Lehman Brothers and shadow banking system

Shadow Banking System

A definition

The term "shadow banking system" started to be used widely at the onset of the recent economic crisis.
According to April 2011 and October 2011 FSB reports[1] [2] , the shadow banking system can be defined as "the system of credit intermediation that involves entities and activities outside the regular banking system".
This definition implies the shadow banking system is based on two intertwined pillars.
First, entities operating outside the regular banking system engaged in one of the following activities:
  • accepting funding with deposit-like characteristics;
  • performing maturity and/or liquidity transformation;
  • undergoing credit risk transfer;
  • using direct or indirect financial leverage.
Second, activities that could act as important sources of funding of non-bank entities. These activities include securitisation, securities lending and repurchase transactions ("repo").

Therefore, can be included in shadow banking system: hedge funds, money market funds, structured investment vehicles (SIV), repurchase agreement ("repo") markets, special purpose entity conduits (SPE) and other non-bank financial institutions.
The FSB has estimated the size of the global shadow banking system at around € 46 trillion in 2010, having grown from € 21 trillion in 2002. This represents 25-30% of the total financial system and half the size of bank assets.

Risks and benefits

According to EU Green Paper on Shadow Banking[3] , shadow banking activities can constitute a useful part of the financial system, since they perform one of the following functions:
  • they provide alternatives for investors to bank deposits;
  • they channel resources towards specific needs more efficiently due to increased specialization;
  • they constitute alternative funding for the real economy, which is particularly useful when traditional banking or market channels become temporarily impaired;
  • they constitute a possible source of risk diversification away from the banking system.

Shadow banking entities and activities may however also create a number of risks:
  • Build-up of high, hidden leverage:
High leverage can increase the fragility of the financial sector and be a source of systemic risk. Shadow banking activities can be highly leveraged with collateral funding being churned several times, without being subject to the limits imposed by regulation and supervision.
  • Circumvention of rules and regulatory arbitrage:
Shadow banking operations can be used to avoid regulation or supervision applied to regular banks by breaking the traditional credit intermediation process in legally independent structures dealing with each other.
  • Disorderly failures affecting the banking system:
Shadow banking activities are often closely linked to the regular banking sector. Any failures can lead to important contagion and spill-over effects. Under distress or severe uncertainty conditions, risks taken by shadow banks can easily be transmitted to the banking sector.
  • Deposit-like funding structures may lead to "runs":
Shadow banking activities are exposed to similar financial risks as banks, without being subject to comparable constraints imposed by banking regulation and supervision.

Contribution to the economic crisis

Paul Krugman, a famous American economist, accounts the lack of control on the shadow banking system as one of the main causes of the current economic crisis.

"As the shadow banking system expanded to rival or even surpass conventional banking in importance, politicians and government officials should have realized that they were re-creating the kind of financial vulnerability that made the Great Depression possible, and they should have responded by extending regulations and the financial safety net to cover these new institutions. Influential figures should have proclaimed a simple rule: anything that does what a bank does, anything that has to be rescued in crises the way banks are, should be regulated like a bank"[4] .
  1. ^ FSB, "Shadow Banking: Scoping the Issues. A Background Note of the Financial Stability Board", 12 April 2011
  2. ^ FSB, "Shadow Banking Strengthening Oversight and Regulation. Recommendations of the Financial Stability Board", 27 October 2011
  3. ^ European Commission, "Green Paper. Shadow Banking", Brussels, 19.03.2012
  4. ^ Krugman Paul, The Return of Depression Economics and the Crisis of 2008, W. W. Norton & Company, 2009