t required also within the context of regulation and how regulation needs to deal with a variety of variables and constantly changing objectives. Zetzsche et al. analyze possible new regulatory approaches, ranging from doing nothing (which spans from being permissive to highly restrictive, depending on context), cautious permissiveness (on a caseby-case basis, or through special charters), structured experimentalism (such as sandboxes or piloting), and development of specific new regulatory frameworks. A new regulatory approach, which incorporates these rebalanced or rebalancing objectives is coined ‘smart regulation’. See in detail: D. Zeitzsche, (2017), Regulating a Revolution: From Regulatory Sandboxes to Smart Regulation, EBI Working Paper Series, Nr. 11, August; T. Adrian, (2018), Shadow Banking and Market-Based Finance, in Shadow Banking: Financial Intermediation Beyond Banks (Ed. Esa Jokivuolle), SUERF Conference Proceedings 2018/1, Larcier, pp. 14–37. 838  M. Harris, et al. (2017), Higher Capital Requirements, Safer Banks? Macroprudential Regulation in a Competitive Financial System, Wharton School Working Paper, mimeo; R. Irani, et al. (2018), The Rise of Shadow Banking: Evidence from Capital Regulation, CEPR Discussion Paper No. 12913; G.  Ordoñez, (2018), Sustainable Shadow Banking, American Economic Journal: Macroeconomics, Vol. 10, pp. 33–56. 839  SME financing stays a sensitive topic, especially since evidence that the more stringent risk-based capital requirements under Basel III slowed the pace and in some jurisdictions tightened the conditions of SME lending at those banks that were least capitalized ex ante relative to other banks. These effects are not homogeneous across jurisdictions, and they are generally found to be temporary. The evaluation also provides some evidence for a reallocation of bank lending toward more creditworthy firms after the introduction of reforms, but this effect is not specific to SMEs. See the public consultation started by the FSB on 9 June 2019. FSB, (2019), Evaluation of the effects of financial regulatory reforms on small and medium-sized enterprise (SME) financing: Consultation report, June 9, via fsb. org. Also see: R. Sébastien and S. Frédérique, (2017), SMEs’ Financing: Divergence Across Euro Area Countries? Banque de France Working Paper Nr. 654, December 12. Three external financing sources, bank loans, credit line/overdraft and trade credit, are analyzed. They find substantial differences between countries in the SMEs’ use of the three financing sources. In particular, the cross-country differences related to SMEs’ use of bank loans have significantly increased over the period 2010–2014. This divergence is not related to a global increase in the volatility of this use between countries. Instead, it has been driven by a sharper increase (resp. decrease) in the countries where SMEs’ use was initially higher (resp. lower). The results suggest that indicators about banking concentration are good candidates to explain the cross-country divergence of SMEs’ use of bank loans. 840  E. Farhi and J. Tirole, (2017), Shadow Banking and the Four Pillars of Traditional Financial Intermediation, NBER Working Paper Nr. 23,930, October. 837

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question of banks when supervision reduces moral hazard,841 and the riskiness of balance sheets and financial intermediaries can migrate to shadow banking in response to regulatory requirements. Their first key insight is the complementarity between regulation and the forms of insurance provided by the state: LOLR to banks and deposit insurance to depositors. Insurance is costly and supervision helps reduce the risk that its promises are called upon. Second, they provide the first formal rationale for ring-fencing and for incentivizing the migration of transactions toward CCPs. They documented how imperfect regulatory information may lead to gaming of hedging among financial intermediaries, resulting in banks being only partially covered as they hoard ‘bogus liquidity’ and in public liquidity being siphoned off to the shadow sector. The picture emerging from the analysis is a hexalogy: prudential supervision of banking goes hand in hand with servicing special borrowers (SMEs) and special lenders (retail depositors), LOLR, deposit insurance, incentivized migration to CCPs and ring-fencing.842 The problem with private money is that they come to exist without being subject to any form of control. And once they did, it must be made possible to convert them in other forms of money, if not a collapse of credit is likely. That is, freely rewritten what Friedrich Hayek already wrote in 1931 in his essay ‘Prices and Production’. We have witnessed this during the Great Recession. Collateral market liquidity is critical to ensure the convertibility of shadow money. This way they can ensure an ultimate backstop to runaway markets, which requires some sort of formalized coordination between the central bank and the Treasury in terms of debt issuance and debt management in general. In terms of the question what markets the central bank needs to act for as a backstop, the answer can be that the central bank needs to ‘continuously (and thus not only under stress) support core funding markets’. Core markets are sovereign debt, repos, securities lending, unsecured short-term bank debt and foreign exchange (FX). Those markets would need permanent support. But there is a policy dilemma in this position. Central banks and governments have pledged to use no or as little taxpayer’s money as possible. But in this model they no longer underwrite (systemic) banks but they underwrite systemic markets. That doesn’t only sound scary and way worse, but the individual accountability of holding banks accountable in a bank-­financed model is now replaced by an anonymous market-financed model. As Minsky already highlighted a long time ago regarding the lender of last resort model:

 How one organizes supervision—how we define the allocation of supervisory powers to different policy institutions—can have implications for policy conduct and for the economic and financial environment in which these policies are implemented. See for an analysis, also regarding (de)centralization: M. Ampudia et al., (2019), The Architecture of Supervision, ECB Working Paper Nr. 2287, May 27. Also see: A. Maddaloni and A. Scopelliti, (2019), Rules and Discretion(s) in the Prudential Regulation and Supervision: Evidence from EU Bank in the Run-up to the Crisis, ECB Working Paper Nr. 2284, May 22. 842  E. Farhi and J. Tirole, (2017), ibid., p. 38. Also see: P. Feve, et al. (2017) Financial Regulation and Shadow Banking: A Small-Scale DSGE Perspective, TSE Working Paper Nr. 17-829; J. Beguenau and T. Landvoigt (2017), Financial Regulation in a Quantitative Model of the Modern Banking System, Stanford University Working Paper, mimeo. 841

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‘[l]ender of last resort powers provide the Federal Reserve with powerful m ­ edicine, but like most powerful medicines, they can have serious side effects.’843 But also the banking sector needs a rethink in terms of what it really is: maybe it isn’t the cornerstone of capitalism and entrepreneurialism as we always thought it would be. Maybe it is more like what Graeber844 highlights: banks aren’t banks but financial bureaucracies both judging their operations, their state-­backed nature, their political power (and the power to create money) and their anti-entrepreneurialism. Banks are quasi-state extensions of a neoliberal sovereign state. Graeber identifies some serious anti-democratic instincts in this model. Maybe not surprising then that Kregel advocates the democratization of money or maybe the redemocratization.845 He explains his position: ‘[i]n the Western interpretation of democracy, governments exist in order to manage relations of property, with absence of property ownership leading to exclusion from participation in governance and, in many cases, absence of equal treatment before the law. Democratizing money will therefore ensure equal opportunity to the ownership of property, and thus full participation in the democratic governance of society, as well as equal access to the banking system, which finances the creation of capital via the creation of money.’ Obviously, when the divergence between capital and labor—between rich and poor—is explained by the monopoly access of capitalists to finance, then reducing this divergence is crucially dependent on the democratization of money. That is a complicated process as ‘the role of money and finance in determining inequality between capital and labor transcends any particular understanding of the process by which the creation of money leads to inequity, specific proposals for the democratization of money will depend on the explanation of how money comes into existence and how it supports capital accumulation’, Kregel explains. And let’s be fair about those new capital ratios. Besides the fact that standard Tier 1 capital ratios of banks are completely uninformative, banks that had to be rescued in 2008 had higher Tier 1 capital ratios than banks that did not need to be rescued. Enhanced over, even doubled capital ratios mean nothing. Doubling nothing leaves you with (close to) nothing. Too often supervisors look at capital requirements as buffers that can absorb losses when needed, whereas they effectively are a source of financing bank activities. Shadow banking as part of the banking sphere is also promoted for international development purposes. This debates the fact that there seems to be a banking reform fatigue emerging.846 They correctly highlight that risks tend to migrate to new unexpected corners of the financial system, and more importantly I may add, the financial system expands into all sorts of unchartered domains that do not operate according to traditional banking rules and

 J.  Kregel, (2010), Is This the Minsky Moment for Reform of Financial Regulation? Levy Economics Institute Working Paper Nr. 586, February. To be read together with J. Kregel, (2018), Preventing the Last Crisis, Minsky’s Forgotten Lessons Ten Years After Lehman Levy Economics Institute Policy Note Nr. 2018/5, November. 844  D. Graeber, (2018), The ‘Yellow Vests’ Show How Much the Ground Moves Under Our Feet, Critical Legal Thinking, December 9, via criticallegalthinking.com 845  J. Kregel, (2019), Democratizing Money, Levy Economics Institute Working Paper Nr. 928, May. 846  A. Barajas et al. (2018), A Decade After Lehman, the Financial System Is Safer. Now We Must Avoid Reform Fatigue, IMFBlog, October 3, via blogs.imf.org 843

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dynamics. Reforming our banking and financial system is only in its first inning,847 to use a sports term,848 while at the same time tightening the liquidity requirements for banks.849 In fact, some scholars believe it, after having reviewed the post-crisis regulatory initiatives aimed at shadow banking, and conclude that most such regulations could result in a less stable financial system to the extent that higher regulatory costs on shadow banks like insurance companies and asset managers could discourage them from participating in shadow banking. And the net effect of this regulation, by limiting the amount of marketbased capital available for nonbank risk transfer, may well be to increase the concentrations of risk in the banking and overall financial system.850 Model-based reforms always raise questions especially now that the economics profession has been doing some soul searching and questions are being asked about the validity of the dynamic stochastic general equilibrium (DSGE) model851 that has been dominating macroeconomics for the better part of the last three decades or so. Inadequate modeling of the financial sector meant that they were ill-suited for predicting or responding to a financial crisis; and a reliance on representative agent models meant that they were illsuited for analyzing either the role of distribution in fluctuations and crises or the consequences of fluctuations on inequality, Stiglitz concludes.852 It has allowed banks to grow

 G. Tett, (2018), European Banks Still Have Post-Crisis Repairs to Do, FT, July 19. Also see: BIS, (2018), Annual Economic Report, June, via bis.org, pp. 43–47. See also: S. Ingves, (2018), Basel III: Are We Done Now? Keynote speech by Stefan Ingves, Chairman of the Basel Committee on Banking Supervision, at the Institute for Law and Finance conference on ‘Basel III: Are we done now?’, Goethe University, Frankfurt am Main, 29 January, via bis.org, p. 3. Full, timely and consistent implementation: more than just words, and p. 4 Enhancing financial stability: an ongoing journey. 848  The EBA seems to somewhat agree with that view, although in more hidden terms. At least this is the impression I got when cruising through the Basel reform impact report. See in detail: EBA, (2018), 2018 Basel III Monitoring Exercise Report, October 4, via eva.europe.eu 849  EBA, (2018), EBA Report on Liquidity Measures Under Article 509(1) of the CRR, October 4, via eba.europe.eu 850  L. Culp and A. Neves, (2018), Shadow Banking, Risk Transfer and Financial Stability, Journal of Applied Corporate Finance, Vol. 29, Issue 4, pp. 45–64. 851  Dynamic stochastic general equilibrium (DSGE) models. See in detail: J. Fernández-Villaverde, (2009), The Econometrics of DSGE Models, NBER Working Paper Nr. 14,677, January; A. Gulan, (2018), Paradise Lost? A Brief History of DSGE Macroeconomics, Bank of Finland Research Discussion Papers, Nr. 22, Helsinki. R. Deb et al., (2018), Evaluating Strategic Forecasters, American Economic Review, Vol. 108, Nr. 10, October, pp. 3057–3103; H.F. Sonnenschein, (2018), Chicago and the Origins of Modern General Equilibrium, Journal of Political Economy, Vol. 125, Nr. 6, December, pp.  1728–1736; J.  Breitung and M.  Knüppel, (2018), How Far Can We Forecast? Statistical Tests of the Predictive Content, Deutsche Bundesbank Discussion Paper Nr. 7, April 25. 852  J.  E. Stiglitz, (2018), Where Modern Macro-Economics Went Wrong, Oxford Review of Economic Policy, Vol. 34, Issue 1–2, Spring-Summer, pp. 70–106; C.-W. Chiu et al., (2018), A New Approach for Detecting Shifts in Forecast Accuracy, Bank of England Staff Working Paper Nr. 721, April 13; T.  Nakata and T.  Sunakawa, (2019), Credible Forward Guidance, Finance and Economics Discussion Series 2019-037. Washington: Board of Governors of the Federal Reserve System, https://doi.org/10.17016/FEDS.2019.037; J.R.  Campbell et  al., (2019), The Limits of Forward Guidance, FRB of Chicago Working Paper Nr. 3, March 20; M. Ehrmann et al., (2019), Can More Public Information Raise Uncertainty? The International Evidence of Forward Guidance, ECB Working Paper Nr. 2263, April 15. 847

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way beyond its useful size for an economic and effectively ruin the economy. Mismanagement of economies was part of the story that led to the destabilized political systems as we’re experiencing them at this stage.853 Globalization and market concentration also occur in the financial sector.854 This has macroeconomic implications and leads to increase in average market power: (1) decrease in labor share, (2) increase in capital share, (3) decrease in low skill wages, (4) decrease in labor force participation, (5) decrease in labor flows, (6) decrease in migration rates and (7) slowdown in aggregate output.855 Market power then in turn does have an impact on capital buffers for banks. Results show that more competition leads to higher buffers in developed countries but to lower buffers in developing ones. This evidence suggests that the ‘competition-stability’ thesis adheres in developed economies, whereas ‘competition-fragility’ makes more sense in developing countries. This asymmetric result may have important policy implications, particularly with regard to new, globally negotiated capital adequacy standards.856 In a world where financial markets, central banks and governments are highly intertwined, it is also fair to indicate that central banks alone cannot deliver on stable markets or finance alone. Governments should chip in and deal with the growing risk of elevated asset valuations.857 Under a neoliberal horizon, banking transforms through the intertwining forces of quasi-markets, quasi-state entities, central banks and governments.858 The  Liberal democracies operate with a majority that is always temporary. Any dominance or victory is temporary. In many ways, this idea seems more theoretical than actual. See: M. Wolf, (2018), Saving Liberal Democracy from the Extremes, FT, September 25. In line with that and how permanent networks seek rent capture: R. Haselmann et al., (2018), Rent Seeking in Elite Networks, The Journal of Political Economy, Vol. 126, Nr. 4, August, pp. 1638–1690. 854  See, for example, B. Braun, (2018), Central Banking and the Infrastructural Power of Finance: The case of ECB Support for Repo and Securitization Markets, Socio-Economic Review, February 20, online: https://doi.org/10.1093/ser/mwy008; T.  Walter and L.  Wansleben, (2019), How Central Bankers Learned to Love Financialization: The Fed, the Bank and the Enlisting of Unfettered Markets in the Conduct of Monetary Policy, Socio-Economic Review, March 21, online: https://doi.org/10.1093/ser/mwz011, both in preprint 855  J. de Loecker and J.  Eeckhaut, (2017), The Rise of Market Power and the Macro-Economic Implications, NBER Working Paper Nr. 23,687, August. 856  See in detail: O.C. Valencia and A.O. Bolaños, (2018), Bank Capital Buffers Around the World: Cyclical Pattern and the Effect of Market Power, Journal of Financial Stability, Vol. 38, October, pp. 119–131; J. R. LaBrosse et al., (2018), ‘Multinational Banking’: Capturing the Benefits and Avoiding the Pitfalls, Journal of banking Regulation, Vol. 19, January pp. 1–3. 857  M. Wolf, (2017), Central Banks Alone Cannot Deliver Stable Finance, FT, October 24. Wolf indicates, ‘It has to be possible for the financial system to cope with changes in asset prices without blowing up the world economy. This should not need saying.’ True, but so far we haven’t moved an inch closer in achieving that objective. Partly because both regulation and policy are two very imperfect tools to achieve that objective. But, as a starter financial excess and leverage should be curbed. That is within the remit of both regulation and macroprudential policies. Banks ultimately remain far too undercapitalized for comfort, the same M. Wolf highlights. See FT 21 September 2017. Since then leverage position has only aggravated. 858  Also: R. Guttman, (2017), The Transformation of Banking, in (eds. A. Nesvetailova), Shadow Banking: Scope, Origins and Theories, Routledge, Abingdon UK, pp. 25–39; E. Engelen, (2017), How Shadow Banking Became Non-Finance: The Conjectural Power of Economic Ideas, in (eds. A. Nesvetailova), Shadow Banking: Scope, Origins and Theories, Routledge, Abingdon UK, pp. 40–54; T. Grung Moe, (2017), Shadow Banking and the Challenges for Central Banks, in (eds. A. Nesvetailova), Shadow Banking: Scope, Origins and Theories, Routledge, Abingdon UK, pp. 217–237. 853

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backbone of a liberal capitalist political economy is at work.859 There is a growing awareness of the role of money and money creation.860 And there is an equally rising understanding that such a ‘state-market’ kind of political economic is unequally responsive to reflect ­preferences of different society segments. This was observed to hold true despite the differences in mechanical institutional and political settings.861 This liberal but coordinated political model of capitalism implies that in coordinated economies liberalization has not taken place primarily through outright deregulation, but has involved alternative mechanisms that increase employer discretion without fundamentally altering the form of existing institutions. Secular stagnation or the structural issue for advanced economies creates sufficient aggregate demand. It is argued that strong unions and centralized collective bargaining were cornerstones of the wage-led Fordist model, and that the liberalization of industrial relations has undermined a crucial institutional channel for transmitting productivity increases into real wages and aggregate demand. Post-Fordist growth models are based on alternative drivers of growth, but they are all fundamentally unstable.862  See also: M. Renner and A. Leidinger, (2016), Credit Contracts and the Political Economy of Debt in Reshaping Markets. Economic Governance, the Global Financial Crisis and Liberal Utopia, (eds. B. Lomfeld, A. Somma and P. Zumbansen) in Cambridge University Press, Cambridge, pp. 133–158. 860  Koddenbrock argues, ‘[a]s a social structure and process, it makes moneymaking through capital permeate all our societies. As a public-private partnership between the state, rentiers, banks, and taxpayers that has existed since the foundation of the Bank of England in 1694, it binds these actors together in shifting relations of dependence. In today’s financial capitalism, what counts as money and how far moneyness stretches into the realms of financial innovation has been the core object of struggle in the public-private partnership of money.’ See in detail the excellent paper: K. Koddenbrock, (2017), What Money Does: An Inquiry into the Backbone of Capitalist Political Economy, MPIfG Discussion Paper Nr. 17/9, Max-Planck-Institut für Gesellschaftsforschung, Köln. Also see: L. Baccaro and J. Pontusson, (2018), Comparative Political Economy and Varieties of Macroeconomics. MPIfG Discussion Paper Nr. 18/10, Max-Planck-Institut für Gesellschaftsforschung, Köln. Regarding the role of money creation by shadow banks, see: J. Michell, (2017), Do Shadow Banks Create Money? ‘Financialization’ and the Monetary Circuit, Metroeconomica, Vol. 68, Issue 2, pp. 354–377. 861  L.  Elsässer et  al., (2018), Government of the People, by the Elite, for the Rich: Unequal Responsiveness in an Unlikely Case, MPIfG Discussion Paper Nr. 18/5, Max-Planck-Institut für Gesellschaftsforschung, Köln. 862  L. Baccaro and C. Howell, (2017), Unhinged: Industrial Relations Liberalization and Capitalist Instability, MPIfG Discussion Paper Nr. 17/19, Max-Planck-Institut für Gesellschaftsforschung, Köln; P.-R. Agénor et al., (2018), The Effects of Prudential Regulation, Financial Development and Financial Openness on Economic Growth, BIS Working Paper Nr. 752, October 5, via bis.org. Besides the fact that the latter provide analytical overview of the various channels through which prudential regulation can affect economic growth, they show that growth may be promoted by prudential policies that seek to mitigate financial risks to the economy. At the same time, financial openness tends to reduce the growth benefits of these policies. This may reflect either greater opportunities to borrow abroad or increased scope for cross-border leakages in regulation. Also see: F. Manaresi and N. Pierri, (2018), Credit Supply and Productivity Growth, BIS Working Paper Nr. 711, March 28, via bis.org. Literature has shown that credit supply helps firms purchase inputs, most notably capital, thus allowing them to increase production. They (Manaresi and Pieri) extend this research by showing that credit affects firm productivity beyond the estimated scale effect. These credit contractions have a negative and persistent effect on firm productivity. Positive credit supply shocks have a much more limited positive impact, implying that credit volatility may be bad for productivity growth. The estimated impact is found to result from several productivity enhancing activities. These include R&D, patenting, adoption of IT, improved management practices and propensity to export. 859

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Claiming that shadow banks have been tamed therefore is a grotesque statement and demonstrates the profound ignorance on the part of some of the supervisory and regulatory bodies. And let’s be fair, we are still digesting the past, and have to come to terms that the 2008 financial crisis was more about Europe than we actually want to admit. For long it was all blamed on the US housing and securitization market, combined funding issues in their funding and collateral market. Only in recent years, we have heard advocates arguing that Europe had its role to play, by having capital flowing into the US, now known as the ‘European banking glut hypothesis’. It was discussed before but a gentle reminder should work here. The European banking glut hypothesis holds that gross inflows into private bonds led to the boom. Leveraging up by European banks enabled the leveraging-up of US households. Gross flows from Europe better matched US mortgage market trends toward private credit risk, floating interest rates and narrow spreads. What is more, European banks produced, not just invested in, US mortgage-backed securities. Their US securities affiliates held huge exposures to such securities that deserve recognition. Furthermore, European banks’ leveraging-up also provided credit that enabled housing booms in Ireland and Spain.863

7.20.6  W  hat About Leveraged Loans and the NBFIs Involvement?864 Leveraged loans are loans provided to nonfinancial corporates that typically have high levels of indebtedness, below-investment grade credit ratings, or a spread at issuance higher than a certain threshold.865 Leveraged loans are secured and sit above high-yield bonds in the capital structure. High-yield bonds are typically rated below investment grade.

 See in detail most recently: R. McCauley, (2018), The 2008 Crisis: Transpacific or Transatlantic, in BIS Quarterly Review Q4, pp. 39–58. 864  See for further guidance: BIS (2018): The Rise of Leveraged Loans: A Risky Resurgence?, BIS Quarterly Review, September, pp.  10–12; Bank of  England, (2018), Financial Stability Report, Issue Nr. 44. November, pp. 42–48; ECB (2018): Financial Stability Review, May, pp. 74 ff.; ECB (2018): Financial Stability Review, November, pp.  10, 47–48, 54–55; Federal Reserve Board of  Governors, (2018), Financial Stability Report. November, pp.  11–12, 18–19, 28–29; Fitch Ratings, (2016), European Leveraged Loan Funds, October; IOSCO, (2018), Leverage, Consultation Paper, CR08/2018, regarding leverage used in  investment funds and  the  analysis of  critical metrics of  leverage (pp.  5–18) and  the  actual risk analysis at  fund level (pp.  19–20); Moody’s (2018), High Corporate Leverage Signals Future Credit Stress Even as the Default Rate Remains Very Low, 24 May; Moody’s (2018), Leveraged Finance – US: LBO Credit Quality Is Weak, Bodes Ill for  Next Downturn, 18 October; Standard & Poors (2018), When the  Cycle Turns: Leverage Continues to Climb: Has It Finally Peaked?, 9 October. 865  FSB, (2019), Global Monitoring Report on Non-Bank Financial Intermediation 2018, February 4, Case Study 2: Recent developments in leveraged loan markets and the role of NBFIs, pp. 73–78. 863

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Leveraged loans have floating rates and cannot necessarily be easily refinanced.866 The ­leveraged loan market has grown significantly against a background of low interest rates and lenders’ willingness to extend loans with fewer credit protections. Spreads have compressed in recent years and market share of leveraged loans/covenant-lite loans has reached 60–70% (compared to 20% on average pre-crisis). The level of debt relative to earnings for nonfinancial corporates that raise funds in the high-yield debt market (HY corporates) has increased significantly. HY corporate debt has increased faster than earnings (Earnings before Interest, Tax, Depreciation and Amortization (EBITDA)) in all regions and debt multiples in this segment are structurally above pre-crisis levels and in some segments even higher than precrisis (e.g. in M&A). Corporations sponsored by PE firms tend to have higher debt multiples than on average. There are material risk concerns due to the combination of (1) compressed spreads, (2) lower creditor protection and (3) HY debt valuations.867 Within this market, the role of NBFIs has been rising in recent years. They have worked their way into this segment in a variety of ways: (1) nonbanks have provided an increasingly large share of financing in the leveraged loan market globally after the global financial crisis; (2) the way nonbanks provide financing has expanded, that is, direct lending (rather than through traditional banks) and buying bank products in the syndicated loan market (term loans or revolving credit facilities); (3) collateralized loan obligations (CLO) issuance has been strong and CLOs end to support the high-leveraged loan market, holding up to 30–60% of assets across jurisdictions. CLOs are repackaging products (of other loans) and data availability is often sketchy. Two-thirds of all CLOs are held by nonbank investors. (4) PE firms got even more engaged in the leveraged loan industry and the same holds true for the other institutional investors (pension funds, insurance companies, etc.). The conclusion is that high demand has eroded covenants, increased debt multiples, reduced financial flexibility of companies and limited refinancing options leading to economic vulnerability, liquidity stress and defaults. The low credit spreads lead to structural underpricing. As nonbanks have purchased the majority of leveraged loans in recent years (in the primary market), their exposure to adverse market conditions also increased. Spillovers to other market segments are possible and under conditions likely caused by rising defaults or sharp market repricing. The size and intrinsic risks in this market are as it stands disproportional with the lack of data and transparency in this market segment. CLOs redistribute risks without insight into who the ultimate risk-takers are. There is ultimately the risk of creating slow but gradually zombie firms across the different jurisdictions.868 And can central banks stimulate economic activity when they ­cannot

 FSB, (2019), ibid., p. 73.  FSB, (2019), ibid., pp. 74–75. 868  Zombie firms can be defined as firms that are unable to cover debt servicing costs from current profits over an extended period. See in extenso: R. Banerjee and B. Hofmann, (2018), The Rise of Zombie Firms: Causes and Consequences, in BIS Quarterly Review Q3, September, pp. 67–78. Also see: D.  Andrews and F.  Petroulakis, (2019), Breaking the Shackles: Zombie Firms, Weak Banks and Depressed Restructuring in Europe, ECB Working Paper Nr. 2240, February 14; D.J.  Herok and G.  Schnabl, (2018), Europäische Geldpolitik Und Zombiefizierung (European Monetary Policy and Zombification), Austrian Institute Paper Nr. 21, June 1. 866 867

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cut short-term interest rates any further? Forward guidance is limited and a lot of open questions remain,869 regardless of whether the forward guidance is quantitative or qualitative in nature.870 If market-based finance is more than a structural part of the future solution of global finance, then why is it that we don’t seem to get beyond the first-line analysis of those financial markets?871 Even in the recent BCBS report on ‘Establishing Viable Capital Markets’, I read: ‘[c]apital markets provide an important channel of financing for the real economy, they help allocate risk, and they support economic growth872 and financial stability. Moreover, capital markets have played an important part in financing the recovery from the Great Financial Crisis (GFC), a reminder of their “spare tyre” role in the financial system.’ ‘The analysis highlights the importance of macroeconomic stability, market autonomy, strong legal frameworks and effective regulatory regimes in supporting market development. Better disclosure standards, investor diversity, internationalization and deep hedging and funding markets, as well as efficient and robust market infrastructures,

 P. Andrade et al., (2018), Forward Guidance and Heterogeneous Beliefs, BIS Working Paper Nr. 750, October 3, via bis.org 870  Central bank communication is important, but the exact form of that communication is less critical. See in extenso: G.-A. Detmers et al., (2018), Quantitative or Qualitative Forward Guidance: Does It Matter? BIS Working Paper Nr. 742, August 28, via bis.org; S.  Morris and H.S.  Shin, (2018), Central Bank Forward Guidance and the Signal Value of Market Prices, BIS Working Paper Nr. 692, January 23. 871  As Endrejat and Thiemann correctly highlight, the reorientation of European regulatory agency on shadow banking post-crisis, from curtailing it to facilitating resilient market-based finance, has been a cause for irritation by academic observers, dismissed by some as mere rebranding or taken as a sign of regulatory capture. Not only the redesign of MMFs, STS reforms, ABCP and CRR, as well as the way how they have been transformed in such a way that their final versions allow to reestablish the shadow banking chain linking MMFs, the ABCP market and arguably the regular banking system. They also conclude that it was a coordinated effort by the regulator with private actors in order to maintain a channel for credit creation outside of bank credit, a task made more complicated by the rushed politicized final negotiations coupled with technical complexity. In detail: V. Endrejat and M. Thiemann, (2018), Reviving the Shadow Banking Chain in Europe: Regulatory Agency, Technical Complexity and the Dynamics of Co-habitation, SAFE Working Paper. 222, August 28. It is aimed at creating a regulatory infrastructure able to sustain the orderly flow of real economy debt. 872  Much has been said about the questionable role of finance in economic growth and how too large a financial sector hampers economic growth. Popov reviews and appraises the body of empirical research on the association between financial markets and economic growth that has accumulated over the past quarter-century. The bulk of the historical evidence suggests that financial development affects economic growth in a positive, monotonic way, yet recent research endeavors have provided useful and important qualifications of this conventional wisdom. More precise links between theory and measurement have been studied. Popov also highlights the mechanisms through which financial markets benefit society, as well as the channels through which finance can slow down long-term growth. In detail: A.  Popov, (2017), Evidence on Finance and Economic Growth, ECB Working Paper Nr. 2115, December 6. 869

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also play a key role.’873 Safe but fragile, then, indeed becomes the right way to describe the current status-quo.874 There are even those that question of the current set of macroprudential regulation would have prevented the last crisis.875

7.21 F rom Shadow Banking to Market-Based Finance 7.21.1  What Does It Take? The many regulatory interventions and macroprudential policies that have been put in place into a wide variety of areas within the financial sphere had led us to believe that the pejorative connotation that goes with shadow banking could be left behind for the more neutral, accommodating and business-friendly term of ‘market-based finance’.876 That transition was made starting 2015, and although every initiative has been given lots of attention, it is in the fine print that the truth reveals itself. In the third ‘Implementation and Effects of the G20 Financial Regulatory Reforms report’, it is highlighted that the ‘implementation of reforms on oversight and regulation of shadow banking entities, including money market funds, securities financing transactions and securitization, is progressing but remains at a relatively early stage’.877 However, there is truth in the fact that certain aspects of shadow banking that contributed to the (previous) financial crisis have declined significantly and generally no longer pose financial stability risks (or at least according to the prevalent models). Reforms have also contributed to a reduction in vulnerabilities in areas such as money market funds and repos, although none of that has been tested in real life. On the other hand, investment funds have grown, underscoring

 See in detail: CGFS, (2019), Establishing Viable Capital Markets, CGFS Papers Nr. 62, January, via bis.org 874  P.J. König and D. Pothier, (2018), Safe but Fragile: Information Acquisition, Sponsor Support and Shadow Bank Runs, Deutsche Bundesbank Discussion Paper Nr. 15, June 4. 875  Without answering the question directly, they argue that a large proportion of the fall in US GDP associated with the crisis can be explained by two factors: the fragility of financial sector— represented by the increase in leverage and reliance on short-term funding at nonbank financial intermediaries—and the buildup in indebtedness in the household sector. The former has decreased, the latter has increased post-crisis. As argued before, there is, and in contrast with public debt levels, a systemic risk also in private debt that often is ignored. See in detail: D. Aikman et al., (2018), Would Macroprudential Regulation Have Prevented the Last Crisis, Bank of England Staff Working Paper Nr. 747, August 3. 876  See regarding the stability dimension in market-based finance: S.  Maijoor and C.  Boidard, (2017), Banque de France, Financial Stability Review Nr. 21, April, The Impact of Financial Reforms, pp. 149–156. 877  FSB, (2017), Implementation and Effects of the G20 Financial Regulatory Reforms report, 3rd report, July 3, p. 1. 873

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the importance of effective operationalization and implementation of policies agreed to address their structural vulnerabilities.878 I have lamented throughout both volumes of this book that there is no room for untimely self-congratulations in this sphere. I have commented on the arguments regarding the individual segments of the shadow banking market in the right place. In more general terms, each of these regulatory and macroprudential interventions ultimately were balancing acts and agreed solution to a problem that could no longer be denied. In some cases, it became very obvious where the timeline was unnaturally long and erratic as was the case in negotiating the European MMF regulation. The harsh reality in the way that I look at the problem embraces the fact that when solving shadow banking issues, there are a tremendous amount of underlying issues and concepts that we only start to get our head around in the sense that we’re building models that allow us to somewhat understand how systems and market-based financial infrastructure respond to a variety of shocks and post-event effects and how contagion spreads and systemic risk manifests itself. In many instances it used to be so that models assumed efficient markets and structurally rational behavior of all market participants. We knew these were theoretical constructs, but they were used to hide behind and built upon to develop regulatory and macroprudential models. During the last ten years this is changing, slowly and painfully, and not necessarily in a way that matters. And yes, one could respond like some do that ‘more equity’ would be the solution to all sorts of destabilizing events in the marketplace. But we had bank runs long before equity positions at bank balance sheets became marginal. We do realize that the higher amounts of capital required from banks will help, we don’t know however how much and for how long. The small incremental nature of capital requirements, liquidity and leverage ratios, and so on are very well positioned to leave the impression that the financial infrastructure is no longer built on quicksand. But that conclusion I built on a theoretical construct as well. The reality is that we don’t know and most likely we will never know. The market complexity, the interaction between a variety of market players, new strategies and products that arrive in the market, increasingly higher levels of debt in the world, and the real-life effect of regulation on behavior and positions are largely unknown. So to those who feel very comfortable with the road traveled in terms of regulation and policy and sometimes lose themselves in all sorts of selfcongratulations, I would say this: sleep with one eye open every single night, because one never knows when the next crisis comes along. There is no honor in making statements about the robustness of a regulatory and policy infrastructure if you don’t have to prove anything. When the next crisis comes along, we all will observe what all the intermediate claims were worth. And many self-acclaimed specialists will then not be around to justify the outcome. An undergraduate course in complex or embedded systems would have learned then that with the level of complexity currently around in the marketplace, there is no type or sort of regulation that can justify hard claims in this context. Some therefore believe it makes more sense to focus on the post-event management and have regulation focus on resolution and restabilizing the marketplace. For now, I’m still in the place where I’m convinced that both are needed. 878

 FSB, (2017), ibid., p. 2.

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However, our current belief that market-based finance can work fine if guided by the right amount of regulation and policies still assumes that the ‘free’ market is still the best mechanism to provide credit and other instruments to the economy and society. Now a free market is assumed to be functioning better under conditions. One of the conditions is that the market brings market participants together, which when combined provide sufficient knowledge to create a demand and supply relationship that is optimal at a certain price. However, we have elaborated often enough that the debt market is an information-­ insensitive market. This implies that debt investment decisions are made not based on product- or instrument-specific knowledge but rather on broad-brush movements observed in the market, often guided by third-party information on certain matters. It is justified to ask the question whether it makes sense to assume that market-based finance will work well under a majority of circumstances, as it has the potential to develop its own demise as it doesn’t qualify for our theoretical construct underlying the free-market assumptions. I’m therefore saddened each year that the FSB (in fact every institution involved on a national or supranational institution that communicates on a recurring basis) in its updates seems to leave the impression that it believes all is good and that the right measures were taken to prevent financial crisis-lookalikes going forward.879 Often statements read like the following: ‘FSB jurisdictions should establish a systematic process for assessing shadow banking risks, and ensure that any non-bank financial entities or activities that could pose material financial stability risks are brought within the regulatory perimeter; address identified gaps in the availability of data to assess financial stability risks, taking into account the potential materiality of those risks; and remove impediments to cooperation and information-sharing between authorities, including on a cross-border basis.’880 The idea that more measuring, more theoretical constructs, more processes, more identification models will lead us to better answers is something that doesn’t work well for me. I would like to use the example of a Tube map of a random city. If one looks at the map, one knows what is visualized, the metro system of a city. If one would ask the question whether this map is accurate, one would tend to believe that the answer is ‘no’. A tube map is not realistic and makes absurd assumptions. If it did not, it would be illegible. And useless. The map is useful precisely because it abstracts from unnecessary details to show you the way.881 I guess that in our shadow banking data collection effort we’re at the brink of believing that more and more granular data will allow better anticipation, better resolution and better regulation and policy. But the risk is that we end up with a troubled map. Not every incremental data point improves understanding of the problem or leads directly to better decision-making. Dozens of years of global shadow banking segment

 See, for example, FSB, (2017), ibid., pp. 15–17.  FSB, (2017), ibid., p. 16; FSB, (2016), Thematic Review on the Implementation of the FSB Policy Framework for Shadow Banking Entities, May, section 4. 881  See O. Attanasio et al., (2018), Dismal Ignorance of the ‘Dismal Science’—a Response to Larry Elliot, The Prospects Magazine (www.prospectmagazine.co.uk). 879 880

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measurements will not alter the fact that in information-insensitive debt markets, the free-market concept is flawed right out of the gate. The study of market inefficiencies and frictions is where the current state of research and literature lets us down. From there you can go two ways: you accept the situation as it is or you decide and wait for the next crisis to come along and hope that you got it right enough to survive and hope the economy doesn’t come to a grinding halt ‘or’ you decide at some point that given the initial flaw identified the ‘to be expected risk’ of certain shadow banking activities is too material to be tolerated from a public interest point of view and you decide to restrict the freedom ‘to contract’ by prioritizing the ‘public interest argument’. Ultimately, this is what has been done in niche areas of the shadow banking market (restrictions on redemption in MMFs, random distribution of securitized tranches in the securitization space, untangling of CCP relations, haircuts for over-the-counter [OTC] trades,882 etc.). The activity survived, but certain aspects or peculiarities that contain market freedom have been constrained. The massive lobbying by the financial industry has however created legislation where general rules and exceptions have been constructed in such a way that the freedom to contract prevails, despite the understanding of imperfection, over public interest. This happened in a context where, given the weakness of the models, the understanding that the market doesn’t function properly when parties are information-insensitive like in the debt markets, and the aberration or dysfunctionalities are not (yet or never will be) properly modeled. Under such conditions, the regulator could have been firmer in validating and protecting the ‘public interest’ argument. Remember, untested and imperfect markets that aren’t properly understood leave room for nothing but fact-free political decision-making in many areas including the shadow banking sphere. I would like to invite the reader to observe the shadow banking assessments regarding regulation and policies and the way their functioning is observed by supranational institutions.883 The feeling regarding the overall direction is positive, and the reforms will lead to a resilient financial system.884 Even more, the net social benefits of reforms in reducing the frequency and severity of future crises could be higher than estimated when the reforms were established.885

 See on the OTC derivative reforms: FSB, (2017), ibid., pp. 21–23.  See, for example, FSB, (2017), ibid., pp. 24–26. It won’t take long to find firm statements: ‘[t]he aspects of shadow banking generally considered to have made the financial system most vulnerable and contributed to the financial crisis have declined significantly and are generally no longer considered to pose financial stability risks at the current conjuncture’ (p. 24); ‘Reforms have contributed to a reduction in vulnerabilities in other areas associated with the crisis, such as MMFs and repurchase agreements (repos)’ (p. 24); ‘At present, the FSB has not identified other new shadow banking risks that require additional regulatory action at the global level’ (p. 26). 884  See, for example, FSB, (2017), ibid., pp. 27–33. 885  I. Fender and U. Lewrick, (2016), Adding It All Up: The Macroeconomic Impact of Basel III and Outstanding Reform Issues, BIS Working Paper Nr. 591, November. 882 883

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Further observations are as follows: • Market-based indicators show improvements in perceived bank resilience since the crisis, although bank business models and structures are still undergoing adjustments in search of more sustainable profitability. • Large internationally active banks continue to build capital and liquidity buffers and reduce leverage. • Work is underway to enhance globally systemically important banks’ (G-SIBs’) resolvability through total loss-absorbing capacity (TLAC) mechanisms. • The cost of financing for the real economy, whether by banks or debt markets, has remained generally low in recent years. • Nonbank financial intermediation continues to grow post-crisis. • The most rapid asset growth was experienced by trust companies (primarily in China) as well as money market, fixed-income and other funds. Underlying drivers include long-term structural (e.g. demographics leading to asset accumulation) and conjunctural (e.g. accommodative monetary policies, declining risk aversion and search for yield) factors. Reforms may have contributed to this growth by making bank-based financing relatively more expensive.886 It should be observed that coining that ‘the shift toward more market-based finance represents a welcome increase in diversity of the sources of finance supporting economic activity, but will need to be matched with appropriate measures to monitor and address any associated financial stability risks’, and that ‘[a]n open and integrated financial system has major benefits, provided the system as a whole is resilient against shocks’,887 leaves the impression that monitoring and oversight replace proper decision-making as to what to leave to the market and what not. Quality decision-making front-runs these operational models where everything is allowed as long as it can be observed. To the best of my abilities, I have not been able to find convincing evidence for some of the claims that are made by supervisory institutions, such as ‘an open global financial system contributes to the efficient allocation of global savings across countries’, ‘the system is now more vulnerable than before the reforms’ and ‘securitization reduced the cost of financing and leads to better distribution of risk in the market place’. In fact, this list of undocumented claims is close to endless. The semantics surrounding the achievements so far is always skewed toward ‘a reduced likelihood’ at best of certain risk that could lead to contagion effect, collateral interconnectedness issues, financial stability risk and so on. In fact, since the financial crisis there has not been a year when all sorts of evaluation frameworks888 have been materially adjusted to account for new insights and novel understanding. Within

 This is also the conclusion of L. Grillet-Aubert et al., (2016), Assessing Shadow Banking – NonBank Financial Intermediation in Europe, ESRB report nr. 10, July. 887  FSB, (2017), Implementation and Effects of the G20 Financial Regulatory Reforms report, 3rd report, July 3, pp. 33–34 ff. 888  Including that of the FSB; see FSB, (2017), ibid., pp. 46 ff. 886

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the context of those shifting paradigms, I trust there is no room for firm and butch ­statements regarding financial market stability. It needs to be stressed that this is true for individual reforms but all the more for the interaction and coherence among reforms in recent years. I therefore am rather reluctant to underwrite the FSB’s marketing campaign which carried the title ‘How is the financial system safer, simpler and fairer than before?’889 It is worthwhile reading the guiding report.890 Its main conclusions are as follows: • The aspects of the shadow banking activities that are generally considered to have made the financial system most vulnerable and that contributed to the financial crisis have declined significantly and are generally no longer considered to pose financial stability risks. Primary factor: regulation. • Since the financial crisis, policies have been introduced at the international level, and both regulatory reforms and new policy tools have been introduced at national/ regional levels to address financial stability risks from shadow banking that have materialized to date.891 • FSB countries have begun implementing a forward-looking high-level policy framework to detect and assess sources of financial stability risks from shadow banking.892 • Consolidation rules for off-balance sheet entities were enhanced so that banks now must bring a large proportion of their off-balance sheet special purpose entity assets onto their balance sheets, where they are subject to prudential rules. Bank prudential rules have also been strengthened to better capture and capitalize banks’ exposures to shadow banking entities and activities. • Authorities have acted to reduce liquidity and maturity mismatches and also leverage in the shadow banking system. Regulatory reforms of MMFs are addressing the liquidity mismatches and improving their ability to respond to run risks. • Market infrastructure reforms in OTC derivatives and tri-party repo markets also help reduce the risks associated with these transactions. In some jurisdictions, enhanced prudential standards and consolidated supervision for certain large nonbank financial institutions that could pose a threat to financial stability reduced their leverage and maturity mismatches.

 Dated 3 July 2017, and accompanying video can be sourced via fsb.org and youtube.com  FSB, (2016), Assessment of Shadow Banking Activities, Risks and the Adequacy of Post-Crisis Policy Tools to Address Financial Stability Concerns, July 3. 891  A question that keeps reemerging is as to how domestic regulation causes cross-border spillovers; see in detail: R.  Hills et  al., (2016), Cross-Border Regulatory Spillovers: How Much? How Important? What Sectors? Lessons from the United Kingdom, Bank of England Staff Working Paper Nr. 595, April. They observe little cross-border effects in the UK but document the literature concluding otherwise. 892  Along the lines of the already discussed five economic functions in which entities engage that might give rise to shadow banking risks including liquidity and maturity transformation, leverage and imperfect credit risk transfer; see in detail: FSB, (2017), Assessment of Shadow Banking Activities, Risks and the Adequacy Of Post-Crisis Policy Tools to Address Financial Stability Concerns, July 3, pp. 21–25. 889 890

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• National and regional reforms have been undertaken to address incentive problems and opaqueness associated with securitization. • The transparency and standardization of securitization products has been enhanced to reduce the opaqueness and complexity associated with such products and to enable market discipline to function properly. Retention requirements were introduced in the largest securitization markets (i.e. the US and EU) to align the incentives among ­originator (or issuer) of a securitization and its investors. • While some of the more vulnerable aspects of shadow banking have shrunk from precrisis levels, others have grown or remained relatively large. The continued existence of interconnectedness and potential for financial stability risks warrants continued attention by authorities. The latter sentence is more relevant than you might think. These features should not only warrant continued attention because of their embedded but also and primarily because we don’t understand them properly. It is therefore quite cynical to read that ‘[a]t present, the FSB has not identified other new financial stability risks from shadow banking that would warrant additional regulatory action at global level’.893 I would suggest to have a simple look at the ‘Debt security Statistics’ and/or the semi-annual ‘Semiannual OTC derivatives statistics’ of the BIS894 to understand some of the basic concerns. What is the value of haircuts, repo constraints, rehypothecation constraints, slightly higher capital and liquidity ratios, and somewhat lower leverage ratios in case the total amount of outstanding debt and derivative positions vastly exceeds the real economy.895 Regardless of the legal shield put up, future dislocations will be material and potentially devastating. I then wonder how the conclusion of the FSB should be read when indicating ‘[h]owever, new variations of shadow banking activities are likely to develop in the future’.896 One of these concerns might be the ‘step-in risk’, that is, the risk of banks stepping in to provide financial support to nonbank financial entities beyond, or in the absence of, its contractual obligations should the entities experience financial stress.897 The nature of financial risk898 is evolving continuously and is codependent on external factors such as policy normalization, trade patterns, cryptocurrencies, technological

 FSB, (2016), Assessment of Shadow Banking Activities, Risks and the Adequacy of Post-Crisis Policy Tools to Address Financial Stability Concerns, July 3, p. 4. 894  Via www.bis.org 895  See also: G.  Hoggarth et  al., (2016), Capital Inflows  – the Good, the Bad and the Bubbly, Financial Stability paper Nr. 40. 896  See for some ideas: F.  Restoy, (2018), The Post-Crisis Regulatory Agenda: What is Missing?, Speech, February 19. 897  Regarding this matter, the BIS released two consultative documents, ‘Identification and management of step-in risk’ in December 2015 and March 2017. 898  And of shadow banking in general with a deep intertwining with traditional banking as continued central principle. See: A. Musatov and M. Perez, (2016), Shadow Banking Re-Emerges, Posing Challenges to Banks and Regulators, Dallas Fed Economic Letter, Vol. 11, Nr. 10, July, pp. 1–4. Traditional banks are between a rock and a hard place: by providing liquidity to depositors and 893

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e­ volution and so on.899 A macroprudential view regarding market-based finance might reveal some interesting conclusions, some good and some bad.900 Market-based finance has become a bigger part of the global system, and it has become diversified, often away from the riskier parts of the former shadow banking model. Cunliffe lists the common arguments as to why bank financing is more destabilizing than market-based finance when under stress901 and concludes that market-based finance is expected to be a materially less disruptive way of passing very substantial losses back to end investors (risk sharing) than bank lending, although he also observes material risk in market-based finance.902 He offers the insight that liquidity risk is dominant in shadow banking and amplified by a number of factors and indicates that ‘[i]t is of course difficult to gauge the probability of a stress event leading to a self-reinforcing downward spiral of redemptions and forced asset sales’. Simulation models have been developed that give an indication of the point at which liquidity would break down and such effects could set off.903 But simulations are what they are and they ignore the understanding of what we don’t know (the unknown unknowns).904 In the context of identifying gaps and recognizing residual risk before they become a real threat to the financial system, the frameworks developed or the methodologies provided by academia and supervisory bodies don’t go a long way in providing comfort that a clear and comprehensive understanding is developed of what could be a threat and what could become a destabilizing factor. In fact, if we judge the two areas post-crisis that constitute a common ground where potential risks have been identified and about which

credit line borrowers, banks are exposed to double runs on assets and liabilities, that is, these simultaneous activities expose banks to the risk of correlated double runs on their assets (credit lines) and on their liabilities (wholesale uninsured deposits). See in detail: F. Ippolito et al., (2016), Double Bank Runs and Liquidity Risk Management, ESRB Working Paper Series Nr. 8, April, p. 27. 899  See in detail: A. Carstens, (2017), The Nature of Evolving Risks to Financial Stability, Speech, December 15. 900  See Sir J. Cunliffe, (2017), Market-Based Finance: A Macroprudential View, Speech February 9. See in detail the extensive and thematic number of the Financial Stability Review of Banque de France, The Impact of Financial Reforms, April 2017 edition. 901  J. Cunliffe, (2017), ibid., pp. 4–5. In line with earlier statements, see J. Cunliffe, (2015), Market Liquidity and Market-Based Financing, Speech, October 22. 902  J. Cunliffe, (2017), ibid., pp. 7–10. See also: J. Bats and A. Houben, (2017), Bank-Based Versus Market-Based Financing: Implications for Systemic Risk, DNB Working Paper Series nr. 577, December; S. Langfield, and M. Pagano, (2016), Bank Bias in Europe: Effects on Systemic Risk and Growth, Economic Policy Issue 31, pp. 51–106. 903  See in detail J.  Baranova et  al., (2017), Simulating Stress Across the Financial System: The Resilience of Corporate Bond Markets and the Role of Investment Funds’ Bank of England Financial Stability Paper Nr. 42. All stress-testing models are subject to continuous evaluation. See, for example, the reevaluation of the BCBS of the stress-testing models for banks: BCBS, (2017), Stress testing principles—consultative document, December which will lead to the replacement of the May 2009 principles; BCBS, (2009), Principles for Sound Stress Testing Practices and Supervision, May. For an elaboration on the wide range of stress-testing practices: BCBS, (2017), Supervisory and Bank Stress Testing: Range of Practices, December. 904  See also: CGFS, (2016), Fixed Income Market Liquidity, CGFS Papers Nr. 55, January. Drivers of market liquidity in the fixed-income sphere include technology, competition, leverage, r­ egulation and monetary policy (pp. 15–21).

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there is consensus, it is ‘investment funds’ and ‘asset management activities’. About the former, the FSB and other annualized reports indicate that this is a wide set of funds with a variety of strategies and that certain strategies pose more risk than others (fixed income, funds with maturity transformation, liquidity risk or those that involved in imperfect shifting of credit risk). The latter has been subject to extensive analysis and is analyzed in depth in the appropriate chapter. But there also you see a certain pattern emerging. As an example, we can take the asset management sector where a number of sensitivities have been identified that could pose financial stability risks. Those vulnerabilities can be summarized as being: (1) liquidity mismatch between fund investments and redemption terms and conditions for open-ended fund units; (2) leverage within investment funds; (3) operational risk and challenges at asset managers in stressed conditions; and (4) securities lending activities of asset managers and funds.905 Most of the 14 recommendations focused on addressing liquidity mismatch in open-ended funds. It can only be but observed that the analysis of future risks is done through the consolidated experiences of the previous financial crisis. It is highly unlikely that any future dislocation in the market will emerge because of any of these issues, even without the incoming regulation of the last decade. But especially now that we have that regulation in place the market will reshape itself along those lines and therefore will produce destabilizing catalysts that we are currently unfamiliar with. I guess that is the battle that can’t be won. Either you define an economic market as something about which there is social consensus based on clear benefits for society at large or you are left to regulate a ‘free market’ that can operate independently and autonomously from the ‘demos’ that created that free market (or allowed it to emerge to begin with). There is no room in this context for an extensive philosophical debate about this, but the dynamics of the story remind me of the work of Polanyi and in particular about how the economic dimension of society that gets disconnected from the underlying and constituting demos. This dynamic stays even in a globalizing world. According to Polanyi, it will trigger what he calls a ‘great transformation’ in case not properly managed.906 Ultimately, markets are constructs of groups, societies and humankind in general. They are not the result of the ius naturale, but are created and shaped based on dominant interests within a social construct. They tend to grow up till the point that the dominant force in society will undermine its own market construct due to excessive dynamics, abuse of market forces and, ultimately, mismanagement of public interest.907 The recommendations to also deal with vulnerabilities are constructed in a way that leave the impression that more data and more reporting will help not only to mitigate the impact but also to neutralize ex ante certain vulnerabilities. Most of the recommendations in, for example, the asset management sphere are built around improving reporting

 See in detail FSB, (2017), Policy Recommendations to Address Structural Vulnerabilities from Asset Management Activities, January 12. 906  See K. Polanyi, (2001), The Great Transformation, Beacon Press, Boston, MA [1944]. 907  See for an excellent and historical write-up on this topic: B. van Bavel, (2016), The Invisible Hand. How Market Economies Have Emerged and Declined Since AD 500, Oxford University Press, Oxford. 905

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and disclosures; addressing gaps in liquidity management throughout the life cycle of funds, including in the design phase and on an ongoing basis; improving the adequacy of open-ended funds’ liquidity risk management tools to deal with exceptional circumstances; and addressing additional market liquidity considerations.908 Also the overall recommendations to address residual risk and to address them through policy responses tend to leave the impression that this is a job with clearly defined boundaries and dynamics one can look for through the use of systematic processes so to bring them within the regulatory perimeter in a timely manner.909 It leads to tables and structures that help us develop a level of comfort that might not be justified.910 They are technically correct, increasingly comprehensive and reflective of the experiences during the last decade. They can be justified by arguments that involve agency friction (misaligned incentive problems) and Informational asymmetries, sponsor backstop and contingent liabilities as well as regulatory arbitrage.911 For now, we predominantly hide behind statements that sound like ‘it is too early to draw firm conclusions on the steady state impact, given that implementation of post crisis reforms is still under way. However, assessments of banks’ resilience through stress tests indicate that we have already seen substantial improvements.’912 More than ten years after the start of the financial crisis, we argue that we have done a good job creating legislation to address the issues as they emerged in the previous crisis, that we can’t say anything

 FSB, (2017), FSB, (2017), Assessment of Shadow Banking Activities, Risks and the Adequacy Of Post-Crisis Policy Tools to Address Financial Stability Concerns, July 3, p. 27. 909  FSB, (2017), Assessment of Shadow Banking Activities, Risks and the Adequacy Of Post-Crisis Policy Tools to Address Financial Stability Concerns, July 3, pp. 28–32. 910  See, for example, a stylized view of the structural characteristics of credit-based intermediation around which regulation and policy is built: T. Adrian, (2017), Shadow Banking and Market-based Finance, Speech, September 14, Table 1 via imf.org 911  See in detail: J.W. Jurek and E. Stafford, (2015), The Cost of Capital for Alternative Investments, The Journal of Finance, Vol. 70, Issue 5, pp. 2185–2226; A. Muley, (2016), Collateral Re-Use in Shadow Banking and Monetary Policy, MIT Working Paper, January 7, mimeo. 912  D. Nouy, (2017), Safer Than Ever Before? An Assessment of the Impact of Regulation on Banks’ Resilience Eight Years on, in Financial Stability Review, Banque de France, The Impact of Financial Reforms, April, pp. 23–32; also relevant in this context and to be found in the same thematic number of the Financial Stability Review: D.J. Elliott and E. Balta, (2017), Measuring the Impact of Basel III, pp. 33–44; A. Weber, (2017), The Impact of Financial Regulation: A G-SIB Perspective, pp. 45–54; and K. Chousakos and G. Gorton, (2017), Bank Health Post-Crisis, pp. 55–70; S. Krug and H.-W. Wohltmann, (2016), Shadow Banking, Financial Regulation an Animal Spirits – An ACE Approach, Economics Working Paper, Christian-Albrechts-Universität Kiel, Department of Economics, Nr. 2016–08, June. Krug and Wohltmann’s prime finding is not so much the analysis that banks cope with incoming regulation but that ‘an unilateral inclusion of shadow banks into the regulatory framework, i.e. without access to central bank liquidity, has negative effects on monetary policy goals, significantly increases the volatility in growth rates and that its disrupting character materializes in increasing default rates and a higher volatility in the credit-to-GDP gap. However, experiments with a full inclusion, i.e. with access to a lender of last resort, lead to superior outcomes relative to the benchmark without shadow banking activity.’ See also: M.  Montagna, (2016), Systemic Risk in Modern Financial Systems, PhD thesis, Kiel University, Kiel, mimeo. 908

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about how solid this effort is as implementation is ongoing but that according to the stress tests developed by the same institutions that hold the regulatory pen in this matter, all looks fine and good. Adrian913 describes the post-crisis evolution of shadow banking as a move toward more market-based finance. Two dynamics support that view: (1) a material swing away from riskier aspects of shadow banking toward market-based finance, that is, a reduction in the types of shadow banking activities that amplified the effects of the global financial crisis (more simplicity and transparency). This is mostly a matter of advanced economies; and (2) in emerging markets we observe a deepening of nonbank financing, particularly through OFIs. This is partly reflected in post-crisis regulation, policy and supervision and partly due to that same regulation, policy and supervision.914 And yes, there are certain things still ongoing, as Adrian points out in areas such as ‘[h]armonizing retention rules, reforming certain rating agency practices, and winding back implicit official backstops’. He refers to the shadow banking market in China and the reemergence of structured leverage finance in the US as emerging areas of concern. Very prudently, Adrian hints at hidden spots in the financial universe that could cause trouble going forward when indicating that ‘[t]here are still lingering question marks as to whether some of the earlier discussed economic motivations for shadow banking activities have been fully addressed, and whether risk has simply shifted towards corners of the financial system where we have less visibility and fewer instruments to deploy. This should give us reason for pause if we accept that systemic risk stems, at least in part, from market failures such as moral hazard, information frictions, agency problems, and coordination failures that afflict large institutions.’915 Be it as it may, a serious amount of literature tends to run in circles or limit to reiterating existing viewpoints we know are ‘by definition’ incomplete. The bureaucratic nature of the process triggers researchers and policy analysts to stay in the hamster wheel when producing output on the matter and are less inclined to observe the universe that was untested yet.916 Financial stability is a constituting element of a stable free market and

 T.  Adrian, (2017), Shadow Banking and Market-based Finance, Speech, September 14, via imf.org 914  T. Adrian, (2017), ibid., chapter ‘Strengthening Supervision and Regulation – How Far Have We Come?’ 915  T. Adrian, (2017), ibid.; also T. Adrian, (2015), Financial Stability Policies for Shadow Banking, in S. Claessens, D. Evanoff, G. Kaufman and L. Laeven (Eds.), Shadow Banking Within and Across National Borders, World Scientific Studies in International Economics, Issue 40; D. King, et al., (2017), Central Bank Emergency Support to Securities Markets, IMF Working Paper Series, WP/17/152; K. Pan, and Y. Zeng, (2017), ETF Arbitrage under Liquidity Mismatch, Working Paper, Harvard University, mimeo. 916  Robbert Dijkgraaf, Physics professor and director of the Institute for Advanced Study in Princeton, made meaningful comments in this respect. I believe he got it right when indicating that the best science is produced not along the lines of what has been done before, although that is tempting within a context ‘peer review pressure’, but that it often is the consequence of eloquently and diligently searching in the dark without structure, processes and frameworks. In his native language, which sounds like ‘doelgericht tasten in het duister’, of which a proper translation could 913

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that requires consolidation on approaches and assessment but predominantly ­reenforcement, reevaluation and the ability to look beyond the regulatory or data set horizon.917 Reenforcing data and research that display partial realities leave room for policy makers and regulators to engage in ‘governing through financial markets’. Braun et al. produced a very fine analysis regarding the European CMU. They conclude that the CMU is not an end in itself and that governing through financial markets is a political strategy adopted by state actors in pursuit of policy goals that exceed their institutional capacity.918 It is therefore not without risk that research into shadow banking and its artificial successor is structured along the lines of what we know, what we think we know and are overly focused on gathering data to fill processes and the system constructed based on that understanding. What we do know is that traditional banking is built on four pillars: SME lending, access to public liquidity,919 deposit insurance and prudential supervision.920 Shadow banks are positioned asymmetrically in that quadrilogy. There are basic complementarities between regulation and the other components of the quadrilogy. For example, regulation is there to reduce the cost of the put option that shadow banks have as they rely on the liquidity backstop by the central bank. Supervision is in place to reduce the cost of that backstop. And so is the use of CCPs. Fahri and Tirole showed ‘how imperfect regulatory information may lead to gaming of hedging among financial intermediaries, resulting in banks being only partially covered as they hoard “bogus liquidity” and in public liquidity being syphoned off to the shadow sector’.921

be ‘purposeful sensing in the dark’: R. Dijkgraaf, (2017), Doelgericht tasten in het donker, NRC, via nrc.nl, February 10. What he aims at is that major leap forward is often not the consequence of systematically building on what exists, but steering into unchartered territory with a mission while not forgetting what you already know. The abovementioned peer review dynamics of this day and age contribute in a way to safeguarding quality but also create a situation where certain quality work doesn’t get the attention it deserves (or the funding to even engage in that research). I made the statement before that many ‘renaissance works’ (that we consider tectonically shifting our understanding on a certain matter) would have not seen the light if the authors would have lived and worked at present time. 917  See F. Villeroy de Galhau, (2017), Towards Financial Stability: A Common Good That Needs to Be Consolidated and Reinforced, in Financial Stability Review, Banque de France, The Impact of Financial Reforms, April, pp. 7–12, who tends to move in that direction; also in the same thematic number: A.  Persaud, (2017), Have Post-Crisis Financial Reforms Crimped Market Liquidity?, pp.  141–148, and S.  Maijoor and C.  Boidard, (2017), A Stability Perspective of Market-Based Finance: Designing New Prudential Tools?, pp. 149–156. 918  B.  Braun et  al., (2018), Governing Through Financial Markets: Towards a Critical Political Economy of Capital Market Union, Competition & Change, Vol 22, Issue 2, pp. 1–16. 919  See about the relationship between regulation and market liquidity: A. Persaud, (2017), Have Post-Crisis Financial Reforms Crimped Market Liquidity, Banque de France, Financial Stability Review Nr. 21, April, The Impact of Financial Reforms, pp. 141–147. 920  E. Farhi and J. Tirole, (2017), Shadow Banking and the Four Pillars of Traditional Financial Intermediation, Working Paper, December 21, mimeo. 921  E.  Farhi and J.  Tirole, (2017), ibid., p.  39. See also: J.  Beguenau and T.  Landvoigt, (2017), Financial Regulation in a Quantitative Model of the Modern Banking System, Stanford Working

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And then there is the continuous concern that the low interest rate environment can persist, although maybe not at bottom rates. Some see it as a continuous threat as it destabilizes or inflates asset pricing, disconnects investors from real risk analysis and fosters excessive valuations. Others see the low interest rate environment as an opportunity to accelerate the transition toward a more market-based financial structure, thereby enhancing the resilience of the economy to shocks.922

7.21.2  T  he Road to Be Traveled: Between Shadow Banking and Free Market-Based Finance Shadow banking is out, and market-based finance is the new kid on the block. But this isn’t without implications. Bats and Houben923 assess merits of bank-­based versus marketbased financing by exploring the relationship between financial structure and systemic risk. The results show that bank-based financing generates systemic risk, while marketbased debt and especially market-based stock financing reduce systemic risk. The findings indicate that countries can increase their resilience to systemic risk by reducing the share of bank-based financing and increasing the share of market-based financing. They explain: ‘[f ]inancial structure matters. In contrast to markets, banks contribute to systemic risk due their more leveraged nature, larger asset-­liability mismatches and greater interconnectedness. The systemicness of banks is clearly evident…. [H]owever, banks are found not to generate systemic risk when bank-based financing is limited. Moreover, in relatively market-based financial structures, the influence of banks on systemic risk is low. Diversity within the financial sector is thus important. Markets can provide “spare tire” insurance against problems within the banking sector turning into economy-wide distress’; ‘market-based financial structures outperform bank-based financial structures. The contribution of bank-based financial structures to systemic risk explains this economic underperformance in times of financial instability. While market-based financing generally helps reduce systemic risk, market-based equity financing contributes most to financial sector resilience.’924 They conclude that given their findings the financial structure of the US is close to optimal in terms of systemic risk. Other countries can increase their resilience to systemic risk by reducing the share of bank-based financing and increasing

Paper, mimeo; T. Berg and J. Gider (2016), What Explains the Difference in Leverage Between Banks and Non-Banks? Journal of Financial and Quantitative Analysis, Vol. 52, Issue 6, pp. 2677–2702; P. Feve and O. Pierrard, (2017), Financial Regulation and Shadow Banking: A Small-Scale DSGE Perspective, TSE Working Paper Nr. 17-829, July; O. Shy and R. Stenbacka, (2017), Ring-Fencing, Lending Competition, and Taxpayer Exposure?, Working Paper, mimeo. 922  ESRB, (2016), Macroprudential Policy Issues Arising from Low Interest Rates and Structural Changes in the EU Financial System, November, pp. 23–26. Also see: G. Beck et al., (2016), Euro Area Shadow Banking Activities in a Low-Interest Rate Environment: A Flow-of-Funds Perspective, SAFE White Paper Series Nr. 37, February. 923  J. Bats and A. Houben, (2017), Bank-Based Versus Market-Based Financing: Implications for Systemic Risk, DNB Working Paper Nr. 577, December. 924  J. Bats and A. Houben, (2017), ibid., p. 18.

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that of market-based debt and especially market-based stock financing.925 They therefore advocate the completion of the European CMU, which would lead to more market-based financing.

7.22 Are Things Really as They Seem They Are? Throughout the book, I have lamented often enough that although many initiatives taken from a regulatory point of view have made the financial sector a safer place compared to the pre-crisis period, I’m left anno 2019 with a deeply unsatisfying understanding that when the next crisis comes along, all these efforts will show to be of only marginal effect. A lot of this has to do with a myriad of reasons ranging from the persistently high levels of leverage on bank balance sheets (and still by any industry standard low levels of common equity), the unknown effects of all sorts of new regulation acting together, the unknown (cross-border) spillover effects of regulation and macroprudential policies, the undefined balancing act of ex ante and ex post regulation working in harmony, the complexity of some of the regulation enacted often caused by heavy lobbying (and whether it will still do what it is supposed to do when it really matters), and the fact that the sheer complexity of interbank networks and concepts as contagion and systemic risk are only mildly understood from an academic and practical point of view. Also the role that taxation should play is still largely up for debate ten years out from the crisis, where options range from quantity regulation to Pigovian models. It took my position and it is for you to review. And then there is time passing by, causing the shadow banking market to evolve as well,926 and the traditional intermediation function that is exercised more and more outside a banking framework and the fact that regulation itself co-shapes the nature and functioning of markets, and thus also the shadow banking market. All that makes me nervous.927 Nervous because the huge volumes of regulation and policies have a numbing

 J. Bats and A. Houben, (2017), ibid., p. 19.  Chiu discusses the limitations that the functional approach has when measuring and defining the shadow banking market. She also proposes to overcome those limitations by ‘deliberate channelling of the functional approach into a rational communicative framework that is inclusive, so that financial innovation and its merits can be fully debated upon, to feed into regulatory policy-making’. She communicated about the Habermasian-based idea at an earlier stage: M. Andenas and I. H-Y Chiu, (2014), The Foundations and Future of Financial Regulation, Routledge, Oxford, chapter three. And then later in I. H.-Y. Chiu, (2018), Taking a Functional Approach to Understanding Shadow Banking: A Critical Look at Regulatory Policy, in Research Handbook on Shadow Banking. Legal and Regulatory Aspects, I.H.-Y.  Chiu and Iain MacNeil (eds.), Edward Elgar, Cheltenham, pp. 47–84. The communication framework is intended to achieve optimal fact-finding in order to develop a body of knowledge through which evolving practices are identified and assessed. Such body of knowledge should be, as she indicates, fostered independent of power domination, interest preferences and arguments rooted in national legal structures. 927  Others as well apparently. See, for example, on the impact of blockchain and the underlying technology known as ‘distributed ledger technology’ (DLT): A.P.  Donovan, (2018), (Shadow) 925 926

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effect on each one of us. It still breathes the confidence that next time we’re prepared. It echoes the confidence that got us in trouble to begin with. It is my understanding, and that of many others, that when a model is market based, it will show with vigilance serious instability from time to time.928 Regulation should then either be put in place to prevent those instabilities to occur and/or ensure that the post-event calamities are reduced as much as possible, including allocating the financial cost to the party which activities or externalities caused the calamity. Other factors that reduce attention in this matter are the large quantity of self-declared experts, policy makers and politicians that keep telling us that we’re doing just fine,929 maybe not perfect and that the FI sector is in a much better shape than pre-crisis. The question is if that is good enough. Too often I have seen incoming regulation being the result of a political compromise or the result of heavy lobbying. A regulator whose object is to ensure a well-functioning free market should be found more often than not, to simply prohibit certain activities for the sake of a higher objective. Smoothing the problem by throwing excessively lengthy and complicated regulation at the problem is then unconvincing and very likely disappointing in the long run. But regulators, supervisors and politicians believe that if you keep reenforcing a storyline, then it ultimately will sink in and become the standard. Let’s take a simple example. Hasn’t the standard story become that the financial crisis was US made and caused by an unholy combination of deregulation, lax loan origination, badly understood securitized products, ill-constructed third-party ratings, unfocused institutional cash pools looking for returns and a huge amount of moral hazard and agency conflicts spread throughout the FI sector.930 The rest of the world saw itself as a victim of

Banking on the Blockchain: Permissioned Ledgers, Interoperability and Common Standards, in Research Handbook on Shadow Banking. Legal and Regulatory Aspects, I.H.-Y.  Chiu and Iain MacNeil (eds.), Edward Elgar, Cheltenham, pp. 314–336; on the role of ETFs, see: P.F. Hanrahan, (2018), Exchange Traded Funds in the Shadow Banking System, in Research Handbook on Shadow Banking. Legal and Regulatory Aspects, I.H.-Y.  Chiu and Iain MacNeil (eds.), Edward Elgar, Cheltenham, pp. 363–398; crowdfunding, marketplace lending and peer-to-peer lending all having their own characteristics but all cutting out the financial intermediary: E.F. Greene et al., (2018), Blockchain, Marketplace Lending and Crowdfunding: Emerging Issues and Opportunities in Fintech, in Research Handbook on Shadow Banking. Legal and Regulatory Aspects, I.H.-Y. Chiu and Iain MacNeil (eds.), Edward Elgar, Cheltenham, pp. 253–296. 928  Market participants don’t behave rational, and mirror that of other market agents. This is also (or definitely) true for institutional cash pools like pension funds. See for an analysis of that industry and the herding behaviors observed D.  Broeders et  al., (2016), Pension Funds’ Herding, DNB Working Paper Nr. 503, February. They distinguish between weak, semi-strong and strong herding behavior. Weak herding occurs if pension funds have similar rebalancing strategies. The motive for weak herding is based on the fact that pension funds have the same market information and will react similar to that as they want stay close to their strategic asset allocation over time. Semi-strong herding arises when pension funds react similarly to other external shocks, such as changes in regulation and exceptional monetary policy operations. Finally, strong herding means that pension funds intentionally replicate changes in the strategic asset allocation of other pension funds. Without an economic reason, that is, it is driven by reputation. They find evidence that Dutch pension funds engage in three types of herding behavior. 929  The saying ‘an empty barrel makes the most noise’ apparently applies here as well. 930  It also creates new types of risks. Leveraged and other high-yield loans are typically syndicated and therefore arranged by banks but distributed to institutional investors. When institutional cash

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the Wall Street ghetto mentality. So when George Bush Jr., incumbent president of the US at that point in time, said, ‘we messed up’, the rest of the world, including the European political elite were drowning in condescending self-­pity, breathing scornful and disdainful echoes to their US counterparts. But is this what really happened? You noticed that much of the literature reviewed does take that implicit stand. The US self-awareness caused them to act much more intrusively and decisively, leading to a fairly stable banking market in the US. Europe however, is still struggling with its banking sector and even their banking masterpieces show signs of material and intrinsic weaknesses. The capital positions of many banks are still weak and the painful effects of having to operate many heterogeneous economies within the context of a single currency area were largely ignored (until they could no more starting 2012). It can even be argued that the sovereign debt crisis was in effect a European banking crisis.931 It could have saved Europe from a deep recession. Bayoumi932 takes that thought a couple of notches up. Wrong diagnoses can have cruel consequences. He claims that the crisis wasn’t caused in the US but in Europe where unstable undercapitalized megabanks had been blowing housing bubbles across a number of European countries as well as the US using the export surpluses of large European multinationals to do so. Or to put it differently: Europe provided a large proportion of the financing that created the European housing bubble. The proof of that he finds in the fact that the volume of US assets on the balance sheets of European banks in the period 2002–2007 was in line with the volume of US subprime mortgage volumes during that same period. Of course, it was the US regulatory framework that made possible what ultimately happened but the European banks provided the fuel to get it going. The benefits for these European banks were clear: using their internal risk models they could reduce their capital buffers (because subprime was rated AAA) and earn higher returns on what was listed on their balance sheet as risk-free. These European capital flows toward the US in that period were as large as the Chinese export surpluses in that period and who have traditionally been blamed for what happened. But this Chinese capital ended up in

pools cannot be tempted to buy into the new instrument as much as anticipated, banks will have to hold a larger share of the syndicated loan thereby exposing themselves to ‘pipeline risk’. This creates a debt overhang which reduces, once exposure materializes, its subsequent arranging and lending activity. See M. Bruche et al., (2017), Pipeline Risk in Leveraged Loan Syndication, Finance and Economics Discussion Series Nr. 48, Washington: Board of Governors of the Federal Reserve System, April. 931  The European repo market performs as an amplification channel for sovereign debt crises. Amakolla et al. document that ‘following increases in sovereign risk, haircuts set by major CCPs on peripheral sovereign bonds increased significantly. The procyclicality of haircuts and the concentration of bilateral repos raise concerns about the CCP-intermediated repo market as a source of systemic risk in the Eurozone.’ See: A.  Armakolla et  al., (2017), Repurchase Agreements and the European Sovereign Debt Crises: The Role of European Clearinghouses, Working Paper, October 6, mimeo. Also see: C. Boissel et al., (2017), Sytemic Risk in Clearing Houses: Evidence from the European Repo Market, Journal of Financial Economics, Vol. 125, Issue 3, pp. 511–536. 932  T. Bayoumi, (2017), Unfinished Business: The Unexplored Causes of the Financial Crisis and the Lessons Yet to Be Learned, Yale University Press, New Haven, CT.

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US Treasuries and not in securitized subprime paper. Those securitized products ended up on European bank balance sheets. Basel II, which was officially applicable starting 2008, was largely implemented already in the run to the crisis, as these rules were finalized in 2004. It allowed banks to use internally developed risk models to determine the size of the capital buffers that were needed given the types of products the banks invested in. Self-regulation wad clearly not the way. Their capital buffer was often lower than 2% of their balance sheet. This is now under the new regulation at 3%,933 but still means that if bank’s asset base drops 20% or so in value, the bank is still insolvent.934 A drop of 20% across all asset classes might not be occurring that often, but often enough to leave a price tag that is truly unaffordable. I get it: with such a low level of equity you can get doubledigit return on equities (ROEs) for sure. But an insolvent bank that needs to rely on the lender of last resort is an indigestible liability for the society it relates to. Inadequate and fragmented oversight has also been blamed for what happened. And although there is now a European-wide monitoring and resolution system in place, the system works based on the national oversight systems as they existed during the crisis. In the US, the supervisor had its act together and used the banking system to clean up insolvent banks like Bear Stern and Merrill Lynch. In Europe, we saw none of that and in most countries the sovereign had to provide state support to the ailing banking system. And yes, the US decision to accept a wider set of collateral for interbank lending to include securitized products didn’t help. It expanded the balance sheet of banks for years on end to grow far beyond deposits provided by citizens and companies. Liquidity makes or breaks the housing market and so, with much liquidity and relaxed collateral rules, the amount of mortgages grew to the extent that good loans pushed bad loans off balance sheet and overall balance sheets grew beyond the size of the economies the banks served by a multiple often beyond 2 or 3. The securitization market grew simply because national savings rates were insufficient to serve the growing mortgage market. European banks bought tremendous amount of US-securitized products as said for higher returns and lower capital buffers but also to serve as collateral in the interbanking market (repos). European banks did not only buy US securitized products; they produced national securitized products as well and sold it to whoever was willing to buy. To that effect, one can conclude that securitization is mainly driven by (regulatory) arbitrage rather than diversification of risks across a wide spectrum of investors with varying levels of risk appetite. It is regulatory arbitrage for the very simple fact that the capital buffers (on aggregate) for securitized

 For Europe. In the US capital, buffers have always been higher and now easily reach 6%. See, for example, J. Cetina et al., (2017), Capital Buffers and the Future of Bank Stress Tests, OFR Brief Series Nr. 17-02, February 7. See also p. 2 on how the capital structure is or should be put together. Capital buffers and stress testing are intrinsically linked in such a way that the Federal Reserve proposed a ‘stress capital Buffer’. See, for example, Board of Governors of the Federal Reserve System, (2018), Proposed Rule Regarding the Stress Buffer Requirements, April 5 (via federalreserve.gov). 934  See on the relationship between bank equity and the cost of capital: S. Alnahedh and S. Bhagat, (2017), Impact of Bank Equity on Bank Cost of Capital, University of Colorado-Boulder Working Paper, mimeo. In contrast to what you might expect, they find that an increase in equity raises the private cost of capital for banks regardless of the size of the FI. More equity, however, has a positive impact on bank lending. 933

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products was structurally lower than for the aggregate pool of mortgages constituting the securitized product. Innovation should be embedded in the products and not measured by the returns it (tries to) generate(s). It was argued before that the EC is selling nonsense as it states that Europeansecuritized product has been upholding better during the crisis than their US counterparts and that it can be seen as a proxy of enhanced quality.935 The creditor protection model is more extended in Europe (full recourse vs. non-­recourse). In the US, you can walk away from your liability if the equity of your house is under water. In Europe, you will be, even under those circumstances be followed until and beyond the gates of hell by creditors and that is a legally facilitated way. So this was not a matter of better risk management of absence of adverse selection in putting securitized instruments together. The difference in impact made that clear. The implosion of the housing bubble had a massive impact on national consumption levels (as mortgages had to be paid regardless of the situation) and Europe nosedived into a long and avoidable recession. The cost of the crisis and the recession had to be picked up by the sovereign. The European political elite noticed that extensive national levels are an issue to be avoided in a single currency union. And so the welfare state was the issue creating large state deficits and sovereign debt levels (unless you want to share national budget risks). Citizens lived beyond their means and state support systems had to be gradually dismantled. If you want to put it sharply: the victim became the perpetrator and the European political scene failed to see the design errors in the eurozone framework as well as adequate supervision on their banks. Bayoumi concludes in his own way that the road to be traveled is not finished yet. Yes, good stuff has been happening. Basel III and Basel IV have seen the light, the shadow banking market has been reigned in to some degree, oversight has been enhanced and more intense, and internal risk models used by banks have been abandoned or severely limited. And yes, there has been overkill. The relaxation of the Dodd-Franck Act in 2018 was to a large extent fair and justified. The compliance costs for smaller banks (and there are many in the US) were disproportionate and often accounted for 10% of turnover. The partial rollback included the following measures936: • Banks that are considered SIFI were subject to more stringent regulation including an annual stress test by the Federal Reserve and the submission of living wills which are both seen as safety valves designed to plan for financial disaster. That was applicable to banks with more than USD 50 billion in assets. This new law sets the bar at USD 250 billion and will reduce the number of banks subject to more stringent regulation and supervision from 35 to 12. • Smaller banks are also exempted from the ‘Volcker Rule’. This rule seeks to discourage banks from reckless trading by barring depository institutions from investing in hedge

 See the discussion in the securitization chapter (Volume I).  See for some critique on the rollback: P. Jenkins, (2018), Trump’s Deregulators Risk Repeating past Mistakes, Financial Times, Instant Insight, May 31. Small banks can also be dangerous is the argument. 935 936

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funds and private equity funds, as well as from engaging in proprietary trading. The new bill exempts banks with less than USD 10 billion in assets from the rule. • The Volcker Rule seems to trigger massive compliance requirements. So separate from the rollback discussed, it was proposed to ‘enforce the prohibition “without undue burden” by replacing “overly complex and inefficient” compliance requirements with a “more streamlined set of requirements’.937 Three tiers would be created. Tier 1 includes the banks that on aggregate account for 95% of trading and will continue to be subject to the strictest rules. Tiers 2 and 3 will have a smaller trading book and therefore be subject to less comprehensive rules. Additionally, compliance procedures would use economic criteria rather than legalistic criteria to ensure that the compliance program of banks is ‘commensurate with the size, scope and complexity’ of their business. Bank would further have to develop risk guidelines to decide whether they engage in trading or in market making. In case of the latter, less strict monitoring is required. In Europe, the Basel III rules apply obviously as well, but capital rules are less strict in terms of what products capital buffers might include impacting the total loss-absorbing capacity. The practice of banks determining their own risk models is to a large degree continued and oversight on this matter leaves plenty of room for manipulation. Also in Europe, deregulation has resurfaced again. Although the STS regulation is there to streamline the market, the bottom-line idea is to reduce capital buffers for these securitized products. The whole idea that markets and market agents always act rational has been proven bogus, and the same works for the ‘efficiency of markets’ hypothesis. Macroprudential policy was an ex post activity and international capital flows can be largely ignored. All features have been looked at, but the approach of the regulator and supervisor has not fundamentally changed and these elements are still at the center of how we do things and allow them, by far and large, to play out the natural way. The monoculture in the economics discipline as well as the fact that technocratic policy has been largely put at length from any democratic process is a continued concern. Financial and macroeconomic policy is developed for a large part outside the institutional capacity of democratic institutions. You can’t get it wrong all the time, you can’t defend policies that no one else but the technocratic field understands and you surely cannot do that without society turning its back on you. For now, the adversity in society toward technocrats and experts has been met with disdain. I guess it will only be a matter of time before that also changes. Public

 Jerome Powell (Fed Chairman) quoted in C.W. Calomiris, (2018), Fix the Volcker Rule, but Look for Alternatives, Too, NY Times, June 4. Calomiris further highlights: ‘[t]he existing enforcement approach is simply too burdensome: It requires banks to show that each trade they undertake isn’t speculative but is initiated to serve as a hedge or to make a market in a particular security. There is no clear criterion to use when making that argument, so there is a significant risk of getting it wrong. To avoid that risk, banks avoid some market making. Aggravating that problem, the rule presumes that any security held for more than 60 days in the trading book is a proprietary trade. To avoid having to defend a 61-day holding, banks may liquidate securities held for market-making purposes. This is a particular problem for certain bonds, where transactions are infrequent.’ 937

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market and financial stability are too important to get ignored in a structural way. Admati hasn’t particularly been shunning the limelight when it comes to breaking the cycle of mantra’s developed by politicians, central banks and yes even academia as well as media when it comes to justifying business practices or explaining unholy relationships between the sovereign and the banking system. He puts it straight when she highlights that ‘[r]eassurances that regulators are doing their best to protect the public are false. The underlying problem is a powerful mix of distorted incentives, ignorance, confusion, and lack of accountability.’938 Willful blindness, she asserts, seems to play a role in flawed claims by the system’s enablers that obscure reality and muddle the policy debate. But what are the promises made in the context of shadow banking? What does the rise of shadow banking mean for monetary theory and practice? (How) should we change our traditional theories of money to capture the complex practices through which money is created in modern financial systems? What can we expect from private safe money creation backed by a tradable collateral system with the central bank939 as a necessary ultimate backstop? Does it mean that we need a new theory of money as private agents can create safe assets?940 The shadow banking system and the creation of credit money by the traditional banking sector are symbiotic processes, but the circuit operates in a perverse form in which household debt is stored on the balance sheets of shadow banks, allowing the banking system to break the historical connection between money creation and productive activity. Michell argues: ‘[t]he new forms of credit relationships mediated by the shadow banking system have characteristics of both banking and market-based finance but, from a circuitist perspective, these claims are not money because they cannot be used as final means of settlement’. ‘The accumulation of claims in the shadow banking sector logically relies on the prior creation of money claims by the “traditional” banking sector.’941 If a new theory of money is unavoidable, it will raise an avalanche of questions942 and a redefinition of the role

 A.R. Admati, (2017), It Takes a Village to Maintain a Dangerous Financial System, chapter 13 in Just Financial Markets: Finance in a Just Society, (ed. L. Hertog), Oxford University Press, Oxford, pp. 293–322. 939  K. Nyborg, (2017), Central Bank Collateral Framework, Journal of Banking & Finance, Vol. 76, pp. 198–214. 940  See for some insights into these affairs: D. Gabor and J. Vestergaard, (2016), Towards a Theory of Shadow Money, Working Paper, mimeo. The opening question there is ‘How much of what we know about money and central banking is still valid?’ See also: L. Wang et al., (2017), Money and Credit: Theory and Applications, IMF Working Paper Nr. 17/14, January. They develop a theory of money and credit as competing payment instruments. The central bank dislocates the collateral market with its unlimited purchasing program as we have witnessed in recent years. Haircut applied did not reflect all the embedded risk and a premium was paid for the fire purchases. See in detail: C. de Roure, (2016), Fire Buys of Central Bank Collateral Assets, Deutsche Bundesbank Working Paper Nr. 51, Frankfurt am Main. 941  J.  Michell, (2016), Do Shadow Banks Create Money, ‘Financialization’ and the Monetary Circuit, UWE Economics Working Paper Series, http://eprints.uwe.ac.uk/28552. Shadow banking is a warehouse of debt claims through which the monetary circuit is able to escape the confines of production (p. 33). 942  Recall the Swiss referendum regarding the return to a ‘Vollgeld’ (full reserve) banking model on 10 June 2018. 938

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of central banks943 and the nature of the authority they exercise over markets.944 And what are the consequences for the real economy,945 productivity and labor markets946 when credit cycles and credit boom and busts are defined outside the regulatory remit? How far are macroprudential tools (still) adequate?947 And what is the impact on international trade?948 To a lot of these questions we can’t formulate definitive answers yet. Now that we are a few years into the Basel III framework, although progress is made continuously and implementation is uneven in the world, the first assessments have been put in place. We will always have to keep in mind that quantifying the regulatory impact remains subject to caveats, the results suggest that Basel III can be expected to generate sizeable macroeconomic net benefits even after the implied changes to bank business models have been taken into account.949 The macroeconomic impact of bank capital and liquidity regulation as enacted operates within the following paradigm: banking regulations may reduce

 See for a nice compilation of thoughts: Ph. Hartmann et  al. (eds.), (2018), The Changing Fortunes of Central Banking, Cambridge University Press, Cambridge, March. And for an evaluation of their current conduct: M.D.  Negro et  al., (2017), The Great Escape? A Quantitative Evaluation of the Fed’s Liquidity Facilities. The American Economic Review, Vol. 107, Issue 3, pp.  824–857. Also see: M.  Crosignani et  al., (2017), The (Unintended?) Consequences of the Largest Liquidity Injection Ever, Finance and Economics Discussion Series Nr. 11. Washington: Board of Governors of the Federal Reserve System, January. They figured out that the European LTRO intervention and the provision of long-term liquidity incentivize purchases of high-yield short-term securities by banks, which could be pledged to obtain central bank liquidity. The effect is known as ‘collateral trade’. Also see: M.  Di Maggio et  al., (2016), How Quantitative Easing Works: Evidence on the Refinancing Channel, Working Paper, December, mimeo; I.  Drechsler et al., (2016), How Borrows from the Lender of Last Resort, The Journal of Finance, Vol. 71, Nr. 5, pp. 1933–1974; I. Chakraborty et al., (2017), Monetary Stimulus and Bank Lending, Working Paper, December 20, mimeo; L. Carpinelli and M. Croisignani, (2017), The Effect of Central Bank Liquidity Injections on Bank Credit Supply, Finance and Economics Discussion Series Nr. 38, Washington: Board of Governors of the Federal Reserve System, March. 944  For example, E.A. Posner, (2016), What Legal Authority Does the Fed Need During a Financial Crisis?, University of Chicago Law School, Coase-Sandor Working Paper Series in Law and Economics Nr. 741, January 22. 945  See regarding the disentanglement between society and economy: A. Ebner, (2015), The Regulation of Markets: Polanyian Perspectives in B.  Lange, F.  Haines and D.  Thomas (eds.), Regulatory Transformations: Rethinking Economy-Society Interactions, Hart Publishing, Oxford, pp. 31ff. 946  See, for example, C.  Borio et  al., (2015), Labour Reallocation and Productivity Dynamics: Financial causes, Real Consequences, BIS Working Paper Nr. 534, December. 947  K.  Sonoda and N.  Sudo, (2016), Is Macroprudential Policy Instrument Blunt, BIS Working Paper Nr. 536, January. 948  N. Patel, (2016), International Trade Finance and the Cost Channel of Monetary Policy in Open Economies, BIS Working Paper Nr. 539, January 22. He focuses on the role of trade finance and how it impacts spillover effects. 949  I. Fender and U. Lewrick, (2016), Adding It All Up: The Macroeconomic Impact of Basel III and Outstanding Reform Issues, BIS Working Paper Nr. 591, November. They use historical data for a large sample of major banks to generate a conservative approximation of the additional amount of capital that banks would need to raise to meet the new regulatory requirements, taking the potential impact of current efforts to enhance G-SIBs’ total loss-absorbing capacity into account. To provide a high-level proxy for the effect of changes in capital allocation and bank 943

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the aggregate supply of credit. On the other hand, they promote the allocation of credit to its best uses. Accordingly, in a regulated economy there is less but more productive lending. Boissay and Collard950 find that both liquidity and capital requirements are needed and must be set relatively high.951 They also mutually reinforce each other, except when liquid assets are scarce. What is clear from their and other analyses performed is that the multiple-matrix-model as used by Basel III was the right way to go. Regulating means having a very clear understanding of the target or preferred behavior, which by definition will be displayed somewhere in the future. This means that there is volatility around the probability that certain behaviors will occur. This estimation error surrounding the probability dimension is what we call risk. The financial industry uses a variety of models to measure risk (Value at Risk, expected shortfall, etc.). We know that the accuracy and reliability of these standard techniques is very sloppy or, more technically, ‘risk forecasts are extremely uncertain at low sample sizes’.952 It reduces the effective ability of regulation to change fundamentally business practices and incumbent behaviors. That has led some to believe that an overall alternative model is needed.953 Others got convinced that one size fits all doesn’t work and that country specificities and state dependencies are too decisive in banking crises to be captured by regulatory monoculture.954 This is true as well for the effectiveness and channels of macroprudential policies.955 But

b­ usiness models on the estimated net benefits of regulatory reform, they simulate the effect of banks converging toward the ‘critical’ average risk weights (or ‘density ratios’) implied by the combined risk-weighted and leverage ratio-based capital requirements. Also see: J. Caruana, (2016), Financial Regulation: Cementing the Gains of Post-Crisis Reforms, CI Meeting of Central Bank Governors of the Centre for Latin American Monetary Studies (CEMLA), Lisbon, May 10. For a broader evaluation, see K. Alexander and R. Dhumale (eds.), (2012), Research Handbook on International Financial Regulation, Edward Elgar Publishing, Cheltenham. 950  F. Boissay and F. Collard, (2016), Macro-Economics of Bank Capital and Liquidity Regulations, BIS Working Paper Nr. 596, December. 951  What is remarkable in the context of the literature discussion of liquidity regulation and buffers is that in the financial infrastructure of the twenty-first century there is absence of a discussion regarding who, when and how liquidity is provided. See in detail: B.  Biais et  al., (2016), Who Supplies Liquidity, How and When, BIS Working Paper Nr. 563, May. 952  For a very nice overview and conclusions, see: J. Danielsson and C. Zhou, (2016), Why Risk Is so Hard to Measure, DNB Working Paper Nr. 494, January. Their analysis comes in three parts: the choice of risk measures, the aggregation method when considering longer holding period and the number of observations needed for accurate risk forecast. 953  For example, Minsky’s theories on investment, financial stability, the growing weight of the financial sector, and the role of the state. See: G. Mastromatteo and L. Esposito, (2016), Minsky at Basel: A Global Cap to Build an Effective Postcrisis Banking Supervisory Framework, Levy Economics Institute Working Paper Nr. 875, September. See also regarding the causes of protracted periods of under-investments: G. Guttiérrez and T. Philippon, (2017), Investment-Less Growth: An Empirical Investigation, Working Paper, September, mimeo. 954  S. Ferrari and M. Pirovana, (2016), Does One Size Fit All at All Times? The Role of Country Specificities and State Dependencies in Predicting Banking Crises, NBB Working Paper Nr. 297, May. 955  T. Tressel and Y.S. Zang, (2016), Effectiveness and Channels of Macroprudential Instruments. Lessons from the Euro Area, IMF Working Paper Nr. 16/4, January. They find that instruments

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then again, correlation isn’t causality and so the risk of wrong conclusions is imminent. A good example is that of foreign bank lending after the financial crisis. Changes in banks’ business models and balance sheet adjustments, as well as the tightening of banking regulations, are potential drivers of this prolonged slowdown and were used as argument postcrisis. But an opposite effect related to regulation was identified (and which didn’t get the necessary attention at that time), with tighter regulations encouraging foreign lending through regulatory arbitrage.956 Romer argued: ‘[j]ust like regulation, economics and in particular macroeconomics has stagnation in their problem-solving capacity by getting stuck in their stylized models. Now either you find that a problem or one can ignore the output. In the post-real macroeconomic world, findings can easily be ignored.’957 In case the panels on macroeconomics start moving, they do as well when it comes to regulation. It was argued before that industries, and thus also the shadow banking industry, reshape after incoming regulation puts conditions and restrictions on their functioning. One of the questions that keep coming back is how the new banking regulations enacted post-financial crisis impact the shadow banking industry, and more precisely whether regulating the banking network increases systemic risk in the financial network that is global these days, knowing that there is an unregulated shadow bank present. The answer seems consistently to be positive.958 One can develop a cascade of questions to throw at the current way we have been dealing with post-crisis regulation and policy. One of the elements that stay remarkable is the fact that the regulator has been hammering out regulation for each of the domains that were seen as a critical contributor to the crisis. Beyond question if this is the way to deal

targeting the cost of bank capital are most effective in slowing down mortgage credit growth, and that the impact is transmitted mainly through price margins, the same banking channel as monetary policy. Limits on loan-to-value ratios are also effective, especially when monetary policy is excessively loose. 956  See: H. Ichiue and F. Lambert, (2016), Post-Crisis International Banking: An Analysis with New Regulatory Survey Data, IMF Working Paper Nr. 16/88, April. 957  Romer further quotes, ‘how many economists really believe that extremely tight monetary policy will have zero effect on real output?’ (p.  22) in P.  Romer, (2016), The Trouble with MacroEconomics, NUY Stern Business School Speech, delivered 5 January 2016 as the Commons Memorial Lecture of the Omicron Delta Epsilon Society. Reply by D. Orrell, (2016), Economic Depression: A Commentary on Paul Romer’s The Trouble with Macroeconomics, World Economics Association Newsletter, Vol. 6, Issue 5, October, pp. 10–11. Full transparency requires me to indicate that Romer’s paper is extremely controversial and opinions vary significantly, ranging from full endorsement to qualifications as ‘unconstructive criticism and arm-chair philosophizing’. See also: R. Reis, (2017), Is Something Really Wrong with Macroeconomics, LSE Working Paper, August, mimeo. He concludes that ‘[m]acroeconomic forecasts perform poorly in absolute terms and given the size of the challenge probably always will. But relative to the level of aggregation, the time horizon, and the amount of funding, macroeconomic forecasts are not so obviously worse than those in other fields.’ 958  R. Ging and F. Page, (2016), Shadow Banks and Systemic Risk, Working Paper, mimeo. Also concluding in a similar fashion: D.  Acemoglu, et  al., (2015), Systemic Risk and Stability in Financial Networks, American Economic Review, Vol. 105, Issue 2, pp. 564–608; D. Duffie, et al.,

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with the root cause of issues in the financial sector, it ignores by and large intertwinements that exist between all these domains. Money market funds, commercial paper markets and repo markets all interact and respond to each other. Long- and short-term relationships exist between those markets, and value of the financial assets held in each of those segments will react to changes in the other segments.959 The other element deals with information gaps. Information gaps can be defined as ‘pockets of information that are pertinent and knowable but not currently known’. Judge argues that information gaps are a by-product of shadow banking and a meaningful source of systemic risk. Like banks, shadow banks rely heavily on short-term debt claims designed to obviate the need for the holder to engage in any meaningful information gathering or analysis. She accounts for how the information-related incentives of equity and money claimants explain many core features of securities and banking regulation and, ultimately, explain the inherent fragility of institutions that rely on money claims. In contrast to the well-discussed information asymmetries between depositors and bank managers or coordination problems among depositors, she argues a third way to explain the nature of fragility that comes with the reliance on short-term debt. Her focus is on two under-highlighted features: (1) information gaps increase the probability of panic by increasing the range of signals that can cast doubt on whether short-term debt that market participants had been treating like ‘money’ remain sufficiently information-insensitive to merit such treatment; and (2) information gaps impede the market and regulatory responses that can dampen the effects of a shock once panic takes hold. Shadow banks, she argues, create information gaps leading to enhanced fragility.960 Financial stability and money creation go hand in hand. Money as

(2014), Systemic Risk Exposures: A 10-by-10-by-10 Approach, Systemic Risk and Macro Modeling, K. Brunnermeier, and A. Krishnamurthy (eds.), University of Chicago Press, Chicago; M. Elliot, et al., (2014), Financial Networks and Contagion, American Economic Review, Vol. 104, Issue 10, pp. 3115–3153. 959  M. H. Rizi et al., (2016), Exploring the Dynamic Relationship in the Shadow Banking System, Working paper, March 15, mimeo. 960  See in detail: K. Judge, (2017), Information Gaps and Shadow Banking, Virginia Law Review, Vol. 103, Nr. 3, May, pp. 411–482; also as Columbia Law and Economics Working Paper Nr. 529. We might add another element in the mix here, that is, regulatory arbitrage. Sponsor banks that issued ABCP conduits, during times that their capital was constrained, also act as administrators due to obtaining informational advantages related to regulatory arbitrage. Choi et  al. also test whether regulatory arbitrage affected bank performance and find that the sponsor banks’ various performances, not only return on equity (ROE) and return on assets (ROA) but also net interest margin, are significantly related to ABCP exposure and securitized collateral assets. See in detail: J. Choi et al., (2016), Captivation of Regulatory Arbitrage: Evidence from the Euro-Issued AssetBacked Commercial Paper, Working Paper, mimeo. Boyer and Kempf argue in the same direction, but from a different angle. Regulatory arbitrage is defined by the efficiency of different banks, an informational benefit they have over the regulators. They conclude that banks with different efficiency levels in risk management are subject to regulatory contracts that allow more efficient banks to have a riskier portfolio. They argue in favor of a liquidity requirement that regulates the riskiness of banks’ portfolio and a tax levied on profit to control the size of banks. But their main result I guess is that ‘the internationalization of banks annihilates the capacity of national public authorities in charge of banks’ regulation to use the proper set of regulatory instruments’. See in detail: P.C. Boyer and H. Kempf, (2016), Regulatory Arbitrage and the Efficiency of Banking Regulation, CESifo Working Paper Nr. 5878, April.

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such is a claim on a financial institution. This understanding defines the concept of ‘financial stability’ as well.961 Fundamental questions are structurally avoided, not only about the conduct of market players, or simply about forbidding activities that become uncontrollable in their effects given the market-based platform they are conducted on. Or even more fundamental: it might be so that the good old ‘entry restriction’ so well known in banking law is up for renewal. If financial instability is largely a problem of monetary system design, something we can all agree on, this question regarding banking law’s traditional entry restriction provisions cannot and should not be avoided. Morgan uses the shadow banking system as a starting point in answering this question. He first reconfirms that the shadow banking system constitutes a parallel system of money creation (cash equivalents), inasmuch as shadow banks’ short-term liabilities are, functionally speaking, quite similar to bank deposits. The recognition that shadow banks are engaged in money creation raises basic questions of institutional design, he argues. No institution can incur ‘deposit’ liabilities without a banking charter. But then the question is what belongs in the category ‘deposits’ and how that should be defined. Is a differentiated legal status between deposit liabilities and cash equivalents legally justifiable or defendable? Or, more accentuated Ricks reflects: ‘[i]f the issuance of deposit liabilities is a legally privileged activity with restricted entry, shouldn’t the issuance of cash equivalents be so as well?’962 The question is as to ultimately what constitutes a monetary instrument and who can issue them. No doubt that reviewing the entry requirements against this background is in no need for a policy justification. The alternative is a free entry into banking. The unique fragility of a model based on short-term debt that is continuously rolled over as a way of funding activities has been demonstrated on many occasions through the two volumes. So, it is (also) about financial and macroeconomic stability, but also monetary control (limit the creation of money balances) and ‘seigniorage’ (i.e. government revenue that arises from money creation).963 A compelling justification for entry restrictions when it comes to money cre-

 See in detail: R.  Morgan, (2014), The Money Problem: Rethinking Financial Regulation, University of Chicago Press, Chicago and the reviews by J. Crawford, (2016), Shining a Light on Shadow Money, Vanderbilt Law Review, Vol. 69, pp.  185–207, and K.  Judge, (2017), The Importance of ‘Money’, Book Review of The Money Problem: Rethinking Financial Regulation by Morgan Ricks, Harvard Law Review, Vol. 130, Issue 4, pp. 1148–1183. 962  He correctly indicates that this question is different from the question whether banking regulation should simply be expanded to shadow banking entities but is much more fundamental. Should we allow this to happen? Should it be possible for a nonbank to issue deposit-like claims? Or as Ricks puts it: ‘it is whether nonbank entities should be prohibited from issuing cash equivalents— defined on some functional basis—just as they are now prohibited from issuing deposit liabilities’ (p. 3). See: M. Ricks, (2016), Entry Restriction, Shadow Banking and the Structure of Monetary Institutions, Journal of Financial Regulation, Vol. 2, Issue 2, August, pp. 291–295; also as Vanderbilt Law School Working Paper Nr. 37, July. 963  Regarding the latter, Ricks ponders the puzzlingly low yields that characterize the short end of the US Treasury yield curve. Specifically, short-term Treasury yields are much lower than an extrapolation of longer-term yields would predict; ibid., p. 4. This convenience yield benefits public but also shadow banking issuers. Do the latter than capture a public asset value that arises from money creation (private seigniorage). 961

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ation isn’t hard to find. However, it seems that the issue has been given little attention (in contrast to panic and crises periods in the past). Ricks argues that the regulator structurally overlooks the need for a ‘functional legal definition of what constitutes a monetary instrument’, and then to restrict the issuance of such instruments to the chartered banking system.964 So ultimately, I’m not convinced that it is time to move on when it comes to the banking sector.965 As highlighted before, the avalanche of incoming regulation tends to leave citizens and society as well as supervisory authorities with a false, yes even artificial, feeling of safety. Although no attempt to be comprehensive can be successful, especially not within the context of a handbook on shadow banking, a few core items cannot be left undiscussed. In general terms, the intertwining between public and private interests in the banking sector have stayed afloat. Both interest domains still collide on banks’ balance sheets which still have to maneuver between achieving their objectives as a private institution and the role they play within the public domain and their contribution to financing market agents and creating a stable marketplace. Second, the capital requirements for banks are still too low when being offset against the overall amount of leverage and the systemic risk that is hidden somewhere between banks balance sheets and the interbank network. An open question for Europe is to what degree one is looking to maintain a full recourse debtor model. The model, in contrast to a superficial analysis, isn’t always in favor of the banks either, although there is the intrinsic nature of protection through the guarantee provided. But letting the debtor go broke and having to liquidate assets at liquidation value also foregoes the ability to benefit from current and/or future capital appreciation of those assets. In general, the nexus of society-financial sector hasn’t been properly restored. Just like any company, banks need a purpose and that purpose cannot be making as much money as possible. This, at best, would be the consequence of getting everything else right, including a differentiating and appealing purpose. This would mean a long-term vision that doesn’t sit well with the still-short-term-oriented financing of banks and their equally short-term-directed shareholders. Historically, the idea was that banks have an information advantage to allow them to allocate capital in a more efficient way than those agents that don’t hold that information advantage. This is how they created return on capital, by exploiting and maximizing maturity asymmetries between funding and loan book. This information benefit has been partly lost by the emerging information age and partly made obsolete by the behavior of the banks themselves. Their willingness to constantly prioritize mortgage loans over corporate loans966 implied that

 Basel III, Basel IV and other aligned regulation enacted in recent years do narrow operational capabilities of (shadow) banks but focus only on stability as an objective (to the degree they will demonstrate to be effective when the next crisis comes along). 965  In contrast to what the BIS hints at in their 86th Annual Report: BIS, (2016), 86th Annual Report, VI. The Financial Sector: Time to Move On, pp. 103. For an evaluation after ten years about where we are: R. van Tilburg et al., (2018), De lessen van de crisis van 2008: zijn ze geleerd en in de praktijk gebracht, SustainableFinancelab Report, June (via sustainablefiancelab.nl). 966  In fact, I need to rephrase this: a better choice of working would be that mortgage loan crowd out corporate loans. See in detail: L. Zhang et al., (2017), Did Pre-Crisis Mortgage Lending Limit PostCrisis Corporate Lending? Evidence from UK Balance Sheets, Bank of England Working Paper 651, March. Also concluding a shift away from traditional business lending: D. Bezemer, et al., (2017), 964

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this nexus became loser and got lost over time. To the degree that cost of funding or ­symmetry of risk being tighter in mortgage loan portfolios, it only underscores the deviating nature of public and private interest that coincides with bank balance sheets. A further concern deals with the question, position and operability of financial market authorities and supervisors. The problem as appreciated breaks down in two elements: (1) the lack of transparency as to how control is exercised in a timely, independent and professional manner. The second deals with the question of the efficiency of the work produced and goes back to what ultimately can be called ‘output legitimacy’. Career switching between supervisors and banks is very common and unfortunately well accepted. Hiding behind econometric models cannot be the endgame of any type of prudent supervision. Sometimes I guess it doesn’t hurt to be a bit more Austrian and focused on facts and possible outcomes rather than hiding behind model-based legislation.967 It also points at the fact that (cross-border) capital flows are critical in understanding not only the procyclicality of asset pricing but also the need to link macroprudential policy to a countercyclical objective in terms of liquidity management. New regulations have created or increased capital and liquidity buffers, in effect quantitatively constraining leverage and maturity transformation especially in ‘systemic’ institutions, Landau argues.968 But what is additionally needed for macroprudential policy is to ‘regulate the financial cycle, preventing the build-up of imbalances and reducing the risk of financial fragility. The best approach is to cyclically regulate liquidity creation and maturity transformation inside the financial system as, ultimately, they drive the dynamics of leverage and credit supply.’969

The Shift in Bank Credit Allocation: New Data and New Findings, DNB Working Paper 559, June 5. Even more concerning if you want is the fact that the shift toward mortgage lending is associated with the depth of the recession experienced and growth loss during that same period. Mortgage growth combined with increasing bank leverage was particularly damaging to output growth. This had an impact on investment levels and the quality of investment of investment allocation, which was true for both the private and public sectors. See: D. Bezemer and L. Zhang, (2017), A Global House of Debt Effect? Mortgages and Post-Crisis Recessions in Fifty Economies, Working Paper, mimeo (via sustainablefinancelab.nl). Bank-specific capital requirements tend to have a material effect on mortgage loan supply. A rise of only 100 basis points in capital requirements leads to a 5.4% drop in individual loan size. See: A.  Uluc and T.  Wieladek, (2017), Capital Requirements, Rik Shifting and the Mortgage Market, ECB Working Paper Nr. 2061, May. 967  Details were already discussed. See, for example, M. Behn et al., (2016), The Limits of ModelBased Regulation, ECB Working Paper Nr. 1928, July. 968  J.P. Landau, (2016), A Liquidity-Based Approach to Macroprudential Policy, BIS Papers chapters in: Bank for International Settlements (ed.), Macroprudential policy, Vol. 86, pp. 147–156. Also see: A. Dombret, (2016), Challenges in Identifying and Monitoring Risks from Non-Bank Financial Entities and How to Address Them, Introductory statement by Dr. Andreas Dombret, Member of the Executive Board of the Deutsche Bundesbank, at the Symposium on Asian Banking and Finance, San Francisco, July 11 (via bis.org). 969  Ibid., p. 155.

8 Statement of Principal Conclusions

I admit that the title chosen for my postscript isn’t random. I intellectually borrowed it from William Barr.1 Rather than to provide a summary, I wanted the postscript to be more reflective of an attempt to describe ‘what did I learn?’ after seven years of research regarding shadow banking. And that is exactly what it became, a reflection of the critical aspects I took away cruising through thousands of papers, books, articles and countless conversations, long and short, descriptive or analytical in nature. I organized the following content in a sequential bullet point overview to not let the individual aspects get blurred and disappear in one long ocean of words. I guess the content is reflective of who I am. I give you my thoughts the way it is, or at least the way I think it is. Without lashing out at anybody or trying to minimize the (often superb) work that has been done so far by regulator and supervisors globally, I ‘state’ what I thought my accumulate learning yielded after all those years of looking into the matter. As I did throughout the two volumes, I never created a hard line between the traditional and the shadow banking segment. It is ­difficult to comment on the latter without dragging the former into the pool on the deep end. Some argue, and I relate to that thought, that there is no shadow banking segment outside the traditional banking sector. Everything in the shadow banking segment is driven by traditional bank activities and strategies.

 He is the US attorney general and who in recent times rose to fame mainly because of his involvement in the Mueller investigation regarding the potential meddling of Russia in the 2016 US presidential elections and the role of incumbent President Trump having committed obstruction of justice. He used the term ‘statement of principal conclusions’ rather than ‘summary’ when appearing in front of Congress to communicate on the matter. A statement of principal conclusions isn’t a summary he claimed as it wouldn’t capture the ‘nature, substance and context’ of the full report. It is messing with words in a way only lawyers can do. But his point is clear. A summary would be reflective of the whole content of, in his case, the Mueller report. A statement of principal conclusions on the contrary is a (meandering) reflection on the critical points that the author has deduced from the main text, without the ambition however of being comprehensive in terms of covering all (relevant or constituting) aspects of the main text. I further refuse to use the term ‘non-technical summary’, as doing so would logically prevent me from becoming ‘technical’. 1

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The starting point of my statement is what we learned from the great recession and the involvement of traditional and shadow banks. We realized why banks are licensed. They engage in potentially market destabilizing activities, and we only allow that to happen if certain conditions are met. In particular, we want them to hold a certain amount of capital commensurate with the size and nature of the risks they engage in. Basel II, which was in place prior to the great recession, detailed what risks and how capital requirements were to be calculated. We learned in 2007–2009 that both needed a rethink. And so Basel III (and later on the aftermath which was coined ‘Basel IV’, although it never became the official name for all the post-Basel III measures enacted) was born. Basel III tried to achieve many things, and some are, even a decade after the financial crisis, still being implemented. A number of aspects that we learned the hard way were central in that analysis: banks engage in ‘maturity transformation’ (they lend in short and lend out long and bank the difference in terms of net interest margin) and ‘liquidity transformation’ (they lend in cash which is liquid and invest in less than liquid or sometimes even illiquid assets [themselves or via clients]) and they produce products whose creditworthiness was or is often seen as being less risky than the riskiness of the constituting assets that went in the product, on average. In each of those cases, there is a shift and transformation of risk, sometimes an imperfect transformation of risk.2 Opaqueness and complexity had become overwhelmingly part of the financial sector. That is a problem, in particular in the debt markets, which are information-insensitive in nature. The latter implies that no real information discovery occurs and that investors steer their investment decisions based on first line and often external criteria (like credit ratings). So Basel III created rules that would lead to higher capital buffers, more liquidity, less leverage and a higher and transparent set of assets to be held by banks. How can it be otherwise: the riskier and the opaquer the assets, the higher the capital buffers ought to be. That in itself is a good thing, although we know that capital buffers and in particular Tier 1 capital (the strongest part of banks’ capital that can absorb losses best) at failed banks during the ­recession were higher than at some of the surviving banks. So it seems like buffers only create relative safety. What else is relative is the amount of capital now held by banks. Leverage is still a constituting aspect of a bank’s business model. They use leverage much more and in a different way than any other industry. So capital buffers were next to nothing prior to the great recession, and in a way they still are now, although on average they have doubled since the introduction of Basel III. They stand on average at 5% of bank liabilities. That means 95% still is leverage one way or the other. So the real question is, how much better off we are now than we were a decade ago? Initial research shows that some of the Basel III aspects clearly worked their magic and that the financial sector is in much better shape than a decade ago. Nobody would be willing to go as far as saying that the banking sector would not be able to survive a similar crisis. Maybe that isn’t an interesting question to begin with, as the next crisis will be anyway different than the previous one. They always are.

 For those interested in figuring out how these transformations are calculated, see: FSB, (2019), Global Monitoring Report on Non-Bank Financial Intermediation 2018, February 4, p.  49, Exhibit 4.10. 2

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The banking sector is for a reason one of the most innovative sectors of the economy. It has produced products to cater to industry needs and overall has brought the cost of funding down. But that innovation has a villain dimension to it.3 The banking sector is known to find solutions—in a legal way—to work around hurdles built up and thrown in front of them by regulators. By exploiting the law, they engage in transactions with similar economic effect but without the hurdles created by the legislators. That process is known as ‘regulatory arbitrage’4 and already exists for decades. So if executing certain activities becomes too burdensome, banks shift them to places outside the regulatory straightjacket they are subject to. And the shadow banking segment was born. It was born long before the great recession, but the recession retaught us what happens when those critical banking activities occur outside a regulated space. The shadow banking house is a space with many rooms, many weird twists, many opaque spots and very few places where the sun can act as a disinfectant. And so here is what I learned about that house, a place that has brought positive things, but a place that ultimately always needs somebody else to take care of it. It doesn’t manage itself or is characterized by convincing levels of self-discipline. It has created assets that are claimed to be ‘safe’; it produced private money for which apparently there was demand, and it generated above-market returns without incurring above-market risk. Supervisory bodies, regulators and policy makers all went into overdrive after the great recession and as always directed their blind fury toward the defects as they showed up during the financial crisis. At all cost it needed to be avoided that taxpayers would have to bail out the banking sector again. But is that a realistic statement given the limitations that regulation and policies naturally have? To achieve this, a fundamental redesign would be needed, which is clearly way beyond what the world is willing to accept. Even the recent changes were met with discontent and responded to with a crushing amount of lobbying from the side of the financial sector, leaving the world with often expensive, unreadable, unenforceable and inexecutable pieces of legislation, where the robustness is questionable, the ability to respond to the ‘unknown unknowns’ fragile and the intrinsic nature to prevent or mitigate financial disasters limited.5 The traditional banking reform was large, has positive vibes to it, but was done, given the refusal for fundamental rethink of the financial infrastructure, in a way that doesn’t matter. The next crisis will prove that in all its dimensions.  S. de Vries-van Ewijk, (2018), Looking Ahead: Financial Innovations and Institutions— Opportunities and Risks from a Stability Perspective, in Shadow Banking: Financial Intermediation Beyond Banks (Ed. Esa Jokivuolle), SUERF Conference Proceedings 2018/1, Larcier, pp. 73–76. 4  Partnoy documents that regulatory arbitrage tends to produce two different prices for economically equivalent transactions that are subject to different regulatory costs, a phenomenon he coins ‘the law of two prices’. As long as the regulatory cost wedge persist, as a wedge between the prices of economically equivalent transactions, due to differences in regulatory costs. In detail: F. Partnoy, (2019), The Law of Two Prices: Regulatory Arbitrage, Revisited, Georgetown Law Journal, Vol. 107, Issue 4, April, pp. 1017–1043; D. Nouy, (2018), Gaming the Rules or Ruling the Game? How to Deal with Regulatory Arbitrage, in Shadow Banking: Financial Intermediation Beyond Banks (Ed. Esa Jokivuolle), SUERF Conference Proceedings 2018/1, Larcier, pp. 53–59. 5  The stress-testing models are adjusted with regular intervals, which indicated the relative (but flexible) dynamics of such tools. See, for example, EBA, (2019), EBA issues 2020 EU-wide stress test methodology for discussion, June 25, via eba.europe.org; Comptroller of the Currency, (2019), Amendments to the Stress Testing Rules for National Banks and Federal Savings Associations, February 12, via federalregister.gov. 3

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Now I haven’t said a whole lot about the role of shadow banking yet. But hang on, I will. First, it needs bearing attention that a fundamental rethink of the financial markets would imply that certain aspects would be simply ‘prohibited’. If regulation and policies cannot prevent a crisis, activities that have a large chance of creating or contributing to financial crises would have to be met with an outright ban, not with regulation and oversight. In many spheres, the regulator has chosen to ban certain activities, simply because it couldn’t manage it or thought that society couldn’t afford a structurally dysfunctional part to contain it at large. Regulation and oversight have their natural limits, and what falls outside their scope, you simply ban. But not so in the financial sphere. The divine free markets rule the waves and will decide what transactions to engage in and what not. Free markets don’t need oversight. Free markets are welfare enhancing, it was claimed. Unfortunately, there is no proof in the history of mankind, historians tell us, of that principle as most market-­based societies were relatively tightly controlled, and so laissez-faire was a ­laissez-faire with clearly defined boundaries and objectives. That way they were found to be welfare enhancing, at least for a while until the dominant class in that society started to abuse the market model for its own advantage, thereby initiating the decline of those markets and their parenting societies. The standardization of that process throughout history is impressive. One can get the impression that the current economic and political elite is running down the clock this time around, with only cosmetic features being implemented. There was nothing that would hold back regulators from imposing capital buffers amounting to 10–25%. Banks are different but not that different that they cannot survive under conditions other industries can. Equity is ultimately also a (stable) source of financing, not just a regulatory requirement. We get it: equity doesn’t allow you, like debt does, to bank the difference between the return of an investment and the cost of funding that investment. Bank returns with more equity would come down. But we can’t have that happening, can we? Although, why not? Why couldn’t a bank with routine operations not yield a 3–6% return on equity, rather than the current 10–15% or the 20%+ often promised prior to the financial crisis? When such high returns are promised or yielded, it simply means that there is more risk than the balance sheet shows at first glance. The banking sector is ultimately a highly competitive place. And let’s not forget: we’re looking at more than USD 260 trillion in debt that largely runs through the fuse box that the banking system is. If only a marginal fraction of that defaults, it literally evaporates the capital buffers of our banking system. And that is not hard to imagine with a skittish bond market or a raging high-yield debt segment. And there are only two who hold the bag in the end: shareholders and, more importantly, the central bank. Yes you, the taxpayer. That is the implicit promise that states make to their banking system. We will not let you fail, whatever the case. Banks are the fuse boxes of the economy, and so if the repairman comes, he will take care that the flow of credit will restart. The combination of those implicit guarantees combined with the fractional banking system in place worldwide leads undeniably to the same conclusion and implications. Under those circumstances, financial stability becomes an odd thing. A market that naturally destabilizes every now and then, where the odds are asymmetrically stacked up against the taxpayer, is a battle you can’t win. Financial stability maybe needs to be redefined to better reflect the interest of all stakeholders involved in this. Even if that

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would lead to a smaller banking sector. Evidence has been tabled in recent years that the growth of the financial sector only leads to economic growth up to a certain point. Beyond that, the financial sector starts crowding out and cannibalizing the other parts of the economy, leading to overall lower growth. The small- and medium-­sized enterprise sector thereby is always taking the biggest hit. We are at risk of having built vicious illusions in our regulations and s­ upervisory frameworks. Banks still operate within a regulated monopolistic capitalism, with implicit subsidies which equate to the idea of ‘never let them fail’. That has attracted a lot of cheap debt into the shadow banking market. In a monopolistic capitalistic system, you end up with only large players,6 which has led to the ‘too big to fail’ concept. In fact, being big is not a problem in itself. But big banks become opaque and engage in all sorts of hybrid intermediary activities that partly fall within and partly fall outside the scope of their license. They became mastodons, and so the key challenge would have to be ‘too complex to regulate’ rather than ‘too big to fail’. Complexity (or chaos) is truly a problem in itself. One can solve this, as Admati suggests, by nationalizing the money-creating process and letting banks be simple pass-on entities. That would obviously largely pull the plug on banks as being an investible universe. It would have to go hand in hand with a split between core lending activities and more complex investment banking activities and proprietary trading. Such a separation existed since the Glass-Steagall Act in 1933. In the 1970s and 1980s, the rule was gradually brought down during the wave of deregulation. Although a firm political promise after the great recession, a reintroduction of the rule didn’t make it in Europe, and the Volcker Rule, which reintroduced the separation principle in the US after the financial crisis, has been modified and partly neutralized in recent years.7 And so, driven by regulatory arbitrage not only products change, but also bank business models change, and when certain activities become too expensive to engage in under a banking license, then those activities migrate to the shadow banking scene. Given the hybrid nature of large financial conglomerates these days, and the long-winded credit intermediation chain now covering multiple entities in different jurisdictions, bank business models change or better migrate in line. The same activities often happen under the same roof, but differently framed, regulated and supervised. It all further enhances the complexity which has become clear in itself as a root cause of financial distress and financial instability. Rather than regulating complexity which is difficult given the natural limitations of the rule of law, social welfare improves in case those activities would be banned. But where do all these activities go, where are they sheltered, and what does it mean for financial stability and the state which still guarantees these implicit subsidies for banks with balance sheets often ten times larger than their economy? The ‘lender of last resort’ refers to the central bank as ultimate public backstop for shadow banking activities, just

 What else can one expect especially when combined with many layers of requirements and hurdles? Smaller banks are crowded out or consolidated. 7  For example, E. Flitter and A. Rappeport, (2018), Bankers Hate the Volcker Rule and Now It Could Be Watered Down, NY Times, May 21. It doesn’t go without a fight and the Volcker Rule would not be totally taken down, but the process of how tidy it might be is seen as a big win for Wall Street. See, for example, J. Hamilton and B. Bain, (2019), Wall Street Nears a Big Win in the Latest Revamp of the Volcker Rule, Bloomberg.com, April 25; J. Adler, (2019), Agencies Are Close to Finishing Volcker Rule Changes: FDIC’s McWilliams, americanbanker.com, June 12. 6

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like it does for traditional banking, and has become a central concept in the analysis of shadow banking and its implications. This is what I learned: • A tremendous amount of effort has been going into analyzing and measuring shadow banking markets around the world. Often these shadow banking institutions help financing the economy, in particular when the traditional banking sector is state-driven, liquidity-dry or just dysfunctional (emerging economies). In advanced economies, its primary drivers are as mentioned regulatory arbitrage (and so to optimize profitability) as well as the demand for private money and (safe) assets. Most advanced economies have an aging population, and thus a natural excess of liquidity is looking for yield without running (all too much) risk. The demand for safe assets thereby often outstrips the supply of T-bonds. The private market steps in and produces allegedly8 safe assets but which are equally (like T-bonds) information-insensitive and prone to run risk. In case that run risk emerges and liquidity dries up, the central banks step in and underwrite the shadow banking assets. Is this ideal? No. But having a central bank produce as many T-bonds in order to meet ‘actual’ safe asset demand also has material implications. It would, beyond driving down interest rates, even further crowd out investments. • But all the measurement data reveals a persistent problem, that is, the fact that for some sectors data granularity is limited, understanding of risk is foggy, and some segments lack basic understanding which are then qualified as ‘unallocated’. Remarkably enough that unallocated segment is still growing (you would think that, with time passing by and more efforts being put in, that segment would diminish). Other segments, like the investment fund segment, collate all sorts of vehicles and activities, and therefore, the question is what aggregate data tell us about the real risks in those segments. • Those ‘safe assets’ can be produced in a variety of ways by the shadow banking sector. One can identify the legal entities that produce them like money market funds (MMFs), securitization firms or vehicles, investment funds and so on. The list very quickly becomes limitless. So focusing on legal entities doesn’t work and so supervisors and policy makers changed their approach and targeted a certain amount of economic functions capturing the variety of transformations mentioned at the beginning of this statement. That sounds good but it stays descriptive. Since financial markets are evolving, a robust regulatory framework needs to demonstrate the agility to identify ‘the unexpected’. Too often I have felt that research was looking for extraterrestrial life with a picture of Homo sapiens in their hand. Robust systems and regulations are characterized by certain qualities such as adaptability, diversity, proportionality, resolvability, and ability to embody a systemic perspective9 and to remodify based in real time on  Transparency was limited pre-crisis as to what the underlying asset pools were made up of.  S.L. Schwarcz echoes concern about the lack of a more systematic approach to building a regulatory framework, closing chapter in (2019), Systemic Risk in the Financial Sector: Ten Years After the Great Crash, edited by D. W. Arner, E. Avgouleas, D. Busch, and S. L. Schwarcz, Centre for International Governance Innovation, CIGI Press. Also in S.L.  Schwarcz, (2019), Systematic Regulation of Systemic Risk, Wisconsin Law Review, Vol. 1, pp. 1–53. Enriques et al. argue in the same direction with their suggested ‘network-sensitive’ financial regulation. Regulation now is 8 9

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incoming data (informational dimension). I have a hard time convincing myself that this currently is the case, with or without the complications of regulating ‘complexity’ as a root cause. • Shadow banking regulation is often model based (and thus data driven). A lot of these models are ‘stylized’, that is, they approach reality but ultimately reflect a reality that doesn’t exist. It is a problem that goes beyond shadow banking markets and affects the entire macroeconomic discipline with its standard econometric dynamic stochastic general equilibrium models dominating the scene. Model-based regulation isn’t robust as the model doesn’t reflect a changing and dynamic reality. • Debt is still the largest driver of performance in any shadow banking business model. The debt bias, largely encapsulated by the tax code, embodying a preferential treatment of debt over equity is still around. The tax code or limiting the use of corporate structures for the purpose of benefiting from interest-deductions is probably the place to deal with the issue. But there is very little animosity to tackle the problem. It is often not so that we don’t know what to do, but we just don’t do it or procrastinate until the next crisis comes along. • If shadow banks engage in bank-like activities and the central bank is the liquidity window for both traditional and shadow banks, why don’t we then just regulate them like banks? That has been suggested, but adverse consequences were identified. There were also concerns about the ­availability of equity to support that transition. And it isn’t so that many shadow banking activities aren’t regulated these days, but all of them create the illusion of safety, whereas a ban or more equity to support those activities would be the only real answer. A few examples: (1) money market funds have experienced material run and liquidity risk during the financial crisis. And so the answer was all sorts of techniques to discourage investors to use their ‘first-mover’ advantage and leave the fund. Gates, fees, limits, swings prices, the whole arsenal was used. But they are reactive mechanisms to what embodies a deeper problem. Money market funds (MMFs) came to exist in the 1970s when the US Federal Reserve Bank (Fed) put a cap on how much interest a deposit account could generate (remember, it was a high-inflation environment). The MMFs promised a higher return, but with similar or slightly enhanced risk, thereby constantly guaranteeing full liquidity at all times. But to yield a higher return (and pay the fees), more risk had to be taken on board. That risk needs to move somewhere, either to the fund (or fund sponsor) or to the investor. The illusion still is alive that there is no material elevation of risks. Risks that can only be managed with a broader equity cushion at the level of the fund or fund sponsor. That option was quickly taken of the table both in Europe and the US, although research demonstrate improved results when equity positions increased; (2) transparency had to be improved in the securitization market post-crisis. Underlying asset pools had to become transparent, and therefore also standardized and simple. That way, through creating homogeneous pools of assets, instability was reduced and transparency improved. It was written into atomistic or transaction based, while the structure of the financial system is a key determinant of systemic risk. In detail: L.  Enriques et  al., (2019), Network-Sensitive Financial Regulation, European Corporate Governance Institute (ECGI) – Law Working Paper Nr. 451/2019; L. Enriques et al., (2020), Network-Sensitive Financial Regulation, Vol. 45, Issue 325.

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the law, standards were developed and the illusion was created that a once heavily battered product group was now ready to revive the EU capital markets. Two key points in this discussion have always been ignored: (1) securitization regulation has focused a lot on the product and how it is put together (investor protection), but little has changed at the backside of that model, that is, where assets are originated. The original ‘originate-to-hold’ model, whereby entities hold the loans generated until maturity (and ran the entire risk during the holding period), is replaced by the ‘originate-to-distribute’ model, whereby the assets are raised with the intention to be repackaged and resold. Research shows that subdued lending standards emerge when assets are raised to be resold10; (2) the simple fact that securitization implies a concentration of (now largely) homogeneous risks also exacerbates and elevates intrinsic risk levels beyond the aggregate risk naturally embedded in the assets being pooled, that is, concentrating risk produces more risk than the aggregate underlying risk levels embedded in the assets. Concentration risk is a feature totally ignored by regulators, also when considering capital requirements for licensed banks versus the nature of the business pushed out to the shadow banking segment. That combined with higher capital requirements for licensed banks tend to increase rather than decrease systemic risk in markets.11 • Markets are inherently unstable and a next crisis cannot be averted. This means that from a regulatory point of view both ex ante12 and ex post regulation are required. Ex ante legislation is there to prevent things from happening where possible. It is absolute necessary but inherently insufficient. Ex post legislation is there to ensure that when things go wrong, the damage and exposures are minimized and the mess is cleaned up at the lowest cost possible. However, finding the right balance between those two dimensions is like finding the holy grail. One can favor one dimension over the other, and it will bear consequences. One can maximize both dimensions and then disproportionality of the relevant legislative rules becomes a major problem crowding out (also useful economic) activity. Attempts to find that balance are unknown to me and therefore the balance stays largely arbitrary and a wide variety of approaches exist worldwide. • And I get it, up to a certain point. Since the crisis, we have been buried in libraries full of research trying to define or specify our understanding of concepts such as ‘systemic risk’, ‘transmission of risks through market and (shadow) banking channels’, ‘contagion risk’, ‘run risk’ and so on. We have progressed in our understanding, but only a little. We are still exploring the nature of a lot of these concepts, often using modelbased stylized econometric models. So our true understanding of these matters are at best ‘relative’, which is in sharp contrast with the impressive body of literature that  For example, D.B. Choi and J.-E. Kim, (2018), Securitization and Screening Incentives: Evidence from Mortgage Processing Time, Working Paper, March 8, mimeo. 11  C. Diem et al., (2019), What Is the Minimal Systemic Risk in Financial Exposure Networks? INET Oxford Working Paper, June 6, mimeo. 12  Flannery and Bliss argue that effective market discipline involves two distinct steps: monitoring a bank’s condition and influencing it to avoid unacceptably large risks. Both phases of market discipline are necessary; neither alone is sufficient. See in detail: M.J. Flannery and R.R. Bliss, (2019), Market Discipline in Regulation: Pre- and Post-Crisis, in The Oxford Handbook of Banking (Eds. N. Allen, P. Molyneux and J. Wilson), 3rd edition, Oxford University Press. 10

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emerged on these matters during the last decade. And those things we think we understand are subject to evolution. The nodes in the global financial net are continuously subject to change and increasingly concentrated. Only few players can meet all the hurdles built up by regulators. This is in particular the case for the derivative markets. The implication is that when patterns are observed, the analyses fall prey to reductionism. Just like sticking a thermometer into a bowl of water provides you with an average temperature, and thus average velocity of the molecules. But it tells me nothing about all those things going on remote from the average findings. Tail risk, which is the hardest part of understanding standardized risk exposures, is just about the hidden deviations. They cause the risk, they become the ‘unknown unknowns’, they provide shelter to what will hit us next time around. Let’s call it the ‘neglected risk syndrome’. Needless to say that producing meaningful regulation then becomes an illusion. Sure, one can and has produced legislation, sometimes even to the best of their abilities. But some battles you can’t win, and an outright ban would be more convincing from a public interest point of view. Disintegrating markets don’t do so in an orderly fashion, and chaos is the operative word. Regulating chaos is impossible. The many extremely complicated econometric models tested and retested in the literature create the risk of building an intellectual illusion regarding something models just can’t grasp. Just like regulating, evolution is impossible at least if the concept of evolution is arbitrary. But nothing in this world is arbitrary. We just don’t know the parameters upfront in many cases and therefore call it arbitrary. To make a long story short: we only have a fluid idea of the parameters driving the concepts mentioned, and this limited insight and protection needs to be offset against how the next crisis will unfold. It’s a bit like buying fire insurance on your home while it’s already on fire. • In a free-market economy, natural evolution works. Things come and go. This means that activities that aren’t in demand disappear and entities that don’t perform default. But not so in the (shadow) banking sphere. The central bank was coined the ‘lender of last resort’ for a reason. It will, as the ultimate monetary firefighter, do ‘whatever it takes’ and a bit more. So default is not an option and not tolerated as we’re talking about supporting privately generated safe assets in which substantial amounts of public capital are typically invested. And so default is no longer a threat and bailout/in guaranteed when things get tough. Capitalism without default or bankruptcy is like Catholicism without hell, a whole lot less daunting and a license to do whatever you want as a (shadow) banking market. Even the bankers see it that way.13 • That is the consequence of regulators still thinking that the free market works. That it is an ‘ius naturale’ and only needs modest support and d ­ irection. Regulation should be as limited as possible as it constrains ­something that works best when left on its own. But it is never on its own; it is never disentangled from the state which licenses ad guarantees banks and bails out entities. Sometimes it is even developed as a political project, like the CMU European capital markets project, where solutions are suggested using techniques that got us into trouble during the last financial crisis. But now that we’ve thrown some regulation to the shadow banking markets, it became a good thing. The name was changed  J.  Luyendijk, (2015), Swimming with Sharks: My Journey into the World of the Bankers, Guardian Faber Publishing, London UK, February, p. 70. 13

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to ‘market-based finance’, and it was the solution to reduce systemic risk in markets and foster economic growth. For the latter, some arguments are to be found, but for the former a whole lot less. In fact, only equity and information sensitivity reduce systemic risk and market instability. There is a reason why the tech bubble crash in the early 2000s was cleaned up in a matter of years and the debt crisis in 2007 is dragging its feet all the way into today. Equity is information-sensitive, absorbs risks and losses and acts as a buffer against unexpected market moves and transactions that went sideways. Given the primacy of the free-market philosophy, the regulator has taken itself unpurposefully hostage between ex ante and ex post regulatory initiatives. One would almost start thinking that most states still believe that one can change the world or the shadow banking market by applying the extreme mechanisms of market capitalism that got us where we are today to begin with. Some observers see another neoliberal story in the making. That of sovereign states that on their own accord and in coordination develop a market-based financial system to push through a neoliberal agenda for which it has not only no mandate but for which it would have to cross materially the boundaries of its institutional legitimation and capacity. Or to put differently, we can’t justify it doing ourselves (i.e. taking such measures and, for instance, gradually fading out European welfare states) but by outsourcing the mandate to the market we can not only hide behind it but also build our own legitimation for not engaging as it is now beyond our control. I wouldn’t discard this line of thinking as it has a lot of merit working for it. • A lot of shadow banking areas are now covered by supervisory frameworks. That in itself is a good thing, as this way opaqueness can be driven out of many corners of the shadow banking house. But it was also observed that many are very admin heavy and bureaucratically inclined. The concerns are twofold: (1) to what degree is it going to work just to understand what happened or will it show to be incapacitated to act when needed simply because of that admin-heaviness; (2) there is a material risk that we will confuse understanding the shadow banking markets with managing them. Managing implies understanding but only as a first step. It further requires the willingness to act, and the ability to tackle issues with two feet forward. I compare it with a military example I recently read about. Although the US military has a budget that is a material multiple (almost a factor 10) of that of the Russian army, experts claim that the Russian military would be able to deploy and display as much, if not more, military force than the US army. The missing factor is the ‘willingness and ability to act’, which then seems to outpower the 10x budget factor. The budget is our understanding of shadow banking, the ability and willingness to manage and enforce frameworks and rules is the ‘willingness and ability to act’. The bureaucratic nature of supervisory bodies relies heavily on understanding and not on acting. Unfortunately, both are often confused. • Part of managing the shadow banking market has to do with corporate law: already mentioned before is the requisite of shadow banking to use corporate entities to benefit from debt-driven tax deductions, limited liability and bailout prognoses or eventuality. In terms of corporate governance, the needle unfortunately hasn’t moved a lot in recent years. Piercing the corporate veil stays a rare exception and broader director (civil and or criminal) liabilities turned out to be unachievable. And so many evils remain: abuse of corporate structures, undercapitalization, cross-jurisdictional arbitrage and exploiting the debt bias are still all part of the level playing field within

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shadow banking. Self-discipline in the shadow banking industry is near non-existent. It is driven by demand, and only that. It is a justification for just about anything. Corporate governance is however a structural and fundamental building block for financial resilience, and unsanctioned abuse of corporate structures constitutes an eroding factor of market confidence.14 • The financial markets continue to grow, and in some jurisdictions at a rapid pace. With that rapid growth, a concentration of activities is to be observed with a limited number of market agents. That kind of concentration isn’t just bad for competition, quality of services and ultimately customer satisfaction. But it is also concerning for the stability of financial markets. A poster child of that is the market for asset management and wealth ­planning. A market worth well in excess of USD 100 trillion worldwide, and adding weight every single day, sees 70% of its activities concentrated in just 30 firms. No wonder questions are asked about the very systemic nature of those firms and, more importantly, their activities. In most cases, the investment risk is passed on to end investors, but potential risks might arise from (non-)concerted investment efforts across firms, use of leverage, the dominance of passive investment strategies and so on. • We already hinted at the fact that financial crises can be managed through a combination of ex ante and ex post regulation. Ex ante regulation is needed but inherently insufficient. Ex post is mainly about how to deal with the aftermath of a crisis, accountability, who pays for what and so on. Each jurisdiction deals with recovery and resolution their own way, although global guidelines and approaches have been developed as well as infrastructure is built to deal with the extra-jurisdictional nature of certain cases and location of assets and investors. Having reviewed them all, one thing that struck a chord with me was the emergent understanding that, besides the admin-heavy nature of these frameworks built apparent here, recovery and resolution models are not distinct or pronounced. Of course, they aim for different outcomes but the techniques used are largely the same. It echoes something uncomfortable. It echoes the inability to be precise about things and how you want them dealt with in the crisis or the aftermath. In Europe, there is the Bank Recovery and Resolution Directive regulation and single-resolution mechanism, and both seem to be ill-­thought through to deal with all the complications of a union-based recovery and resolution mechanism. The same can be said about central clearing party recovery and resolution, and many aspects are in my understanding merely work in progress. The implicit assumptions made and risk assessments conducted are often reflective of insight being dangerously unfit for solving the issues on the table.

 See regarding how regulation has focused on risk taking and very little on the internal governance of banks: D. Min, (2017), Balancing the Governance of Financial Institutions, Seattle University Law Review, Vol. 40, Nr. 743–764; S.L. Schwarcz, (2018), Corporate Governance of SIFI RiskTaking, Duke Law School Public Law & Legal Theory Series 2018–41, May 11; S.L. Schwarcz, (2018), Responsibility of Directors of Financial Institutions, Duke Law School Public Law & Legal Theory Series Nr. 2018–23, February (also published in Corporate Governance of Financial Institutions: Law, Conduct and Culture (D. Busch, G. Ferrarini and G. van Solinge, eds.), 2018, Oxford University Press). 14

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• All in all, there is very little attention for the macroeconomic or society-­wide implications of shadow banking activities. A well-known example is the housing market, a market that is structurally in danger of blowing devastating bubbles with regular intervals. Obviously shadow banks are not single-handedly responsible, but the liquidity to fuel those bubbles often originate from the shadow banking sector. • With new activities and asset classes being developed or considered, so does the risk of new exposures multiply. How we define what risks are acceptable and what we want to achieve. Now that the first securitization of an asset pool of online mortgage broker was produced (2019), the question raises about the justification of such activities. Let’s stay with fintech for a second. The idea was to process applications faster and judge them equally, if not better, in quality terms. It would enhance the democratic nature of finance as an industry and allow more people access to credit which would turn out to be welfare improving. Reality however is painfully disappointing. Not in terms of the speediness and quality of applications, but in terms of creating a more level playing field. Fintech hasn’t resulted in low(er) funding costs, or higher-risk lenders getting access to finance. They lend to exactly the same pool of potential customers, at more or less the same rates. Fintech is by a large the next level of regulatory arbitrage rather than anything else that would advance mankind. Fintech sees itself limited to being lending money outside the scope of a banking license. • Now that shadow banking has become market-based finance, the implications should become clear. The lender of last resort concept cannot be avoided, and the taxpayer is and will always be the final public backstop in this financial model of capitalism. He (the taxpayer) doesn’t underwrite banks no more, but instead the entire market, which by itself is not a calming nor satisfying thought. But then again, traditional banking runs largely through market finance already. • We live in an age of mass info- and data distribution. We all came to understand how difficult but relevant it has become to be selective in terms of which data to work with. In the context of financial markets, this has produced the following ‘migration of information’ deadlock. In the past the focus of law was on ensuring that there was no information asymmetry between contracting parties. That problem has not migrated to become dealing with mutual misinformation of both parties (in terms of the value of collateral, interconnectedness, etc.) given the distinct role that the media plays in the formation of (international) asset prices. We might end up all confused, despite all the data available. That is a major challenge for contractual economics and the more narrow ‘law and economics’ field. The fact that the central banks still are the lenders of last resort implies that the private creation of safe assets by banks doesn’t trigger the incentive to produce private information about its quality. • Optimizing shadow banking legislation is a matter of having the propensity to distinguish between explicit and implicit dimensions of risk and their respective externalities. Transaction-specific rules do not deal with (negative) externalities, nor the constant change or the complexity markets and market agents have to deal with. Nevertheless, most financial regulations these days are still transaction based and not holistic or systemic in nature.

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• We live in a globalizing world. That isn’t a linear process, and sometimes it feels like we’re taking a step back. But the long-term trend is in place. Technology, mobility and changing business model make that happen. And so the question is, what kind of regulation do we need? We discussed already the deadlock between ex ante and ex post regulation, so we can leave that discussion behind. How do you design regulations with objectives that change over time? Does one prefer command-and-control regulation or nudging, or do we go the way of regulatory sandboxes in the shadow banking sphere? Regulatory sandboxes are regulatory safe havens, often summarized in writing and published, that allow direct and time-barred testing of innovations under a regulator’s oversight. I am not particularly positive about the technique as I question the viability and realistic nature of the stylized testing in a confined environment. Markets ultimately adjust to incoming regulation. A good example of that in the shadow banking sphere is that of the repo markets and securities lending reforms.15 The repo market is in many ways the cornerstone of any financial system. It facilitates the flow of cash and securities across the system and facilitates the interactions required between the different financial market segments and their users. It is a trust-based system, where collateral plays a prime role. Key is to keep volatility low and liquidity high. It is the engine of the financial markets, and despite its significant role, it is little known and, for many, still materially obscure. Everything that we have a hard time getting our head around comes together in this market: the role of trust in the system and belief of investors, herding behavior, interconnectivity, contagion and run risk, clearing requirements, and abrupt and even overnight liquidity dry-ups. Regulation in recent years focused therefore on the quality of the collateral used, the intensity of collateral reuse, valuations of collateral and ensuring liquidity, and as a consequence, some parts of the repo market are still today adapting to the new regulations. In fact, they aren’t just adapting to their own regulations (including the net stable funding ratio and haircut regulation reducing the transactional value of collateral thereby potentially constraining capacity), but also those of banks. Banks will, because of their own regulatory changes, feel forced to reduce balance sheet exposure at reporting dates to low risk/return activities. All in all, it implies that securities lenders will be faced with structurally lower returns, dealer banks can no longer provide liquidity as before, price discovery for short sellers will become complicated and ultimately clients of that segment will face the consequences of increased costs and reduced capacity. The market segment clearly suffers from calibration and coherence failures. As a node where so many things come together, the holistic nature of the many different regulatory puzzles that come together here are seriously ill-considered. The reform of this segment is the ultimate poster boy of how mind-bendingly bizarre cut-and-paste multilayered regulatory reforms like this one can impact a market and make itself guilty of material regulatory overreach. Despite all that, the repo market functions at capacity or just above that. Arguments for that ­position are given, for example, the entry of less regulated participants. Contrary to that, systemic risk concerns are still in the open and users still count on the availability of  See for a recent evaluation: GFMA/ICMA, (2018), The GFMA and ICMA Repo Market Study: Post-­Crisis Reforms and the Evolution of the Repo and Broader SFT Markets, December, via icmagroup.org 15

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central bank facilities to plug the gap. Although volatility is low, reduced repo capacity due to new regulations leads intrinsically to enhanced levels of volatility.16 Reforms must have been -commensurate with risks, otherwise we couldn’t have ended up here. The consequences are structural and have changed the repo market (unnecessarily).17 There are many reasons why from here on out proportionality and adaptability will need to go hand in hand. Steering regulation doesn’t need to occur based on perceived risks but based on an ‘object permanence’ kind of understanding. Risks are there even if you don’t perceive them, can’t measure them or simply don’t understand them. Market fragmentation and cross-border regulation so far deliver more questions than answers and an immensely complex regulatory playing field.18 The attentive reader has long understood that I didn’t and couldn’t capture all the issues surrounding shadow banking and the incoming regulations19 over the last decade in this statement. But I seriously hope I did so, one way or the other, in one of both volumes of this book. In this segment, I used those examples that helped me bring my macro-concerns across. Unless we leave the paradigm of ‘efficient markets’, we’re going to run into trouble each time a new crisis comes along. The banking sector is through the central bank liquidity window a quasi-state-owned industry and should be treated that way. If banks want to be the engine that the global economy relies on, and many banking transactions are already running through the open market facility, sovereigns basically underwrite the market. Something tells me that this is asking for trouble, and I’m afraid the future will prove me right. Robustness is what we can and may expect from a banking- and market-based financial system.20 The idea of ‘robustness’ strangely enough reminds me of a verbal arm wrestling in the mid-1990s between the CEOs of Microsoft and General Motors. The former accused the automotive industry of not being sufficiently innovative and at risk of falling behind in the technology-driven future that most believed in, in the 1990s, that is, before the tech crash in the early 2000s. The CEO of General Motors at that stage responded by saying that he thanked the Microsoft executive for his insights, but that he would pass implementing his advice in his company if that  GFMA/ICMA, (2018), ibid., pp. 5–6.  I guess their massive reliance on short-term funding and collateral velocity was the only real feature causing concern. 18  See the recent IOSCO report on the matter: IOSCO, (2019), Market Fragmentation & CrossBorder Regulation Report, IOSCO Report Nr. FR07/2019, June 4. 19  See for a recent wrap-together of all (or at least the most important) open-ended issues in financial regulation: P. Bolton et al., (2019), Sound at Last? Assessing a Decade of Financial Regulation, The Future of Banking 1, Center for Policy Research, June 3, via voxeu.org. They also conclude that a lot remains to be done including designing holistic regulation, ensuring stress testing doesn’t relax, focusing on robustness and resilience, and rethinking financial stability. Very recommended. Also very recommended: E. Jones and P. Knaack, (2019), Global Financial Regulation: Shortcoming and Reform Options, Global Policy, Vol. 10, Issue 2, May 2019 pp. 193–206. 20  ‘Addressing emerging vulnerabilities’ and ‘harnessing the benefits of financial innovation while containing risks’ are not the approaches or statements that provide me with the necessary comfort. See R.K. Quarless, (2019), FSB Chair’s letter to G20 Leaders meeting in Osaka, June 25, pp. 1–3, via fsb.org 16 17

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would mean running the risk that his cars would have to use the emergency lane every few hundred miles to reboot or restart due to systems failure. If you want to be at the center of things, like the banking sector aims for, you might better shape up, because patience is running out despite record earnings in the industry in recent years. Either we can rely on the system or not. If not, we might as well tank it and go back to the drawing board and come up with something better.

List of Abbreviations1 and Glossary

Asset-Backed Commercial Paper (ABCP) An asset-backed commercial paper (ABCP) is a short-term investment product that typically has a maturity between 90 and 270 days. It is therefore considered a money market instrument. In most cases the security is issued by a bank or nonbank financial institution. The instrument is backed by physical or other financial assets. The instrument is used for short-term financing purposes. Given its short-term maturity, it can be considered a promissory note backed by the credit rating of the issuer. The instrument is bought at a discount to fair value and is repaid at maturity at face value. Occasionally, the security is not backed by collateral and its risk then solely depends on the creditworthiness of the issuer. During the 2007–2009 financial crisis they played a crucial role as the creditworthiness of these ABCPs was not in line with combined creditworthiness of the underlying assets which created an imploded ABCP market and subsequent loss of liquidity.

Asset-Backed Commercial Paper Conduits (ABCPC) These conduits (or structured investment vehicle (SIV)) are typically set up by a sponsoring financial institution. This happens in case the bank or nonbank financial institution plans on rolling out a comprehensive asset-backed ­commercial paper program. The sole purpose of such a conduit is to purchase and hold (financial) assets. The conduit raises funds to

 See for an excellent and very extensive and global abbreviation and glossary overview regarding the post-2008 crisis (shadow) banking (regulatory) environment: Morrison and Foerster, (2014), A Regulatory Reform Glossary, NY. 1

© The Author(s) 2020 L. Nijs, The Handbook of Global Shadow Banking, Volume II, https://doi.org/10.1007/978-3-030-34817-5

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finance these assets by selling asset-backed commercial paper (ABCP) to investors such as insurance firms, pension funds and money market funds. The asset pool that serves as collateral is often diversified (but fixed-income generating) and typically consists of assetbacked securities (ABS), residential mortgages (RMBS), commercial loans and collateralized debt obligations (CDOs). In most cases, these assets hold an AAA rating, although some assets might not have an independent rating attached.

Asset-Backed Securities (ABS) An asset-backed security is a security whose value and income payments depend on the underlying pool of assets which also serve as collateral. Often pool of assets contains assets such as loans, leases, credit card debt, home equity loans, royalties, car or student loans, receivables and/or corporate debt. In case mortgage loans are included, the product is often referred to as mortgage-backed security. The individual assets held are often illiquid and cannot be sold individually. By securitizing (‘bundling’) the pool of assets, the instrument becomes marketable and tradeable. The pool of assets can be diversified or put together based on a certain risk profile. Concerns related to the product include the understanding that the credit rating or risk profile of the instrument is not in line with the aggregate risk profile of the underlying asset pool and therefore it can be riskier than anticipated. Critical in understanding the risk profile is to observe the quality and characteristics of the asset pool although an open question will always be how the assets respond in case of a systemic market shock and how concentration of certain risks in the portfolio behaves during periods of enhanced market distress.

 lternative Investment Fund Management A Directive (AIFMD) The Alternative Investment Fund Management Directive (AIFMD) (2011/61/EU with amendments in 2013 (2013/14/EU) and 2014 (2014/64/EU)) is a European Directive that governs and applies to hedge funds, private equity funds and real estate funds. The AIFMD was developed following the crisis to capture all financial operators and vehicles that were not covered yet by European financial regulation including the MiFID legislation (Market in Financial Instruments Directive I and II) that has been in place since 2007 and the UCITS (Undertakings for Collective Investment in Transferable Investment Schemes, 2009/65/EC) regulation in place since 2009 which is Europe’s collective investment scheme regulation. The AIFMD has as its principal objective the protection of investors and the monitoring of potential systemic risks that could up in these funds that could destabilize the marketplace.

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Auction Rate Security (ARS) An auction rate security (ARS) refers to a debt instrument with a typically long-term nominal maturity (often 20–30  years) for which the interest rate is reset regularly. In principle the technique can be applied to all sort of fixed-income instruments but is mainly used for corporate and municipal bonds. The resetting of the interest rate occurs based on the principle of a Dutch auction (i.e. whereby the auction starts from a high rate and drops until demand and supply meet for the instrument; then the interest rate is locked in for the next period). The auction rate security is therefore sold at an interest rate that will clear the market at the lowest yield possible. The technique is used as it traditionally offers lower funding costs for the issuers of the debt instrument, at least compared to the cost of fixed rate instruments or variable rate demand obligations or notes. For buyers it provides a (somewhat) higher yield than alternative money market instruments. Most instruments for which the technique is used have an AAA credit rating.

Asymptotic Single Risk Factor (ASRF) This refers to an asset value factor of credit risk. The asymptotic single risk factor (ASRF) model is a simplified credit portfolio risk model that documents the Basel II capital requirements (the internal ratings-based (IRB) approach to capital adequacy for credit risk). It uses as input the risk characteristics of a portfolio of credit (sensitive) instruments and calculates the necessary capital using an asymptotic single risk factor model. The model implies that for each instrument, the capital is defined as the loss in excess of the expected loss (EL) at a high confidence level. It uses a number of assumptions and limitations: it uses a one-year risk horizon, a single factor model (risk revolves around one factor), a normal distribution pattern (of the variables involved) and a homogeneous and large pool of exposures (assuming a large but homogeneous pool of credit instruments). The asset pool is often also internationally diversified, but that is not a necessity.

Assets Under Management (AUM) The assets under management (AUM) measures the total market value of all financial assets that a fund, investment firm, bank or brokerage manages on behalf of its clients and/or themselves. It includes both the capital of outside investors and the capital of the firm and/or its managers that they have left in the investment vehicle. The managers of the vehicle have a fiduciary responsibility vis-à-vis the outside investors to invest the allocated capital as ex ante agreed upon, and act as a good steward during the investment period. AUM needs to be set apart from assets under administration (AUA), which refers to the assets owned and managed by outside clients but for which the firm or fund provides administrative services which typically include fund accounting, tax reporting, trade reporting, custodian services and so on. It also needs to be set apart from the net asset

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value (NAV) which refers to the value (and in most cases price) of each unit in the fund or vehicle. The NAV can be calculated by dividing the AUM by the total number of units in the fund or vehicle.

Basel Committee on Banking Supervision (BCBS) The Basel Committee on Banking Supervision (BCBS) is a committee of banking supervisory authorities that was established by the central bank governors of the Group of Ten countries in 1974 and which expanded over time to become a group of 45 members (2019) from 28 jurisdictions. The BCBS is the primary global standard setter for the prudential regulation of banks and provides a forum for regular cooperation on banking supervisory matters.

Bank for International Settlements (BIS) The Bank for International Settlements (BIS), established in 1930, is an international financial institution owned by central banks (60 (2019)) representing 95% of global gross domestic product (GDP), which mandate is to foster international monetary and financial cooperation and serves as a bank for central banks. The BIS’ mission is to serve central banks in their pursuit of monetary and financial stability, to foster international cooperation in those areas.

Bank Holding Company (BHC) A bank holding company (BHC) is a company that controls one or more banks, although it doesn’t necessarily. The holding doesn’t have to engage in banking activities itself. According to the US Bank Holding Act of 1956, a bank holding company is defined as ‘any company that has control over a bank’.2 The benefits of being a bank holding companies lies in the flexibility in case multiple banks are held by the holding, the holding can buy problem assets from the banks so that they don’t have to be sold to the open market under distressed terms, the holding can create a market for the stock of the bank(s), something the bank itself cannot engage in, and a variety of regulatory simplifications which smaller banks might appreciate as excessively burdensome in case it would have to meet those requirements on a standalone basis. In turn, the BHC is subject to a whole set of regulatory, reporting and balance sheet requirements including financial buffers. Becoming a bank holding also provides access to the discount and liquidity window of  See for an analysis D. Avraham et al., (2012), A Structural View of U.S. Bank Holding Companies, Federal Reserve Bank of NY Economy Policy Review, July, pp. 65–81, and R. Chami et al., (2017), What’s Different About Bank Holding Companies, IMF Working Paper Nr. WP/17/26, February. 2

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the central bank, which a standalone investment bank cannot. That was the main reason why most Wall Street banks during the 2007 financial crisis converted into being a BHC. Investment holdings have to register as a bank holding the moment they acquire or exceed 5% of the outstanding shares of any class of voting securities in a bank or bank holding company. Particularly most small- and mid-tier banks in the US are held by a BHC.

Bank Recovery and Resolution Directive (BRRD) The Bank Recovery and Resolution Directive (BRRD) was adopted in 2014 to provide authorities with (1) comprehensive and effective arrangements to deal with failing banks at national-level cooperation arrangements to tackle cross-border banking failures; (2) the directive requires banks to prepare recovery plans to overcome financial distress. It also grants national authorities powers to ensure an orderly resolution of failing banks with minimal costs for taxpayers. The directive includes rules to set up a national resolution fund that must be established by each European Union (EU) country. All financial institutions have to contribute to these funds. Contributions are calculated on the basis of the institution’s size and risk profile. The EU’s bank resolution rules ensure that the banks’ shareholders and creditors pay their share of the costs through a ‘bail-in’ mechanism. If that is still not sufficient, the national resolution funds set up under the BRRD can provide the resources needed to ensure that a bank can continue operating while it is being restructured.

Contractual Bail-In (CBI) A contractual bail-in (CBI) is, next to a statutory bail-in (SBI), a tool to impose losses on private stakeholders to recapitalize a bank in resolution. In case a jurisdiction does not recognize mandatory bail-ins, a CBI might not be feasible absent sufficient provisions in the debt contracts of banks that allow a resolution authority to bail-in claims under such contracts. The International Swaps and Derivatives Association (ISDA) members are required to include such clauses in their debt contracts such that a later bail-in is feasible when needed. Conditions can still be attached.

Central Clearing Party (CCP) A central counterparty (CCP) is a financial institution that takes on counterparty credit risk between parties to a transaction and provides clearing and settlement services for trades in foreign exchange, securities, options and derivative contracts. Most CCPs are owned by a conglomerate of banks. CCPs bear the largest share of the buyers’ and sellers’ credit risk when clearing and settling market transactions. A CCP concentrates therefore a large portion of market and client specific risk. CCPs avoid that non-cleared contracts

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float in the market carrying risks that stay undocumented and unaccounted for. But ­having many contracts cleared also implies that large volumes of (a)symmetric risks are concentrated and could create issues when adverse market conditions occur. A large chunk of the remaining discussion deals with how CCP losses should be allocated (and in what order) between the CCP, its shareholders and its members.

Collateralized Debt Obligation (CDO) A collateralized debt obligation (CDO) is a structured financial product that pools cash flow–generating debt instruments and repackages this asset pool into tranches (often with different risk profiles) that are sold to investors. The name refers to the fact that the pooled assets (often mortgages, bonds and loans) are all debt obligations and serve as collateral for the CDO. The more senior the tranche, the safer it is assumed. That is because they have first priority on payback from the collateral in the event of default. They often have a higher credit rating.

Credit Default Swap (CDS) A credit default swap (CDS) is a financial contract whereby a buyer of often corporate or sovereign debt attempts to eliminate possible loss arising from default by the issuer of the bonds. The buyer buys insurance against possible future losses on the instrument. The underwriter (of the CDS) therefore absorbs (or better swaps) potential losses on the underlying instrument in line with contractual terms. A future loss can be offset with the benefits of the CDS. To swap the risk of default, the lender buys a CDS from another investor who agrees to reimburse the lender in case the borrower defaults. The insurance premium tends to reflect the anticipated risks. In a CDS, the buyer of the swap makes payments to the swap’s seller until the maturity date of a contract. The seller from his side agrees that in case of a default of the issuer of the debt instrument he will pay the buyer the security’s value as well as all interest payments that would have been paid between that time and the security’s maturity date.

Commercial Mortgage-Backed Securities (CMBS) Commercial mortgage-backed securities (CMBS) are a type of mortgage-backed security backed by commercial mortgages rather than residential real estate. CMBS tend to be more complex and volatile than residential mortgage-backed securities due to the unique nature of the underlying property assets and the fact that the product group isn’t standardized as some others, which makes also valuation often problematic. A CMBS can provide liquidity to real estate investors and commercial lenders alike. Commercial mortgage loans act as the collateral, with principal and interest passed on to investors.

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679

The loans are typically contained within a trust, and they are highly diversified in terms of term, property type and amount. Different tranches with different risk profiles are created, thereby appealing to different types of investors with different risk appetites.

Collateralized Mortgage Obligation (CMO) A collateralized mortgage obligation (CMO) is a fixed-income security that has mortgagebacked securities as collateral. CMOs are typically subdivided into different risk classes, called tranches. Structured by maturity and level of risk, CMOs receive cash flows as borrowers repay the mortgages that act as collateral on these securities. CMOs distribute principal and interest payments to their investors based on the predetermined CMO rules and agreements. CMOs are sensitive to a number of market conditions such as interest rate changes, foreclosure rates, refinance rates and the rates at which properties are sold.

Capital Markets Union (CMU) The Capital Markets Union (CMU) is a plan of the European Commission being rolled out to mobilize capital in Europe. It will channel it to all companies, including small- and medium-sized enterprises (SMEs), and infrastructure projects that need it to expand and create jobs. Deeper and more integrated capital markets will (1) provide businesses with a greater choice of funding at lower costs offering new opportunities for savers and investors and (2) make the financial system more resilient. The creation of a true single market for capital in the EU by 2019 as was originally planned hasn’t been fully achieved. Part of the reason is that it involves many areas of law and conflicting views exist. Also the EU Parliamentary elections of May 2019 have delayed progress. The CMU program was launched in 2014 by the European Commission and carries the following objectives: (1) develop a more diversified financial system complementing bank financing with deep and developed capital markets; (2) unlock the capital around Europe which is currently frozen and put it to work for the economy, giving savers more investment choices and offering businesses a greater choice of funding at lower costs; (3) establish a genuine single capital market in the EU where investors are able to invest their funds without hindrance across borders and businesses can raise the required funds from a diverse range of sources, irrespective of their location.

Constant Net Asset Value (CNAV) Constant net asset value (CNAV) refers to funds (money market funds or MMFs) which use amortized cost accounting to value all of their assets. They aim to maintain a net asset value (NAV), or value of a share of the fund, at EUR 1 or USD 1 and calculate their price to two decimal places known as ‘penny rounding’. Because it is rare for the NAV of an

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MMF to move by as much as 50 bps, the share price of a CNAV fund tends to remain constant, hence the description of the fund as tending to have a ‘constant’ NAV. CNAV funds that fail to maintain a constant price are described as having ‘broken the buck’. CNAV funds are inherently prone to large redemptions because they provide investors with a ‘first redeemer advantage’.

Contingent Convertible Bonds (CoCos) Contingent convertible bonds (CoCos) are a hybrid type of security that absorbs losses when the capital of the issuer falls below a certain preset threshold. They pose two characteristic features3: they include (1) a mechanism that specifies how losses will be absorbed (conversion into common equity or principal write-­down) and (2) a trigger that activates this mechanism (often a given level of the common equity Tier 1 (CET1) ratio and sometimes a ‘point of nonviability trigger’ (PONV) left at the discretion of the supervisor). An important benefit of CoCos—especially relative to equity—is their lower after-tax cost. Regulatory capital eligibility considerations determine the other CoCo features, including maturity. CoCos are supposed to be a first line of defense and to be triggered/depleted by the time a resolution authority decides to use its bail-in powers. These instruments play a crucial role in the context of resolution frameworks but also and maybe more importantly in the context of the Basel III to make bank balance sheets more robust and loss absorbing.

Commercial Paper (CP) Commercial paper (CP) is an unsecured, short-term debt instrument issued by a corporation. It is typically used for the financing of accounts payable and inventories (working capital) and meeting other short-term liabilities. Maturities on commercial paper hardly range longer than 270 days, but can go up to one year. Issuers need to be investmentgrade firms or vehicles (given the unsecured nature of the instrument). CP is raised directly from the market, without involvement of an investment bank, and comes often at significantly lower costs than bonds for the issuing party.

Commercial Paper Funding Facility (CPFF) The Commercial Paper Funding Facility (CPFF) was a system created by the US Federal Reserve Board during the global financial crisis of 2008 to improve liquidity in the shortterm funding markets. The CPFF funded a special purpose vehicle (SPV) that purchased  See G.  Dell’Ariccia et  al., (2018), Trade-offs in Bank Resolution, IMF Staff Discussion Note SDN/18/02, February, p. 29. 3

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681

three-month unsecured and asset-backed commercial paper from eligible issuers. This resulted in greater availability of credit for firms doing business. The facility expired on 1 February 2010.

Credit Rating Agency (CRA) A credit rating agency (CRA) is a company that assigns credit ratings, which rate a debtor’s ability to pay back debt by making timely principal and interest payments and the likelihood of default. A credit rating facilitates the trading of securities in the secondary market. Most traded instruments (debt or equity, vehicles, securitized products, etc.) require a credit rating by law. The most visible CRAs are Moody’s, Standard & Poor’s (S&P) and Fitch. China has its own agency (Dagong).

Capital Requirements Directive (CRD) A capital requirement (also known as regulatory capital or capital adequacy) is the amount of capital a bank or other financial institution has to hold as required by its financial regulator. This is usually expressed as a capital adequacy ratio of equity that must be held as a percentage of risk-weighted assets. There are different models available through which the capital requirement is calculated. In the European Union, there are a set of five directives that cover the issue, the first edition being implemented in 1993. See also Capital Requirements Regulation (CRR).

Commercial Real Estate (CRE) The term ‘commercial real estate’ (CRE) refers to buildings or land intended to generate a profit, from either capital gain or rental income. Commercial real estate includes office buildings, retail/resto buildings, apartment complexes, land and self-storage, hospitals and hospitality infrastructure. The term is often used to contrast with residential real estate, which is typically owner occupied, although that trend is changing as well.

Credit Risk Mitigating (CRM) Techniques Credit risk mitigating (CRM) techniques refer to the pool of techniques that allow reducing the credit risk (including default risk) of an instrument, firm or vehicle. The methods can include: (1) risk-based pricing, or adjusting the cost of credit according to the credit strength of the borrower; (2) credit tightening, or reducing the amount of credit available to higher-risk applicants; (3) diversification, or increasing the portfolio mix of borrowers

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List of Abbreviations and Glossary

and purchasing credit insurance. Particular instruments include netting (offsetting a ­variety of risk profiles of the same issuer), hedging, using off-balance sheet credit and volatility-reducing instruments.

Capital Requirements Regulation (CRR) Capital requirements are set to ensure that banks and depository institutions are not holding investments that increase the risk of default. They also ensure that banks and depository institutions have enough capital to sustain operating losses while still honoring withdrawals. Implemented through Capital Requirements Regulation (EU) Nr. 575/2013. See also Capital Requirements Directive (CRD).

Capital Relief Transaction (CRT) Regulatory capital relief is an investment strategy whereby nonbank investors underwrite losses on portfolios of bank loans. The transactions that they structure transfer the risk of a portion of losses away from the bank, without removing the assets from their balance sheets. The banks themselves then have to hold less capital, while keeping the loan portfolio on their books. In that sense, one can see it as a parallel instrument for securitization, with the difference that under securitization the assets leave the securitizers’ balance sheet.

Central Securities Depositories (CSD) A central securities depository (CSD) is a specialist financial organization holding securities such as shares in either certificated or uncertificated (dematerialized) form so that ownership can be easily transferred through a book entry rather than the transfer of physical certificates. A CSD can be national or international in nature, and may be for a specific type of security, such as government bonds. There exist domestic and international CSD models. The functions include: (1) safekeeping of securities; (2) deposit and withdrawal of securities; (3) dividend, interest, and principal processing, as well as corporate actions including proxy voting; (4) securities lending and borrowing, matching, and repo settlement, or international securities identification number (ISIN) assistance; and (5) pledging of shares and securities. CSD is often regulated separately by law and in the EU by Regulation. Annually a list, in both Europe and the US, of certified CSD is published.

Diversified Broker-Dealer (DBD) A broker-dealer is typically a firm that buys and sells securities for its own account or on behalf of its customers. The term ‘broker-dealer’ is used in securities regulation to describe stock brokerages because most of them act as both agents and principals. A brokerage acts

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683

as a broker (or agent) when it executes orders on behalf of its clients, whereas it acts as a dealer, or principal, when it trades for its own account. Broker-dealers can perform different functions: they provide investment advice to customers, supply liquidity through market-making activities, facilitate trading activities, publish investment research and raise capital for companies.

Dodd-Frank Act (DFA) The Dodd-Frank Wall Street Reform and Consumer Protection Act is a law enacted in 2010 that regulates the financial markets and protects consumers. Its components help prevent, or at least that is the idea, a repeat of the 2008 financial crisis. The act pools a wide variety of topics including financial stability, liquidity, supervision and oversight, oversight of alternative investment managers, transparency and accountability, investor protection, clearing and settlement, mortgage and mortgage-reform, securitization and consumer finance. Because of the wide scope, individual chapters of the law are continuously under review and subject to amendments.

Development Finance Institutions (DFIs) Development finance institutions (DFIs) provide directly or indirectly equity, loans and guarantees to companies operating in the world’s most challenging markets. They are often categorized based on the development index categories by the United Nations (UN). These institutions are often fully or partially funded by development aid budgets. Historically, their mandate was closely linked to development objectives. Gradually that is changing as they often receive a wider mandate to attract non-public office capital and manage their balance sheet independent from the Treasury. Also in terms of investment strategy there is a gradual shift occurring whereby the DFIs weigh commercial motives and bankability of a project or proposal with the pure development objectives.

Department of Energy (US) (DoE) The US Department of Energy is a cabinet-level department of the US government concerned with the US policies regarding energy and safety in handling nuclear material.

Debt-Service-to-Income (DSTI) The debt-to-income (DTI) ratio is the percentage of your gross monthly/annual income that goes to paying monthly/annual debt payments on, for example, a mortgage loan. The DTI ratio is one of the metrics that (mortgage) lenders use to measure an individual’s ability

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to manage monthly payments and repay debts. To calculate the debt service coverage ratio, simply divide the net operating or spendable income by the annual debt. The ratio is also used for macroprudential oversight as in periods of credit expansion the ratio reduces which might indicate stability risk, overvaluation of real estate and/or bubble scenarios.

Deposit-Taking Institutions (DTIs) A deposit-taking institution (DTI) is one of the three main chapters in the financial system, encompassing those which accept deposits and make loans. This category includes banks, trust companies, credit unions and mortgage loan companies. DTIs are specifically licensed and are subject to capital requirements and intense oversight taking into account their deposit-taking nature. They benefit from the deposit insurance mechanism in place in many countries, assuming compliance with all regulations.

European Commission (EC) The executive branch of the European Union’s institutional framework. The European Commission is an institution of the European Union, responsible for proposing legislation, implementing decisions, upholding the EU treaties and managing the day-to-day business of the EU. The Commission operates as a cabinet government, with 28 members.

European Union (EU) The European Union is a political and economic union of 28 member states. Historically it emerged out of the European Coal and Steel Community and later on the economically centered European Economic Community (EEC).

European Banking Authority (EBA) The European Banking Authority (EBA) is a Paris-based regulatory agency of the European Union. Its activities include conducting stress tests on European banks to increase transparency in the European financial system and identifying weaknesses in banks’ capital structures. The EBA is thus an independent EU Authority that works to ensure effective and consistent prudential regulation and supervision across the European banking sector. Its overall objectives are to maintain financial stability in the EU and to safeguard the integrity, efficiency and orderly functioning of the banking sector. The Authority also plays an important role in promoting convergence of supervisory practices and is mandated to assess risks and vulnerabilities in the EU banking sector. The EBA was established on 1 January 2011.

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685

 egulation on OTC Derivatives, Central R Counterparties and Trade Repositories (EMIR) In 2012 the EU adopted the European Market Infrastructure Regulation (EMIR). The aims were to increase transparency in the over-the-­counter (OTC) derivatives markets, mitigate credit risk and reduce operational risk. It further established common rules for central counterparties and trade repositories. The overall objective of the legislation is to reduce systemic counterparty and operational risk, and help prevent future financial system collapses.

European Supervisory Authorities (ESAs) The European System of Financial Supervision (ESFS) is the framework for financial supervision in the European Union in operation since 2011. The system consists of the European Supervisory Authorities (ESAs), the European Systemic Risk Board, the Joint Committee of the European Supervisory Authorities and the national supervisory authorities of EU member states. There are three European Supervisory Authorities (ESAs). They are responsible for microprudential oversight at the European Union level: (1) the European Banking Authority, (2) the European Securities and Markets Authority (ESMA) and (3) the European Insurance and Occupational Pensions Authority (EIOPA).

European Systemic Risk Board (ESRB) The European Systemic Risk Board (ESRB) was established in 2010 to oversee the financial system of the EU and prevent and mitigate systemic risk. The ESRB is responsible for the macroprudential oversight of the EU financial system and the prevention and mitigation of systemic risk. The ESRB therefore has a broad remit, covering banks, insurers, asset managers, shadow banks, financial market infrastructures and other financial institutions and markets. In pursuit of its macroprudential mandate, the ESRB monitors and assesses systemic risks and, where appropriate, issues warnings and recommendations. Its operations are organized through Regulation (EU) No 1092/2010.

European System of Central Banks (ESCB) The European System of Central Banks (ESCB) consists of the European Central Bank (ECB) and the national central banks (NCBs) of all 28 member states of the European Union. The ESCB is not the monetary authority of the eurozone, as not all EU members states use the euro as their currency.

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List of Abbreviations and Glossary

 uropean Securities and Markets E Authority (ESMA) ESMA is an independent EU Authority that contributes to safeguarding the stability of the European Union’s financial system by enhancing the protection of investors and promoting stable and orderly financial markets. It achieves this by assessing risks to investors, markets and financial stability; completing a single rulebook for EU financial markets; promoting supervisory convergence and directly supervising credit rating agencies and trade repositories. It works closely with the other European Supervisory Authorities competent in the field of banking (EBA), and insurance and occupational pensions (EIOPA). The three main objectives are investor protection, orderly markets and financial stability.

Employee Retirement Income Security Act (ERISA) The Employee Retirement Income Security Act of 1974 (ERISA) is a US federal law that sets minimum standards for most voluntarily established retirement and health plans in private industry to provide protection for individuals in these plans. The main purpose of ERISA is to protect the interests of employees (and their beneficiaries) who are enrolled in employee benefit plans, and to ensure that employees receive the pensions and groupsponsored welfare benefits that have been promised by their employers.

Exchange-Traded Fund (ETF) An exchange-traded fund (ETF) is an investment fund traded on a stock exchange, much like individual stocks. An ETF holds assets such as stocks, commodities or bonds (or a mixture) and generally operates with an arbitrage mechanism designed to keep its trading close to its net asset value, although deviations can occasionally occur. Historically, most ETFs were index-tracking funds, and were positioned as low-cost passive products. Over time, that has changed in the sense that while continuing to compete on costs, the product group became more strategic for investors and the investment strategies they used being more complex, and focused on more than just capturing the beta in the market. Enhanced strategies combined with low costs are now the focal point as a product group. The ETF group in a way became a more ‘active product’ or at least a passive product in an active strategy-denominated portfolio.

Eigenvector Centrality (EVC) Eigenvector centrality (EVC) is a measure of the influence of a node in a network. Relative scores are assigned to all nodes in the network based on the concept that connections to high-scoring nodes contribute more to the score of the node in question than equal connections to low-scoring nodes. In finance, and particularly the literature on systemic risk

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687

and systemically important institutions, the concept refers to the element to assess the systemic importance of a node (e.g. a financial player) by reference to the importance of the nodes it is connected to. In the case of systemic risk, it is possible to become systemically important either by having links to a large number of nodes or by having a smaller number of links to nodes which themselves are systemically important.

Financial Activities Tax (FAT) A financial activities tax (FAT) is a tax on the sum of bank profits and bankers’ remuneration packages, with the proceeds going into general government revenues. Not to be confused with a financial transaction tax or a financial stability contribution. See Financial Transaction Tax.

Fallback Approach (FBA) This refers to one of the methods used to determine the capital standard for funds investment or more in general for credit risk by institutions subject to capital requirements. It is typically the last option in row as the name reveals that it is a kind of contingency option as all the other options for whatever reason don’t work or aren’t preferred.

Federal Deposit Insurance Corporation (FDIC) The Federal Deposit Insurance Corporation (FDIC) is a US government corporation providing deposit insurance to depositors holding deposits with US commercial banks and savings institutions. The standard deposit insurance coverage limit is USD 250,000 per depositor, per FDIC-insured bank and per ownership category, even in case they are held at the same bank. The FDIC thus provides separate coverage for deposits held in different account ownership categories. The FDIC covers all the traditional consumer banking products such as checking, savings and money market deposit accounts, and certificates of deposit (CDs). 401(k) plans are considered investment products or plans and are therefore not covered. Also excluded are stocks, bonds, mutual funds, life insurance policies, annuities or securities. The FDIC is funded by member banks (which all must meet certain criteria in terms of liquidity and capitalization) and the government acts as a backstop in case the FDIC runs out of cash.

Federal Reserve Bank (US) (Fed) The Federal Reserve Bank is the central bank of the US. It was created in December 1913, after a series of financial panics led to the desire for central control of the monetary system in order to alleviate financial crises. Its mandate includes the following: (1) conducting

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the nation’s monetary policy by influencing money and credit conditions in the economy in pursuit of full employment and stable prices; (2) supervising and regulating banks and other important financial institutions to ensure the safety and soundness of the nation’s banking and financial system and to protect the credit rights of consumers; (3) maintaining the stability of the financial system and containing systemic risk that may arise in financial markets; and (4) providing certain financial services to the US government, US financial institutions and foreign official institutions, and playing a major role in operating and overseeing the nation’s payments systems.

Federal Housing Administration (FHA) A US government agency established in 1934, it provides mortgage insurance and sets standards for constructing and underwriting and insures loans made by banks while others provide lending for home building. The overall objective is to improve housing standards and conditions and also build and maintain an adequate financing system through the insurance of mortgage loans. Stabilizing and maintaining a stable mortgage market also is included in its mandate.

Federal Housing Financing Agency (FHFA) An independent US federal agency with its legal and regulatory authority inherited from the Federal Housing Finance Board (FHFB). Its authority includes the ability to place government-sponsored enterprises (GSEs) into receivership and conservatorship. It regulates Fannie Mae and Freddie Mac and another 11 Federal Home Loan Banks. It operates separate from the Federal Housing Administration (FHA) which provides mortgage insurance.

Federal Home Loan Banks (FHLB) The Federal Home Loan Banks (FHLB) are 11 US government–sponsored banks that provide reliable liquidity to member financial institutions. Collectively, the FHLB represent the largest collective source of home mortgage and community credit in the US. The system was established in 1932. The prime mission is to provide member financial institutions with financial products and services that assist and enhance the financing of housing and community lending. The banks are each structured as owned and governed by their member financial institutions, which today include savings and loan associations, commercial banks, credit unions and insurance companies. A primary benefit of FHLB membership is access to reliable liquidity through secured loans.

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689

Financial Institution (FI) FI refers typically, as an umbrella term, to the collectivity of institutions that are active in the (private and/or public) financial markets. A financial institution typically provides a wide variety of deposit, lending and investment products to individuals, businesses or both. As the term covers a wide spectrum of activities, it is classified for regulatory, oversight and other purposes. A possible classification would be: central banks, retail and commercial banks, internet banks, credit unions, savings and loan associations, investment banks, investment companies, brokerage firms, insurance companies and mortgage companies.

Financial Market Infrastructure (FMI) Financial market infrastructure (FMI) refers to critically important institutions responsible for providing clearing, settlement and recording of monetary and other financial transactions. A payment system is a set of instruments, procedures and rules for the transfer of funds between or among participants. On a global scale the FMIs are governed by a set of principles developed by CPMI/IOSCO (Committee on Payments and Market Infrastructures/International Organization of Securities Commissions).  The principles for financial market infrastructures are the international standards for financial market infrastructures, that is, payment systems, central securities depositories, securities settlement systems, central counterparties and trade repositories.

Floating Net Asset Value (FNAV) A floating NAV (FNAV) money market fund prices and transacts at a net asset value per share that can change or fluctuate based on pricing of the underlying fund holdings. FNAV funds are priced using basis point rounding, to four decimal places. Floating NAVs are calculated at pricing intervals throughout the day. This differs from a stable NAV fund, which calculates NAV once a day. The same factors that can have the biggest impact on a stable money market fund’s NAV—changes in credit, interest rates and investor flows—are the most significant drivers of a money market fund’s floating NAV.

Financial Stability Board (FSB) The Financial Stability Board (FSB) is an international body that monitors and makes recommendations about the global financial system. It was established after the G20 London summit in April 2009 as a successor to the Financial Stability Forum. The FSB monitors and assesses vulnerabilities affecting the global financial system and proposes actions needed to address them. In addition, it monitors and advises on market and systemic developments, and their implications for regulatory policy.

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List of Abbreviations and Glossary

Financial Transaction Tax (FTT) A financial transaction tax (FTT) is a levy introduced on a specific type of financial transaction and often for a particular purpose. The FTT has been most commonly associated with the financial sector, but the levy is attached to the transaction and not the transaction-engaging institution. So it doesn’t fall within the category of bank taxes, stability contributions or financial activity taxes. The philosophy is to selectively discourage excessive speculation without discouraging broader economic activities and development. The financial transaction can carry securities, derivatives or currencies.

Financial Vehicle Corporations (FVC) See Special Purpose Entity (SPE).

Gross Domestic Product (GDP) Gross domestic product (GDP) is a monetary measure of the market value of all the final goods and services produced in a period of time, often quarterly or annually (for a particular country, region or the world). Different definitions exist, although they essentially capture the same phenomenon. The Organisation for Economic Co-operation and Development (OECD) frames it as ‘an aggregate measure of production equal to the sum of the gross values added of all resident and institutional units engaged in production (plus any taxes, and minus any subsidies, on products not included in the value of their outputs)’. The International Monetary Fund (IMF) states: ‘GDP measures the monetary value of final goods and services—that are bought by the final user—produced in a country in a given period of time (say a quarter or a year).’

Guaranteed Investment Contract (GIC) A guaranteed investment contract (GIC) is an agreement between the purchaser (of a contract) and an insurance company whereby the insurance company provides a guaranteed rate of return in exchange for keeping a deposit for a fixed period of time. A guaranteed investment contract therefore is a contract that guarantees repayment of principal and a fixed or floating interest rate for a predetermined period of time. Guaranteed investment contracts are typically issued by life insurance companies. A GIC is used primarily as a vehicle that yields a higher return than a savings account or US Treasury securities.

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691

Global Flow of Funds (GFF) The global flow of funds (GFF) concept is an extension of the domestic flow of funds. It connects domestic economies with the rest of the world. GFF data could provide valuable information for analyzing interconnectedness across borders and global financial interdependencies. Flow of funds (FOF) accounts are used to track the flow of money to and from various sectors of a national economy. Flow of funds accounts are collected and analyzed by a country’s central bank. The FSB also uses the data sets to formulate analysis and policy recommendations.

Government-Sponsored Entity (GSE) Government-sponsored enterprises, or GSEs, are quasi-governmental, privately held entities established to improve or enable the flow of credit to specific sectors of the economy or to otherwise provide essential services to the public. Government-sponsored enterprises do not lend money to the public directly. Instead, they guarantee third-party loans and purchase loans in the secondary market, thereby providing money to lenders and financial institutions. GSE bonds carry the implicit backing of the US government, but they do not qualify as direct obligations by the US government unlike Treasury bonds.

High-Quality Liquid Assets (HQLA) A concept to be situated as part of the ‘liquidity coverage ratio’ which is part of the Basel III standards for deposit-taking regulated banking institutions. The aim of the requirement is to have sufficient liquidity at all times to meet short-term obligations and deposits withdrawals. The high-quality liquid assets (HQLA) include only those with a high potential to be converted easily and quickly into cash (in times of distress). HQLA are cash or assets that can be converted into cash quickly through sales (or by being pledged as collateral) with no significant loss of value. A liquid asset can be included in the stock of HQLA if it is unencumbered, meets minimum liquidity criteria and its operational factors demonstrate that it can be disposed of to generate liquidity when needed. The HQLA group includes Level 1 assets, which can be included without limit, and Level 2 assets, which cannot exceed 40% of the liquidity reserve. Level 2 assets are themselves subdivided into Level 2A assets, whose value is subject to a 15% haircut, and Level 2B assets, which are subject to higher haircuts but cannot exceed 15% of the stock of HQLA.

Internal Assessment Approach (IAA) The internal assessment approach allows banks to map their internal credit assessment of a securitization exposure to an equivalent (i.e. to mirror) external credit rating from a recognized statistical rating organization. It results in a risk-weighted amount of

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List of Abbreviations and Glossary

capital to be held against a certain portfolio of securitized products. As the methodology used is ‘internally generated’ it needs to be approved by the designated supervisory body in terms of the robustness of the methodology, the quality of the data used and policies, procedures and controls used to mitigate risks and ex post interventions.

Insurance Corporation and Pension Fund (ICPF) Insurance Corporation and Pension Fund is used as a reporting group by the ECB for statistical purposes. Insurance corporations comprise both insurance (life and non-life) and reinsurance types of business. Pension funds consist only of those pension funds that are institutional units separate from the units that create them.

Investment Fund (IF) An investment fund is a way of investing money (through a vehicle) alongside other investors in order to benefit from the inherent advantages of working as part of a group. These advantages include, among others, an ability to engage professional managers, benefit from lower transaction costs and economies of scale, and reduce idiosyncratic risk through enhanced asset diversification. It is an umbrella term that includes a wide variety of funds with a variety of strategies and governed by different regulations and oversight. Terminology therefore varies with country but investment funds are often referred to as investment pools, collective investment vehicles, collective investment schemes, managed funds or simply funds. An investment fund can be held by the public, such as a mutual fund, exchange-traded fund, special purpose acquisition company or closed-end fund, or it may be sold only in a private placement, such as a hedge fund or private equity fund. They therefore can be listed or private.

International Financial Reporting Standards (IFRS) International Financial Reporting Standards (IFRS) is a set of accounting standards developed by an independent, not-for-profit organization called the International Accounting Standards Board (IASB). The goal of IFRS is to provide a global framework for how public companies prepare and disclose their financial statements. IFRS provides general guidance for the preparation of financial statements, rather than setting rules for industry-specific reporting. Currently, well over 100 countries permit or require IFRS for public companies. IFRS is sometimes confused with International Accounting Standards (IAS), which are older standards that IFRS has replaced.

  List of Abbreviations and Glossary 

693

Insurance-Linked Securities (ILS) Insurance-linked securities are financial instruments whose value is affected by an insured loss event. The term ‘insurance-linked security’ includes catastrophe bonds and other forms of risk-linked securitization. Insurance-linked securities are generally thought to have little to no correlation with the wider financial markets as their value is linked to nonfinancial risks such as natural disasters, longevity risk or life insurance mortality. As securities, insurance-linked securities can be and are traded among investors and on the secondary market. They allow insurers to offload risk and raise capital.

Internal Ratings-Based Approach (IRBA) The internal ratings-based approach (IRBA) is one of the methodologies under the Basel II guidelines to be used by banks to calculate the level of regulatory capital required to compensate for credit risk. Only banks meeting certain minimum conditions, disclosure requirements and approval from their national supervisor are allowed to use this approach in estimating capital for various exposures. Each of the exposures by banks (corporate, sovereign, bank, retail and equity) has its own classification and subclassification. To effectively calculate the required capital, the methodology uses certain risk parameters, a weighting system for the different exposures while the bank must fulfill certain minimum standards.

International Organization of Securities Commissions (IOSCO) The International Organization of Securities Commissions (IOSCO) is the international body that brings together the world’s securities regulators and is recognized as the global standard setter for the securities sector. IOSCO develops, implements and promotes adherence to internationally recognized standards for securities regulation. It works intensively with the G20 and the Financial Stability Board on the global regulatory reform agenda.

(Total) Loss-Absorbing Capacity ((T)LAC) Loss-absorbing capacity (LAC) refers to the question to what extent, in the case a bank is facing failure, a systemic crisis or other displacement scenarios that might put the bank’s survival at risk, the bank’s balance sheet is composed of financial instruments that can effectively and under such circumstances absorb risk in such a way that depositors with the bank stay unaffected and/or not public funding is required to stabilize the firm and ensure

694 

List of Abbreviations and Glossary

continued operations. Even in case a bank goes into receivership or resolution, the LAC allows for an orderly unwinding of the bank’s business operations. Under Basel III, the systemically important banks are required to TLAC in accord with their risk-weighted assets and leverage ratios. The EU version, known as ‘minimum requirement of own funds and eligible liabilities (MREL)’, applies to all EU banks, regardless of size, at both the individual and group consolidated levels.

Leveraged Buyouts (LBOs) A leveraged buyout (LBO) is the technique used for buying a company thereby using a significant amount of debt. The assets and operations of the company are often used as a collateral for the loans. This is in addition to the assets of the acquiring company in case the buyer is an operational or strategic buyer. In case the buyer is a financial sponsor (private equity firm or venture capital firm) such assets are typically not available. The LBO scheme works with an equity portion of between 5% and 15% complemented with additional layers of debt from senior secured to junior and subordinated and with a maturity scale to avoid that too much debt becomes due at the same time or during a short period of time. Typically the acquired company is sold in a five- to seven-year period and remaining acquisition debt is then fully repaid. The LBO scheme also uses bridge financing to cover the initial period after acquisition (normally 12–24 months), during which potential re-­organizations, sell-offs and other restructuring efforts are completed to ensure that continued operations afterward can meet the debt service that follows from the acquisition debt.

Liquidity Coverage Ratio (LCR) The liquidity coverage ratio (LCR) refers to the proportion of highly liquid assets that need to be held by a financial institution subject to the Basel III framework. It ensures that under a wide set of market conditions the firm can meet its short-term obligations. Essential in the Basel III arrangements regarding the LCR is the definition of what constitutes a highly liquid asset. The LCR ratio essentially is a stress test (typically measured over a 30-day period) that aims to anticipate a variety of market- and system-wide shocks and the necessity for banks to maintain sufficient liquidity to meet short-term obligations.

Legal Entity Identifier (LEI) The Legal Entity Identifier (LEI) is a unique and global identifier for individuals, funds, firms or public entities that participate in financial transactions. The LEI is used in a variety of reporting standards to financial regulators. It consists of 20 characters. The objective is to connect the LEI to key reference information that enables clear and unique

  List of Abbreviations and Glossary 

695

identification of legal entities engaged in financial transactions. In short, it can be seen as a global directory of ‘who is who’ in global financial markets. The Global Legal Entity Identifier Foundation (GLEIF) accredits those parties that can issue LEIs. Those parties typically are financial exchanges or financial data vendors as they are best suited to act as primary interfaces to such database and maintain its operational and up-to-date status.

Loss Given Default (LGD) Loss given default (LGD) is that part of an asset that is lost in case a borrower defaults. It is a common element in risk models and further a parameter used in the calculation of economic capital, expected loss or regulatory capital under Basel II(I) for a banking institution. The most frequently used method to calculate this loss compares actual total losses to the total amount of potential exposure sustained at the time that a loan goes into default. In most cases, LGD is determined after a review of a bank’s entire portfolio, using cumulative losses and exposure for the calculation. Banks and other financial institutions determine credit losses by analyzing actual loan defaults.

Local Government Financing Vehicles (LGFVs) Local government financing vehicle (LGFV) is a financing company which is typically owned by a local government in China. They often sell local land’s bond to the China Development Bank which is in turn used to finance real estate development. There is structural concern about the indebtedness of these entities, the subprime nature of many securities they hold and the real estate of portfolio they own or have financed. Lianhe Ratings Global, a local Chinese credit rating agency, developed a rating model for this specific type of institution (2018). The problem is that they operate in relative obscurity and provide very little guidance or transparency. Nevertheless, under adverse market conditions they can pose a systemic risk and impact the public debt record of the Chinese government. In recent years the pace of issuing new debt has decreased but concerns continue to emerge given the massive historic buildup of their portfolio and the political, rather than bankable, nature of their investment decisions.

Local Government Investment Pool (LGIP) A government investment pool (GIP), or local government investment pool (LGIP), is a state or local government pool (the US) offered to public entities for the investment of public funds. These pools offer safety with a competitive yield. Many GIPs are managed by the government, but there are also GIPs that are managed by outside investment firms. Participants in a government investment pool may include state or local municipalities, counties, school districts, utility districts and local government units. Investments may

696 

List of Abbreviations and Glossary

include, but are not restricted to, certificates of deposit (CDs), US Treasuries, US a­ gencies, repurchase agreements and commercial paper. LGIPs aren’t Securities and Exchange Commission (SEC) regulated.

Lender of Last Resort (LOLR) A lender of last resort (LOLR) is the institution in the financial system that is the provider of liquidity to a financial institution in case it finds itself unable to obtain sufficient liquidity itself in the interbank lending market and when other facilities or sources have been exhausted. The concept became more mainstream after the 2008 financial crisis when the central banks in countries around the world had to step in and provide a liquidity window to avoid solvency issues or outright defaults of banks and other financial intermediaries. It refers more broadly to the fact that when markets go sideways, there is no intrinsic mechanism to correct the situation and an external (public) body is required to avoid further defaults in the market.

Long-Term Note (LTN) A long-term note is a (often secured) debt security with a maturity beyond one year.

Limited Purpose Finance Company (LPFC) Under limited purpose banking, all financial corporations engaged in financial intermediation, including all banks and insurance companies, would function exclusively as middlemen who sell safe as well as risky collections of securities (mutual funds) to the public. They would never, themselves, own financial assets. A limited purpose finance company is a company engaged in such activities. Limited purpose banking can also be structured as a trust and is then referred to as a ‘limited purpose trust company’.

Look-Through Approach (LTA) The look-through approach (LTA) is one of the (and preferred) methodologies to determine the capital requirements for banks to hold against equity investment in other funds. The LTA embodies the most granular approach. The look-through methodology essentially looks through the equity investment and analyzes the assets held by the fund invested in. What is important is that the institution knows with sufficient certainty the underlying assets contained in the fund. If the risk weight of the underlying asset is known, the use of the look-through approach will provide the most accurate measure of the fund’s overall risk and ensure capital requirements are commensurate with the risk.

  List of Abbreviations and Glossary 

697

Where an institution does not have sufficient information about the underlying individual exposures to use the look-through approach, it may calculate the risk-weighted exposure amount of those exposures in accordance with the limits set in the fund’s mandate and relevant legislation.

Loan-to-Income (LTI) Ratio The loan-to-income ratio is used in real estate finance and indicates the relationship between the mortgage loan taken out and the annual income of the lender. It says something about the ability of the lender to repay the loan. In some countries there are caps on the ratio that banks have to apply (e.g. 3.5 times), others only provide guidance on the matter but do not effectively interfere. The concern is with the amount of credit flowing into real estate, the prime or subprime nature of the loan and lender, and the macroeconomic risks that might be attached to the volume of credit floating in real estate markets. Often, distinction is made between ‘principal-dwelling’ and ‘secondary real estate’ markets in setting potential limits or caps.

Loan-to-Value (LTV) (Ratio) The ‘loan-to-value’ (LTV) ratio means the ratio of the amount of a housing loan to the (market) value of the real estate pledged as loan collateral. In case the ratio is 100%, the loan covers the market value (or any other ex ante determined value) of the collateral (i.e. the property). In case transaction-related expenses are also debt-financed the ratio will even be higher than 100%. On aggregate it says something about how much credit is flowing into a real estate market, which in itself influences the valuation in that market. As real estate bubbles are almost always credit-induced, and a steep fall in real estate prices always tends to adversely impact confidence and therefore fosters panic in markets, supervisors tend to carefully monitor the amount of credit in the real estate market through a number of these ratios and some even set (mandatory) limits to the ratios. The ESRB regularly advises on limits in respective European real-estate-sensitive markets.

Market Abuse Directive (MAD) The Market Abuse Directive (MAD) is a European Directive which contains a comprehensive framework that addresses situations whereby investors have been unreasonably disadvantaged. The objective is to address abusive behavior often enabled by (new) technology and to protect the financial market integrity and to strengthen investor confidence. The initial MAD I which was adopted in 2003 operated its objective by requiring the market participants to commit to transparency, closer cooperation and equal enforcement of the framework. However, as the financial infrastructure has changed materially

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List of Abbreviations and Glossary

during the last decade allowing for new forms of market manipulation, the MAD I was replaced by MAD II/MAR (Market Abuse Regulation) in 2015 (effective July 2016). The most important changes related to both capturing new technologies and their abusive applications, but predominantly by expanding the scope of the directive. For example, MAR doesn’t apply only to financial instruments traded on a regulated market, but also to those traded or admitted to trading on a multilateral trading facility or on an organized trading facility, as well as to instruments traded over the counter which might influence the price or rate of the financial instruments and commodities covered by the MAR definition. Moreover, manipulation of financial instruments might also take place outside of trading venues or just by having the intention to trade, that is, placing orders without executing them.

Multi-Agent Financial Network (MAFN) The term is used in the context of understanding, identifying and analyzing systemic risk in financial markets and to build a model to reflect the complexity and nature of financial markets. There is still both a data and a skills gap in implementing large-scale data-driven multi-agent financial network models that can operationalize macroprudential policy. The idea is to provide a quantitative integrative financial framework using multi-agent modeling, which can monitor and analyze systemic risk from activities of financial intermediaries within the context of the regulatory incentives and prevailing market conditions.

Mandate-Based Approach (MBA) The mandate-based approach (MBA) is one of the (three) methodologies supported by the Basel Committee on Banking Supervision to calculate the capital requirements banks must hold for equity investments in other funds. The approach should be used when the look-­through approach cannot be used or when the conditions for use aren’t met. Under the MBA banks may use the information contained in a fund’s mandate or in the national regulations governing such investment funds.

Mortgage-Backed Securities (MBS) A mortgage-backed security is a type of asset-backed security, secured by a pool of mortgages. It usually pays periodic payments that are similar to coupon payments and the mortgages typically originate from a regulated and authorized financial institution. It is issued by a federal government agency, government-sponsored enterprise, or private financial company. Secondary trading of those securities occurs through regulated brokers. There are two common types of MBS: pass-throughs and collateralized mortgage

  List of Abbreviations and Glossary 

699

obligations. Both are differently structured and have different maturities, but both can have fixed rates or adjustable mortgage rates. They both have tranches that have their own credit rating, and the rates of return depend on the tranche held by the investor.

Marginal Expected Shortfall (MES) Marginal expected shortfall (MES) is the prime statistical methodology used to measure systemic risk. It was first coined by V. Acharya et al. (2010). The MES of an institution can be defined as its expected equity loss when the market itself is in its left tail. Or more technically the MES of a financial firm can be defined as its short-run expected equity loss conditional on the market taking a loss greater than its Value at Risk at α %. The expected shortfall of the market (ES) equals the expected loss in the index conditional on this loss being greater than the tail risk in the market.

Micro-Finance Institutions (MFI) Micro-finance is a type of financial services targeting predominantly individuals and small businesses who often lack access to conventional banking. Micro-­finance includes the provision of microcredit, the provision of small loans to poor clients, savings and checking accounts, micro-insurance and payment systems. They tend to be regulated either as banks or under a different but similar regulatory model. In terms of its usefulness to society and underserviced customers elsewhere, the views are mixed. Concerns exist with respect to its contribution to higher indebtedness in society, loan pricing and the depth of impact.

Markets in Financial Instruments Directive (MiFID) The Markets in Financial Instruments Directive (MiFID) 2004/39/EC (implemented on 1 November 2007) is a European Union law that provides harmonized regulation for investment services across the 31 member states of the European Economic Area. There are currently two MiFID Directives in place. The latter is accompanied by a regulation (Markets in Financial Instruments (MiFIR) – Regulation (EU) No 600/2014). MiFID 1 governs provisions of investment services in financial instruments by banks and investment firms and operation of traditional stock exchanges and alternative trading venues. MiFID 2 was enacted after flaws were detected after the 2008 financial crisis. The second directive (applicable as of 3 January 2018) reinforces the rules on securities markets by (1) ensuring that organized trading takes place on regulated platforms introducing rules on algorithmic and high-frequency trading; (2) improving the transparency and oversight of financial markets, including derivatives markets; and (3) addressing some shortcomings

700 

List of Abbreviations and Glossary

in commodity derivatives markets, enhancing investor protection and improving conduct of business rules as well as conditions for competition in the trading and clearing of financial instruments.

Microprudential Instruments (MIPI) Microprudential instruments consist of such measures concerned with the stability of individual entities and the protection of clients of the institutions. Although micro- and macroprudential instruments show a certain overlap, the focus of microprudential instruments is different—that is, the main focus of microprudential supervision is to safeguard individual financial institutions from idiosyncratic risks and prevent them from taking too much risk. The macro-view is, however, needed as individual actor stability isn’t sufficient to guarantee market stability. The focus of microprudential policy therefore is the stability of individual financial institutions. By contrast, the focus of macroprudential policy is the stability of the financial system as a whole.

Money Market Funds (MMFs) A money market fund is a type of mutual fund that typically invests only in highly liquid instruments, that is, cash and cash equivalent securities, as well as high credit rating debtbased securities with a short-term maturity (often less than 13 months). Different types of MMFs exist (e.g. those with a constant net asset value and those with a floating net asset value). These funds offer high liquidity with a very low level of risk. The fund typically invests in instruments such as bankers’ acceptances, certificates of deposits, commercial paper, repurchase agreements and US treasuries. During the 2008 financial crisis, they were part of the problem as liquidity dried up in this segment of the market quite materially which was caused by investors withdrawing hoping to benefit from a firstmover advantage. Multiple regulatory interventions occurred in recent years. In Europe, the common denominator for these kinds of funds is UCITS.

Money Market Mutual Funds (MMMFs) See Money Market Funds (MMFs).

Monoline Insurance (Company) (MI(C)) A monoline insurance company is an insurance company that provides coverage for a variety of insurable risks. The term ‘monoline’ refers to the practice of insurers specializing in a single domain or discipline of the financial services industry. As such, it often refers

  List of Abbreviations and Glossary 

701

to company providing its services in only one industry or segment, product or service (e.g. life insurance, credit card issuance and mortgages). Historically, they commenced providing their services for municipal bonds issues, but have broadened their scope of operations ever since. The objective is to enhance the credit of the issuer (maintain or improve credit rating). Although the instrument used can vary, the coverage is often provided in the form of credit swaps. These insurers were and are also active in the shadow banking segment enhancing the credit profile of mortgage-backed securities and collateralized debt obligations. Some of them participated as counterparties in credit default swaps, sold assurance of payment to the buyer of swaps if the credit quality of the securitized product deteriorated.

Macroprudential Instruments (MPIs) The focus of macroprudential policy is the stability of the financial system as a whole. However, macroprudential instruments (MPIs) go hand in hand with microprudential instruments. The latter is concerned with stability at the level of the individual actor in the financial space. The former, however, focuses on the market as a whole. Macroprudential supervision takes into account the interactions among individual financial institutions, as well as the feedback loops of the financial sector with the real economy, including the costs that systemic risk entails in terms of output losses.

 inimum Requirements for Own Funds M and Eligible Liabilities (MREL) The minimum requirement for own funds and eligible liabilities (MREL) is the European equivalent of the internationally used concept of total loss-absorbing capital. The Bank Recovery and Resolution Directive, which has been transposed in all participating Member States’ legislation, requires banks to meet a minimum requirement for own funds and eligible liabilities so as to be able to absorb losses and restore their capital position, allowing banks to continuously perform their critical economic functions during and after a crisis. It is a key tool in enhancing the resolvability of banks. In 2017, the European Single Resolution Board (the overarching resolution authority in Europe) developed its MREL-specific policy. That process is still ongoing whereby the Single Resolution Board makes explicit its position and policies for a variety of scenarios.

Modified Supervisory Formula Approach (MSFA) The Modified Supervisory Formula Approach (MSFA) is the new Basel methodology for calculating capital requirements to be held against securitized products. The methodology replaces the former Supervisory Formula Approach (SFA), which assumes a

702 

List of Abbreviations and Glossary

one-year maturity for the underlying pool of securitized loans (‘pool’) and is based on the Value-at-Risk approach with adjustments to reflect the securitized products held. The MSFA, on the contrary, is based on an underlying expected shortfall. Expected shortfall refers to the tail risk and the unknown nature of some of these exposures. The regulatory model is assumed to be an unbiased, but nevertheless imprecise. Concentration risk is still neglected in the model. Improvements, however, were made in the methodology how a system of equations is designed for approximating a tranche’s capital charge.

Medium-Term Note (MTN) A medium-term note (MTN) is a debt instrument with a maturity of five to ten years, but may be (considerably) more. They can carry a fixed or floating coupon. MTNs are most commonly issued as senior, unsecured debt of investment-grade credit rated entities which have fixed rates.

Net Asset Value (NAV) Net asset value (NAV) is the value of an entity’s assets minus the value of its liabilities. It is a term often used in relation to open-ended or mutual funds, in particular since shares of such funds registered with the US Securities and Exchange Commission are redeemed at their net asset value. The term is also applicable to ETFs, in which case the NAV represents the per share/unit price of the fund on a specific date or time. In the context of companies and business entities, the difference between the assets and the liabilities is known as the net assets or the net worth or the capital of the company.

Nonbank Financial Intermediary (NBFI) Nonbank financial intermediaries (NBFIs) are a large and mixed bag of institutions ranging from leasing, factoring and venture capital companies to various types of contractual savings and institutional investors (pension funds, insurance companies and mutual funds). The common denominator is that none of these institutions hold a banking license and should comply with banking capital requirements. Also supervision is absent and/or differently organized. These are a material part of the shadow banking segment of the market and concerns existed and persist to what degree these institutions engage in activities that involve credit-, maturity-, and liquidity-transformation without being sheltered by the capital buffers like banks.

  List of Abbreviations and Glossary 

703

Nonbank Noninsurance (NBNI) Nonbank noninsurance (NBNI) institutions are those institutions that don’t qualify as banks, nor as insurance firms. NBNI financial entities often have very different legal forms, business models and risk profiles. This makes the task of supervisory bodies particularly challenging in that the methodologies have to allow sufficient flexibility to capture different risks (or externalities) posed by entities in each type/sector appropriately while maintaining a certain degree of consistency across the entire NBNI financial space. Also the systemic nature of such entities is difficult to establish. The FSB therefore provided, in their 2015 methodology for NBNIs, not a definition, but a set of criteria that can help in identifying those entities. Those criteria include (1) the size of a single entity, (2) the level of interconnectedness of such an entity, (3) the substitutability of those entities, (4) the business, structural and operational complexity of entities and (5) the global nature or remit of the entities’ activities.

Notice of Proposed Rulemaking (NPRM) A notice of proposed rulemaking (NPRM) is a US public notice issued by law when one of the independent agencies of the US government wishes to add, remove or change a rule or regulation as part of the rulemaking process. It typically starts a process of public comments on the raised matter. NPRM procedure is required and defined by the Administrative Procedure Act, but is not a constitutional requirement.

Net Stable Funding Ratio (NSFR) The net stable funding ration (NSFR) is defined as the amount of available stable funding (ASF) relative to the amount of required stable funding (RSF). This ratio should be equal to at least 100% on an ongoing basis. The requirement is a minimum requirement that is applicable to all internationally active banks since 1 January 2018. In terms of the definition, the ASF of a bank refers to the portion of its capital and liabilities that will remain with the institution for more than one year. The broad characteristics of an institution’s funding sources and their assumed degree of stability are the basis for determining ASF.

Other Depository Corporation (ODC) The other depository corporation (ODC) is a subsector of the financial institutions sector. It consists of all financial corporations, excluding the financial bank, whose principal activities consist of intermediation and which have liabilities in the form of deposits or financial instruments such as short-term certificates of deposit which are close substitutes for deposits in mobilizing financial resources and which are included in the broadly

704 

List of Abbreviations and Glossary

defined concept of ‘measures of money’. The institutional coverage of the ODC sector varies per country, but at the broadest level may include commercial banks, credit unions, savings institutions and money market mutual funds.

Other Financial Corporation (OFC) Other financial corporations consist of non-money market investment funds, other financial intermediaries, financial auxiliaries and captive financial institutions and moneylenders. The term is used by supervisor and policy bodies to indicate a subsector of the shadow banking segment in their jurisdiction as consisting of other financial intermediaries (excluding insurance corporations and pension funds), financial auxiliaries and captive financial institutions and moneylenders. See also Other Financial Intermediary (OFI).

Other Financial Intermediary (OFI) See Other Financial Corporation (OFC).

Over-the-Counter (OTC) Over-the-counter (OTC) refers to the process of how securities are traded that are not listed on a formal exchange. It can involve debt instruments, equities, derivatives or any other assets class. The benefits are that parties can agree on pretty much whatever they want. The downside is that parties are directly exposed to counterparty risk without clearing. From a macro-point of view the concern is that there is no comprehensive view of whether systemic risk is building up in the financial system as contracts and their content are largely unknown to authorities. Given the highly concentrated nature of some parts of the financial sector, clearing of, for example, OTC derivatives has been mandated in recent years.

Originate-to-Distribute (OTD) ‘Originate-to-distribute’ refers to the business model whereby lenders intend to securitize part of their (or their entire) loan book. It implies that the loans are not kept on the balance sheet of the lender but sold off at some point before maturity of the loans. The income for the lenders in this model originates predominantly from the fees and gains realized when selling off the loan bundles, both paid for by the buyers of the loan bundles (securitization certificates). It has been documented that lenders tend to be less strict in applying their lending standards when they intend to sell off the loans as the risk ulti-

  List of Abbreviations and Glossary 

705

mately doesn’t sit on their balance sheet until maturity. Particular discretion is required as some securitized products contracts refer default risk back to the securitizer (in this case the initial lender). The originate-to-distribute business model is part of the shadow banking segment although it involves traditional banks.

Organized Trading Facility (OTF) An organized trading facility (OTF) is any facility or system designed to bring together buying and selling interests or orders related to financial instruments. OTFs were introduced by the European Commission as part of MiFID II and are focused on non-equities such as derivatives and cash bond markets. The original MiFID covered only multilateral trading facilities. OTFs are intended to be similar in scope to a swap execution facility (SEF), a type of entity created by the Dodd-Frank Act in the US. The goal of SEFs and OTFs is to bring transparency and structure to OTC derivatives trading.

Originate-to-Hold (OTH) ‘Originate-to-hold’ refers to a business model where the lenders intend to hold the loans they (intend to) sell and keep them on their balance sheet until they mature. The income in this model predominantly comes from the borrowers who pay interest and at maturity the principal amount. Front-loaded and back-end expenses are also incurred by the borrowers. In this model the intrinsic credit quality and quality of the borrowers matter. The risk ultimately sits with the lender throughout the entire lending period and default risk eats directly into the equity position of the lender.

Probability of Default (PD) Probability of default (PD) describes the methodology to assess the likelihood of a default over a particular time horizon of a debtor/debt obligation. It provides an estimate of the likelihood that a borrower will be unable to meet its debt obligations. PD is used in a variety of credit analyses and risk management frameworks, including Basel II.  The ‘expected loss’ on an instrument is the product of PD, the loss given default and the exposure at default.

Private Equity (PE) Private equity is an alternative investment class and consists of investment vehicles that raise and/or invest equity in private (non-listed) companies. Some strategies, however, use material volumes of senior, junior and/or mezzanine debt to acquire the company.

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List of Abbreviations and Glossary

Investments can be in non-listed young or start-ups (venture), more mature companies (LBO), firms facing a restructuring and across a variety of industries and assets (infrastructure, real estate, etc.). Independent financial investors are often organized as a partnership whereas listed private equity firms often are corporate. Within larger conglomerates and multinationals private equity activities tend to take place in corporate structures as well.

 rinciples for Financial Market P Infrastructure (PFMI) Issued by the Committee on Payments and Market Infrastructures (CPMI) and the International Organization of Securities Commissions (IOSCO), the principles for financial market infrastructure are part of a set of 12 key standards that the international community considers essential to strengthening and preserving financial stability. They are based on the 2012 report issued by IOSCO called ‘Principles for Financial Market Infrastructures’ and which establishes new international standards for payment systems that are systemically important, central securities depositories, securities settlement systems, central counterparties and trade repositories. There is a second 2012 report by IOSCO that deals with the disclosure framework preferred to support the objectives and principles.

 ackaged Retail Investment and Insurance-Based P Products (PRIIPs) Packaged retail investment and insurance-based products (PRIIPs) are a broad category of financial instruments that are provided to consumers in the European Union, often through banks or other financial institutions and developed as an alternative to savings accounts. It intends to cover all packaged, publicly marketed financial products that have exposure to underlying assets (stocks, bonds, etc.), provide a return over time and have an element of risk. The group covers all packaged retail investment products marketed in the European Union, including insurance policies. Relevant PRIIP regulation is in place since 1 January 2018.

Qualifying Central Counterparties (QCCPs) A qualifying central counterparty (QCCP) is an entity that is licensed to operate as a CCP, and is permitted by the appropriate regulator to operate as such with respect to the products offered. Their role is to essentially clear transactions between market participants and thereby reduce counterparty risk. The implication is that contracts cleared are (more) standardized than often is the case in private non-cleared markets.

  List of Abbreviations and Glossary 

707

Revised Ratings-Based Approach (RRBA) Under Basel II a bank must determine the risk-weighted asset amount for a securitization exposure that is eligible for the ratings-based approach by multiplying the amount of the exposure by the appropriate risk weight. Under Basel III, that rule was ‘revised’. Under the new rules (2013), a securitization exposure is eligible for the ratings-based approach depending on whether the bank holding the securitization exposure is an originating bank or an investing bank. An originating bank is eligible to use the ratings-based approach for a securitization exposure if (1) the exposure has two or more external ratings or (2) the exposure has two or more inferred ratings.

Research and Development (R&D) Research and development refers to all sorts of activities built around the objective of improvement and/or innovation. Activities can be undertaken by corporations or governments in developing new services or products, or improving existing services or products. It can be directed toward application (i.e. improvements to existing products or services, or the development of new products or services) or it can be fundamental in nature (i.e. develop new insights and knowledge that can at a later stage be used in an applied setting). Fundamental research remains largely the activity of public bodies, as most firms don’t have the risk appetite to conduct such research or don’t prioritize it over applied research.

Real Estate Investment Trust (REIT) A real estate investment trust (REIT) is a company that owns and/or operates real estate. It generates income through rental, buy/sell activities, and auxiliary services. A REIT can focus on a certain type of real estate or can hold a mix of real estate classes. Greenfields and/or developments are often excluded. REITs can be public or privately held. They can specialize in terms of the asset classes to access real estate (e.g. equity or mortgages). In some countries (like the US) they are obliged to pass on at least 90% of their annualized net income to investors in the form of dividends.

Repurchase Agreement (Repo) A repurchase agreement (repo) is a short-term loan where both parties agree to the sale and future repurchase of assets (or pool of assets) that act as collateral within a specified (usually short) contract period. The seller sells, for example, a Treasury bill or other government security with a promise to buy it back at a specific date (often after the closing date of the current accounting period) and at a price that includes an interest payment. The sector got

708 

List of Abbreviations and Glossary

a bad name during the 2008 crisis, as Lehman Brothers used the technique to deleverage its balance sheet prior to closing the accounting quarter or year, leaving investors with a skewed view regarding the actual leverage on the company’s balance sheet. In order for the technique to work accounting rules and contract rules should go hand in hand which was the case with Lehman Brothers International. Nevertheless, they fulfill a genuine financing need for large financial institutions, banks and some businesses as they provide temporary lending opportunities to fund ongoing operations. They come in a variety of models, that is, reverse repos (buying securities with the intention of returning—reselling—those same assets back in the future at a profit), or tri-party repo (an agent in the middle intermediates the deal between the two parties to the repo to facilitate services like collateral selection, payment and settlement, custody and management during the life of the transaction). Also the Fed uses the repo instrument to facilitate liquidity in the markets.

Residential Mortgage-Backed Securities (RMBS) Belongs to the securitized product group. They are debt instruments backed by a pool of residential mortgages. The pool acts as a collateral and ensures payment of interest and repayment of the principal. Pooling can occur based on different real estate criteria, or based on the credit quality of the mortgages (prime or subprime). The benefits include diversification and a slightly higher rate for any given level of risk included in the pool. Risk profiling can be a challenge, however, especially in mixed pools of mortgages. The ultimate investor carries the investment and credit/default risk, although contractual stipulations might deviate.

Return on Capital (ROC) Return on capital employed is an accounting ratio. It measures the profitability of projects or companies and provides for a percentage outcome which makes comparisons possible across firms, sectors and projects with many different characteristics. The difference with the return on equity (ROE) is the fact that in this ratio all funding sources are included (including debt instruments). The ratio should be set apart from return on investment (ROI) and return on invested capital (ROIC). The ROIC focuses on the actual invested capital and compares it with the operating profits generated. The ROI measures the return assessing all income (thus also non-operating income).

Return on Capital Employed (ROCE) An accounting ratio that measures the return generated by a firm or project (net operating profits or EBIT) by investing the actual capital invested. Most often capital employed refers to the total assets of a company less all current liabilities. Return on capital employed

  List of Abbreviations and Glossary 

709

(ROCE) includes all capital available in the firm or project; ROIC considers only the capital actively used in the business. ROCE is a pre-tax measure, whereas ROIC is an after-tax measure.

Return on Equity (ROE) An accounting ratio that measures the net income (thus in principle after tax, unless stated otherwise) generated by investing the equity portion available to the project or firm, often averaged out over the maturity of the project or averaged across the accounting cycle of the firm, to ensure correspondence with the net income measurement used in the ratio.

Recovery and Resolution Planning (RRP) Recovery and resolution planning (RRP)4 is a joint task of national authorities and the supervised institutions and deals with scenarios whereby a bank or banks cannot continue operations due to either intrinsic reasons or market instability (or both). These resolution protocols tend to end in a bailout or bail-in. The national authorities are responsible for ‘ensuring that resolution frameworks are put in place and that banks are subject to periodic resolvability assessments as part of resolution planning exercises’. Recovery plans are required to be ‘prepared by the governing boards of banks to help their recovery from financial distress, with a minimum disruption of critical services’. These plans typically include ‘scenario analysis’ to cover different firm and market conditions. Resolution authorities are further required to ‘prepare resolution plans for each bank reflecting concrete strategies for resolving them while safeguarding financial stability’. Supervisory and resolution authorities are also required to undertake ‘annual resolvability assessments for banks, and to require changes in the legal and operational structures of a firm if that is necessary to ensure continuity of critical functions in resolution. RRPs must reflect crossborder issues, including ex ante agreement on operational resolution strategies to be used for resolving such firms.’ In case there are banks in a specific jurisdiction that operate cross-border operations, a crisis management group should be established with members of each of the relevant jurisdictions to prepare for and facilitate resolution of cross-border banks as well as to enter into institution-specific cooperation agreements for each bank that is active cross-border. The agreements negotiated facilitate execution of any agreed resolution strategy. In such case typically two strategies are used: (1) the single point of entry (SPE) whereby the home resolution authority resolves the holding company in their country; shareholders and designated creditors of the holding absorb losses of the entire group and capital freed up is passed down to subsidiaries; and (2) multiple points of entry  See G.  Dell’Ariccia et  al., (2018), Trade-offs in Banks Resolution, IMF Staff Discussion Note SDN/18/02, February, p. 31. 4

710 

List of Abbreviations and Glossary

(MPE). In this case the relevant authorities resolve their own part of the group structure under separate proceedings, but which was formalized in an ex ante agreement between all authorities involved.

Reverse Repo Program (RPR) See Repurchase Agreement (Repo). Often a matter of perspective, as it resembles the opposite view of a ‘normal’ repo. In this transaction, banks purchase government securities from the central bank and lend money to the banking regulator.

Regulatory Technical Standards (RTS) Regulatory Technical Standards are standards published regularly by the EBA or other European supervisory bodies. The standards clarify legislative positions or substantiate items that were intentionally left blank by the regulator to be documented by the EBA. By definition, a regulatory technical standard ‘is a delegated act, technical, prepared by a European Supervisory Authority’. Accordingly, an implementing technical standard is a technical implementing act providing for the uniform application of certain provisions in the basic legislative act.

Risk-Weighted Assets (RWA) Risk-weighted assets are a bank’s assets or off-balance sheet exposures, weighted according to risk. The Basel guidelines provide guidance on classification and categorization. This sort of asset calculation is used in determining the capital requirement or capital adequacy ratio for a financial institution. The underlying principle: the riskier the assets, the most capital should be held against those assets.

Shadow Banking (SB) In the most general terms the shadow banking sphere contains all entities and activities that engage in financial activities, including those that involve credit-, maturity- and liquidity-transformation but are unregulated or regulated differently than banks who engage in those activities but are regulated and hold capital against the risk profile of the assets held on their balance sheet. The real nature of the activities and entities involved changes materially per countries as the design and make-up of the sector are the consequences of the outlook of the traditional banking sector in that respective jurisdiction.

  List of Abbreviations and Glossary 

711

Small Business Administration (SBA) The Small Business Administration (SBA) is a US government agency that provides support to entrepreneurs and small businesses. The SBA also provides loans, although the actual lending takes place through normal banks, credit unions and other lenders partnering with the agency. The SBA provides a government-backed guarantee on part of the loan.

Statutory Bail-inn (SBI) The statutory bail-in (SBI) is a resolution tool that enables the recapitalization of a failed financial firm through cancellation, conversion, transfer or write-down of claims of equity holders and unsecured and uninsured creditors, to the extent necessary to absorb losses on its balance sheet. Bail-in-able claims must be clearly specified in legislation or contracts. They can exclude certain claims of being bailed-in or leave that authority to the resolution authority to judge on a case-by-case basis. Typically a bail-in framework must respect the order of priorities of claims established in a given jurisdiction for bank liquidation. That typically implies that equity must bear losses first, followed by subordinated debt, with deposits being the last to absorb losses in jurisdictions that provide for depositor preference. In case certain claims are excluded from bail-in that order changes and will deviate from the standard liquidation schedule.5

Shadow Banking System (SBS) This refers to the segment of the financial markets where transactions take place and entities engage in activities not covered by traditional banking supervision and not buffered by capital regulations and adequate balance sheets.

Single Counterparty Credit Limit (SCCL) The credit limits of the single counterparty credit limit (SCCL) rule applies to aggregate net credit exposure, which means the sum of all net credit exposures of a covered company and all of its subsidiaries to a single counterparty, including all of its affiliates. On 14 June 2018, the Federal Reserve Board passed a final rule to establish single counterparty credit limits for covered large US bank holding companies, foreign banking organizations and intermediate holding companies.  See G.  Dell’Ariccia et  al., (2018), Trade-offs in Banks Resolution, IMF Staff Discussion Note SDN/18/02, February, p. 30. 5

712 

List of Abbreviations and Glossary

Securities and Exchange Commission (SEC) An agency within the US federal government. The Securities and Exchange Commission holds primary responsibility for enforcing the federal securities laws, proposing securities rules and regulating the securities industry, the nation’s stock and options exchanges, and other activities and organizations, including the electronic securities markets in the US.

 ecuritization Internal Ratings-Based Approach S (SEC-IRBA) See IRBA.

 ecuritization External Ratings-Based Approach S (SEC-ERBA) See ERBA.

Securitization Standardized Approach (SEC-SA) The securitization standardized approach (SEC-SA) is the Standardized Approach for measuring credit risk/capital requirement when analyzing securitized products. The SEC-SA is used when the SEC-IRBA cannot be used. It will define the capital requirements based on the pool capital requirement calculated under the Standardized Approach for credit risk (known as ‘KSA’). The capital surcharge for the SEC-SA is typically higher than the capital surcharge under the SEC-IRBA methodology.

Systemic Expected Shortfall (SES) A bank’s contribution, denoted as systemic expected shortfall (SES), is its propensity to be undercapitalized when the system as a whole is undercapitalized, which increases its leverage, volatility, correlation and tail-dependence. SES, the systemic-risk component, is equal to the expected amount a bank is undercapitalized in a future systemic event in which the overall financial system is undercapitalized.

  List of Abbreviations and Glossary 

713

Supervisory Formula Approach (SFA) A bank using the SFA determines the risk-weighted asset amount for a securitization exposure by multiplying the SFA risk-based capital requirement for the exposure as provided. The seven criteria relevant for such measurement are as follows: (1) the amount of the underlying exposures; (2) the securitization exposure’s proportion of the tranche that contains the securitization exposure; (3) the sum of the risk-based capital requirement and Expected Credit Loss (ECL) for the underlying exposures; (4) the tranche’s credit enhancement level; (5) the tranche’s thickness (the volume of a tranche within the total pool of assets distributed); (6) the securitization’s effective number of underlying exposures; and (7) the securitization’s exposure-weighted average loss given default. A bank may only use the SFA to determine its risk-based capital requirement for a securitization exposure if the bank can calculate each of these seven inputs on an ongoing basis. The bank may not use the SFA in case it cannot compute the risk-based capital requirement for all underlying exposures (KIRB).

Securities Financing Transactions (SFTs) Securities financing transactions (SFTs) are broadly defined as any transaction where securities are used as a collateral to borrow cash or vice versa. Practically, this mostly includes repurchase agreements (repos), securities lending activities and sell/buy-back transactions.

Structured Finance Vehicles (SFVs) A structured finance vehicle (SFV) or investment vehicle (SIV) is a pool of investment assets that tries to profit from the difference in credit spreads between short-term debt (lower) and long-term structured finance products (higher). These entities can be involved in a variety of activities but often borrow for the short term by issuing commercial paper in order to invest in long-term assets with credit ratings of BBB or higher (e.g. mortgagebacked securities, asset-backed securities and the less risky tranches of collateralized debt obligations). They are often also referred to as structured investment vehicles or special purpose funds (SPFs) as well as special purpose entities (SPEs). Funding for SIVs comes from the issuance of commercial paper that is continuously renewed or rolled over. The credit differential is banked as profit.

Systemically Important Financial Institution (SIFI) A systemically important financial institution (SIFI) or systemically important bank (SIB) is a bank, insurance company or other financial institution whose failure might trigger a financial crisis because of its size, interconnectedness and/or assets held. The FSB

714 

List of Abbreviations and Glossary

has laid out criteria which institutions qualify as SIFIs, based on certain categories (banks, nonbanks, insurance companies, noninsurance companies, non­bank noninsurance companies), and for each category the domestic or global relevance. Each year the FSB issues a list with all the SIFIs per category.

Structured Investment Vehicle (SIV) See Structured Finance Vehicle (SIV).

Small- and Medium-Sized Entity (SME) Small- and medium-sized entities (SMEs) are privately held organizations whose asset levels, staff numbers, turnover or other criteria don’t meet certain thresholds. Standardized criteria exist (International Chamber of Commerce), but thresholds differ per country.

State-Owned Enterprises (SOEs) A state-owned enterprise (SOE) is a legal entity that is created by a government in order to engage in commercial activities on the government’s behalf. It can be either wholly or partially owned (or even a minority stake with a golden share) by a government and is typically earmarked to participate in specific commercial activities. Although each country and government has SOEs, the concept often refers to a wide body of entities that engage in a wide set of economic activities in countries where the government holds tight control over (large parts of ) the economy. Poster child example is China, where small and large SOEs engage economy-wide in transactions and even dominate segments of the economy. They are often also used to acquire foreign strategic activities or firms.

Special Purpose Entity (SPE) An SPE is an entity created by another entity (e.g. parent company of a group) to engage in certain predefined activities, but which assets, risks and leverage it doesn’t want to see emerge on its own balance sheet. In that sense, the SPE is ‘bankruptcy remote’ as it cannot impact the balance sheet of the creating parent company. Its operations are limited to the acquisition and financing of specific assets as a method of isolating risk. SPEs are often also used to load-on leverage without further burdening the balance sheet of the parent company. The Enron bankruptcy reminds us of the possible consequences.

  List of Abbreviations and Glossary 

715

Special Purpose Vehicle (SPV) See Special Purpose Entity (SPE).

Single Resolution Board (SRB) The Single Resolution Board (SRB) is the European Banking Union’s resolution authority. It is a key element of the Banking Union and its Single Resolution Mechanism. The SRB is the central resolution authority within the Banking Union. Together with the National Resolution Authorities (NRAs) of participating Member States (MS), it forms the Single Resolution Mechanism. Its mission is to ensure an orderly resolution of failing banks with minimum impact on the real economy, the financial system and the public finances of the participating MS and beyond.

Social Structure of Accumulation (SSA) The Social Structure of Accumulation (SSA) approach provides a new way to analyze the structure and development of capitalist economies and societies. The term SSA refers to the complex of institutions which support the process of capital accumulation.

Simplified Supervisory Formula Approach (SSFA) Simplified Supervisory Formula Approach (SSFA) is a Basel III formulated approach for measuring risk embedded in (a pool of ) assets. The SSFA is based on the prior supervisory formula approach (SFA/Basel II). SSFA is a formula-based approach which takes into account the risk weighting of the underlying assets, the exposure’s subordination level, the performance of the underlying assets and whether or not the exposure is a re-securitization in order to define capital adequacy.

Short-Term Note (STN) Short-term notes are financial debt instruments that typically have original maturities of less than nine months. Short-term paper is typically issued at a discount and provides a low-risk investment alternative. They can be either unsecured or backed by assets such as loans issued by a corporation. Examples of short-term paper include US T-bills, commercial paper, promissory notes, bills of exchange and certificates of deposit.

716 

List of Abbreviations and Glossary

 imple, Transparent and Standardized S (Securitization) (STS) Securitization products in the EU issued after December 2018 need to meet the simple, transparent and standardized (STS) criteria in order for the securitizer-­originator to benefit from a reduced capital requirement for the pool of assets securitized. The EU’s securitization regulation leaves the definition of the STS criteria largely open. The EBA was mandated to document and substantiate the criteria. It took until December 2018 before final guidelines were released. By creating simple, transparent and standardizes products the EU, under the umbrella of the Capital Markets Union project, tries to revive the securitization market in Europe, which, in contrast to the US securitization market, has largely been in the doghouse since the 2008 financial crisis.

Term Asset-Backed Loan Facility (TALF) The Term Asset-Backed Loan Facility (TALF) was a funding facility that helped market participants meet the credit needs of households and small businesses by supporting the issuance of asset-backed securities collateralized by loans of various types to consumers and businesses of all sizes. The program was administered by the Federal Reserve Board and financed with both public and private funding. The TALF began operation in March 2009 and was closed for new loan extensions on 30 June 2010.

To-Be-Announced (Market Facility) (TBA) The TBA market allows for the sale of securities before they have been finalized—as in before the mortgages that back the securities have been identified. ‘To be announced’ (TBA) is a term describing forward-settling mortgage-backed securities trades. The term TBA is derived from the fact that the actual mortgage-­backed security that will be delivered to fulfill a TBA trade is not designated at the time the trade is made. The securities are announced 48 hours prior to the established trade settlement date.

Tender Option Bond (TOB) Tender option bonds are special purpose trust investments that create leverage by borrowing from money market funds to invest in high-quality municipal bonds. A tender option bond therefore is the common phrase for a security issued by a special purpose trust (a tender option bond trust) into which bonds are deposited, and which then issues two types of securities. One of the securities—the floating rate security—is typically sold to a money market fund that is only permitted to buy investments of high quality and short maturity. The other

  List of Abbreviations and Glossary 

717

security—the inverse floating rate security—is retained by the fund/trust. The product is often used by MMFs to generate higher yields (difference between yields on long-term bonds and the borrowing rate paid on short-term floating securities).

Tri-Party Repo (TPR) See Repurchase Agreement (Repo). Tri-party repos are typical repo instruments with the difference that a tri-party agent acts as an intermediary between the two parties to the repo to facilitate services like collateral selection, payment and settlement, custody and management during the life of the transaction. It is considered a market of systemic importance and policy design issues to neutralize possible exposures remain until today despite numerous but more elusive regulatory interventions ever since the 2008 crisis. During the 2008 financial crisis three weaknesses were exposed in the tri-party repo market: (1) markets’ reliance on intraday credit from the clearing banks; (2) the procyclical risk management practices or procyclicality of risk management practices; and (3) the lack of effective plans to support the orderly liquidation of the defaulted dealer’s collateral. Interventions since then include: moving the daily unwind of some tri-party repo transactions which shortens the period of intraday exposure, and the implementation of a mandatory three-way trade confirmation between dealers, cash investors and the clearing banks. Less progress has been made on issues like creating an alliance with this market on intraday credits or improving risk management and collateral practices to avoid fire sales in the event of a large dealer fault.

Total Return Swap (TRS) Total return swap (TRS) is a financial contract that transfers both the credit risk and market risk of an underlying asset. They are typically classified as credit derivatives. Total return swaps allow the party receiving the total return to gain exposure and benefit from a reference asset without actually having to own it. The instrument is attractive for financial sponsors who want to get exposure to certain risk without having to own the asset and suffer the associated cash outlay.

Trust Preferred Securities (TruPS) Trust preferred securities (TruPS) are securities issued by (often) large banks and bank holding companies. The bank opens a trust account which is funded with debt. The bank then sells shares in the trust to investors. The resulting share is called a trust preferred security, or TruPS. It has as a security the characteristics of both debt and equity. The security is a hybrid security with characteristics of both subordinated debt and preferred stock (paying dividend) in that it is generally very long term (30 years or more), allows

718 

List of Abbreviations and Glossary

early redemption by the issuer, makes periodic fixed or variable interest payments, and matures at face value. In addition, trust preferred securities issued by bank holding companies will usually allow the deferral of interest payments for up to five years.

 ndertakings for Collective Investments U in Transferable Securities (UCITS) UCITS are investment funds regulated by the European Union. The UCITS regulation was put in place to provide transparency and liquidity to investors but also to ensure that products could be sold in other EU members (EU-wide distribution) regardless of where the sponsor or issuer was located. The EU therefore standardized the rules and regulations across Europe regarding open-ended funds and transferable securities. The UCITS regulation is in place since 2003 and has been amended on a number of occasions. The UCITS group is the main European framework and product group covering collective investment schemes. This category of investment funds accounts for around 75% of all collective investments by small investors in Europe. All funds that do not meet the UCITS criteria fall within the scope of other European fund legislation (real estate, money market funds, venture funds, long-term investment funds or alternative investment fund regulation). UCITS is the European retail investment fund brand.

Value at Risk (VaR) Value at Risk (VaR) is a measure of the risk of loss embedded in an investment. It estimates how much an investment (or pool of investments) might lose (with a given probability) in value, given normal market conditions, in a set time period, often a day (24 hours). One measures VaR by assessing the amount of potential loss, the probability of occurrence for the amount of loss and the time frame. Despite the hiccups in its performance over time, it is still a central metric in the investment fund industry.

Variable Net Asset Value (VNAV) A concept of the money management fund industry. Next to fixed or constant net asset value funds, the market offers variable net asset funds. VNAV, or variable net asset value, refers to funds which use mark-to-market accounting to value some of their assets. The NAV of these funds will therefore vary by a slight amount, due to the changing value of the assets and, in the case of an accumulating fund, by the amount of income received. This results in a degree of variability in the investment values calculated and reported, as the market values of the underlying investments change. This method of accounting is contrasted by using an amortized cost basis of accounting for all of the investments, which is what constant net asset value (CNAV) funds do.

  List of Abbreviations and Glossary 

719

 ariable Rate Demand Obligation/Note (VRDO/ V VRDN) A variable rate demand note (VRDN) is a debt instrument (offered to investors through money market funds) that embodies borrowed funds and which accrue interest based on a prevailing money market rate (prime rate). The interest rate applicable to the borrowed funds is set upfront (mostly the specified money market rate plus margin). The notes allow a municipal government to borrow money for long periods of time while paying short-term interest rates to investors. Typically, the interest rate on VRDN is adjusted periodically, that is, daily, weekly or monthly to reflect the current interest rate environment. The instrument is payable on demand—that is, the investor or lender of the funds can request repayment of the entire debt amount at his or her discretion. It has the dynamics of an embedded put option. VRDN issuers often use credit enhancement techniques through letters of credit (LOCs) from highly rated financial institutions.

Weighted Average Maturity (WAM) Weighted average maturity (WAM) is the weighted average amount of time on mortgages in a mortgage-backed security until they mature. The term is used more broadly to describe average maturity in a portfolio of debt securities, including corporate debt and municipal bonds.

Weighted Average Life (WAL) The weighted average life (WAL) of an amortizing loan or amortizing bond, also called average life, is the weighted average of the times of the principal repayments: it’s the average time until a dollar of principal is repaid.

Wealth Management Product (WMP) A wealth management product is an uninsured financial product sold in China by banks and other financial institutions. Typically they offer a high rate of interest (i.e. higher than savings accounts), and, sometimes, guaranteed return. Given their uninsured nature, they tend to pose a financial stability risk. Therefore the PBOC (Central Bank China) and the China Banking and Insurance Regulatory Commission (CBIRC) for a couple of years now have been trying, through a variety of measures, to curtail the volume and the growth of the product group and more importantly to de-risk the product group. Given the fact that the investment options for Chinese residents are limited, capital supply is abundant and cash pools continue to look for enhanced yields. Wealth management products and funds are, for example, allowed to directly invest in stocks since October 2018.

Index1

A

ABCP conduits, 653n960 Absolute return funds, 41n169 Activity-based approach, 282 Adverse market scenarios, 546, 569 Adverse selection, 10, 24, 25, 91n387, 112, 121, 123n29, 647 Agency conflict, 242, 644 Aggregate risk, 2n4, 4, 49n205, 293, 297, 664 Algorithmic trading, 699 Algorithms, 197n318, 584, 615n818 Alpha, 38, 41 Alternative Investment Fund Managers Directive (AIFMD), 201n340, 220n50, 269, 475n178 Alternative investment strategy, 569n627 Ambiguity, 213, 525–526, 526n419, 592n733, 603 Amortized cost model, 447 Anti-abuse legislation, 46 Arbitrage CDOs, 396 Argentina, 175, 327

Asset-backed commercial paper (ABCP), 23, 23n99, 24, 32, 73, 149, 157, 213, 231, 248, 286n319, 332n33, 333, 356, 396, 531, 561, 629n871, 653n960 Asset-backed securities (ABS), 3–5, 21, 33, 61, 73, 92, 113n477, 149, 156, 157, 213, 214, 218, 219n43, 231, 242, 251, 312, 332n33, 362, 370, 373, 394, 394n228, 396, 443 Asset bubbles, 73, 120, 213, 243, 466 Asset encumbrance, 560 Asset homogeneity, 220n48 Asset-liability mismatch (ALM), 41, 42, 355, 368, 546n509, 568, 569, 569n627, 569n628, 642 Asset management, 32, 62, 141, 199n330, 222, 246, 268, 361, 378, 380, 381, 404–405, 414, 418–420, 420n354, 453–487, 475n182, 614, 615n817, 638, 667

 Note: Page numbers followed by ‘n’ refer to notes.

1

© The Author(s) 2020 L. Nijs, The Handbook of Global Shadow Banking, Volume II, https://doi.org/10.1007/978-3-030-34817-5

721

722 Index

Asset price bubbles, 46n190, 51, 120, 369, 467, 492 Asset purchasing program, 316 Asset risk, 75, 220n48, 296, 434, 522, 523, 560, 587, 614n815 Asset securitization, 31, 230, 373, 393, 394 Asymmetric incentives, 256–257, 459 Asymmetric information problem, 7, 187, 237, 256, 448n63, 502, 530 Asymmetric regulation, 144, 330, 497 Asymptotic single risk factor (ASRF), 675 Austrian, 656 Authorized participants, 481, 481n205 Automatic stay, 297n378, 298, 559n581 Automatic stay exception, 297n378, 298, 559n581 B

Backstop, 36, 36n151, 37, 39, 43, 62–65, 75, 80n335, 98, 113, 117, 119, 140, 204, 204n4, 218, 245, 255, 262n195, 299, 303, 303n410, 312, 317, 393, 411n311, 416, 438, 489, 498, 547–557, 565, 622, 639–641, 649, 661, 668 Bagehot, 68 Bahama’s, 169, 327, 328, 330n25, 334, 338, 338n63 Bail-in, 312 Bail-out, 310, 659 Balance sheet linkages, 562 Bank bailout, 84, 125, 393, 412n311, 414 Bank-based financial system, 119 Bank-based financing, 257, 257n172, 634, 642 Bank capital effect on growth, 433–435 Bank deposits, 23, 39, 139, 143, 200n332, 324n11, 360, 366,

373, 387, 411n308, 506n335, 654 Bank failure, 48, 49, 447, 551 Bank for International Settlements (BIS), 198, 424, 442, 443, 452, 530, 580, 636n897, 655n965 Bank holding company (BHC), 31–34, 50, 52n219, 74, 188, 532, 585, 606–607n784 Bank of England (BoE), 219, 274, 443 Bank run, 13n65, 50, 78, 296n374, 463, 509, 573, 574, 617, 618, 631 Bankruptcy exemption (repo), 559n581 Bankruptcy law, 59, 145, 147, 260, 367 Bankruptcy remoteness, 278 Bank’s large exposures, 489, 558 Bank-sovereign link/nexus, 314 Bank-sovereign/nexus, 545 Bank vulnerabilities, 496 Banque de France, 97n411, 112n475, 215n28, 499n299, 612n804, 614n810, 617n823, 630n876, 639n912, 641n917, 641n919 Basel accords, 447 Basel I, 139, 144, 523, 619 Basel II, 139, 244, 522, 523, 587, 587n708, 588n709, 619n831, 646, 658 Basel III, 14, 30n128, 35, 48, 50, 59, 60, 78, 79, 87, 94, 105, 118, 139, 165, 196, 238, 244, 267, 307, 323, 325, 329, 437, 464, 475, 478n190, 489, 490, 508–518, 520, 536, 546, 569, 573–575, 579, 579n676, 580, 582, 583, 590n720, 611, 614, 621n839, 647, 648, 650, 651, 655n964, 658 Basel IV, 647, 655n964, 658 Belgium, 179n253, 267–268, 267n227

 Index 

Benchmarking, 133, 236n118, 453–454, 461–467 Bencmarking incentives (AM), 453–467 Beta, 38–43, 38n155, 115, 115n486, 304n412, 441 Blockchain, 614, 614n816, 643n927 Borrowing capacity, 292n350, 582 Boundary problem (regulation), 145 Brazil, 167, 179n253, 322–327, 329, 336, 338 Breaking the buck, 460 Broad/narrow definition of shadow banking, 119, 129, 163–165, 277, 279, 341, 342, 344, 346, 362 Broker, 3, 31, 33n138, 35, 109, 121n22, 141n106, 156n154, 210, 224–226, 277, 325, 354, 359, 381, 404, 405, 420n354, 668 Broker dealers, 32, 33n138, 34, 36, 39–41, 62, 100, 104, 108, 109, 165, 178, 179n250, 186, 188, 189, 191, 192, 274, 322, 323, 325, 325n11, 328, 329, 334, 570, 585, 585n699 Build-up of risk, 221 C

Canada, 322, 324–327, 331–333, 336, 337 Capital flow, 78, 111n472, 115, 128, 135, 136, 277, 287–289, 288n333, 311, 384, 462, 462n119, 488, 493, 516, 527, 616n819, 645, 648, 656 Capital markets union (CMU-EU), 206, 206n14, 214, 215, 238–265, 241n138, 242n141, 260n186, 264n208, 283, 286, 443, 536–542, 542n492, 641, 643, 665

723

Capital Requirements Directive (CRD), 443, 451, 475n181 Capital requirements regulation (CRR), 220n50, 232, 233, 247, 248, 250, 252, 629n871 Capital surcharge, 79, 268, 313n446, 517n384 Captive insurance, 322, 328 Career risk, 454, 455 Cash flow waterfall, 296, 502, 559n581 Cash pool, 38–42, 42n175, 130, 138, 199n329, 199n330, 285, 292, 293, 345, 412, 441, 444, 452, 487, 546, 546n509, 546n512, 568–570, 569n627, 569n628, 644, 644n928, 644n930 CCP stress tests, 585 Central Asia, 371 Central bank (CB), ix, 16, 23, 45, 48n204, 58–69, 67n273, 71, 73, 77, 80, 89, 92, 92n390, 93, 96, 99, 101n432, 113, 113n477, 115, 117, 152, 155, 175, 206, 240, 267, 286n319, 293, 294, 299n386, 301, 302, 305n419, 306n421, 317, 325, 325n11, 330, 339, 353, 355, 362n59, 372, 375, 393, 394, 401, 402, 431n24, 489, 509, 515, 527, 534, 540, 543, 546n512, 549, 567, 569, 570, 574, 580, 589n714, 660–663, 665, 670 Central bank intervention, 509, 618 Central clearing party (CCP), 35, 61, 90, 92, 98, 99, 109, 111, 178, 188, 189n289, 221, 224, 236n121, 237, 237n126, 238n129, 274, 364, 525n419, 547, 553, 622, 633, 641, 645n931, 667 Central securities depositories (CSD), 107n454, 110n465 Charter value (of bank), 618 Chengtou bonds, 379, 379n160

724 Index

Chile, 322–327, 329, 330 China, 128, 137, 229, 229n81, 230, 307, 345, 360, 375–409, 421–426, 442, 634 Circuit breaker, 447, 579, 613 Circular 107 (China), 403 Clearing member, 98, 99 Cliff effects, 451 Closed-end, 188, 194, 201n341, 328, 355, 377, 378, 414n322 Collateral, 2n4, 3, 57, 81–116, 120, 323, 354, 429n13, 439, 668 Collateral chain, 60, 87, 100, 106 Collateral channels, 112n475, 454, 459 Collateral collector, 439 Collateral damage, 69, 95–96, 530, 581 Collateral framework, 88, 91–94, 91n387 Collateral intermediation, 86, 87, 149 Collateralized debt obligations (CDO), 2, 73, 142, 157, 171, 239, 240, 278, 289, 292n349, 396 Collateralized loan obligation (CLO), 394n228, 396, 606n783, 628 Collateral liquidity, 517n387 Collateral management, 36, 86, 89, 107, 224 Collateral mining, 10 Collateral multiplier, 100 Collateral optimization, 96 Collateral pyramid, 112 Collateral quality, 77, 89, 452 Collateral requirements, 61, 68, 98, 116, 298, 307, 475, 555 Collateral run, 9, 13, 13n65, 104 Collateral transformation, 60, 88, 89, 92, 97, 317n456 Collateral trap, 111–116 Collateral values, 4, 7, 10, 12, 13, 83, 89, 93, 94, 94n398, 112n475, 115, 115n485, 439, 478n190, 541 Collateral velocity, 60, 99, 100, 670n17 Collective investment in transferable securities (UCITS), 109n465,

178n242, 193, 201n340, 220, 220n50, 249, 269, 284, 314, 486 Collective investment vehicles (CIV), 159, 160, 183, 184, 189, 190, 195, 269, 280, 280n300, 336n53, 462 Collective trust products (CTPs), 387 Colombia, 324–327, 324n11, 339 Command-and-control regulation, 223, 439, 440, 442, 505, 535, 553, 669 Commercial mortgage-backed securities (CMBS), 396, 567n620 Commercial paper (CP), 29, 30, 66, 112n475, 138, 142, 143, 157, 373n129, 559n578, 653 Comparability, 220n48, 228, 616n819 Complex assets, 598 Complex markets, 371 Complex shadow banking, 409, 546, 546n509, 568, 569, 569n628 Concentration of fund flows, 459 Concentration risk, 19n87, 100, 111, 312, 664 Conditional VaR (CoVaR), 80n337, 397, 398 Conduits, 51, 73, 170, 189n287 Conflict of law approach, 45, 46 Constant net asset value (CNAV), 267, 279, 347, 380 Contagion, 16, 18, 50, 57, 63, 81, 84, 90, 103, 104, 112n474, 112n475, 113, 120, 123, 134, 135, 195, 217, 221, 227–229, 231, 234, 259, 289, 299, 302, 323, 329, 347, 354, 378, 397n250, 447, 450, 459, 462, 463, 465, 474, 476, 482n210, 485–487, 486n229, 503, 509, 510, 517, 530, 533, 534, 556, 562, 563, 565, 570, 574, 586, 588, 607, 608, 614, 616, 631, 634, 669 Contagion channel, 153, 211, 217, 225, 447

 Index 

Contagion risk, 18, 63, 69, 75n310, 94, 95, 125, 165, 169, 217, 226, 228, 234, 245, 276, 284, 310, 317, 331, 368, 397n250, 465, 500–504, 507, 564, 643, 664 Contagion shock, 485, 486n229 Contingent capital, 395 Contractualization, 289, 293 Convex risk, 524n413 Core assets, 40 Core funding ratio, 517n384 Core liabilities, 40 Corporate control, 530, 552 Corporate governance, 51–53, 69, 421n358, 425, 451, 499n299, 513, 514, 530, 552, 589–590, 613n809, 666, 667 Correlation, 19, 42, 47, 83, 93, 101n430, 136, 138, 139, 289n338, 290n341, 295, 312, 312n438, 380n160, 455, 462, 488, 652 Cost of default, 582 Countercyclical capital buffer (CCyB), 492, 581, 606n782 Counterparty, vi, 45, 57, 83, 86, 91n387, 107, 161, 216, 221, 297, 467n148, 468, 474, 478n190, 479n194, 517, 574 Counterparty channel, 467, 468 Counterparty credit risk, 99, 107, 114, 248, 250 Counterparty default, 35, 237, 237n126, 478 Counterparty risk, 39, 84, 86, 90, 92, 96, 101n432, 104, 107, 187, 221, 236, 237, 245n146, 297, 371, 534, 547 Covered bonds, 539 Credit default swap (CDS), 46n190, 62, 123, 125, 193, 237, 237n127, 254, 284, 309n430, 310, 367, 396, 461, 464–465n135, 579 Credit derivatives, 187

725

Credit enhancement, 35, 181, 356, 363, 395 Credit expansion, 69, 243, 256, 405, 488n239 Credit-fueled booms, 530 Credit guarantees, 35, 73, 157, 356, 371, 372, 380, 383n176, 389n205, 392, 412n311 Credit hedge funds, 73, 82, 84, 183, 190, 267 Credit intermediation chains, 31, 33, 143, 160, 163, 164, 164n179, 166, 179, 184, 280, 336n52, 450, 567, 595, 661 Credit performance, 452 Credit protection, 628 Credit quality, 110, 161, 186, 187, 191, 194, 196, 283, 284, 422, 541, 589n715 Credit rating, 87, 92, 140, 196, 196n310, 239, 240, 309n430, 310, 312n438, 346, 355, 371, 372, 451, 452, 521, 559n578, 606n783, 627, 658 Credit rating agency (CRA), 214, 239, 248, 374, 445, 451, 451n72, 452n73 Credit rationing, 376 Credit risk, 32, 90, 93, 119, 140, 154, 160, 167, 167n185, 175, 179n253, 180n254, 180n255, 183, 184, 187, 194, 196, 197, 201, 216, 236, 236n119, 248, 250, 252, 254n160, 276, 284, 294, 309n430, 327, 340, 346, 368, 380, 384, 385, 388, 395, 396, 417, 418n343, 419, 420, 425, 444, 464n135, 465, 468, 502, 503, 520, 522, 523, 540, 543, 548, 548n517, 579, 587, 627, 638 Credit risk transfers (CRTs), 145, 160, 162, 183, 186, 187, 191, 201, 233, 233n98, 356, 358, 635n892

726 Index

Credit (risk) transformation, 292 Credit supply, 3, 5, 34, 37, 49n205, 176, 200, 313–314n446, 385, 386n191, 422, 433, 434n3, 435, 489, 493, 568, 610n794, 626n862, 656 Credit-to-GDP gap, 19n81, 424n374, 494, 549, 639n912 Credit transformation, 2n6, 35, 63, 73, 230, 272, 292, 340, 358, 375, 416 Creditworthiness, 69, 94, 121, 153, 186, 187, 219, 239, 284n314, 310n430, 311, 380n166, 451n72, 594n738, 658 Cross-border capital flow, 493, 616n819, 656 Cross-border lending, 18, 48, 454, 487, 488, 494 Cross-border liabilities, 198 Crowdfunding, 193–194, 197n318, 435, 441, 610n795, 610n796, 644n927 Crypto-assets, 197n318, 336n49, 612–614, 612n806, 613n809 Cryptocurrency, 611 Culture (in financial industry), 562 Curbside lenders, 401 Currency channel, 527 Currency risks, 309n430 Custodian, 36n151, 467, 477 Cybersecurity, 476, 612n806, 615 D

Data capture, 584 Data-driven finance, 615 Dealer, 33, 34, 39, 40, 40n162, 60, 65, 82–84, 98, 101, 104, 106n449, 141n106, 157, 205, 271n252, 274, 568–569n627 Dealer banks, 66, 67, 669 Dealer-broker, 133

Dealer-intermediated market, 579 Debt service to income (DSTI), 131 Debt-to-income ratio (DTI), 326 Default cascade, 180n255 Default costs, 460, 460n110 Default risk, 29, 83, 84, 102, 126, 237, 237n126, 245n146, 290n340, 291, 296, 297n375, 298, 312n438, 317n456, 378n152, 383, 384, 396, 397, 414n322, 415n328, 424, 499n304, 600, 621 Deflation, 125, 491n252, 539 Deposit guarantee, 45, 230, 323, 363, 449 Deposit insurance scheme, 449 Deregulation, 263, 263n202, 331, 390, 391, 393, 425n378, 626, 644, 648, 661 Derivative product companies, 137 Devaluation, 221 Direct approach (risk retention), 214 Direct bundling, 64 Direct lending channel, 460 Disclosure, 108, 109, 110n467, 135, 210, 214, 216n32, 219n43, 220n50, 223, 240, 251n155, 339, 340, 354, 367, 386, 388, 429n13, 442, 442n38, 446n55, 448–451, 448–449n63, 449n64, 464, 473, 498n295, 553, 570, 629, 639 Disclosure requirements, 47, 105, 109, 214, 245n146, 340, 354, 359, 443, 446, 448–450, 451n73, 558 Disclosure rules, 448, 448n62, 450 Discretionary regulatory policies, 518 Disruption spread, 468 Distress, vi, 9, 10, 17, 36, 57, 66, 70, 78, 80n337, 89, 98, 107, 120, 123, 135, 141, 199n326, 222, 235, 237, 289, 290n340, 294, 300, 302, 308, 313, 329, 334, 354, 378, 398, 449n68,

 Index 

474–477, 483n212, 485, 486n229, 491, 500, 505–507, 525, 539, 550, 570, 642, 661 Distressed debt, 137, 269 Distressed firm, 507 Distributed ledger technology (DLF), 643n927 Dodd-Franck Act, 647 Due diligence, 107, 154, 214, 216n32, 245n146, 247–250, 367n94, 442, 443, 451, 452, 481n205 Due diligence requirements, 442n38 Duration collateral quality, 452 E

Early-warning, 18, 19, 222 Economic development, 381, 390, 415n329, 552 Economic growth, 13, 15–16, 42, 66, 125, 161, 216, 217, 242n141, 243, 257, 305n419, 379, 408, 422, 429, 433–436, 434n3, 442, 488, 518, 519, 530, 539, 541, 543, 548, 550, 552, 575, 586, 599n759, 626n862, 629, 629n872, 661, 666 Egypt, 431 Eigenvector centrality (EVC), 281n302 Electronic trading, 578 Emerging economies, 111n472, 115n486, 124, 128, 137, 138, 168, 174–176, 176n229, 176n230, 178, 189, 255, 294, 301, 307, 462, 488, 488n239, 489, 491n252, 492n260, 518–520, 519n397, 527, 662 EMIR regulation, 236 Endogenous inefficiencies, 506 Entity-based approach, 282 Entrusted loans, 128, 139, 378, 378n154, 378n155, 381, 382, 403, 411n309, 412, 412n313,

727

418–420, 418n343, 418n344, 420n353, 420–421n354, 425n377 ESBie, 289, 290n340, 291, 292n349, 308–309n429, 311, 312n438 Europe, 99, 108, 108n462, 110, 158, 179n250, 188, 193, 194, 203–205, 212–214, 212n15, 218, 222, 224, 229, 231, 234, 236–241, 238n129, 244, 245, 250, 252, 253n159, 255, 257, 258, 258n174, 260, 262n197, 267, 282, 282n303, 301, 309, 310n431, 343, 384, 393, 409, 438n24, 442, 443, 443n44, 469, 475n181, 491n252, 536, 537, 537n463, 539, 540, 541–542n491, 542n492, 558, 584, 606n783, 627, 645–648, 646n933, 655, 661, 663, 667 European Banking Authority (EBA), 196n310, 204, 212, 232, 233, 233n99, 236, 238n131, 244, 244n144, 245n146, 247–250, 284, 284n314, 443n42, 595n747, 611, 613n809, 624n848 European Central bank (ECB), 91–93, 219, 219n43, 231n89, 234–236, 261, 264, 267n223, 283, 286, 308n428, 315, 316, 443, 468, 538, 539 European Commission (EC), 204, 210, 212n14, 215, 220, 223, 224, 231, 238, 238n131, 241, 241n138, 244, 250, 259–261, 261n193, 263, 310, 311, 557, 647 European Market Infrastructure Regulation (EMIR), 236 European Securities and Markets Authority (ESMA), 214, 451n72 European systemic risk board (ESRB), 181, 205, 217, 224, 224n64, 232n94, 272n258, 281, 284–289, 287n328, 291, 497

728 Index

Eurosystem, 91, 93, 213, 214, 253n159, 489n242 Eurozone, 85, 119, 126, 141n108, 167, 177, 178, 227, 232, 237n127, 285–290, 288n330, 290n340, 290n342, 308, 310, 312, 312n438, 313, 442, 538, 540, 545, 645n931, 647 EU Shadow Banking Monitor, 281 Ex-ante default risk, 503 Ex ante regulation, vi, 84, 508–516, 524, 530, 551, 556, 584, 667 Excess credit elasticity, 554 (Excessive) risk taking, 187, 462, 566, 607, 608 Exchange-traded funds (ETFs), 62, 184, 200n332, 205, 221, 222, 272, 315, 329, 354, 453, 453n78, 469, 479–482, 481n205, 481n206 Exogenous shock, 563 Expected loss (EL), 22, 290, 290n341, 416n334 Ex post regulation, 84, 509–516, 524, 535, 643, 664, 667, 669 Externalities, 25, 49, 53–56, 53n227, 65, 80, 131–134, 234, 243, 306, 397, 436, 448, 448n63, 461, 464, 473n171, 479, 484, 484n221, 492–494, 507, 511, 514, 514n374, 517, 517n384, 527, 547, 562, 563, 580, 593, 600, 603n775, 604, 606–608, 609n792, 644, 668 Externality, negative, 22, 54, 218, 439, 479, 509, 517, 604, 668 F

Fair value accounting, 446–448, 446n55 Fannie Mae, 241 Feedback loop, negative, 447

Feedback loops, v, 47, 153, 221, 463, 496, 515, 582 Ferry banks, 486n229 Financial Conduct Authority (FCA), 195 Financial engineering, 285, 380n166, 389, 577, 609 Financial innovation, 2, 9, 30, 49, 52, 142, 143, 170, 172–174, 256, 415n329, 441n35, 494, 537, 565, 584n695, 609, 611, 626n860, 643n926, 670n20 Financial intermediation, 2n4, 21–23, 31, 32, 34, 35, 37, 75, 76, 120, 124, 150, 159, 161, 162, 168, 182, 183, 188, 188n281, 203, 255, 267n223, 278, 279, 293, 341n2, 356, 358, 372, 375, 453, 494, 495, 508, 517, 552, 571, 577, 584n695, 597, 634 Financialization, 37, 126, 130, 170, 255, 256, 261, 292, 435, 442, 526–528 Financial network, 507 Financial plumbing, 87 Financial sector growth, 371, 436 Financial stability, vii, 1, 128, 323, 569, 570, 611, 640, 653, 660 Financial Stability Board (FSB), viii, 8, 34, 76, 81, 100, 101, 103, 105, 106, 108, 110, 119, 127, 138, 142, 145, 149–153, 150n133, 153n139, 158–161, 163–166, 164n179, 165n182, 168, 169, 174, 176n229, 176n232, 177, 180–184, 181n259, 187, 188, 190, 191, 193–195, 203–204n4, 204, 205, 217, 222–224, 227, 228, 233, 255, 267n223, 268, 269n239, 275–277, 275n272, 276n276, 279, 283, 321, 324, 325, 328, 330, 334, 336, 341, 343, 344, 346, 347, 355, 356,

 Index 

362, 364, 367, 371n119, 382, 404n279, 409, 427–430, 428n10, 432, 437, 439, 464, 468, 469, 473, 478, 479, 488, 557, 558, 606n783, 612n806, 613, 632, 633n883, 635, 636, 638 Financial vulnerability, 69, 185n277, 474, 549, 597n755 Fintech, 197, 197n318, 336n49, 584, 587n706, 610, 610n796, 614, 668 Fire sale, 21–23, 25, 26, 26n118, 44, 61, 63, 66, 72, 80, 94, 95, 99, 104, 120, 123, 127, 133, 134, 138, 140, 194, 195, 211, 213, 217, 221, 225, 231, 234, 295n368, 355, 447, 457, 461–463, 465n135, 470, 478n190, 478n191, 483n215, 484, 484n221, 484n223, 485, 486n229, 553, 563, 564, 581, 600–602, 601n767, 604 First loss, 3 First-mover advantage, 454, 459, 462, 463, 471, 663 Fiscal cost, 264 Fiscal policy, 1, 77, 85, 147, 305n414, 306, 318, 437, 491, 494, 495, 515 Fixed-income funds, 150, 168, 178, 183, 184, 190, 355, 465, 469, 638 Fixed net-asset-value (NAV), 329, 373 Floating net asset value (FNAV), 380n161 Flow of funds, 127, 140, 150, 269, 307n425 Fractional reserve banking system, 506n335 Fragility, 43–45, 49, 50, 54, 57, 58, 68–80, 93, 112, 260, 274, 293, 301, 319, 412n312, 435, 470,

729

536, 550, 554, 564, 586, 653, 654 Fragility (monetary or financial), 57, 77, 415n329, 526, 630n875, 656 France, 213, 266, 273, 310n432 Franchise value, 505, 506, 572, 573 Fraus legis, 46 Freddie Mac, 241 Full recourse, 240, 647, 655 Full reserve banking model, 649n942 Functional approach, 510 Fund flows, 195, 459, 464, 473n171 Funding agreement-backed securities, 530, 531, 564 Funding centrality, 180–181n255, 192 Funding liquidity, 7, 79, 84, 482n210, 576 Funding costs, 102 Fund structures, 190, 459 G

Germany, 62n263, 167, 179, 213, 266, 273, 273n260, 310–311n432 Glass-Steagall Act, 661 Globalization, 42n175, 43, 158, 487–490, 496, 591n731, 600n763, 625 Global SIFI (G-SIFI), 468 Global systemically important bank (G-SIB), 210, 370, 412n311, 558, 571, 574, 634, 650n949 Government guarantee/backstop, 22, 36, 36n151, 37, 39, 42, 43, 49, 54, 62–65, 71, 75, 80n335, 94n398, 98, 113, 117, 119, 140, 156, 204, 204n4, 218, 245, 255, 262n195, 299, 303, 303n410, 312, 317, 393, 411n311, 416, 425n378, 438, 489, 498, 547–557, 565, 595, 622, 639–641, 649, 661, 668 Government insurance, 618

730 Index

Government intervention, 16, 64, 133, 260, 386 Government-sponsered entities (GSE), 8, 326 Government support, 140, 366, 423, 424, 560 Grandfathering, 314 G-SIB surcharges, 574 Guarantee, 32, 36, 49–51, 53, 74, 80n335, 92, 109, 112, 129, 155, 158, 186, 187, 229, 230, 241, 244, 247, 248, 277, 291, 292, 292n349, 294, 299, 309n429, 312, 323, 339, 345, 354, 356, 363, 371, 372, 379–382, 380n165, 380n166, 383n176, 386–389, 389n205, 392–394, 397, 401, 411, 412n311, 414, 414n322, 415n328, 418, 419, 423, 423n366, 424, 425n377, 447, 449, 471n165, 474, 478, 478n190, 478n191, 485, 501, 504n326, 536, 545, 563, 595–597, 601n769, 602, 655, 660, 661, 665 H

Haircuts, 12, 13, 22, 25, 73, 83, 83n346, 84, 87, 88, 91, 92, 94–96, 98, 102n434, 103, 103n439, 105, 107, 107n456, 111–114, 112n475, 113n478, 158, 196n310, 210, 225, 237, 283, 297n378, 307, 325n11, 343, 344, 354, 474, 479n194, 484, 509, 526, 526n419, 534, 559, 559n580, 570, 633, 636, 645n931, 649n940 Haircuts (repo), 84, 114 Haircuts (securities lending), 114, 158, 570 Hedge fund, 34, 41, 62, 64, 101, 137, 139, 152, 155, 164, 168, 178,

178n242, 179, 184, 186, 188, 189n289, 197, 220, 221, 224, 225, 228, 267, 272, 274, 276, 321, 328, 358, 366, 371, 429, 429n14, 441, 441n35, 475, 476n184, 477, 485n226, 518, 520, 533, 535, 647–648 Herding behavior, 120, 123, 453, 454, 456, 470n164, 644n928, 669 Hierarchy of approaches (Sec.), 250n153 High-quality liquid assets (HQLA), 87, 88, 98, 99, 111, 111n471, 196 High quality securitization (HQS), 212, 214, 253n159, 442n38, 537 High quality securitization products High yielding assets, 253 High-yield finance, 611 High-yield loans, 644n930 Holistic regulation, 670n19 Home bias, 71, 314 Homogeneous assets, 663 Hong Kong, 169, 190, 342, 342n5, 344, 346, 358–360, 488 Household debt, 138, 256n169, 375, 402, 649 Housing finance, 200n333, 326 Hybrid intermediaries, 31–37, 44, 508, 661 Hybridization, 143 Hypothecation, 101 I

Illiquid assets, 22, 62, 127, 194, 195n307, 216, 216n33, 274, 324n11, 329, 334, 338, 338–339n66, 354, 388, 471n165, 473n170, 473n171, 479, 480, 485n224, 486n231, 543n496, 578, 578n672, 600n764, 602, 658 Imperfect transfer of credit risk, 184 Implicit government support, 423

 Index 

Implicit guarantee, 49–51, 309n429, 379, 381, 386, 388, 389, 392, 393, 401, 412n311, 414, 415n328, 423, 423n366, 447, 536, 601n769, 660 Implicit subsidies, 661 Index like product, 441 Index investing, 615 India, 186, 345, 346, 365, 370, 417n337 Indicative net asset value (iNAV), 481n206 Indirect approach (risk retention), 247 Indirect contagion (risk), 471n166 Indonesia, 179, 371, 371n119 Inequality, 423, 570, 623, 624 Information Acquisition Sensitivity (IAS), 122 Informational advantage, 121, 456, 653n960 Informational cascades, 455n85 Informational frictions, 35 Informational rents, 537n466 Information costs, 524 Information-insensitive assets, 66, 304n412 Information-insensitive debt markets, 187, 288, 547, 633 Information insensitivity, 24, 57, 69, 89, 120–123, 125, 231, 444, 558, 559, 618n827 Information-sensitive assets, 304n412, 392 Information sensitivity, 10n63, 57, 122, 231, 289n339, 295, 389, 389n205, 390n210, 391, 392, 666 Infrastructure (loans), 365 Initial margin (IM), 83n346, 98, 98n417, 102, 105, 113 Insolvency, 50, 102, 104, 105, 108, 109, 180n255, 226, 253n159, 394, 452, 506, 559n581, 574, 596, 597, 600n762 Insolvency law, 597

731

Institutional capacity, 264, 291, 307, 588, 641, 648 Institutional cash pools, 38–41, 77, 130, 136, 138, 171, 285, 292, 412, 441, 444, 452, 487, 546, 546n509, 546n512, 568–570, 569n627, 644, 644n928, 645n930 Institutional-focused funds, 463 Institutional investors, 3n14, 26, 34, 36, 38n155, 39–42, 60, 119, 130, 136, 138, 155, 175, 181n256, 192n301, 196, 212, 219, 242, 243, 247, 249, 250, 441, 452, 455–458, 463, 483n210, 530, 537, 628, 644n930 Insurance firms, 26n118, 32, 33, 42, 137, 200n333, 221, 244, 267, 324, 360, 377, 395, 397 Insurance-linked securities (ILS), 339, 340 Insurance premia, 42 Interbanking market, 43, 61, 489, 502, 505, 646 Interbank market, 21, 39, 82, 93, 284, 369, 395, 403n274, 405, 412n312, 485, 486n229 Interconnectedness, 38, 60, 72, 76, 77, 82, 85–90, 99, 100, 103, 119, 123, 132, 134, 140, 149, 152–153, 153n139, 160–162, 165–167, 169, 176, 179–181, 179n251, 179n253, 180n254, 180–181n255, 181n256, 185, 192, 204n4, 205, 211, 217, 221, 221n52, 222, 224, 225, 228, 229, 231–233, 232n93, 237, 269, 270, 272n255, 281n302, 281–282n303, 283, 284, 330, 331, 337, 343, 344, 346, 347, 356, 359, 365, 369, 370, 375, 382, 389, 397, 416, 428, 430n18, 468, 473–475, 485, 491, 492, 496, 500, 501, 511, 512, 520, 521, 557, 585, 586, 634, 636, 642, 668

732 Index

Interest on reserves (IOR), 578, 578n672 Intermediation, 22, 31–37, 40, 44, 50, 74, 75, 98, 124, 127n48, 129, 152, 156, 160, 182, 184, 190, 193, 203, 204, 217, 218, 232, 257, 258, 267, 280n300, 345, 356, 359, 411n310, 428, 451, 461, 462, 469, 528, 544, 544n503, 545, 588n712, 639n910 Internal ratings-based approach (IRB), 523n411, 587, 587n708, 588 Internal risk models, 244, 517, 587, 645, 647 Internal shadow banking system International capital flows, 111n472, 129, 288n333, 516, 648 International Organisation of Securities Commission (IOSCO), 105, 178n242, 210, 214, 236, 464, 464n131, 472n167, 473n170, 474, 474n173, 474n174, 474n177, 475n179, 476n184, 476n185, 481n205, 612n806, 616n819, 670n18 International spillover channel, 514, 515 International spillovers, 111n472, 135, 180n254, 527 Investment company act, 339n66 Investment firm, 105, 109, 186, 187, 209, 210, 234, 245n145, 250n153, 272, 276, 535 Investment fund (IF), 34, 130, 150, 161, 162, 164n179, 168, 178, 189–191, 189n287, 189n289, 193, 195n307, 197n318, 203, 204, 226, 232, 234, 265, 266, 268–270, 271n252, 274, 279, 281n303, 282–284, 314, 315, 321, 322, 324, 325, 327–329, 333, 336–338, 370, 378, 460,

461n114, 469, 474, 475, 482–486, 483n212, 538, 570, 609n791, 615n817, 627n864, 630, 638, 662 Investment grade assets, 175 Investor protection, 144, 356, 464, 465, 472n169, 664 Ireland, 161, 167, 177, 181n257, 182n260, 189, 213, 233, 266, 268–270, 279, 311, 627 Islamic banks, 548n517 Italy, 213, 270–271, 311, 594n740, 616n821 J

Japan, 182n260, 186, 190, 257, 342, 344–346, 368–370 Junior tranches, 212, 244, 287, 287n329, 290, 290n340, 291, 311, 312 L

Lender of last resort (LOLR), ix, 58, 61, 62, 65–68, 71, 101n432, 113, 155, 230, 325n11, 332, 528, 554, 567, 580, 622, 639n912, 646, 661, 665, 668 Lending standards, 71, 187, 245n146, 254n162, 402n269, 450, 516, 608, 664 Leverage, 3–6, 9, 30, 38–42, 59, 61, 74–76, 82, 85, 87, 94, 99, 100, 103, 113, 114, 114n480, 119, 120, 127, 128, 135, 139, 140, 145, 152, 153n139, 154, 156, 159, 160, 162–164, 165n182, 166, 169, 172, 176, 178n242, 180n254, 183–187, 184–185n274, 185n278, 186n279, 189–191, 198, 201n341, 204n4, 211, 221–223,

 Index 

225, 230, 231, 233, 233n98, 234, 257, 259n180, 270, 273n260, 274, 278, 280, 281n303, 283, 284, 290n340, 292, 300n390, 323, 325, 330, 332, 336n52, 336–337n57, 337, 339, 339n69, 340, 343, 344, 346, 354, 356, 358–360, 363, 364, 368n96, 371, 375, 378n152, 381, 382, 396, 398, 399, 401n269, 415n329, 423, 429n13, 439, 453, 457, 459, 461, 464, 466, 469–471, 473–476, 479, 480, 482n210, 483, 484, 488, 489, 492, 505, 508, 509, 515, 516, 519, 520, 523, 524, 535, 536, 538, 546, 546n512, 549, 553, 556, 558, 559, 563, 566, 568, 568n625, 569, 569n627, 569n628, 579, 580, 580n679, 580n680, 582–585, 582n687, 596, 596n749, 599–600n760, 612n806, 613, 625n857, 627n864, 630n875, 634, 635, 635n892, 637n904, 638, 640, 643, 651n949, 655, 656, 656n966, 658, 667 Leveraged beta, 38, 441 Leveraged buyout (LBO), 145, 520, 521, 627n864 Leveraged finance, 520–521 Leveraged loans, 62, 196, 196n313, 223, 244, 461, 502, 503n322, 606n783, 627–630 Leverage ratchet effect, 583 Leverage ratio, 48n205, 111, 156n153, 274, 339, 364, 517n384, 563, 579, 579n676, 582, 583, 631, 636 Leverage ratio requirement (LRR), 579, 580 Limited liability, viii, 51–57, 66, 511, 514, 566, 666

733

Limited-purpose finance companies (LPFC), 73 Liquid assets, 7, 21, 22, 38, 62, 104, 108, 112n475, 140n106, 184, 186, 222, 225, 234, 266, 270, 279, 297n375, 302n402, 308, 323, 338, 342n4, 355, 463–465, 471, 473n170, 485n224, 486n229, 509, 536, 578, 600, 602, 651 Liquidation costs (direct or indirect), 60, 485, 506, 507 Liquidity buffers, 137, 152, 339, 339n67, 485, 486, 486n229, 489, 585, 598, 634, 656 Liquidity constraints, 7, 15, 16, 65, 66, 95, 107, 221, 234, 355, 574 Liquidity coverage ratio (LCR), 59, 98, 111, 111n471, 247, 248, 315, 325, 368, 489, 517n384, 590n720 Liquidity facility, 543 Liquidity illusion, 69, 554 Liquidity mismatch, 180n254, 218, 234, 325, 344, 380n166, 470–474, 483, 483n212, 538, 638 Liquidity regulation, 65, 80, 108, 165, 485, 489, 493, 517n384, 518, 546n512, 547, 574, 575, 578, 578n672, 580, 650, 651n951 Liquidity requirements, 75, 80, 80n335, 284, 314, 376n143, 384, 464, 494, 509, 535, 573, 575, 585, 624, 653n960 Liquidity shocks, 16, 18, 30, 111, 122, 143, 191, 329, 371, 425n379, 485, 486, 524, 525, 564 Liquidity shortage, 579 Liquidity shortfall, 509, 580 Liquidity squeeze, 61, 368, 402, 403n274 Liquidity support, 17, 58, 308n427, 312, 549, 574, 588, 602

734 Index

Liquidity transformation, 9–15, 35, 71, 73, 119, 145, 149, 152, 155, 159, 160, 162–164, 166, 173, 176, 179n250, 183, 184, 186, 187, 189–191, 194, 198, 204, 211, 233n98, 270, 273n260, 276, 280, 281–282n303, 336n52, 340, 346, 358, 359, 363, 371, 372, 453, 471, 471n165, 473, 473n171, 478n190, 479–481, 485n223, 536, 546, 572, 615n817, 658 Liquidity trap, 97–116, 304n412, 305n419, 306n422, 318 Liquidity window (of central bank), 17, 48n204, 60, 66, 68, 71, 91, 230, 393, 498, 534, 663, 670 Living will, 647 Loan origination, 1, 52n219, 201n340, 201n341, 266, 270, 284, 371, 372, 450, 587n706, 644 Loan pool, 3, 25, 255, 362 (Loan) syndication, 501 Loan-to-income (LTI), 52n219, 492n257 Loan-to-value (LTV), 131, 131n66, 333, 363, 412, 492n257, 493, 496, 544, 652n955 Loan warehousing, 204 Local government finance vehicles (LGFVs), 360, 379, 381, 400, 401 Long-term loans, 74, 534 Long-term refinancing operation (LTRO), 526n419, 650n943 Look-through approach (LTA), 314 Loss-absorbing capacity (LAC), 37, 581, 585, 611 Low volatility, 39, 41n169 Luxembourg, 177, 177n238, 181n257, 182, 189, 205, 233, 266, 273, 314, 485n227

M

Macroeconomic forecasts, 528, 652n957 Macro-prudential instruments, 497 Macroprudential policies (MPPs), vi, 9, 19, 68, 75, 113, 126, 128–135, 223, 224, 490, 490n250, 491, 493–497, 505, 516, 547, 583, 606–608, 609n792, 630, 643, 648, 651, 656 Macroprudential regulation, 70, 97n412, 130, 148, 298n380, 390, 438, 505, 516, 544, 564, 589, 596, 630 Macro-prudential stress tests, 495 Malaysia, 344–346, 356, 370–372 Marginal contribution to systemic risk (MCSR), 141, 141n109 Marginal expected shortfall (MES), 290n341, 397, 398, 410n304 Margin calls, 83n346, 90, 103, 474, 475 Margin requirements, 83, 101, 214, 234, 236, 307, 475, 484, 585 Margin spirals, 13 Market-based finance, 66, 76, 258, 261, 263, 274, 297n377, 409, 482, 538, 547, 550, 557–568, 612n804, 629–643, 629n871, 649, 666, 668 Market-based financial system, 76, 286, 382, 530, 548–552, 554, 556, 666, 670 Market-based funding, 30, 252, 371, 437–440 Market channel, 259, 354, 468, 476, 576 Market discipline, 49, 91, 93, 94, 121n18, 125, 260, 308, 446,

 Index 

448, 448n62, 449, 449n64, 449n65, 449n68, 449n69, 581, 582, 597–605, 636, 664n12 Market dislocation, 468 Market failure, 53–55, 65, 113, 131, 187, 191, 203, 299n387, 448, 456, 492, 513, 514, 526, 574, 589, 640 Market fragmentation, 615, 616n819, 670 Market freeze, 213 Market liquidity, 99, 103, 114, 115, 126, 187, 191, 216, 371, 396, 465, 473n171, 575–579, 585, 585n699, 596, 613, 639 Marketplace lending, 610n795, 644n927 Market risk, 76, 222, 325n11, 340, 383, 467, 492, 582n687, 612n806, 659 Markets in financial instruments (MiFID) regulation, 105, 109, 209, 226 Mark-to-market price, 4 Mark-to-market valuation, 290 Matched book (CCP), 40, 569, 569n627 Maturity mismatch, 72, 90n383, 119, 194, 222, 225, 274, 295, 332, 382, 384, 416n334, 471n165, 489, 517n384, 635 Maturity mismatch ratio, 517n384 Maturity risk, 31, 140, 160, 201, 461n114 Maturity transformation, 1, 2n6, 3, 43, 54, 61, 62, 71, 75, 126, 153n139, 159, 160, 162, 165n182, 173, 183, 184, 186, 189–191, 193, 223, 225, 232, 233n98, 268, 277, 279, 286n319, 292, 294n360, 323, 329, 336n57, 338, 342n4, 358,

735

392, 416n334, 448, 467n146, 542–546, 573, 585, 635n892, 638, 656, 658 Mexico, 138, 322–327, 330, 336, 337 Mezzanine funding, 610 Mezzanine tranches, 138, 212, 287n329, 289, 290n340, 502 Microcredit, 126, 328, 383n176, 401 Micro-prudential instruments, 571 Middle East, 431–432, 548 Middle East and North Africa (MENA), 431 Mini-BOTs, 615 Minsky, Henry, 59, 526, 588, 622, 651n953 Model-based regulation, 522, 523, 587, 603, 663 Monetary liquidity, 576, 577 Monetary policy, 5–9, 15, 16, 30, 38, 51n214, 87, 91, 95, 97n412, 102, 107n454, 111n472, 126, 128, 132, 135, 148, 199n326, 218, 232n91, 235, 283, 298n380, 304n414, 306, 307, 317, 360, 386, 391n214, 412n313, 437, 461, 463, 465, 470n164, 473n171, 489–507, 509, 515, 516, 527, 539, 540, 553, 554, 570, 571, 576, 583, 595, 597, 597n755, 598n758, 605n780, 606n782, 634, 637n904, 639n912, 644n928, 652n955, 652n957 Monetary policy transmission, 114, 115, 571n638, 598n758 Money creating function (of banks), 317, 545, 654 Money market deposit accounts (MMDA), 143

736 Index

Money market fund (MMF), 30, 32, 33, 36, 39, 44, 82–84, 133, 138, 139, 140–141n106, 149, 150, 152, 155, 162, 164, 168, 169, 178, 178n241, 179n250, 183, 184, 189–192, 189n289, 195–196, 199n331, 205, 210, 218, 220, 221, 223, 224, 229, 232, 234, 235, 265–270, 273, 276, 279, 283, 297n376, 323, 324–325n11, 325, 327, 329, 332, 336–339, 338–339n66, 343–345, 347, 354, 369, 369n105, 373, 373n129, 375, 380, 380n161, 383, 383n176, 389, 390, 411n309, 427, 429, 439, 460, 460n110, 463, 465, 470, 485, 489, 502, 525n419, 534, 535, 547, 553, 557, 558, 566, 570, 585, 629n871, 630, 631, 633, 633n883, 635, 653, 662, 663 Money market mutual fund (MMMF), 73, 138, 143, 144, 227, 321, 324 Money-like claims, 21–26, 58, 285, 285n319, 302, 536, 564 Money-like collateral, 525n419 Monoline insurer, 186, 191 Monopolistic banking system, 572, 573 Moral hazard, 36, 51, 55, 73, 96, 125, 172, 194, 218, 226, 255, 291, 297, 303, 311n432, 323, 330, 378n151, 379n156, 392, 450, 498n295, 517, 517n387, 526, 540, 559, 567, 574, 602, 602n773, 609n792, 620, 622, 640, 644 Mortgage-backed securities (MBS), 14, 21, 140, 218, 231, 369n108, 528, 546, 559n581, 568, 627 Mortgage lending, 329, 331, 333, 493, 597, 656n966 Mortgage servicing rights, 137

Multilateral netting, 90 Multiplier effect, 221 Multipolar regulatory environment, 517 Multi-regulatory environment, 518 Mutual fund, 26, 26n118, 62, 137, 164n179, 178n242, 193, 273n260, 284, 333n40, 367, 380, 381, 387, 404, 405, 453, 453n78, 454, 459, 460, 463, 471n165, 473n171, 479, 480n199, 481n205, 484, 484n221, 484n223, 573, 576 N

National tranching, 291, 292n349 Negative externalities, 22, 54, 218, 439, 479, 509, 604, 668 Negative spillovers, 507 Neglected risk syndrome, 528–531, 665 Neglected risks, 25n112, 529, 536 Neoliberalism, 438 Net asset value (NAV), 123n29, 178n242, 195, 236, 236n119, 267, 269, 337, 354, 355, 460n110, 472n169, 476, 481, 481n206, 482, 525n419, 534, 535, 558n575 The Netherlands, 167, 169, 177, 179n253, 181n257, 193, 205, 213, 232n91, 233, 266, 267n227, 275–280 (Net) interest margin, 384, 416n334, 605n780, 653n960, 658 Net present value (NPV), 582, 604n780 Net stable funding ratio (NSFR), 59, 111, 489, 517n384, 669 Netting, 237, 475, 476, 559 Netting, 90, 237, 475, 476, 559 Network effects, 80, 145, 468, 562

 Index 

Network externality, 517, 517n384 Network structure, 369, 564 Neuro-economic measures, 466 New Zealand, 361–362 Nigeria, 430, 431 No/low documentation loans, 363 Non-bank financial institution (NBFI), 140, 166–167, 174, 283, 333, 342–344, 346, 347, 356, 372–374, 387, 389, 393, 420, 431n24, 580, 585, 606n783, 627–630, 635 Non-bank non-insurance global systemically important financial institutions (NBNI G-SIFIs), 468 Nonbank-to-nonbank transactions, 559 (Non-cash) collateral, 99, 105, 317n456 Noncore assets, 40, 509 Non-core liabilities, 40, 127, 127n48 Non-performing loan (NPLS), 257, 284, 365n78, 417n338 Normative regulation, 567 O

Off balance sheet, 19n81, 19n87, 156n153, 174, 183–185, 187, 189n287, 190, 191, 212, 217, 282, 326, 327, 366, 377, 379, 384, 390, 392, 393, 399, 399n258, 405, 405n287, 408, 420n353, 423n366, 425n377, 635, 646 Off-balance sheet assets, 228 Off-balance sheet (exposures), 186, 187, 423n366, 448, 476, 601n769 Off-balance sheet financing, 376, 581 Offshore banking, 611 Offshore (financial) center, 169–174, 330, 594 Opaque assets, 75, 577

737

Open gates, 459 Open-ended funds, 194, 195, 196n310, 201, 234, 328, 329, 334, 338, 338n66, 339, 460, 469–475, 481, 483n212, 638, 639 Open-end investment firms, 486 Operational financing models, 500 Operational risk, 83n346, 469, 476–477, 500, 533, 548n517, 612n806, 613, 638 Optimal bank capital regulation, 498, 499 Optimal capital regulation, 620 Optimum quantity of money, 506, 572, 573 Original lender, 247 Originate-to-distribute model, 219, 239, 444, 664 Originate-to-hold (OTH), 64, 664 Originate-to-hold model, 332, 664 Originate-to-mature, 242, 244 Originator (loan, assets), 25, 68, 216, 218, 245n146, 247–250, 254, 255, 267, 272, 362, 363, 411n307, 445, 450, 450n71, 451, 535, 636 OTC derivatives, 96, 98–100, 102, 570, 636 Other financial institutions (OFIS), 95, 116n486, 132, 157, 171, 230, 399n258 Overcollateralization, 84, 123, 302 Overleveraging, 156, 381n171 Overnight repo, 40 Over-the-counter (OTC), 35, 215 Over-the-counter (OTC) derivatives, 92, 236, 236n121, 249, 358, 364, 477, 547, 635 P

Panama, 169, 322, 324–329, 337, 338 Pareto, 77n323, 106

738 Index

Pawn shop, 229 Pecuniary externalities, 492 Peer benchmarking, 455 Peer-to-peer lending, 119, 197, 468, 644n927 Pension funds, 42, 118, 130, 137, 141, 150, 153–155, 162, 163, 168, 177n235, 178n239, 179–183, 179n251, 179n253, 180n254, 181n259, 188, 188n281, 189, 192, 193, 203, 220, 221, 243, 270, 271n252, 274, 275, 283, 324, 326, 336, 337, 341, 344, 369, 372, 373, 427, 429, 455n86, 455n87, 456, 470–471n164, 479–482, 546n509, 568, 569n627, 576, 628, 644n928 Philippines, 345, 361, 370 Piercing the corporate veil, 666 Pierret’s model, 79, 80 Pigou, Arthur, 439 Plain-vanilla investment products, 453 Pooling of loans, 254, 255 Prepayment risk, 452 Price discovery, 99, 102, 120–123, 121n20, 122n24, 125, 216, 216n33, 258, 286, 456, 477, 485, 503n322, 577, 612n806, 618, 669 Price externality, 461, 464 Primary dealers, 93 Prime broker, 110, 178n242, 225, 354 Prime brokerage, 107 Private backstop, 36 Private equity (PE), 64, 137, 139, 150, 153, 155, 205, 220, 221, 229, 276, 358, 371, 399, 518, 520, 521, 535, 591, 628, 648 Private information, 10, 57n238, 121–123, 304n412, 449n69, 455n86, 559, 668 Private label securitization, 138, 332

Private money, 39, 57, 61, 88, 392, 505, 550, 554, 555, 617–627, 659, 662 Private money creation, 68, 74, 77, 85, 216, 255, 317, 505, 535, 572–581, 583 Private securitization, 317 Probability of default (PD), 523, 566, 587, 588n709, 606n783 Procyclical behavior/policy, 59, 446n54, 491, 497, 568 Project finance, 520 Prudential treatment, 219, 220n50, 247, 248, 443n41 Public backstop, 22, 42, 49, 54, 64, 65, 71, 75, 204, 204n4, 218, 245, 255, 303, 489, 498, 548, 554, 565, 661, 668 Public safety net, 72, 84, 145, 203, 218, 554 Q

Quantitative capital ratio regulation, 105 Quantitative easing (QE), 59, 125, 175, 307, 491n252, 582 Quantity regulation, 18, 44, 57, 643 R

Rank-based performance, 460 Ratings-based approach (RBA) Real Estate Investment Trust (REITS), 138, 141n106, 157, 159, 163–165, 165n182, 168, 178, 184, 188, 223, 267, 362 Recapitalization, 125, 538 Re-collateralize, 104 Recourse loans, 240 Redemption, 127, 129, 155, 194–196, 221, 225, 234, 235, 270, 329, 333, 333n40, 337, 354, 355,

 Index 

371, 378, 454, 459, 464, 470–474, 470n162, 471n165, 473n171, 474n173, 477, 481, 483, 483n212, 485, 486, 566, 600, 633, 637 Redemption clauses, 371, 459, 477 Redemption gates (MFF), 337, 472, 474n173, 486 Redemption risk, 468, 486n231, 615n817 Redemption terms, 338, 469–474, 638 Redistributive policies, 570 Refinancing risk, 383 Regulation Q, 390 Regulatory arbitrage, v, viii, 2n4, 3n14, 30, 43–52, 72, 74, 85, 103, 110, 119, 126, 129, 138, 140, 142–144, 154, 162, 169, 170, 176, 187, 191, 201, 216–218, 230, 231, 235, 249, 323, 329, 331, 334, 343, 344, 346, 347, 354, 356, 359, 363, 374, 375, 385, 389n205, 390, 412n312, 419, 419n350, 420n353, 452, 478n190, 494, 497, 497n291, 498n295, 512, 516, 524, 524n413, 527, 534, 536, 553, 565–567, 567n620, 575, 581–584, 586n701, 587n706, 599, 601, 602, 603n775, 604, 610n796, 616n819, 639, 646, 652, 653n960, 659, 659n4, 661, 662, 668 Regulatory-capital arbitrage, 567n620 Regulatory indicators (of systemic risk), 571 Regulatory overreach, 498, 669 Regulatory sandbox, 588n711, 614, 669 Re-hypothecation, 59, 62, 76, 81–85, 83n347, 87, 94–97, 95n399, 99–111, 156, 156n154, 210, 224, 226, 358, 559, 636

739

Rent-seeking, 64, 442, 518, 565, 583, 584 Repackaged loans, 664 Repo, 23n99, 40, 59, 60, 73, 77, 82–84, 83n347, 86–89, 90n383, 97, 99, 101, 102n434, 105, 105n443, 114, 122, 149, 158, 179, 191, 200n332, 213, 218, 219n43, 222–226, 231, 237, 237n127, 251, 274, 284, 286n319, 323, 325, 354, 358, 384, 397, 403, 405, 484, 509, 531, 553, 561, 568n627, 570, 585, 596, 636, 670 Repo market, 39, 40, 60, 60n252, 62, 77, 81–97, 105, 105n444, 107, 114, 115n486, 116, 174, 179n250, 191, 205, 237, 237n126, 238, 260, 272, 283, 284, 325n11, 343, 344, 364, 381, 509, 534, 635, 645n931, 653, 669, 670 Repo runs, 509 Repricing of liabilities, 579n675 Repurchase agreement (repo), 33, 66, 67n273, 104, 156, 157, 286n319, 356, 364, 561, 633n883 Reputational herding, 455 Re-securitization, 209, 396 Reserve requirements, 28, 30, 46, 71, 131n66, 143, 376n143, 391, 404n281, 425n377, 493, 509, 516, 524 Resolution framework, 330 Re-use of collateral, 81, 82, 85, 87, 88, 91, 95, 99–101, 103, 104, 106, 107, 114, 225 Reverse regulatory arbitrage, 49, 51n219 Reverse repo, 40, 100, 161, 179, 192, 225, 354, 509 Reverse repo program (RRP), 546n512, 569

740 Index

Ring-fencing, 513, 602, 622 Ring-fencing risk, 511 Risk analysis, 141, 452, 627n864, 642 Risk-based capital (requirements), 434, 599n760, 621n839 Risk composition, 118 Risk concentration, 59, 204 Risk controls, 403 Risk diversification, 203, 212, 216, 258, 331 Risk externalization, 514n374 Risk-free assets, 293, 316, 438, 546n509 Risk management, 32, 68, 76, 77, 85, 86, 89, 92, 96, 113, 154, 216n32, 221, 233, 236, 244, 246, 250, 258, 388, 446n55, 454, 464, 465, 472–475, 474n173, 477–479, 487, 500, 501, 522, 552, 587, 588n708, 598n756, 639, 647, 653n960 Risk migration, 118 Risk retention, 214, 215, 218, 219, 241, 247, 249, 367n94, 370, 443n41, 566, 570 Risk retention requirements, 218, 247 Risk retention (rules), 218 Risk transfer, 51, 115, 162, 217, 219, 233, 233n98, 242, 279, 425, 452, 496, 624 Risk transformation, 119, 155, 173, 186, 292, 342n4, 383, 615n817, 635n892 Risk waterfall, 502 Risk weighting (of regulatory capital), 48, 105, 200, 442, 452 Rollover risk, 90n383, 296n374, 319, 362, 412n312 Rule 2a-7 (MMF), 339n66 Russia, 175, 271, 657n1

S

Safe assets, 13, 24, 39, 60, 88, 90, 112, 113, 115n486, 125, 130, 147, 216, 285–319, 310–311n432, 389, 390, 412, 433, 460, 460n110, 509, 522, 568, 569, 569n627, 576, 587, 601, 604, 605, 649, 662, 665, 668 Securities and Exchange Commission (SEC), 108, 478n189 Securities financing, 40, 41, 223, 225, 550 Securities financing transactions (SFT), 35n145, 102, 105, 109, 111, 210, 211, 223–226, 274, 284, 333, 478n190, 547, 558, 559n580, 569n627, 585–586n701, 630 Securities financing transactions regulation (SFTR), 109 Securities lenders, 36n151, 73, 130, 669 Securities lending, 32–37, 37n153, 40, 41, 86, 97, 104, 114, 115, 115n486, 120n14, 158, 205, 222–225, 231, 234, 272, 274, 343, 344, 354, 356, 469, 477–479, 535, 553, 570, 585, 622, 638, 669 Securitization, 3, 5, 124, 205, 328, 343, 442–453, 662 Securitization-based credit intermediation, 160, 182, 187–189, 191, 269, 280n300, 336n53 Securitization exposure, 242n141, 451 Securitization special purpose entity (SSPE), 248–250 Securitizer, 445 Self-fulfilling runs, 44, 530, 531, 553, 564, 600n764 Senior tranches, 243, 288, 289, 291, 312, 425

 Index 

Servicer risk, 220n48, 560 Shadow banking supervision, 532–536 Shadow collateral, 546, 546n509, 568, 569, 569n628 Shadow insurance, 142n112, 234, 564 Shariah compliance risk, 548n517 short-selling, 35 Short-selling, 339 Short-term liabilities, 73, 157, 184, 186, 266, 294, 654 Short-term loans, 269, 333, 400 Side pockets, 337, 355, 473, 473n170, 474n173 Signaling hypothesis Simple, transparent and standardized (STS) regulation, 648 Simple, transparent and standardized (STS) securitization, 206n14, 214, 219, 242, 242n141, 244, 246–250, 250n153, 286, 443 Simplicity (STS criteria), 220n48 Singapore, 169, 279, 342, 344, 358–360, 371, 488 Single resolution mechanism (SRM), 667 Skin-in-the-game, 144, 442n38 Small- and medium-sized enterprise (SME), 74, 153, 156, 158, 206, 206n14, 212, 219, 238, 239, 241–243, 241n138, 245, 248, 250n153, 252–254, 253n159, 254n160, 257, 260, 263, 329, 345, 356, 371, 384, 395, 408, 431, 437, 439, 441, 443n41, 443n44, 537, 538, 550, 551, 621, 621n839, 622, 641, 661 Smart beta, 38, 38n155 SME loan (book), 206n14, 257 SME (loan) securitization, 212 Soft law, 71 Solvency I/II Directive, 220n50, 247–249

741

Solvency risk, 79, 218, 229, 397, 483, 484, 600n762, 602 South Africa, 167, 427–432 South Korea, 344, 346, 370–371 Sovereign bond-backed securities (SBBS), 287–291, 308–316 Sovereign debt, 86, 142, 237n127, 286, 287, 289, 291, 292n349, 301, 309, 309n430, 311, 313, 315, 316, 329, 616n821, 622, 645, 645n931, 647 Sovereign default, 237, 291, 312n438, 313 Spain, 167, 167n186, 213, 311, 461, 627 Special investment vehicle (SIV), 356, 381, 396, 596n749 Special purpose entity (SPE), 248, 270, 277–279, 277n284, 395, 635 Special purpose insurers (SPIs), 276, 339, 340, 340n74 Special purpose vehicle (SPV), 2, 25, 33, 73, 137, 138, 155, 157, 171, 186, 188, 205, 268–270, 271n252, 272, 276, 370, 381, 424, 425, 497n289 Spillover effect, 120, 123, 194, 226–227, 234, 290n340, 370, 424, 470, 473, 484, 497n290, 563, 643 Spillover risk, 347, 397, 538 Squeezed returns, 461 Stability risk, 42, 105, 107, 110, 128, 145, 180n254, 181, 181n259, 183, 184, 188, 188n281, 194, 198, 222, 273, 274, 282–284, 334, 413, 426n379, 453, 458, 465, 469, 474, 479, 481, 483, 558, 570, 574, 612, 630, 632, 634–636, 638 Stable net asset value (NAV), 460n110 Standard approach (SA), 523n411, 587, 588, 588n708

742 Index

Steagall Glass act, 534, 661 Step-in risk, 596n749, 636 Strategic complementarities, 104, 132, 463, 492 Stress-test, 490 Structural risk, 220n48, 286, 560 Subsidized haircuts, 526n419 Subsidy value, 560 Substitutability channels, 468 Supervisory frameworks, 111, 331, 558, 661, 666 Sweden, 271–272 Swing prices, 474 Swing pricing, 354, 472, 472n169, 486 Switzerland, 169, 274–276, 279–280 Syndicated loan, 504, 628, 645n930 Syndication, 500 Synthetic CDO, 396 Synthetic leverage, 184, 185, 190, 281n303, 339n69, 464, 470, 476, 483 Synthetic securitizations, 245n146, 248, 250n153, 254 Systemic arbitrage, 93, 103 Systemic contagion risk, 500–504 Systemic expected shortfall (SES) Systemic risk, 18, 118, 204n4, 219, 324n11, 330, 331, 342, 431, 456 Systemically important financial institution (SIFI), 45, 79, 134, 467, 468, 498, 532, 553, 560, 647 T

Tail risk, v, 23, 35, 125, 218, 290, 303, 303n410, 391, 392, 457, 458, 478, 502, 536, 553, 562, 570, 577, 665 Tail risk exposure, 290, 457, 458 Tax avoidance, 48, 171, 278 Tax evasion, 173 Tax havens, 172–174, 173n214

Tax liability, 604 Tax neutrality, 171 Technological innovation, 143, 435 Technology, 31, 33, 33n138, 197, 345, 408, 501, 557, 568, 576, 584, 587n706, 588n711, 593, 610–611n797, 611, 615n816, 637n904, 643n927, 669 Thailand, 344, 345, 355, 361 Tier-1 capital, 313, 314, 558, 623, 658 Timing practices (AM), 455 Title transfer financial collateral arrangements (TTCAs), 109 Too-big-to-fail (TBTF), 564, 590n720 Too-connected-to-fail problem, 507 Too-interconnected-to-fail, 507 Total factor productivity (TFP) growth rate, 436 Total factor productivity (TFP), 436, 530 Total loss-absorbing capacity (TLAC), 634, 648, 650n949 Trade repository (TR), 110n465, 224, 236n121, 553 Trading volume, 455, 471 Tranched credit protection, 288, 289 Tranches, 3, 39, 124, 130, 138, 157, 187, 196, 212, 243, 244, 245n146, 250n153, 253, 287–290, 287n329, 290n340, 303, 309, 310, 312, 363, 395, 396, 452, 633 Tranche thickness, 452 Tranching, 24, 115, 257, 290n340, 291, 292n349, 311, 314, 367n94 Transaction costs, 30, 88, 95, 295, 461, 481, 567 Transfer pricing, 158 Transmission channel, 112n475, 128, 420, 450, 468, 469n155, 493, 571, 607, 608, 614 Transparency, 49, 62, 103, 105n446, 109n464, 110, 112, 120, 121,

 Index 

121n18, 123, 123n29, 125, 132, 135, 208, 210, 211, 219, 219n43, 220n48, 220n50, 223, 224, 247–249, 269, 304n412, 339, 359, 360, 383, 430, 439, 443n41, 445, 448, 449, 449n64, 451, 451n72, 465, 512, 520, 535, 537, 548n517, 557, 560, 577, 612n805, 618, 628, 636, 640, 652n957, 656, 662n8, 663 Transparency (STS criteria), 248, 249 Trial-and-error momentum, 498 Trinidad and Tobago, 330n25, 338n63 Tri-party repo (transaction), 635 Tri-party repo market, 83, 105, 635 Trust beneficiary rights, 377 Trust preferred securities (TruPS), 47n194, 47n195 U

Unanticipated shocks, 529 Uncertainty, 10, 12, 13, 13n65, 46, 89, 110, 124, 153, 195, 212, 213, 228, 239, 255n164, 263, 289, 304n412, 392, 396, 397, 426, 441n35, 448, 494, 512, 515, 527, 547, 559, 578, 589n714, 601 Uncleared derivatives, 98, 585 Unconventional monetary policy (UMP), 93, 126, 463, 490–507, 533, 539, 598n758 Underlying credit risk, 417, 420 Underlying exposures, 247, 248, 250 Underpricing, 218, 554, 628 Undertakings in Collective Investments in Transferable Securities (UCITS) Directive, 109n465, 178n242, 193, 201n340,

743

220–221, 220n50, 249, 269, 272, 284, 314, 481n205, 486, 674, 700, 718 Uninsured bank deposits, 39 Uninsured deposits, 39, 40n162, 161, 449n65, 637n898 United Kingdom (UK), 119, 141, 141n108, 165, 167, 194–195, 213, 227n77, 228, 269n236, 273–274, 276, 580, 584, 635n891 United States (USA), 1, 6, 9, 15, 46, 88, 99, 103, 105, 108, 108n462, 110, 118, 119, 124, 125, 137, 140n106, 141, 141n108, 142, 155–158, 165, 168, 178, 178n241, 182n260, 186, 187, 195, 203, 205, 206, 218, 225, 227, 227n77, 228, 230–231, 238–241, 252, 253, 257, 261n193, 263, 276, 279, 282, 303n406, 307n424, 318, 322–327, 329, 331, 332, 336, 343–345, 373, 375, 384, 389, 389n205, 390, 392, 393, 398, 402, 409, 412, 441n35, 442, 451, 461n114, 469, 475, 475n181, 479, 491n252, 503n322, 526n419, 530, 536, 537, 557, 558, 559n581, 595, 599n760, 606n783, 606n784, 617n824, 627, 636, 640, 642, 644–647, 657n1, 661, 663, 666 Universal bank concept, 542n491 Unsecured debt, 157, 430 V

Value-at-risk, 500 Variation margin (VM), 105 Variation margin gain haircut, 98

744 Index

Vietnam, 361 Volatility, 2–4, 12, 13, 16, 38, 39, 41, 41n169, 43, 83n346, 88, 91, 94, 97, 103, 114, 114n480, 115, 115n485, 115n486, 127, 304n412, 308n427, 309–310n430, 333n40, 446n55, 455–457, 459, 462, 470–472, 473n171, 474, 475, 478n190, 484, 487, 508, 523, 533, 539, 578, 579, 595, 613, 615n817, 617, 621n839, 626n862, 639n912, 651, 669, 670 Volcker rule, 14, 647, 648, 661, 661n7

W

Wealth management product (WMPs), 128, 185n276, 230, 377–392, 380n165, 397, 400, 403, 405, 408, 410, 411n308, 411n309, 412, 412n311, 412n312, 414, 414n322, 414n327, 415n329, 416, 416n334, 417, 417n339, 419–420n350, 420, 423n366, 424 Wholesale funding, 39, 40, 79, 80, 104, 133, 179, 179n250, 183, 186, 191, 192, 218, 282n303, 368, 383, 489, 574 Wholesale funding market, 40, 90, 331 Wholesale funding shocks, 489 Wrong-way risk, 241, 243, 245