Shadow Banking: - Darshna Chande - Dharmesh Mehta

SHADOW BANKING
• Darshna Chande
• Dharmesh Mehta
SHADOW BANKING
• System of non-financial institutions that borrow money in the
short term and take that money to invest in long-term assets.
• Shadow banking systems are able to avoid standard banking
regulations through the use of credit derivatives.
• These are also said to be one of the major problems which
contributed to the subprime mortgage crisis around 2007-2008
• Paul Mcculley coined the word Shadow Banking in August 2007.
SHADOW BANKING
• The idea was to make credit cheaper for the
ultimate borrower and more available, but also
to separate the credit system from the payment
system.
• To get some of the risks off the balance sheet of
the traditional banking .
• You aren't actually getting rid of liquidity risk or
getting rid of solvency risk; you are just moving
them into a different place.
Time -line
Shadow Banks VS Traditional Banks
SHADOW BANKING TRADITIONAL BANKING
• Unregulated • Regulated
• Unprotected from bank-like runs • Government protection
• Involves savers borrowers and available
Non-bank Financial • Involves Savers ,Borrowers and
intermediaries. Banks.
• Credit Intermediation performed • Credit intermediary performed
through chain of NBFC. under one roof
• Relies on issuance of money • Relies on deposits by public.
market instruments • Capital reserves required as per
• Not mandatory to have Capital central bank guideline and
reserve Basel norms.
Participants
• According to McCulley (2007),, the global shadow banking system
includes
• All agents involved in leveraged loans which do not have (or did
not have, according to the rule in force before the outburst of the
crisis) access to deposit insurances and/or to rediscount
operations of central banks.
• These agents are not subject to the prudential regulations of the
Basel Agreements (Cintra & Prates, 2008a and Freitas, 2008).
• Large independent investment banks (brokers-dealers),hedge
funds, investment funds, private equity funds, the different special
investment vehicles, pension funds and insurance companies.
Quote
• Thus a long term corporate bond could actually
be sold to three separate persons. One would
supply the money for the bond; one would bear
the interest rate risk, and one would bear the
risk of default. The last two would not have to
put up any capital for the bond, though they
might have to post some sort of collateral."
- Fischer Black, "Fundamentals of Liquidity" (1970)
Shadow Banking
CDS Rehypothecation
Credit default swaps
A credit default swap (CDS) is a swap contract in which the
protection buyer of the CDS makes a series of payments (often
referred to as the CDS "fee" or "spread") to the protection seller, in
exchange, receives a payoff if a credit instrument (typically
a bond or loan) experiences a credit event.
Participation of shadow banks
• Shadow banker participated as insurance
provider to banks by Buying CDS from banks
for a premium.
• Shadow banks found new means of risk

exposure and profit on the credit market.
credit originators
• Not being credit “originators”, the global shadow banking system institutions
mainly assumed the short position in these derivatives, since they could thus
“synthetically” reproduce exposure to credit and to their gains.
Data collected by the Bank for International Settlements (BIS) indicate:

 The obstinate growth of OTC derivatives, which reached US$ 683.7 trillion in
notional values in June 2008 (practically 11 times the world GNP, estimated at
US$ 62 trillion) US$ 20.3 trillion in gross values of substitutions at market
price,28.7% increase in relation to the previous term .
 An extremely rapid increase in notional values and gross values of CDS
markets, between June 2007 and June 2008 at a time when deals with
structured credit products were practically inexistent.
 The notional values of CDS reached US$ 57.3 trillion and the gross value of
market price substitution reached US$ 3.2 trillion.
Increase in price of CDS
• Higher prices attracted new speculators willing
to assume credit risks for which many sought
protection
• In the impossibility of liquidating positions in
advance, agents with a sharper perception of
risk negotiated to this end “reverse”
operations with other counterparties which
until their maturity are accounted.
Shadow bankers acted as facilitators
• The financial institutions of the global shadow banking system became
the counterparties of banks in these operations, since they chose to
access the credit operations regarded as highly profitable.
• They only had to raise resources on the commercial paper market and
purchase credit-backed long-term bonds and/or assume short positions
on the derivatives market in order to “synthetically” reproduce a credit
operation.
• In this way, the OTC markets became the centre stage of the
negotiation of the financial institutions’ assets and liabilities. As such,
they became a source of funding and investment for the financial
institutions.
The domino Effect
• As the shadow bankers participated in by an
selling of derivative products created by
banking institution as well as synthetic
derivative created by shadow bankers
• When time came for full filling the obligation
which they had taken many institution
defaulted due to liquidity issues or had over
leveraged there exposure assuming this
derivatives as mere means of making profits.
Stricter Norms:
1) CDS shall be permitted only on corporate bonds as reference
obligations and the reference entities shall be single legal resident
entities.
2) Foreign banks and other lenders, which have the appraisal skills
but not the resources to lend, can also gain by taking a credit
exposure through CDS. The actual funding can come from some
other bank which has the resources but does not want to take any
credit risk.
3) CDS shall be permitted to be written on corporate bonds issued by
Special Purpose Vehicle (SPV) of rated infrastructure companies
4) Users shall not, at any point of time, maintain naked CDS
protection
Stricter Norms:
5) Physical delivery is mandated in case of credit events, , adding users are
prohibited from selling CDS
6) Proposes “rigorous audit” to ensure that buyers of CDS have underlying
exposure, and to make “physical settlement” mandatory for CDS buyers.
7) “All CDS trades shall have a RBI-regulated entity at least on one side,”
8) Market-makers cannot enter into CDS transactions without obtaining from
the counterparty a copy of a resolution passed by their boards authorising it
to transact in CDS
9) A Separate trading platform needs to be developed.
10) Related parties or banks and their subsidiaries cannot enter into CDS
transactions between themselves
11) Protection sellers in the CDS market shall have in place internal limits on the gross
amount of protection sold by them on a single entity as well as the aggregate of
such individual gross positions.
Re-hypothecation /Misuse of Funds.
• There are limitation to re-hypothecation in US ,but could be capped
fully in UK. However lately FSA in UK has proposed new rules in
wake of Lehman Brothers Collapse.
• In the year 2007, the seven largest US brokers were getting about
$4,500bn of funding from re-hypothecation activity.
• Total amount of assets pledged fell from $4.5 trillion at the end of
2007 to $2.1 trillion at the end of 2009.
• At the end of 2007 about USD 10 trio was pledged and out of which
40% was from hedge funds and the rest was by banks to each
other .
Source www.ft.com
Trends in Shadow Banking system
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SHADOW BANKING

• Shadow banks found new means of risk

Data collected by the Bank for International Settlements (BIS) indicate:

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