FINANCIAL INDUSTRY STRUCTURE

Chapter 9 & Chapter 13 & Chapter 17 450-454

Shadow Banking System• Over the last 30 years, competitors to banks in providing traditional banking

services. The competitors include• Investment/Merchant Banks• Mutual Funds• Hedge Funds• Finance Companies

• The FSB defines shadow banking as “credit intermediation involving entities and activities (fully or partially) outside the regular banking system”. In the Global Shadow Banking Monitoring Report 20121, 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.

• GSE’s• Pension Funds/Insurance Companies

Decline of Glass-Steagal Act• In 1927, interstate banking eliminated.• In 1933, Glass-Steagal act created FDIC and separated

banking business from securities business.

During 1990’s, these regulations were eliminated and US banks had a wave of consolidation and concentration.

Bank Holding Companies

• Bank holding companies have a corporate structure in which a parent company owns many subsidiaries in different financial industries.

1. Subsidiaries engage in banking, securities, real estate and insurance business.

2. Subsidiaries are separate legal entities so the bankruptcy of one does not mean losses for the other.

3. Losses at one subsidiary do result in losses for shareholders of the holding company.

4. Banks mostly protected from risk of sister companies. Advantages: Protects depositors & bank capital from market

risk. One stop shopping can help build relationships.

Financial Innovation and The Decline of Traditional Banking• Banking is traditionally the business of accepting short-term retail deposits and making long-term loans.

• A number of financial innovations have led to changes in the financial industry and financial regulation.

• Due to reductions in information & transaction costs, the banking industry in US, Japan, and Europe faces competition for both deposits and credit.

IMF Global Financial Stability Report - Chapter 2: Global Shadow Banking

Decline in Advantage in Providing Liquidity

• New Competition: Money Market Mutual Funds – Mutual funds that are redeemable at a fixed price by writing checks. Mutual funds invest in money markets. These are essentially checking accounts issued by non-financial institutions that pay interest.

Decline in Advantage in Providing Credit• Another of banks comparative advantage is their ability to provide loans quickly and provide credit to small or new firms.

• New Competition• Commercial Paper: Short-term corporate bonds.

Many firms that relied on banks for short-term loans now issue commercial paper.

• Junk Bonds: Bonds issued by firms with non-investment grade credit ratings. Many firms that relied on banks for credit now issue junk bonds.

Loan Commitments & Letters of Credit

Banks collect fees for additional off balance sheet activities

1. Loan Commitment: A line of credit giving company ability to borrow when desired.

2. Letter of Credit: Promise by a bank to make good on customer’s credit from another party.

A. Commercial LOC: Customer buys goods on credit. If they get LOC from bank, the bank promises to pay trade bill if the customer does not.

B. Standby LOC: If issuers of commercial paper, get LOC from bank, the bank promises to pay bond investors if issuer defaults.

Loan Securitization• Banks make loans in a certain class, bundle the loans into a portfolio, sell securities, and dedicate the principal and interest payments on the loans to making coupon and face value payments on the securities.• Banks profits come as fee for setting up loan back

securities.

• Banks reduce the maturity mismatch between assets and liabilities by raising funds this way instead of deposits reducing interest rate and liquidity risk. • Primarily mortgage loans are securitized but also

securitization of credit card receivables, auto loans and even leasing payments by rental companies.

Securitization

BorrowerBorrower

Borrower

Borrower

Borrower

BankWill bundle loans

And sell to 3rd partyLoans

3rd PartySecuritization

Company(typically GSE)

Bundle

Bond Market

Bonds

Banks collect fees for making loans and collecting repayment

Shadow Banking and Asia• FSB uses OFI’s (non-bank financial institutions less

insurance, pension funds & public institutions) as indicator of shadow banking (Unit Trusts/Mutual Funds, Finance Companies, Credit Unions, Brokerage Companies, Structured Finance).

• Shadow banking in Asia generally:• Small relative to banking sector but growing • Mostly not financed through financial markets.• Mostly finances simple loans or vanilla securities.

Chinese Banking System1. Major Commercial Bank (BoC, ICBC, CCB, ABC)2. Joint-Stock Commercial Bank (CITIC Industrial Bank, Bank of

Communications, Everbright)3. City Commercial Bank (Bank of Shanghai, Bank of Beijing, Bank of

Tianjian)4. Credit Cooperatives (Collective Banks – Urban and Rural)5. Policy Banks (Export Import Bank, China Development Bank)6. Trust Companies

CBRC

Chinese Trust Companies

• China has heavily regulated deposit rates.

• Rich people seek higher yields. WMP direct funds to trust companies – specialized lenders that finance projects that cannot access traditional banks.

Shadow Banking and the GFC

Growth in I-Banking

Assets of Broker Dealers

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Financing of Investment Banks

October 2004 – SEC lifts capitalization rules for large broker-dealers

M. Brunnermeier, Princeton U. Slides.

I-Banks switched to more S-T financing.

Broker Dealers Source of Financing

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ST CP Equity

Ex. In 2000, Equity to Assets at Morgan Stanley was 4.6%, in May 2008 was 1.1%

CMO: Collateralized Mortgage Obligations

• An SPV is set up to purchase mortgages and issue bonds which pay out in tranches. Tranches are orderings of payments in terms of seniority. Each tranche is has its own credit rating.

Sample

Commercial and Investment Banks often set up SPV

Special purpose vehicle: Quasi-independent company set up to manage asset.

M. Brunnermeier, Princeton U. Slides.

Vanilla Mortgage Backed Security• A bond that raises funds to buy a bundle of mortgages

and uses income to repay bondholders. • Usually sold or guaranteed by GSE (Govt. Natl Mortgage

Assoc., Fed. Natl Mortgage Association, Federal Home Loan Mortgage Corp.)

Mortgages

Mortgages

Mortgages

MBS

Single Tranche

Bondholders

Collataralized Mortgage Obligations• A special purpose vehicle that buys mortgages and

structures payments into tranches.• Usually private label, SPV/SPE , in order to expand base

of allowable mortgages.

Mortgages

Mortgages

Mortgages

CMO

Senior Tranche AAA

Junior Tranche

Special purpose vehicle/entity: Quasi-independent company set up to manage asset.

Structured Securities

• Securitized bonds w/o GSE guarantees are risky because in a slump not all mortgage borrowers will repay their debts. But income is highly diversified.

• CMO’s structure payments according to seniority. Most senior tranches have first call on income, so only lose money if a large fraction of borrowers fail to repay.

• CMO’s concentrate risk among most junior tranches, synthetically creating safe senior securities.

Collateralized Debt Obligations• A special purpose vehicle that buys quantities of debt

securities (often MBS or CMO tranches) that might be low rated and turn it into tranches some of which might be better rated.

BBB Securities

BBB Securities

BBB Securities

SPV

Senior Tranche AAA

Junior Tranche

AAA tranches may have paid higher returns than typical AAA securities. Attractive to institutions restricted to AAA

Sub-prime Lenders• An industry of financial intermediaries that specialized in

making mortgage loans pre-packaged for securitization arose.

• Many of these specialized in the sub-prime market.• Typically, these were sold to SPV’s rather than GSE’s.

• Investors in CMO’s and CDO’s financed their purchases with short-term borrowing and issuing commercial paper often sold to MMMF’s.

• Shadow banking reduced maturity mismatch in traditional banking sector but only shifted it to investment banks and mutual funds.

End of Housing Bubble• In 2005, housing prices reached a peak. • However, by reducing lending standards and increasing

reliance on sub-prime lending, mortgage lending continued to grow.

• By 2007, housing prices began to fall.

Credit performance worse at sub-prime lenders.

Mortgage losses estimated at $1.4 trilion by IMF

Liquidity of CMO’s and CDO’s• There is much uncertainty and asymmetric info in CMO’s.

Difficult for a potential investor to evaluate quality of the mortgage loan bundle while bundler/seller may have better idea.

• Increased risk has generated lemon’s problem.• Wide bid/ask spreads makes it difficult to reasonably

implement M2M accounting.

Issues• Capitalization: Banks and other holders of mortgage

backed securities are likely to take large losses on defaults.

• Liquidity: MMMF are supposed to be safe investments; once risk becomes known MMMF‘s pull out of commercial paper market go into treasuries.

• Complexity: CDO’s and CMO’s are complicated instruments; difficult to tell good from bad. In hard times, adverse selection may make selling them w/o huge discount problematic.

• Business cycle issue. Large contraction in consumption and investment likely to make default rates rise.

Liquidity Runs• Logic of the Diamond & Dybvig model

OFI2 Equilibria CMO’s

Basel III – Link • International regulations change following the crisis. • Requirements for simple leverage ratios, not just risk-

weighted CAR.• Capital requirements for SIFI’s (systematically important

financial institutions) not just banks. • Liquidity Requirements

1. Liquidity Coverage Ratio – Enough liquid assets to cover withdrawals under stress scenarios

2. Net Stable Funding Ratio – Incentives to maintain a minimum level of stable or long-term financing .

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A. Conventional View• Asset Price Indicators should only influence monetary policy as they impact aggregate demand and inflation over the medium term.

• Price stability is the only focus. • Monetary policy should make no effort to affect the speculative component of asset prices.

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“The central bank should respond to movements of stock prices, house values, and other asset prices only insofar as they affect future output and inflation over the medium term. That is, policy tightening might be called for to contain the incipient inflation caused by an asset–market

boom, but not to arrest the boom per se.” Bernanke (2002)

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B. Leaning Against the Wind/Extra Action• ECB 2005 “The central bank would adopt a somewhat tighter policy stance in the face of an inflating asset market than it would otherwise allow if confronted with a similar macroeconomic outlook under more normal market conditions”

• Respond to speculative boom with tight monetary policy. • Trade certainty of worse near-term economic performance

for possibility of better future performance

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C. Post-Crisis View

1. Risk Taking Channel of Monetary Policy2. Dealing with Credit Booms

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1. Bank Risk Taking Channel

• Economic studies suggest that banks respond to persistent periods of low interest rates by taking more risk.

• Yield chasing – Banks may implicitly promise yields to investors, need to earn yields that match those promises. Only by taking on more risk can they do so.

• Evidence suggests that yield chasing is less prevalent in well-regulated banking markets.

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Bank Risk Taking and Interest Rates

Challenges to Monetary Policy Effectiveness

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Dell'Ariccia, G., 2010, “Monetary Policy and Bank

Risk-Taking,” IMF Staff Position Note

No. 10/09

Link

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IT and Bank Risk Taking

BIS View (Borio and Wheelock, 2004; Borio and White, 2004)

• Inflation targeting monetary policy passively allows bank credit to expand to fuel the asset price boom general price inflation

• Unless policymakers act to defuse a boom, a crash will follow.

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IMF WEO Sustaining the Recovery October 2009Figure 3.3. Selected Macroeconomic Variables before and during House Price Busts

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pre-1985 post-1985

Panel 1: Credit/GDP Growth

% Deviation

From 8 quarter trend

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Dealing with Credit Booms• Credit Booms: Credit grows 10-20% faster than GDP

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Often follow domestic or international financial liberalization.

Policies for Macrofinancial Stability: How to Deal with Credit Booms Giovanni Dell'Ariccia, Deniz Igan, Luc Laeven, and Hui Tong,with Bas Bakker and Jérôme Vandenbussche IMF Staff Policy Note May 2012

Good or Bad?

Policies for Credit BoomsLeaning against the Wind• Monetary Policy: Raise Interest Rates.• Fiscal Policy: Counter-cyclical fiscal policy

• Monetary and fiscal policies are important for general macro overheating that may accompany credit boom. But evidence for their effectiveness beyond that is limited and could have significant negative impacts on growth.

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Leaning 2014“Both the objective of keeping consumer price inflation close to 2.5% and the objective of sustaining capacity utilization in the years ahead could in isolation imply a somewhat lower key policy rate forecast.… On the other hand, a lower key policy rate may increase the risk of a further buildup of financial imbalances” (Norges Bank 2014, p. 16).

Challenges to Monetary Policy Effectiveness 48Link LINK

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Macro-prudential Measures (MPM)

1.Loan Eligibility Criteria.

2.Capital and Liquidity Requirements.

3.Asset concentration and growth limits.

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Monitoring Credit Risk: HK50

Link

Final Exam• Thursday, December 11th, LTB 12:30-3:30.• Cumulative. Similar to mid-term and practice exams.• Bring writing instruments and a calculator.• Semi-open book – Bring 1 A4 size paper with handwritten

notes on both sides. • Office Hours: Standard TR 4:30-5:30 and MW 2-3:30.

Currency Internationalization• China creating an offshore Renminbi market by allowing Hong Kong residents to keep quota of RMB deposits .

MacCauley Renminbi internationalisation and China’s financial Development BIS Quarterly Review, December 2011http://www.bis.org/publ/qtrpdf/r_qt1112f.pdf

Offshore RMB FX Market

Shu, He, and Cheng, 2013

Advantages• Chinese (and other!) companies can settle and invoice in

Renminbi. • In 2010, 2% of China’s trade was settled in RMB. In 2011, nearly

7%

• Create more balanced international portfolio of assets. • Questions: Can China have international currency without

capital account convertibility.