The St. Louis Federal Reserve Bank has just issued a paper asking the question, "Is shadow banking really banking?" In the report Economist Rajdeep Sengupta and research associate Bryan J. Noeth give a clear description of what defines a bank and whether the infamous 'shadow banking' system that reportedly helped cause the financial crisis qualifies as banking. By their definition, banks are "intermediaries that obtain funds from lenders in the form of deposits and provide funds to borrowers in the form of loans." The purpose of banking, according to Sengupta and Noeth, is what they call "maturity transformation." Those who deposit funds with banks prefer to be able to access their funds in fairly short windows. Borrowers, however, need much longer maturity horizons to fit their funding needs. That's where a bank comes in. Since banks hold funds from a large swath of depositors, they are able to lend out much of that money knowing that only a small fraction of depositors will actually need to access their cash at one time.
The shadow banking system, according to the report, is a much more complicated process, but one that essentially serves the same function. The shadow banking system is the venue whereby financial insitutions securitize and sell off debt through off-balance sheet constructs called "special purpose vehicles." A bank will sell their loan to a shell company that has no other purpose other than to hold those loans. These shell companies are "bankruptcy remote," meaning their financial health can't affect the financial health of the company that sells it the loans and vice versa. From this special purpose vehicle, the securities are then sold to investors. In this model, companies or mortgagors issuing debt are the borrowers, and investors like pension, hedge or mutual funds are the lenders. Essentially this is just like our traditional banking system, just a little more complicated.
The report concludes, "The reader may question the rationale behind the development of the shadow banking system and all its components. While some analysts have asserted that the shadow banking system is redundant and inefficient, it is not difficult to see the benefits of securitized banking. Securitization allows for risk diversification across borrowers, products and geographic location. In addition, it exploits benefits of both scale and scope in segmenting the different activities of credit intermediation, thereby reducing costs. Moreover, by providing a variety of securities with varying risk and maturity, it provides financial institutions opportunities to better manage their portfolios than would be possible under traditional banking. Finally, and contrary to popular belief, this form of banking increases transparency and disclosure because banks now sell assets that would otherwise be hosted on their opaque balance sheets."
There appear to be several benefits of securitization and the use of special purpose vehicles. I addressed securitization in my first post, but let me explain why these special purpose vehicles might create value. If a financial institutions buys a bunch of loans and then chops them up and securitzes them, anyone who buys that security has to worry not only about the credit risk of the initial issuer, but also about the health of the financial institution that is securitizing these loans. Placing those securities in a bankruptcy remote special purpose vehicle, possibly one that is insured, will relieve that extra layer of risk and make it cheaper for issuers to borrow money. While this maybe a real benefit of these accounting constructs, I would have liked to have seen more attention paid to the potential abuses of these SPVs. After all, it was special purpose vehicles that aided Enron in its fraud a decade ago. Also, financial institutions used these special purpose vehicles to get loans off their balance sheets and therefore avoid regulatory requirements dictating they hold a certain amount of capital in reserve to back up loans. I would have liked to have seen these concerns addressed. All in all, however, the report is a good explanation of what the shadow banking sector is and how it mimics traditional banking.
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