Shadow Banking and Financial Stability

Shadow Banking and Financial Stability Professor Dr. Claudia M. Buch Magdeburg University Institute for Economic Research Halle (IWH) German Council of Economic Experts Symposium Financial Stability and the Role of Central Banks Deutsche Bundesbank, February 27-28, 214 1

The Issue Shadow banks are considered to be main drivers of systemic risk in the financial system due to high degree of opacity and potential links to banks high leverage light regulation and high risk-taking Yet, the term shadow banking can be misleading: Shadow banking is not an illegal activity in the shadow economy. Shadow banks are not well-defined. How important are shadow banks? How to measure and contain systemic risk? How should regulators respond? Claudia M. Buch 2

How important are shadow banks?

Defining Shadow Banking Credit intermediation involving entities and activities (fully or partially) outside the regular banking system (Financial Stability Board FSB) Financial intermediaries that conduct maturity, credit, and liquidity transformation without access to central bank liquidity or public sector guarantees (Pozsar et al. 213): Risk of runs! Financial intermediaries engaging in securitization and collateral intermediation (Claessens et al. 212) Banks are defined as: Deposit-taking financial institutions Financial institutions with access to public-sector safety nets Claudia M. Buch 4

Financial intermediation through the shadow banking sector Source: Claessens et al. (212)

Financial intermediation through the shadow banking sector Collateral as a link to the real economy

Financial intermediation through the shadow banking sector Focus of microprudential regulation

in bn Assets of banks exceed those of other financial intermediaries. 3. 25. 2. 15. 1. 5. Credit institutions Financial vehicle corporations Security brokers and dealers Issuers of asset-backed securities Money market mutual funds Insurance corporations Investment / pension funds Euro Area USA Source: ECB, Fed

USD trillion In the past decade, total assets of financial institutions have increased 16 14 12 Banks 1 8 6 4 2 Insurance companies & pension funds Other financial intermediaries Central banks Public financial institutions 22 23 24 25 26 27 28 29 21 211 212 Source: FSB, Shadow Banking Monitoring Report 213, 2 jurisdictions and Euro Area

% of total... but shares in total assets have remained relatively stable. 6 5 4 Banks 3 Insurance companies & pension funds 2 1 Other financial intermediaries Central banks Public financial institutions 22 23 24 25 26 27 28 29 21 211 212 Source: FSB, Shadow Banking Monitoring Report 213

in % of GDP Size of other financial intermediaries differs across countries, low correlation with banking sector size. 9 8 7 6 5 4 3 2 1 NL UK CH XM HK US KR FR CA ZA DE ES JP BR AU SG IT CL Other financial intermediaries Banks CN MX IN TR ID AR RU SA Source: FSB, Shadow Banking Monitoring Report 213

How to measure and contain systemic risk?

What are systemic risks? Systemic risks in financial systems arise if the distress in one institution or a group of financial institutions threatens the functioning of the entire financial system (Hellwig 1998): Domino effects: Creditors of a financial institution are affected by financial sector distress because of direct contractual linkages. Information contagion: Distress of one institutions leads to a run on the assets of other institutions even without any direct contractual linkages. Both can lead to negative spirals of asset prices: fire sales of assets, losses, further sales,. Shadow banks can affect financial stability through direct links to banks and through the similarity in business models. Claudia M. Buch 13

How can we measure systemic risks? Systemic risk is the contribution of a financial institution to the risk of the financial system: Value at risk (VaR) of the financial system, conditional on institutions being under distress (CoVaR) (Adrian & Brunnermeier 211) Amount of capital that a financial institution needs to raise in a financial crisis (SRISK) (Acharya et al. 212) Game theoretic Shapley Value (Borio et al. 29) The systemic risk of a given financial institutions increases in its risk and the degree of leverage in its size ( too big to fail ) in its degree of connectedness ( too connected to fail ) in its exposure to macroeconomic risks ( too many to fail ) Claudia M. Buch 14

Measuring systemic risk I: The size of financial institutions Firm size in financial services often follows a Power Law -distribution: A few very large firms dominate the market. Shocks hitting large firms do not cancel out in the aggregate but affect the macroeconomy. Concept of granularity (Gabaix 211) Law of Large Numbers does not apply. Aggregate volatility = Idiosyncratic volatility * Herfindahl-Index (concentration) Granular effects are important in banking, but there are few studies for other financial intermediaries. Claudia M. Buch 15

1978 198 1982 1984 1986 1988 199 1992 1994 1996 1998 2 22 24 26 28 21 Concentration in financial services has increased: The case of Germany. 7 Largest 1 (1) firms in % of total 6 5 4 3 2 1 All sectors Banks Insurance companies Source: Monopolkommission. Claudia M. Buch 16

Measuring systemic risk II: Linkages between financial institutions Source: Financial Network Analysis 17

How do linkages between financial institutions affect financial stability? There is a non-linear link between the degree of connectedness and the risk of financial contagion. Tighter linkages improve the diversification of idiosyncratic risks. Tighter linkages ease the transmission of shocks, and contagion effects can arise. Systemic risk can be high in strongly connected markets. There are many empirical studies for banks on the stability of financial networks and the transmission of shocks. Similar empirical studies for non-banks are constrained by a lack of data. Claudia M. Buch 18

Measuring systemic risk III: Common exposure to macroeconomic risks Monetary policy shocks affect the lending and risk-taking decisions of financial institutions: Credit channel: Lower interest rates increase collateral values, and lending increases (Bernanke et al.). Risk-taking channel: Lower interest rates induce financial institutions to search for yield and lend to high-risk customers (Rajan, Borio). Financial institutions may coordinate their exposure to macroeconomic risks: collective bail out (Farhi & Tirole 21) Research shows that low monetary policy rates induce risk-taking of banks. Studies for shadow banks are constrained by a lack of micro-data. Claudia M. Buch 19

Monetary policy House price Demand Supply In the aggregate, banks do not increase risktaking in response to lower interest rates... 2 x 1-3 Non-performing loans/loans Equity capital/assets x 1-3 1 Return on assets.2 Loans 1 5 1 15 2 -.1 -.2 -.3 5 1 15 2 5 5 1 15 2.1 5 1 15 2.1 -.1 -.2 5 1 15 2 -.2 -.4 5 1 15 2 6 4 2 x 1-3 -2 5 1 15 2.2.1 -.1 5 1 15 2 x 1-3 x 1-3 x 1-3 -1-2 5 1 15 2-1 -2 5 1 15 2 2-2 5 1 15 2.2.1 5 1 15 2 -.5 -.1 2 x 1-3 1 x 1-3 1.2.1 -.15 5 1 15 2 5 1 15 2-1 5 1 15 2 5 1 15 2 Source: Buch, Eickmeier, Prieto (JMCB, 213) Claudia M. Buch 2

Monetary policy House price Demand Supply but heterogeneity is substantial, and about 1/3 of the banks do become riskier. Non-performing loans/loans.1 -.1 5 1 15 2 Equity capital/assets.1 -.1 5 1 15 2 Return on assets.5 -.5 5 1 15 2 Loans 1.5 -.5 5 1 15 2.5 -.5 -.1 -.15 5 1 15 2.5 -.5 -.1 -.15 5 1 15 2.5 -.5 5 1 15 2 1-1 5 1 15 2.1 -.1 -.2 5 1 15 2.1 -.1 5 1 15 2.5 -.5 5 1 15 2 1.5 1.5 -.5 5 1 15 2.5.5.2 1 -.5 -.5 -.2.5 -.5 5 1 15 2 5 1 15 2 5 1 15 2 5 1 15 2 Source: Buch, Eickmeier, Prieto (JMCB, 213) Claudia M. Buch 21

How should regulators respond?

1. Improve information and reporting systems Detecting sources of systemic risk in banks and shadow banks requires improved reporting systems. Better information is needed on Sources and uses of collateral Guarantees of banks and non-bank financial institutions Market structure of financial markets outside the banking sector International linkages Proposals for data maps: Risk topography (Brunnermeier et al. 211) Risk map (Issing et al.) Claudia M. Buch 23

1. Improve information and reporting systems Is reporting too costly? Costs of bureaucracy and reporting for financial institutions are high relative to other industries. But these costs are relatively modest compared to the output costs of financial crisis. Are reporting systems sufficiently forward looking? Complexity of financial regulation increases the complexity of evasion strategies: We need simpler rules! Independent Evaluation Office of the IMF: Warnings were not heard because of 'group think', 'intellectual capture', and 'inadequate analytical approaches Use new data source (Big Data) Claudia M. Buch 24

2. Identify the systemic relevance of other financial intermediaries Appropriate regulatory responses should be based on the following criteria for systemic relevance: How concentrated is the industry? Do financial institutions take deposits? Do the institutions have access to public sector safety nets and enjoy too big to fail guarantees? How strong are links to the banking sector? How leveraged are the institutions? Claudia M. Buch 25

Other financial intermediaries have lower leverage than banks, but their degree of leverage has increased. Source: ECB Occasional Paper 133 (212)

3. Design appropriate regulatory responses Complexity of regulatory response needs to take incentives for regulatory arbitrage into account: Limit connectedness? Link regulations to exposure vis-à-vis macroeconomic risks? Lower degree of (international) integration? Increasing capital requirements can reduce systemic risks: Simplified correction mechanisms if the system as a whole is undercapitalized. Complementary reforms are needed: Resolution mechanisms for financial institutions Insolvency regulation Equity market regulation Claudia M. Buch 27

bn Assets of Euro Area Finance Vehicle Corporations are dominated by non-equity investments. 14 12 1 8 6 4 2 Deposits and loan claims Securitised loans Securities other than shares Other securitised assets Shares and other equity Other assets Source: ECB