Principles of Banking (II): Microeconomics of Banking (2) Securitized Banking

Transcription

1 Principles of Banking (II): Microeconomics of Banking (2) Securitized Banking Jin Cao (Norges Bank Research, Oslo & CESifo, München)

2 Outline 1 and risk sharing in real world 2 Securitized banking evolving Repo in securitized banking Repo runs 3 Inside the dark matter Trends, facts, and risks

3 Disclaimer institution-logo-filen (If they care about what I say,) the views expressed in this manuscript are those of the author s and should not be attributed to Norges Bank.

4 and risk sharing in real world and modern banking Modern banking, heavily relying on securitization, has gone far beyond the simple business model presented in the last chapter Allowing borrowing / lending between large financial institutions, reducing transaction cost; Better risk sharing, allowing better and wider access to financial market (at the cost of more fragility); In this chapter we will see How securitization works in a simple example as well as in reality; How modern banking system is organized based on securitization: repo market and shadow banking.

5 ucing systemic vulnerabilities. and risk sharing in real world Payoff An Example structure of assets and preferences of investors Consider in a one-period world where An example of how securitization improves investors access to financial market Asset A needs 400 initial investment, asset B needs 250, and asset C needs 300. Payoffs in different states: There are four states (1,2,3,4) in the payoff of three assets (A, B, C). The probability of each state is 0.25, and the payoff of each state is specified in the following table. Table 1: Asset Payoffs in Different States Asset A Asset B Asset C Sum State State State State Mean Asset A needs 400 initial investment, asset B needs 250, and asset C needs 300. Note all Investor 1 has 400, needs to get a safe, risk-free payoff; investor 2 has 200, no specific preference over the states; and investor 3 has 350, needs at least 100 in state 1. of them are profitable to invest for risk-neutral investors. There are three investors (1,2,3). Investor 1 has 400, investor 2 has 200, and investor 3 institution-logo-filen has 350. They have different preferences over their investments. In particular, investor 1

6 Case 1: pure matching market and risk sharing in real world Consider a pure matching market where there is no intermediary. Investors and entrepreneurs try to match each other: Investor 1 cannot invest because all assets are risky; Investor 2 cannot invest because no project needs as less as 200; Investor 3 can invest on asset B. She cannot invest on asset A because A needs 400, neither on asset C because of her special preference; Only asset B can be financed.

7 Case 2: financial intermediation and risk sharing in real world Consider there is a bank who can pool the investors funds and try to finance as many projects as possible: Given the investors equal seniority over claiming the bank s debts, it is impossible for all the three projects to get financed; If all the projects are financed, the bank can only pay a proportion of the payoff in state 4 (400) to investor 1 so that the maximum payoff of investor 1 in this state is below 400. This contradicts with investor 1 s preference; It s only possible to finance B+C, or A only.

8 It is possible to finance both B and C simultaneously, or A only. The question is then how to finance all assets. and risk sharing in real world Case 3: financial intermediation with securitization Case 3:. The bank can finance all project through securitization. After Consider a bank pooling the investors funds and trying to finance all projects through securitization, i.e., tranching debts into different products (structured products) pooling all assets, the bank secutizes the payoffs and generates three products in the following table. Table 2: Product Payoffs in Different States Product 1 Product 2 Product 3 Sum State State State State Mean Now each investor can choose the product that suits her. and all assets are financed. It s possible to finance all: investor 1 chooses risk-free product 1, and 2 & 3 can choose between product 2 and 3; (pooling-tranching) refines risk levels and provides products that better fit investors risk appitites. Investor 1 chooses product 1, which is risk-free for him. Investor 2 and 3 are free to choose product 2 or 3. It depends on the price of the products, which is determined by the relative market power of the bank or investors. institution-logo-filen

9 at work: MBS and risk sharing in real world One of the most important type of securitization is mortgage financing, which takes its first step through mortgage backed securities (MBS)

10 and risk sharing in real world at work: MBS (cont d) First, mortgage loan originator (e.g. banks or other lending institutions) pool many mortgage loans and sell them to a special purpose vehicle (SPV), which is Usually subsidiary of a big financial institution ( sponsor ), and Bankruptcy remote from parent company such that the parent cannot claw back the loans when it gets bankrupted; Then SPV finances the purchase via issuing investment-grade securities (MBS) with different seniorities ( tranches ) When assets return, securities with highest seniority get repaid first; When there s loss in assets, securities with lowest seniority bear the loss first. institution-logo-filen

11 at depth: CDO and risk sharing in real world MBS can be sold directly to investors, but mostly to investment banks. They are pooled with other financial assets, financed by selling to investors / banks tranched products called collateralized debt obligations (CDOs)

12 CDO tranches Borrowers and risk sharing in real world Investors Figure CDOs4.4 arecdo tranches and further with securitization. different seniorities, which usually Note get credit ratings from rating agencies to reflect risks and fit demand of investors / banks. The credit ratings of tranches are listed in decreasing order, AAA being the highest, AA the n level... and equity the lowest. AAA A BB equity T&F PR Senior Highest rating, least risky, first paid out, bear last losses Mezzanine Higher rating, less risky, paid out in later sequence, bear further losses Junior to equity Lowest rating, most risky, first wiped out, bear first losses Figure 4.5 Seniorities of tranches. Less risk institution-logo-filen

13 Banking: past and now Securitized banking evolving Repo in securitized banking Repo runs With securitization widely at work, traditional banking has nowadays evolved to securitized banking Traditional Depositors Insured deposits Bank Mortgage Borrowers Securitized Investors Collateral Bank Mortgage Mortgage Borrowers

14 Securitized banking evolving Repo in securitized banking Repo runs What s new in securitized banking? is the engine of modern banking, playing a central role Through originate-to-distribute, banks don t hold loans in balance sheets any more ( off-balance-sheet ) less cushion (reserves, capital...) needed to meet regulation; Banks purchase MBS/CDOs with high ratings, (seemingly) reducing risks on balance sheets; Most prominent difference from traditional banking Borrowers / lenders are now big institutions, reducing transaction costs; High quality assets are used as collateral in funding through repurchase agreement (repo).

15 Repo in securitized banking Securitized banking evolving Repo in securitized banking Repo runs The role of repo in securitized banking Traditional Depositors Insured deposits Bank Mortgage Borrowers Securitized Investors Repo Collateral Bank Mortgage Mortgage Borrowers

16 (Bi-party) repo structure Securitized banking evolving Repo in securitized banking Repo runs Repo agreement can be made directly (bi-party) between borrower ( dealer bank ) and lender who is secured by the agreement, X Secured lender Securities, Z Dealer bank Today Secured lender & interest, Y Securities, Z Dealer bank Tomorrow

17 (Bi-party) repo structure (cont d) Securitized banking evolving Repo in securitized banking Repo runs Who are dealer banks? BNP Paribas Bank of America Barclays Capital Citigroup Commerzbank AG Credit Suisse Deutsche Bank AG Goldman, Sachs & Co. HSBC Group J. P. Morgan Stanley The Royal Bank of Scotland Group Société Générale UBS AG institution-logo-filen Wells Fargo

18 (Bi-party) repo structure (cont d) Securitized banking evolving Repo in securitized banking Repo runs 1 The lender buys securities ( collateral ) with market value Z from dealer bank for X (Z > X ) today (in other words, the bank borrows X with Z collateral), and 2 The bank agrees to repurchase the same securities tomorrow for Y (Y > X, in other words, the bank repays Y and gets collateral back); 3 If bank defaults on promise to repurchase, then lender has the right to terminate agreement, keep or sell collateral. Definition The percentage Y X X is called repo rate (interest rate), and is called haircut. Z X X institution-logo-filen

19 Tri-party repo Securitized banking evolving Repo in securitized banking Repo runs In practice repo is often tri-party with a clearing bank (J. P. Morgan Chase and Bank of New York Mellon are major ones in the US) holding collateral and being responsible for returning cash to creditor. Design for better trade and safer custody of collateral Secured lender Clearing bank Securities Dealer bank

20 Securitized banking evolving Repo in securitized banking Repo runs Traditional banking versus securitized banking Traditional banking Securitized banking (1) Cushion: reserves (1) Cushion: haircuts Minumum ratio set by regulator Minumum level set by counterparties Can be borrowed from central bank No access to central bank (2) Backstop: deposit insuance (2) Backstop: collateral Public guarantee or high quality assets (3) Funding cost: deposit rates (3) Funding cost: repo rates Can be raised to attract depositors Can be raised to attract counterparties (4) Products: loans on balance sheet (4) Products: securitized loans Some may be kept on balance sheet and used as collateral in repo

21 Fragility in securitized banking Securitized banking evolving Repo in securitized banking Repo runs In securitized banking, haircut is the key to understanding its fragility, which Is an indicator of information sensitivity. Repo takes high quality collateral, which is immune from adverse private information low haircut; However, under market stress, uncertainty of asset quality peaks, so does haircut: information-insensitive assets become sensitive; Less cash to raise in money market unable to roll over debt asset fire sale bankruptcy; Crisis in securitized banking erupts from peaking haircut and sudden stop in interbank borrowing: run on the repo.

22 Securitized banking evolving Repo in securitized banking Repo runs Episode: repo run in subprime crisis The recent crisis is a perfect example of repo run. Before crisis, securitized banking was much stimulated by subprime mortgages With rising house prices in early 2000s, US banks started lending to less credit-worthy households ( subprime borrowers ); Of the loans, 80% were financed by securitization; However, since mid-2007 house prices falling and mortgage defaults rising Subprime debts were already everywhere due to many rounds of securitization; Haircut rose for all structured products and repo run began.

23 Securitized banking evolving Repo in securitized banking Repo runs Haircuts during subprime crisis: asset classes 9 Too complex & integrated to disentangle: spillover from subprime assets to entire structured financial assets Figure 2: Repo Haircuts on Different Categories of Structured Products The figure confirms that haircuts were higher on subprime-related asset classes. In fact, the haircut

24 assets. Obviously, if the average haircut goes to 40 percent, then $4 trillion has to be raised. The only route available for these banks to make up the Securitized difference was banking asset sales, evolving which caused a further Repo in securitized banking downward movement in the prices of these asset classes, making them less usable as collateral, causing Repo runs further sales, and so on. The securitized bank system is then effectively insolvent, as was the banking system during the pre-fed panics. Haircuts: structured versus corporate bonds The figure also displays a loss of confidence in the sense that the Non-Subprime-Related Group faced very significant haircuts even though it has nothing to do with subprime. It is simply also securitized. It is similar to sales of bagged lettuce dropping when the Food and Drug Administration announces that there E-coli in bagged spinach. To see this loss of confidence, let s compare the average haircut on How structured once products information-insensitive to the haircut on corporate bonds. This is done in products Figure 3. dramatically became extremely sensitive Figure 3: The Average Haircut on Structured Products versus Haircuts on Corporate Bonds All investment-grade corporate bonds J. were C. treated the Microeconomics same with regard to of haircuts. Banking: Corporate bonds are

25 What is shadow banking? Inside the dark matter Trends, facts, and risks A bigger concern associated with securitized banking is the rise of shadow banking: it s around $75 trillion in 2013, accounts for one fourth of total financial assets in the world; Definition Shadow banking refers to financial intermediation involving entities and activities (fully or partially) outside the regular banking system However, some of shadow banking activities can be initiated from, and / or go through banks; Although shadow banks are less regulated and not supposed to access central banks liquidity facilities, they usually do have (less formal) backstops provided by private / public institutions. This excludes entities such as leasing and finance companies.

26 Inside the dark matter Trends, facts, and risks What s inside the shadow? Spectrum of activities 4 Traditional intermediation by institutions Traditional banking (deposit taking and lending) Traditional insurance Figure 1. Spectrum of Financial Activities Activities commonly referred to as forms of shadow banking, including: tranching of claims, maturity transformation, liquidity puts from banks to SIVs, support to par value money funds. Collateral services, primarily through dealer banks, including: supporting the efficient re-use of collateral in repo transactions, for OTC derivatives and in prime brokerage; securities lending. Bank wholesale funding arrangement, including the use of collateral in repos and the operations of the tri-party repo market Deposit-taking and/or lending by non-banks, including that by insurance companies (e.g., France) and bank-affiliated companies (e.g., India and China). Traditional intermediation by market entities In capital markets: Hedge funds Investment companies Underwriters Market-makers Custodians Brokers In non-bank sector: Leasing and finance companies Corporate tax vehicles (Source: Claessens & Ratnovski, SIVs: Structured Investment Vehicles; OTC : Over The II. A NEW WAY TO DESCRIBE SHADOW BANKING Counter) A. Shadow banking: All activities that need a backstop institution-logo-filen To improve on the current approaches and definitions, we propose to describe shadow banking as all financial activities, except traditional banking, which require a private or public backstop to operate. This description captures many of the activities that are

27 How large is the shadow? Europe Inside the dark matter Trends, facts, and risks Total assets of banks and non-banks in Europe (EUR trillions): (Source: ECB, 2014, Q Q MMFs: Market Funds, mutual funds that invest in short-term, safe debt securities such as US Treasury bills and commercial paper; FVCs: Financial Vehicle Corporations, i.e., special purpose vehicles) institution-logo-filen

28 ing by expanding access to credit or by supporting market liquidity, maturity transformation, and risk sharing. For example, in developing Shadow economies, Banking finance companies and microcredit lenders often provide credit and investments to underbanked communities, subprime customers, and low-rated firms (Ghosh, Gonzalez del Mazo, and Ötker-Robe 2012). In advanced economies, various types of funds have been stepping in (often as intermediaries for insurance companies and pension funds) to provide long-term credit to the private sector while banks have been repairing their How large is the shadow? World and were vulnerable to runs when investors withdrew large Inside quantities the dark of funds matter at short notice. This led to fire sales Trends, of assets, facts, which andintensified risks the financial turmoil by reducing asset values and helped spread the stress to traditional banks. Since then, global regulatory reforms coordinated by the FSB have called for greater disclosure of asset valuations, improved governance, ownership reforms, and stricter oversight and regulation of shadow banks (FSB 2013a, 2013b). Since the crisis, the ongoing tightening of bank regulations may be encouraging a shift of traditional Shadow banking assets as (1) percentage of GDP, (2) percentage of bank assets: Figure 2.1. Broad Measures 400 U.S. U.K. Euro area Other AEs EMEs 1. Percent of GDP 2. Percent of Banking Assets (Source: Sources: Financial IMF, Stability Board; AEs: IMF, World Advanced Economic Outlook Economies; database; and IMF EMEs: staff estimates. emerging market economies) Note: AE = advanced economy; EME = emerging market economy. For sample coverage, see Table International Monetary Fund October 2014 institution-logo-filen

29 Inside the dark matter Trends, facts, and risks Structure of shadow banking: institutional CHAPTER 2 SHADOW BANKING AROUND THE GLOBE: HOW LARGE, AND HOW RISKY? Figure 2.3. Traditional versus Intermediation Deposits Banks Securities Dealers Securities Lenders Securities Securities Securities Borrowers market MMMFsmutual funds Securities Hedge funds Securities Finance companies and other nonbank lenders Source: IMF staff illustration. (Source: IMF, Note: This simplified Lenders representation of include the financial sector institutional shows the flow of funds from investors, lenders borrowers. such It does not show as the insurance reverse flows, such as companies bank and deposit withdrawals and money market mutual fund redemptions. The blue boxes represent the components of a bank-based economy, with the rest representing the pension funds, shadow andbanking official sector. The boxes sector on the outside institutions, characterize a simple shadow such banking as system central as might be found banks in a less developed and economy. sovereign The lighter colored wealth funds) boxes in the middle reflect the kinds of shadow banking activities and entities usually associated with more advanced economies, with dealers as the hub of most activity. This activity comprises issuing securities on behalf of borrowers (including securitization vehicles, finance companies, and other nonbank lenders), providing institution-logo-filen prime broker services to hedge funds, and conducting repurchase agreements and securities lending. vehicles do not generally involve borrowers directly. Securitized assets generally come from banks and nonbank lenders, and securities from dealers. See Annex 2.2 for details on the role of securitization. 1 The lenders category includes institutional investors (such as insurance companies and pension funds) and official sector institutions (such as central banks and sovereign wealth funds).

30 (Figure 2.6). Eventually, rapidly rising defaults in the U.S. housing Securitized market in 2007 Banking led to a and liquidity Repo crisis Run in the markets for private-label securitization Shadowand Banking assetbacked commercial paper (ABCP) as investors refused to roll over their holdings (Acharya, Schnabl, and Suarez 2013). MMFs experienced a run in September losses on ABCP and SIV borrowing. Inside each the risk-adjusted dark matter CCA balance sheet, assets equal Trends, equity facts, and risky anddebt. risksan entity s equity can be modeled as an implicit call option on its assets. Risky debt equals the default-free value of debt minus Structure of shadow banking: financial products The author of this box is Dale Gray. 1 For a review of the causes of the crisis in the United States, including the evolution of shadow banking, see FCIC (2011). Figure U.S. System Deposits Banks Lenders Super Securities seniors RMBSs CDOs Credit insurance Credit insurance Monoline insurance Commercial paper market mutual funds Credit & liquidity puts SIVs& ABCP Short-term funding Borrowers Nonbank mortgage originators (Source: IMF, Source: IMF RMBSs: staff. Residential Mortgage-Backed Securities; CDOs: Collateralized Debt Note: This is a simplified schematic of the precrisis U.S. financial sector showing the flow of funds from lenders to Obligations; SIVs: borrowers Structured and the interlinkages Investment between them and Vehicles; shadow banks. ABCPs: Asset-Backed vehicles include asset-backed Commercial Papers) commercial paper (ABCP) conduits, collateralized debt obligations (CDOs), residential mortgage-backed securities (RMBSs), and structured investment vehicles (SIVs). See notes to Figure 2.3 for further explanations. institution-logo-filen

31 Conceptualized, designed and created by Zoltan Pozsar, The Federal Reserve Bank of New York, November, 2009 The Traditional Banking System Ultimate Borrowers Households, Businesses, Governments ` Assets Short-Term Debt Instruments CMOs Regulated Market Unregulated Market Agency MBS (Time-Tranched Agency MBS) Agency Discount Notes Intermediaries Intermediaries ABS ABCP s *Conforming mortgages RRs FH LBs Fannie and Freddie Federal Government "Plus" Funds Other* Discount FFELP ABS (Retained Portfolios) Liquidity Puts A1 *ARS, MMMFs Notes A1 Agency Discount ARSs CP Munis AAA MBS Notes TOBs ABCP $1 NAV Agency * AA-BBB Private Agency or BDP Shares Debt ABS ABS Debt VRDOs RRs *Conforming student loans 2a-7 MMMFs Other* Bank Treasurers FHLBs A1 *ARS, MMMFs, as well as A1 A1 (AAA) ABS Tranches CP MTNs and term ABS CP SBA ABS (Retained Portfolios) A1 Agency Discount ABCP $1 NAV ABCP $1 NAV AAA MBS Notes BDP Shares BDP Shares * A1 AA-BBB Private Agency RRs RRs Short-Term Savings ABS Debt Other* Enhanced Funds Other* *Conforming SBA loans *TOBs and VRDOs A1 *ARS, MMMFs Market Portfolios CP Brokered Brokered A1 ABCP Securities Deposits Long- Short- Deposits AAA Agency BDP Collateral Collateral Lent Fixed Income Portfolios* Term Term Balances AA-BBB Debt RRs MTNs Munis Munis ABS Other* *Done by real money accounts Term LTDs *Broker-dealer affiliate *ARSs, TOBs, VRDOs *Medium-term debt *MMMFs, MTNs, term ABS and on a principal basis. Savings Dollar Single-Seller Conduit A1 AAA Offshore (non-2a-7) MMMFs *ARS, MMMFs, as well as A1 CP 1st Lien Deposits AAA AA-BBB A1 MTNs and term ABS CP Home AA-BBB Repos CP ABCP AA-BBB LTD MTNs CP ABCP $1 NAV ABCP Repo High-Grade CDOs Supers CNs* ABCP $1 NAV BDP Shares Securities LTD Haircuts Supers *Capital Notes BDP Shares RRs Households O/C Multi-Seller Conduit* Broker-Dealer* High-Yield CLOs AAA Asset Manager* RRs Ultra-Short Bond Funds Other* Households and Nonprofits AA-A Subprime Homeowners *FHC affiliate (Warehouse and Term) (LBO ) Repo Conduits AA-BBB Arbitrage Conduit ABCP Other* A1 *MMMFs A1 *TOBs and VRDOs CP Structuring AAA Savings: 1st Lien AAA Reverse ABCP $1 NAV Assets Home ABCP and ABCP ABCP ABCP Excess "" AA-BBB Repos* Mezzanine CDOs BDP Shares Syndication AA-BBB ABS 2nd Lien Supers RRs Finance Company* O/C O/C AAA O/C Other* Sweep Accounts BBB CP Single-Seller Conduit *FHC affiliated *FHC affiliate Consumer ABS AA-BBB *BHC affiliate *ARS, MMMFs, as well as A1 Consumers ABCP (Credit Card ABS) Hybrid Conduits Liquidity Puts* BDPs MTNs and term ABS CP BDP A1 ABCP $1 NAV Goods ABCP Long- Short- AAA BDP Shares & MTNs AA-BBB ABCP Term Term BDPs AA-BBB RRs Services Munis Munis O/C Other* Nonfinancial Corporates O/C AAA AA-BBB Europe an Banks Short-Term Funding Funding ` ABCP BDP RRs Other* *ARS, MMMFs Short- to Long-Term MMDAs CDs Long-Term Investments LTD MTNs Tri-Party Repo System TSLF Supers CNs* Mezz Federal, State TSLF Nonfinancial Businesses Multi-Seller Conduit* Hybrid Conduits *Capital Notes CDO Tri-Party Clearing Banks* and Local Governments PDCF Assets Tax Revenues O/C O/C Europe an Banks ML II, LLC The "Synthetic" System Ultimate Borrowers Assets Bonds Bonds Tax Revenues Structured Credit and Loan CDS Indices Commercial Bank* Source: (Pozsar, Adrian, Ashcraft, Boesky (2010)) A1 AAA AA-BBB Repos AA-BBB *BoNY and JP Morgan Chase O/C (Foreign Central Banks) Haircuts AAA Reinvestment Accounts *Issued to central banks BBB CMBS and High-Yield CLOs AA-BBB *Broker-dealer affiliate A1 Securities Lending* in exchange for investibe FX (LBO ) CP Long-Term Savings Consumer ABS (Card, Auto, Student Loan) Standalone Finance Company Credit Hedge Fund CP Single-Seller Conduit A1 Long-Term nstruments (LTD) Asset Managers* AAA AAA ABCP Repos AA-BBB Long-Term Debt MTNs ABCP AA-BBB Private LTD Client Portfolios* MTNs Haircuts LTD Funds O/C Multi-Seller Conduit* Other ABS Agency Structured Public Term ABS ("Rent-a-Conduit") (Floorplan, Equipment, Fleets) LPFCs LTD Credit Savings A1 AAA *Mutual Funds, ETFs, Separate Accounts CP AAA AA-BBB *Bank and Corporate Debt ABCP AA-BBB MTNs A4 and AA-BBB ABS Tranches LTD CNs* AAA Captive Finance Company Industrial Loan Company* O/C *Capital Notes (A4) CP *Independent conduit Middle-Market CLOs Pension Funds, Insurance Companies* AA-BBB ABCP ( to SMEs) REITs Brokered BDP A1 MTNs Deposits MTN AAA LTD Pension Structured Credit Portfolios* [ ] [ ] LTD AA-BBB CDOs Liabilities Debt HG Super Structured Tranches Term *Finance company affiliate ABS Senior Credit Savings Tranches TLGP Debt MTNs Insurance Credit Hedge Funds CPFF TALF Maiden Lane LLC Maiden Lane III LLC TAF FX Swaps TSLF/PDCF Counterparty Hedges Warehouse Hedges Fannie and Freddie* Agency MBS Purchases GSEs, DoE, SBA Step (4): ABS Warehousing Warehouse Hedges Agency Debt Purchases Federal Government ABS Reserves Public Structured Credit 3/11/08 and 3/16/08, respectively Single-Name and Index Corporate CDS CDPCs CPDOs* Short-Term Synthetic Liabilities Bond(s) Loan(s) The "" System Ultimate Borrowers Bonds Private Portfolio Companies Firms Local Governments Tax Revenues State Bonds Muni Bonds CDS Commercial Banks Unfunded Protection Funded Protection Protection Sold Agency Debt Purchases Medium-Term Instruments Agent Securities Lending Federal Government RMBS Finance Company* (1st lien, private label) Credit Hedge Fund* MTNs Reinvestment Accounts Tax Treasury CP Single-Seller Conduit A1 A1 Securities Lending* AAA Revenues Bonds ABCP AAA Private CP Repos BDP AA-BBB MTNs ABCP Securities ABCP AA-BBB ABS High-Grade CDOs BDP Collateral Collateral Lent RoW MTNs Governments Supers *Broker-dealer affiliate Asset Manager, RRs (Sovereign Wealth Funds) State Governments O/C Broker-Dealer* Subprime ABS AAA Prime Broker Other* *Done by custodian banks Savings: AA-A *Broker-dealer affiliate (2nd lien, subprime, HELOCs) Trading Books AA-BBB Trading Book A2 & A3 (AAA) ABS Tranches *MMMFs, MTNs, term ABS and on an agent basis. Export "" Revenue Unfunded AAA Funded Bond(s) CDS Protection Protection [ ] Protection Insured Term Sold Hedges CDOs Assets Savings Funded *Referencing corporate loan indices, etc. Households, Businesses, Governments Protection Households, Businesses, Governments Single-Name and Index Broker-Dealers* *Hedging Motives and the Rest of the World (RoW) Sovereign CDS Long-Term Synthetic Liabilities Broker-dealer CVA desks, ABS pipeline hedges, Bonds Assets Investments CRE Borrowers "Prime" Homeowners Businesses Businesses C&I CRE LBO CDS Insurance Premia FDIC Dollar Deposits Deposit Insurance (FDIC) Deposit Insurance Deposit Insurance (FDIC) Step (1): Loan Origination *FHC affiliate Industrial Loan Company* Discount Window Loan Collateral Reserves Broker Sweep Accounts Brokerage Clients' Agency Debt Federal Government No Explicit Fees Credit Insurance (Mortgage Insurers) Mortgage Insurers* Premia CP ABCP 11/25/2008 Reserves Implicit Insurance Liability Insurance (Federal Government) Step (2): Loan Warehousing Credit Insurance *Unaffiliated with originators! 10/7/ /25/2008 3/24/ /11/ /12/ /12/2007 Counterparty Hedges (Warehouse and Term) ABCP *European bank affiliated Reserves AAA Reserves Warehouse Hedges *DBD affiliate Protection Bought Protection Sold *Market Makers Step (3): ABS Issuance TBA Market Structuring and Syndication Agency MBS No Explicit Fees * Credit Insurance (Monolines) Monoline Insurers* Premia 11/25/2008 Reserves Implicit Insurance Credit Insurance (GSEs, DoE, SBA) Agency Pass- Through Subprime, RMBS, CMBS Credit Insurance *Unaffiliated with originators! Counterparty Hedges Counterparty Hedges Trading Books (ABS Warehouse Conduits) AA-BBB Warehou sed ABS ABCP Reserves Warehouse Hedges Step (5): ABS CDO Issuance Mezzanine CDOs Credit Insurance (AIG FP) Diversified Insurance Co. Premia CDS on CDOs Supers Credit Insurance (Par Puts) *Unaffiliated with originators! Reserves Warehouse and Counterparty Hedges Warehouse Hedges Agency Debt No Explicit Fees Liability Insurance (Federal Government) Off -Balance Sheet ABS Intermediation Agency MBS *ARSs, TOBs, VRDOs Arbitrage Conduit AAA Super Seniors Super Seniors SIV, SIV-Lite AA-BBB 11/25/2008 SIV Reserves Implicit Insurance CMO Tranches ABCP Repos Liquidity Puts* European Sovereign and Quasi-Sovereign States No Explicit Fees Step (6): ABS "Intermediation" CP Liability Insurance (EU Government) On -Balance Sheet ABS Intermediation [ ] Mezz ABS [ ] Mezz ABS Mezz CDO Credit Insurance (AIG FP) $ FX Funded Synthetic CDOs* (Credit-Linked Notes) Unfunded Synthetic CDOs* Counterparty Risks*, AAA AAA AAA ABS Unfunded [ ] AA-BBB AA-BBB and Protection Treasurys CDOs Referencing ABS and single-name CDS *Referencing single-name CDS indices, etc. *Inability to meet indices, etc. unfunded liabilities, etc. Implicit Insurance Euro Deposits Euro Deposits Reverse Repos Mezz ABS Tri-Party Collatera l Deposits Bank Agency Debt* Synthetic Credit Liabilities, ABS and, ABS and CDOs CP Checking Accounts CDs Bank Catalogue:, Shadow Bank Liabilities ABS ABS Agency Bills ABS Collateral AAA (A2-A3) Super Senior ABS and CDO Funded Protection No Explicit Fees Temporary MMMF Guarantee 9/18/2008 *Funded by UST's $50 billion lending for MMMF Insurance Exchange Stabilization Fund securities collateral AMLF Reserves ABCP Reserves Step (7): Wholesale Funding (Shadow Bank "Depositors") TOBs and VRDOs TOBs and VRDOs MMIFF Nonrepo MM Reserves instrume nts $1 NAV Shares Principal Securities Lending Deposits Real Accounts* Bank Pension Funds Insurance Premia MTNs LTD Insurance Guarantees Direct Market Investors Corporate Treasurers A1 *Public and Private Pension Funds, Alternative Asset Managers* *Hedge Funds and Private (only credit exposures) Subprim e ABS RMBS 9/19/ /21/ /10/2008 CP Hedgers* negative basis traders, real money accounts, etc. "Naked" Positions Depositors PBGC LGIPs Client Funds *Asset Managers, Insurance Companies and Implicit Insurance $1 NAV Shares and Life and P&C Insurance Companies Client Funds Maiden Lane II LLC Reserves Speculators* Proprietary trading desks, credit hedge funds, etc. Market "Portfolios" Checking Account Portfolios Bank Direct Investmen $1 NAV Shares CNs *Bank, Shadow Bank and Corporate Debt *Term ABS and CDO debt and equity tranches Portfolio Protection* Synthetic Exposures* Credit Bets Short- Term Savings Term Savings Short- Term Savings Term Savings *Speculative Motives Ultimate Creditors Households, Businesses and the Rest of the World Ultimate Creditors Savings: Excess Savings: Excess Savings: FX Reserves FX Reserves RoW "" "" Local Currency Bonds* Ultimate Creditors Federal Reserve DW TAF FX Swaps CPFF TALF AMLF MMIFF ML, LLC ML III, LLC LSAPs OMO Collatera l Reserves Inside the dark matter Trends, facts, and risks Structure of shadow banking: working mechanism The System Credit "References" Private Risk Repositories Private Credit Transformation (Tail Risk Absorption) Provision of Risk Capital Credit Hedges Independent Specialists' Credit Intermediation Process Wholesale Funding (Term Debt Funding) Off-Balance Sheet The "External" System DBDs' Credit Intermediation Process (DBDs: Originate-to-Distribute Model Independent Specialists: Originate-to-Fund Model) Wholesale Funding (Medium-Term Funding) Off-Balance Sheet Off-Balance Sheet European Banks' Activites Wholesale Funding (Overnight Funding) Off-Balance Sheet Off-Balance Sheet The "Internal" System (Private Originate-to-Distribute Model) Off-Balance Sheet FHCs' Credit Intermediation Process Off-Balance Sheet Wholesale Funding (Short-Term Funding) Off-Balance Sheet Off-Balance Sheet The GSEs' Credit Intermediation Process The Government-Sponsored System (Public Originate-to-Distribute Model) Public Risk Repositories Public Credit Transformation (Tail Risk Absorption) Public Risk Repositories (Tail Risk Absorption) Traditional Banks' Lending Process The Traditional Banking System ("Originate-to-Hold-to-Maturity-and-Fund-with-Deposits") Private Risk Repositories The "Synthetic" System (Derivatives-Based Risk Repositories) Funding Debt Funding (Short and Long-Term Deposits institution-logo-filen

32 Inside the dark matter Trends, facts, and risks Why do we care about shadow banking? It complements traditional banking and can improve efficiency by Filling the gap in the market when banks are missing, e.g., post-crisis funding; Expanding access to credit and providing better risk allocation, e.g., securitization; It can also blow up the economy as it did in the crisis because of being Excessively leveraged and exposed to illiquidity risks, e.g., breaking the buck in MMMFs; Too complex to correctly price the risks; Simply too big to be neglected.

33 Inside the dark matter Trends, facts, and risks Why are banks moving into shadows? Search for yield Declining interest margin forces banks to look for higher returns from structured financial products; Ample liquidity in global market creates demand for investment opportunities; Regulatory arbitrage: to move risky activities to less regulated realm, and reduce required regulation on banks, e.g. Originate-to-distribute, or, securitization; Off balance sheet activities, to remove risky assets out of balance sheet; Filling gaps in the market: especially in emerging economies, to create markets that used to be missing. institution-logo-filen

34 Inside the dark matter Trends, facts, and risks Has shadow banking been detered by the crisis? Absolutely NOT! It keeps growing for several reasons Tightening banking regulation (Basel III) encourages banks migration to the shadow; Search for yield incentive is still high, because of extremely low policy rates; Shadow banks are mutating: New products are born from ashes of the old ones (even the dead ones, e.g., CDOs, start to revive); Further contribution from the emerging economies Global imbalances provide strong engine, or demand for shadow banking; Financial innovation combining with financial open-up and deregulation, e.g., in China. institution-logo-filen

35 Inside the dark matter Trends, facts, and risks Shadow in China: a new global risk factor? Rapidly growing and highly dynamic shadow banking sector Has been as large as 35% of GDP (Q1 2014), growing at twice the rate of bank credit; About 70% of shadow bank assets are wealth management products (WMPs), resembling SIVs and CDOs in the US; The rest 30% are mainly MMMFs, but grow exponentially; Implicit public guarantee on products involving large state owned banks (which are too-big-to-fail) Largely invested on risky assets, e.g., real estate, mining, local government debts; Implicit defaults already started to emerge.

36 new WMPs are offered by banks, and larger banks tend to issue proportionally more. Because WMP yields are much Securitized higher than bank Banking deposit rates andor Repo repo rates, Run and a significant number of them Shadow have guaranteed Banking returns, lower leverage, suggesting that these banks have larger capital Inside buffers the to absorb darkdeposit matter drains. For smaller banks, there Trends, is no apparent facts, relationship and risks between WMP issuance and leverage. Furthermore, larger banks tend to have WMPs with a longer tenor, which reduces liquidity and rollover risk. Moreover, on the asset side, many of the underlying loans are granted to public sector companies, which enjoy some form of implicit state guarantee. Shadow in The China: authors of this box are Viral aacharya, new Zhishu Yang, and global risk factor? (cont d) Shaun Roache. Figure Wealth Management Products in China Total number of WMPs issued 1. Number of WMPs Issued and Bank Size 16,000 14,000 12,000 10,000 8,000 6,000 4,000 2, Bank size 2. Number of WMPs Issued and Bank Leverage 16,000 Large banks 14,000 Small banks 12,000 10,000 8,000 6,000 4,000 2, Bank leverage multiplier Total number of WMPs issued Average maturity (days) 3. Average WMP Maturity and Bank Size Number of products 4.Gross Monthly WMP Issuance by Expected Return 6, Undisclosed Average expected yield 5,000 More than 8% (right scale) % 4, % 8 2 3% 3, % 6 2, ,000 2 Percent per year Bank size Sources: RESSET Data Tech Co., Ltd.; WIND Info; and IMF staff calculations. (Source: IMF, Note: Bank WMP = wealth sizemanagement takesproduct. logs on total bank assets as of 2013, and bank leverage is 1 Log of total assets for defined as total assets 2 Assets/equity / equity for ratio as of 2013) institution-logo-filen 3 Sample covers all products issued by banks covered in WIND Info.

37 References Inside the dark matter Trends, facts, and risks ( : Recommemded reading) Duffie, D. (2010), How Big Banks Fail and What to Do about It, Princeton University Press. Gorton, G. B. (2010), Slapped by the Invisible Hand: The Panic of 2007, Oxford University Press. Matthews, K. and Thompson, J. (2014), The Economics of Banking (3rd Edition), Wiley, Chapter 9.