UNIVERSITY OF AMSTERDAM
AMSTERDAM BUSINESS SCHOOL
MASTER IN INTERNATIONAL FINANCE
MASTER THESIS
COLLATERAL INTERMEDIATION
AND
SHADOW BANKING
Submitted by:
ALPER KAY
Supervised by:
RAZVAN VLAHU
AUGUST, 2013
ABSTRACT
The aim of this paper is to provide an extensive overview of the growing role and
importance of collateral intermediation in modern finance, mainly in the context of
shadow banking. Use of collateral is a common practice for reducing counterparty
risk in financial transactions. In modern finance, financial assets like treasury bonds,
commercial papers and mortgage backed securities are used as collateral in complex
lending and trading activities. Especially in the run-up to the latest financial crisis in
2008, there has been an increasing demand for high quality assets which can be used
as collateral, and this demand is likely to increase further due to greater risk aversion
of financial institutions. Because of the increasing demand, use of collateral has
become a very important function of the global financial system. This growing
importance comes with costs since such transactions are more complex than
traditional financing activities and they are vulnerable to different type of risks.
Therefore this new phase of global finance needs special attention on both
institutional and regulatory level. In the first part of this paper, we first identify the
shadow banking system in which most of the collateral transactions take place. Then,
we investigate securitization which is one of the primary functions of shadow banking
and an important source of collateral. Third part presents an overview of the collateral
intermediation function, types of collateral transactions and market practices. Last
part will provide a review of the current issues in the market.
TABLE OF CONTENTS
PART 1. INTRODUCTION
1
PART 2. SHADOW BANKING
2.1. What is Shadow Banking?
2.2. Why Does Shadow Banking System Exist?
2.2.1. Bank Runs and Introduction of Deposit Insurance
2.2.2. Regulation Q and Interest Rate Ceilings on Deposits
2.2.3. Emergence of Money Market Mutual Funds
2.2.4. Repo Market and Demand for Safe Assets
2.2.5. Pressure on Banks’ Fire Power –Regulatory Capital
Requirements2.3. Shadow Financial Intermediation
2
3
4
5
6
7
9
10
11
PART 3. SECURITIZATION
3.1. How Does Securitization Work?
3.2. Primary Roles in Securitization
3.3. Why Do Banks Securitize Their Loans?
3.4. Securitization’s Role in Shadow Banking
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15
17
18
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PART 4. COLLATERAL INTERMEDIATION
4.1. Primary Drivers of Collateral Use in Capital Markets
4.2. Main Players in the Collateral Market
4.3. Collateral Based Transactions
4.3.1. Repurchase Agreements
4.3.2. Securities Lending
4.3.3. Re-hypothecation
4.4. Historical Evolution of Securities Lending and Repo Markets
4.5. Benefits on Macro and Micro Levels
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24
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27
29
30
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PART 5. TOPICS OF DISCUSSION
5.1. Role of Shadow Banking in the 2007-2009 Crisis
5.2. Importance of Repo Markets and the Run on Repo
5.3. Haircuts
5.4. The Role of Rehypothecation and Velocity of Collateral
5.5. Collateral Scarcity
5.6. Other Issues
5.6.1. ABCP Conduits and Securitization Without Risk Transfer
5.6.2. Asset Encumbrance
5.6.3. Key Frictions in the Securitization Market
5.7. Concluding Remarks
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39
40
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REFERENCES
LIST OF FIGURES
Figure 1.
US Shadow Bank Liabilities vs. Traditional Bank Liabilities
Figure 2.
A Simple Illustration of Traditional Banking
Figure 3.
The Size of Cash Pools and Deposits
Figure 4.
Distribution of U.S. Financial Assets by the Main Types of Financial
Intermediaries
Figure 5.
Total Net Assets and Number of Shareholders of Money Market
Mutual Funds
Figure 6.
A Simple Illustration of a Repo Transaction
Figure 7.
Channels of Financial Intermediation
Figure 8.
Issuance of Corporate Debt and Asset-Backed Securities, 1990-2009
Figure 9.
The Securitization Process
Figure 10.
Tranching of Securities in a Waterfall Structure
Figure 11.
Illustration of a Repo Transaction
Figure 12.
Illustration of a Securities Lending Transaction
Figure 13.
An Example of Repeated Use of Collateral in a Dynamic Chain
Figure 14.
U.S. Private Label Securitization Market, 2001-11
Figure 15.
Total Assets at 2007Q2
Figure 16.
Repo Haircuts on Different Categories of Structured Products
Figure 17.
Shadow Banking System in the U.S.
Figure 18.
The Safe-Asset Share
Figure 19.
Illustration of Asset Encumbrance
PART 1. INTRODUCTION
Use of collateral is a centuries-old contractual way for reducing counterparty risk in
transactions. Traditionally, this method has been widely used in different types of
traditional banking activities such as utilization of project finance deals and providing
mortgage loans. A simple example of collateralization is pledging a house against the
mortgage loan which is provided to buy that house. By pledging the property, the
bank holds the right to liquidate the asset in case of a default, thus mitigating the
repayment risk of the borrower.
Like physical goods, securities are also used as collateral for financial transactions,
especially in capital markets. Unlike traditional banking, this is a more complex
system in which non-bank financial institutions like dealer banks, hedge funds,
custodians, broker-dealers and money market funds are also involved. Some of the
securities that are used as collateral in this system are treasury bonds, corporate
bonds, equities, collateralized debt obligations and mortgage backed securities. As
mentioned above, this is a more complex system and there are various types of
transactions and different scenarios in which securities are used as collateral. Main
types of transactions are securities lending, repurchase agreements (repo) and overthe-counter derivatives. For example, a hedge fund (the pledgor) who holds some US
Treasury Bills as an investment, can post these assets as collateral and source funding
from a broker to use it for new investments. While the broker reduces the
counterparty risk by receiving collateral against the loan it provides, the hedge fund
enjoys efficient (or extra) use of its assets which otherwise sit idle in its books. A
potential use for the broker is that it can borrow against the same collateral it
received. For instance, the posted collateral can be re-used in a repo transaction in
which broker gets funding from another hedge fund who needs those securities for
covering its short position in the market. This practice of re-using collateral is called
rehypothecation. Rehypothecation process can go on and on in a chain where a single
security can be used as collateral by different parties for more than one transaction.
The use of collateral has risen in the aftermath of the latest global financial crisis. As
financial institutions have become more risk averse and regulatory focus has
increased after Lehman Brothers’ collapse, financial activities have shifted towards
secured transactions and use of collateral has increased sharply. These changes
highlighted the growing importance of collateral for the functioning of the global
financial system. During the same period, it has become apparent that use of collateral
in complex financial transactions is one part of a broader system which is called
shadow banking. In order to understand collateral’s role in modern finance, it is
crucial to identify what shadow banking is and how it functions.
1
PART 2. SHADOW BANKING
Collateral intermediation is one of the main functions of the shadow banking system.
To understand collateral’s ever-growing importance in modern finance, we first need
to understand what the broader “shadow” system is. Shadow banking, which is the
younger brother of traditional banking, has become a very important part of the
financial system in the last 20 years. So important that the markets are heavily
dependent on it for functioning properly, also very fragile to the problems it causes.
Luttrell et al. (2012) point out that at its peak in 2008, US shadow banking liabilities
was about $20 trillion, almost double the total size of commercial banks’ balance
sheets, which was $11 trillion. This makes it apparent that shadow segment needs
special attention from every part of the financial system. Figure 1 illustrates shadow
vs commercial banks’ growth in the last 40 years. Shadow banking exceeded
commercial bank liabilities after 1996 and it continued to grow until the financial
crisis of 2008. Perotti (2012) further noted that while much reduced since 2008, in the
USA, shadow banking’s size still exceeded bank assets in 2011.
Figure 1. U.S. Shadow Bank Liabilities vs. Traditional Bank Liabilities ($ trillion)
Source: Luttrell et al, 2012. Understanding the Risks Inherent in Shadow Banking: A Primer and
Practical Lessons Learned
If you ask different members of the finance family, some of them will say that it’s
difficult to survive without shadow banking, whereas some think it is a problem-child
who has to be disciplined. Of course there are many different motivations behind
these contrary thoughts. Banks advocate that shadow system allows risk sharing and
efficient use of capital. Another supporting argument comes from institutional
investors who say that shadow banking creates a new source of liquid and safe
collateral for their transactions. In contrast, regulators think that it’s a manifestation
of regulatory arbitrage which is prone to systemic shocks and therefore needs to be
carefully controlled. Although above figure already gives some clue about these
2
different approaches, we ‘ll further investigate the motivations behind shadow
intermediation in the following sections.
2.1. WHAT IS SHADOW BANKING?
But what is this shadow banking really? Shadow banking is a complex form of
financial intermediation where a chain of activities is performed by regular banks and
non-bank financial intermediaries in order to channel funding from savers to investors
through a range of securitization and secured funding techniques. Simply, it is the
process of pooling, tranching and transforming illiquid financial assets (e.g.
residential mortgages, auto loans, student loans) into liquid securities which are then
used for trading and pledging outside the regulated financial system. In its broadest
definition, shadow banking includes such familiar institutions as investment banks,
money-market mutual funds (MMMFs), and mortgage brokers; some rather old
contractual forms, such as sale-and-repurchase agreements (repos); and more esoteric
instruments such as asset-backed securities (ABSs), collateralized debt obligations
(CDOs), and asset-backed commercial paper (ABCP) (Gorton and Metrick, 2010a).
Financial Stability Board (2011) describes shadow banking as “the system of credit
intermediation that involves entities and activities outside the regular banking
system”. Pozsar et al (2010) define shadow banks as “financial intermediaries that
conduct maturity, credit, and liquidity transformation without access to central bank
liquidity or public sector guarantees”.
The term “shadow” banking was first coined by Paul A. McCulley in August 2007 at
the Fed’s annual symposium in Jackson Hole. According to McCulley (2009), unlike
conventional regulated banks, unregulated shadow banks fund themselves with
uninsured short-term funding, which may or may not be backstopped by liquidity
lines from real banks. Since they fly below the radar of traditional bank regulation,
these levered-up intermediaries operate in the shadows without backstopping from the
Federal Reserve’s discount lending window or access to FDIC deposit insurance.
ICMA (2012) defines shadow banking as an alternative (and pejorative) term for
market finance. Shadow banking is market-based because it decomposes the process
of credit intermediation into an articulated sequence or chain of discrete operations
typically performed by separate specialist non-bank entities which interact across the
wholesale financial market.
All these different definitions suggest that this type of financial intermediation is
performed outside the regulated financial system. But why were there a need for such
a complex parallel system?
3
2.2. WHY DOES SHADOW BANKING SYSTEM EXIST?
According to Acharya and Oncu (2010), the emergence of a shadow banking system
in the United States may be traced as far back as the early 1970s. Gorton and Metrick
(2010a) supports this argument and adds that shadow banking is the outcome of
fundamental changes in the financial system in the last 30 to 40 years, as a result of
private innovation and regulatory changes that together led to the decline of the
traditional banking model. According to Pozsar (2008), the traditional model of
banking –borrow short, lend long, and hold on to loans as an investment—has been
fundamentally reshaped by competition, regulation and innovation. One force came
from the supply side, where a series of innovations and regulatory changes eroded the
competitive advantage of banks and bank deposits. A second force came from the
demand side, where demand for collateral for financial transactions gave impetus to
the development of securitization and the use of repos as a money-like instrument.
Both of these forces were aided by court decisions and regulatory rules that allowed
securitization and repos special treatment under the bankruptcy code (Gorton and
Metrick, 2010a). As a source of funds for financial intermediaries, deposits have
steadily diminished in importance. In addition, the profitability of traditional banking
activities such as business lending has diminished in recent years. As a result, banks
have increasingly turned to new, nontraditional financial activities as a way of
maintaining their position as financial intermediaries (Edwards and Mishkin, 1995).
As most of the academics agree, a chain of historical events and changes that occured
in financial markets have triggered the emergence of shadow banking system. Bank
runs and Great Depression introduced deposit insurance for retail investors but this
was not able to meet the demand of institutional investors since deposit insurance was
and has always been limited to a certain amount for each account. Also, with the
Federal Deposit Insurance System, banks were prohibited to pay interest on demand
deposits and interest rates on savings accounts were capped. In response to these
challenges (mainly) for institutional investors, money market mutual funds were
created. These instruments act as an insured investment for institutional investors
since they invest only in high quality and liquid assets. But as these funds have grown
so much, availability of sufficient amount of high quality assets came into question.
During the same period, regulations on banking –like minimum capital requirement
ratios- have forced banks to find new instruments which require less (or no) capital
than traditional banking activities and contribute to the expansion of banks’ business.
Also, emergence of repo markets has driven the increasing demand for high quality
safe assets. Due to these developments, financial world has shifted towards an
alternative system where transactions are more complex than traditional banking and
regulatory control is limited. Following parts will briefly explain each of these factors
that motivated the birth of shadow banking.
4
2.2.1. Bank Runs and Introduction of Deposit Insurance
In traditional banking, there are 3 main actors: savers, borrowers and banks. Savers
are primarily households with savings and firms with excess cash, whereas borrowers
are households and firms who need loans for investments such as buying a house or
building a new factory. As illustrated in the below figure, banks act as intermediaries
who obtain funds from savers in the form of deposits and provide these funds to
borrowers as loans.
Figure 2. A Simple Illustration of Traditional Banking
While savers prefer deposits to be of a shorter maturity (to be able to use their savings
whenever it’s needed), borrowers usually require loans of longer periods. Banks
manage this maturity mismatch by exploiting the general belief that only a small
portion of savers have sudden liquidity needs at a given time. Therefore, banks hold a
small portion of deposits in the form of liquid assets –which are easy to convert into
cash- and lend the rest as illiquid loans. This function of traditional banking is known
as maturity transformation. However, by doing this, banks become fragile to bank
runs 1. A bank run occurs when a large number of customers withdraw their deposits
from a bank at the same time. This kind of events happen when there is a sign of
trouble about bank’s financial situation and such bank runs can easily lead to a
banking panic which effects the whole system. In history, governments made
numerous attempts to stabilize deposits through different schemes such as
clearinghouses, but these attempts didn’t stop bank runs and banking panics
happening until after the Great Depression. These runs were ended in the United
States in 1934 through the introduction of Federal Deposit Insurance. With their
deposits insured by the government, savers have little incentive to withdraw their
funds when the financial situation of the bank comes into question. This insurance
scheme works well for retail (household) investors, as most of the retail deposits are
below the limit of deposit insurance, which is 250.000 $ as of 2013. But this cap on
deposit insurance leaves a challenge for institutional investors like pension funds,
municipalities and some other nonfinancial companies with (millions of dollars of)
large cash holdings as they lack access to safe (insured) , interest earning , short-term
(liquid) investments. Below figure illustrates the increasing size of institutional cash
pools. Pozsar (2011) calculated that the volume of institutional cash pools rose from
$100 billion in 1990 to over $3.8 trillion (conservative estimate=$2.2 trillion) at their
1 For
more information on bank runs, please check Xavier Freixas and Jean-Charles Rochet’s book
called “Microeconomics of Banking” Chapter 7.
5
peak in 2007 (3700% growth). He also estimated that in 2010, institutional cash pools
stood at $3.4 trillion (conservative estimate=$1.9 trillion).
Figure 3. The Size of Cash Pools and Deposits
Source: Claessens et al, 2012. Shadow Banking Economics and Policy
Cap on deposit insurance was an important factor for institutional cash pools’ shift
towards alternative investments.
According to Pozsar (2011), insured deposit
alternatives dominate institutional cash pools’ investment portfolios relative to
deposits and the principal reason for this is not search for yield, but search for
principal safety and liquidity. As documented in his study, between 2003 and 2008,
institutional cash pools’ cumulative demand for short-term government guaranteed
instruments (as alternatives to insured deposits) exceeded the supply of such
instruments by at least $1.5 trillion. The “shadow” banking system rose to fill this
vacuum, through the creation of safe, short-term and liquid instruments.
2.2.2. Regulation Q and Interest Rate Ceilings on Deposits
Another challende for large depositors is the Regulation Q which was introduced with
the Federal Deposit Insurance System. Regulation Q prohibited the payment of
interest on demand deposits and authorized the Federal Reserve to set interest rate
ceilings on time and savings deposits paid by commercial banks. The motivation
behind the introduction of Reguation Q was the perception that the bank failures
during 1930s had been the result of excessive bank competition for deposits which
encouraged speculative investment behavior on banks. Because of interest rate
ceilings and limits on deposit insurance, there was a great demand for bank substitutes
that were safe yet could deliver a higher yield than banks were legally permitted. The
imposed interest rate and insurance cap on deposits encouraged the creation of
alternatives to banks, including money market funds. According to Gorton and
Metrick (2010a), money market mutual funds were a response to interest rate ceilings
on demand deposts.
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2.2.3. Emergence of Money Market Mutual Funds
A money market fund is a type of mutual fund that is required by law to invest in lowrisk instruments such as US Treasury bills , commercial papers or other highly liquid
and low-risk securities. Money market funds seek to maintain a net asset value of 1 $
per share, which means that their aim is to never lose money. These funds are closely
regulated by the SEC under the Investment Company Act of 1940 and the rules
adopted under that Act, particularly Rule 2a-7 under the Act. This rule restricts the
quality, maturity, liquidity and diversity of investments made by MMMFs. Money
market funds are required to hold a diversified portfolio composed of high-quality
securities that pose minimal credit risks. The fund must maintain sufficient portfolio
liquidity to meet reasonably foreseeable redemption requests. They must also invest
in securities that are considered short-term.
According to Olson (2012), many investors came to believe that MMMFs were so
thoroughly restricted by regulation that they had an implicit government guarantee, a
viewpoint somewhat validated when the funds were essentially bailed out in 2008.
Like other mutual funds, money market fund shares can be bought or sold at any time.
Besides, these vehicles were not subject to deposit rate ceilings. So, theoretically they
have the potential to offer higher yields than bank deposits. These features of
MMMFs let them become one of the primary investment tools for big cash pools and
fill the gap for institutional investors’ need for safe and liquid instruments. Below
figure illustrates that starting from 1950s, banks -depository institutions- have been
losing ground to other intermediaries. And significant portion of these other
intermediaries consists of mutual funds.
Figure 4. Distribution of US Financial Assets by the Main Types of Financial Intermediaries
Source: Allen and Santomero, 1999. What Do Financial Intermediaries Do?
7
Cook and Duffield (1979) argues that the rapid growth of MMFs in 1978 and 1979
has been both a reaction to government regulations and a result of fundamental
changes in the way some institutional and individual investors manage their shortterm financial assets. MMMFs really took off in the mid-1980s, their assets growing
from $76.4 billion in 1980 to $1.8 trillion by 2000, an increase of over 2,000 percent.
Assets of MMMFs reached a peak of $3.8 trillion in 2008, making them one of the
most significant financial product innovations of the last 50 years. (Gorton and
Metrick, 2010a).
Below figure, which is extracted from Investment Company Institute’s 2013 Annual
Investment Company Fact Book, illustrates money market mutual funds’ growth in
the last 25 years. According to the data provided in the Fact Book, total assets of
money market funds grew from $292 billion in 1986 to $3.8 trillion at its peak in
2008, which is equal to 1/4 of commercial banks’ total assets in the same year. After
its peak in 2008, total assets of money market funds declined due to the crisis and
stood at $2.7 trillion level in 2012. Considering its short history, money market funds
have seen a very rapid increase in assets. Primary reason for this is the ability to act as
a substitution of bank deposits for large cash pools.
Figure 5. Total Net Assets and Number of Shareholders of Money Market Mutual Funds
4,500,000"
60,000"
4,000,000"
50,000"
3,500,000"
3,000,000"
40,000"
2,500,000"
30,000"
2,000,000"
1,500,000"
20,000"
1,000,000"
10,000"
500,000"
0"
19
86
19 "
87
19 "
88
19 "
89
19 "
90
19 "
91
19 "
92
19 "
93
19 "
94
19 "
95
19 "
96
19 "
97
19 "
98
19 "
99
20 "
00
20 "
01
20 "
02
20 "
03
20 "
04
20 "
05
20 "
06
20 "
07
20 "
08
20 "
09
20 "
10
20 "
11
20 "
12
"
0"
Total"Net"Assets"(mn"$)"
Total"#"of"Shareholder"Accounts"('000)"
Source: Extracted from ICI 2013 Investment Company Fact Book
8
2.2.4. Repo Market and Demand for Safe Assets
Development of repo markets has also played an important role in the creation of
shadow banking because it added to the increasing demand for safe assets. A
repurchase agreement (repo) is a financial contract used by market participants as a
financing method to meet short-term liquidity needs. It is the sale of securities
together with an agreement to buy back the securities at a higher price on a later date.
Securities used in this type of transactions include treasury bills, corporate bonds,
commercial papers and asset backed securities. Below figure demonstrates a simple
view of a repo transaction. In this example, a repo seller (for instance a broker-dealer)
agrees with a repo buyer (for instance a money market fund) to sell U.S. Treasury
securities at T0 and buys back the same securities at T1 at a higher price. So, basically
securities act like a collateral in repo transactions. From money market fund’s point of
view, repo allows them to invest their cash in a secured transaction in which they hold
securities as collateral. From broker-dealer’s point of view, repo transaction allows
them to expand their funding sources.
Figure 6. A Simple Illustration of a Repo Transaction
Source: SIFMA, 2012. Repo Market Fact Sheet
Because of institutional investors’ strong preferences on safety, they are not fit to be
intermediated through the traditional, deposit funded banking system. Therefore, for
9
large depositors like pension funds, mutual funds and other institutional investors,
repos can be a good substitute for insured demand deposits because repo agreements
are excluded from Chapter 11, which means they are not subject to the automatic stay
in bankruptcy. Repos also don’t bear any limits on interet rates. So, they can earn
higer interest rates than commercial bank deposits.
The repo contract allows either party to enforce termination of the agreement as a
result of a bankruptcy filing by the other party. This feature allows a lender to
terminate its repo with a bank and sell the collateral if the bank becomes insolvent. As
money under management by institutional investors grew, use of repurchase
agreements has increased as well. Especially during the period of high inflation in the
1970s , rising short-term interest rates made repos highly attractive short-term
investments for institutional investors. Because unlike commercial bank deposits,
repo transactions don’t have any interest rate ceilings and they are safer for large cash
pools as they are backed by a collateral. So large cash pools prefer repo over bank
deposits mainly for two reasons: 1- to earn higher yields , 2- to get insurance.
According to Gorton and Metrick (2010a), one key driver of the increased use of
repos is the rapid growth of money under management by institutional investors,
pension funds, mutual funds, states and municipalities, and nonfinancial firms. These
entities hold cash for various reasons but would like to have a safe investment that
earns interest, while retaining flexibility to use the cash when needed—in short, a
demand deposit-like product. In the last 30 years these entities have grown in size and
become an important feature of the financial landscape. For example, according to the
Bank for International Settlements (BIS 2007, p. 1, note 1), “In 2003, total world
assets of commercial banks amounted to USD 49 trillion, compared to USD 47
trillion of assets under management by institutional investors”. Pozsar (2011) argues
that relative to the aggregate volume of institutional cash pools, however, there was
an insufficient supply of short-term government-guaranteed instruments to serve as
insured deposit alternatives. This shortage amounted to $1.1, $1.6 and $1.6 trillion in
2005, 2006 and 2007, respectively, and has been exacerbated by increasing foreign
official holdings of short-term government guaranteed instruments since 2000. With a
shortage of short-term government-guaranteed instruments, institutional cash pools
next gravitated—almost by default—toward the other alternative of privately
guaranteed instruments, fueling the secular rise of the non-bank-to-bank subset of
wholesale funding markets and the “shadow” banking system in general. Institutional
cash pools’ increasing demand for safe, short-term and liquid instruments was one of
the primary reasons that gave birth to “securitization” which will further be discussed
in the following sections.
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2.2.5. Pressure on Banks’ Fire Power -Regulatory Capital RequirementsUp to this point, we discussed developments mainly on inverstors’ side. Another very
important factor in the run up to the creation of shadow banking was capital
requirements in the banking sector2. The introduction of capital requirements in 1981,
and the various revisions of those requirements in the decades since then (under the
Basel capital rules), has had the significant unanticipated consequence of motivating
banks to move assets off their balance sheets in order to avoid the regulatory capital
cost (Olson, 2012). The last major overhaul of bank capital requirements, commonly
referred to as the Basel Accord, was agreed to in 1988 and implemented in the United
States from 1990. The 1988 agreement implemented what have become known as
risk-based capital requirements, which mandated, for the first time, different capital
requirements for different assets. In particular, banks were required to hold a higher
percentage of equity capital per loan than per government security, to reflect the
presumption that loans are more risky than securities. Because these requirements
made lending relatively more expensive than purchasing securities, banks were given
an incentive to shift their portfolios away from loans into securities. Shortly following
the introduction of the 1988 accord, banks reduced their investments in commercial
lending and simultaneously began to hoard government securities. The share of total
bank credit invested in commercial and industrial loans fell from around 22.5% in
1989 to less than 16% in 1994. The share of total bank credit invested in U.S.
Government securities increased from just over 15% to nearly 25% over the same
time period (Furfine, 2001). Since government securities are limited in supply and
also not as profitable as commercial loans in general, banks had to find another way
to expand their businesses. According to Pennacchi (1988), banks faced with
significant competition for deposit financing, as well as regulatory constraints in the
form of required capital and/or reserves, cannot profit by simply holding moneymarket assets but must provide other services. Loan sales can reduce the cost of
funding these loans. Gorton and Metrick (2010a) argues that if bank regulators
impose capital requirements that are binding (that is, that require banks to hold more
capital than they would voluntarily in equilibrium), then, when charter value is low,
bank capital will exit the regulated bank industry. One way to do is through offbalance-sheet securitization, which has no requirements for regulatory capital.
2.3. SHADOW FINANCIAL INTERMEDIATION
There are 3 main types of financial intermediation. One is direct lending. Direct
lending means that there is no any intermediary involved. So, lender and borrower
2
An extensive review of the subject can be found on the paper “Jackson et al (1999), Capital
Requirements and Bank Behaviour: The Impact of the Basle Accord”.
11
interacts with each other directly. The Second one is traditional banking, where banks
intermediate the transformation of savings to credits. The third type of credit
intermediation is shadow banking, where multiple entities intermediate the
transformation of savings to credits. Below figures is a simple demonstration of these
3 types.
Figure 7. Channels of Financial Intermediation
SOURCE OF
FUNDS
Nonintermediated
CREDIT INTERMEDIATION
Direct Lending (no intermediary)
Households
Business Borrowing
Individual
Traditional Banking (Intermediated)
Households /
Corporations
USE OF
FUNDS
Bank originates and holds loans
Shadow Banking (Multiple Intermediaries)
Households
Corporations
Bank originates loans but instead of holding them,
Institutions
distributes the loans to capital markets through
Securities
multiple steps and intermediaries.
Lenders
Pension Funds
Households
Business Borrowing
Households
Business borrowing
Source: Interpreted from Luttrell et al, 2012. Understanding the Risks Inherent in Shadow Banking: A
Primer and Practical Lessons Learned.
In the traditional model of financial intermediation, banks take deposits from savers
and lend out these deposits to borrowers. This is done by performing three important
activities: maturity, liquidity and credit transformation. Maturity transformation refers
to using short-term deposits to fund longer-term loans. Deposits are banks’ liabilities
which are collected from households and firms. Since traditionally, deposits have
shorter maturity than loans, banks assume the risk of rollovers and duration. They
have pools of deposits with different maturities, which allow them to conduct
financing without being exposed to maturity mismatch. Liquidity transformation
refers to the difference between bank’s assets and liabilities in terms of liquidity.
Liabilities, which are mostly composed of deposits, are available on demand at any
time. Basically, they are very liquid. In contrast, assets of a bank –loans- usually have
longer and fixed maturities, which means that they are not as liquid as deposits. So, if
all deposit customers withdraw their money at the same time, the bank may not be
able to finance all of its loans. To avoid such an illiquidity problem, banks are
required to hold a portion of the deposits as cash. Also central banks provide deposit
insurance to deposit holders to avoid simultaneous cash withdrawals. These features
give banks the ability to use liquid liabilities (deposits) to fund illiquid assets (loans).
Credit transformation refers to the ability to fund lower quality loans by issuing
higher quality debt mainly due to the presence of bank’s equity. Performing these
transformation functions expose banks to various risks. To minimize these risks
12
inherent in financial intermediation, governments support banking sector with public
sector guarantees such as deposit insurance and liquidity backstops in the form of
discount window. While deposit insurance shields banks from maturity mismatch risk,
discount window provides liquidity backstop to banks during times of stress.
Shadow banking, which is a market-based system, decomposes credit, maturity and
liquidity transformation functions of a traditional bank into several different roles.
These roles, organized around securitization and wholesale funding, are performed by
different bank and non-bank specialist institutions who don’t have access to public
sector guarantees. Like traditional banks, shadow intermediaries’ ultimate role is to
create a flow of credit from savers to borrowers. Although shadow banks resemble the
traditional credit intermediation role of banking, they do it in several steps in multiple
balance sheets rather than a single balance sheet. These steps include loan origination,
securitization (including loan warehousing, ABS issuance, ABS warehousing) and
wholesale funding. Traditional banks or other regulated finance companies originate
loans (majority being long-term loans such as auto loans and motgages) and transfer
them to special purpose vehicles. With the support of credit agencies and brokerdealers, these vehicles warehouse the loans and pool them into tranches with different
risk categories. Then, broker-dealers intermediate the issuance and marketing of
securities which are backed by these asset pools. Finally, investors like money market
funds purchase these asset backed securities in wholesale funding markets. As it can
be seen, several different specialist institutions are involved in the wholesale funded
securitization based credit intermediation process. Through securitization, loans are
converted into tradable instruments. These instruments are then funded in capital
markets via transactions such as commercial papers and repos. This intermediation
chain transforms long-term, risky and illiquid assets to seemingly short-term, safe and
liquid claims which are then used in capital markets as an investment. Unlike
traditional banking, in which all risks are gathered in banks’ balance sheets, shadow
credit intermediation disperse financial risks across the whole economy. This
improves credit availability, lowers cost of funding and diversifies both credit risks
and funding sources.
Shadow banking doesn’t have access to deposit insurance and liquidity backstops.
Absence of public sector guarantee leaves shadow banking susceptible to runs. To
avoid such circumstances, shadow intermediaries use various risk mitigation tools like
credit ratings, liquidity support from broker-dealers and collateral backing as a
(explicit) private sector guarantee.
13
PART 3. SECURITIZATION
Securitization, which is one of the most important financial innovations of the latest
century, is an outcome of increasing regulatory pressure on banking and capital
markets’ demand for safe assets. It is the process through which a variety of financial
assets (usually commercial bank loans like mortgages) are packaged into securities
and then sold to investors. By converting their loan portfolios to securities, banks can
free-up regulatory capital and also serve these securities to capital markets where
there is an increasing demand for safe and liquid assets.
Securitization’s origins date back to the Great Depression, when there were
historically high levels of unemployment rates and an unprecedented wave of loan
defaults in USA. These issues in the economy had disastrous effects on the housing
market. In order to overcome these problems, Federal Housing Administration (FHA)
was created to help reviving the housing market and protecting the lenders from loan
defaults. The role of the FHA was to provide insurance against loan defaults in the
housing sector. In 1938, Fannie Mae was chartered to create a secondary mortgage
market by purchasing FHA-insured loans from lenders and thus provide liquidity to
support the flow of credit. In 1968, Fannie Mae was split into 2 separate corporations;
Fannie Mae to purchase non-government backed mortgages, and Ginnie Mae to
provide timely payment guarantee for the mortgage backed securities which are
backed by loans that are insured by FHA (or the government). In 1985, securitization
techniques that had been developed in the mortgage market were applied for the first
time to a class of nonmortgage assets — automobile loans. A pool of assets second
only to mortgages, auto loans were a good match for structured finance; their
maturities, considerably shorter than those of mortgages, made the timing of cash
flows more predictable, and their long statistical histories of performance gave
investors confidence. Since then, securitization technology has been applied to a
number of different sectors such as credit cards, student loans, commercial mortgages
and auto loans. Federal Reserve Flow of Funds data show that the ratio of offbalance-sheet to on-balance-sheet loan funding grew from zero in 1980 to over 60%
in 2007 (Gorton and Metrick, 2010a). Below figure shows the annual issuance of all
securitized products versus corporate bonds as a comparison. As shown in the figure,
both corporate bonds and asset backed securities go almost parallel to each other until
2000s, when securitization really took off. In 2006, annual ABS issuance reached
record high levels of $1.6 trillion and then dropped significantly in 2008 due to the
crisis.
14
Figure 8. Issuance of Corporate Debt and Asset-Backed Securities, 1990-2009 (trillions of dollars)
Source: Gorton and Metrick, 2010a. Regulating the Shadow Banking System
According to Adrian and Ashcraft (2012), securitization is at the heart of shadow
banking, as it allows credit originators to sell pool of credit to other institutions,
thereby transferring the credit risk. The shadow banking system decomposes the
credit intermediation into a chain of wholesale-funded, securitization-based lending.
Through shadow intermediation process, the shadow banking system transforms risky,
long-term loans (subprime mortgages, for example) into seemingly credit-risk-free,
short-term, money-like instruments. Claessens et al (2012) claims that securitization
is the first key shadow banking function, and it is a process that, through tranching,
repackages cash flows from underlying loans and creates assets that are perceived by
market participants as fully safe. This function caters to institutional cash pools that
seek deposit-like safe investments and to banks that use securitized debt for repo
funding and to boost leverage. Noeth and Sengupta (2011) put out that in modern
banking, origination of loans is done mostly with a view to convert the loan into
securities—a practice called securitization, whereby the transaction, processing and
servicing fees are the intermediaries’ principal source of revenue. Due to increasing
competition and regulations, banks shifted their activities from originate-to-hold
model to originate-to-distribute by transforming their long-term loan portfolios to
short-term tradable investment instruments.
3.1. HOW DOES SECURITIZATION WORK?
But how does this originate-to-distribute model work? Instead of holding long term
and illiquid assets like mortgage loans on their balance sheet, banks pool all these
loans together and sell them to other entities, often called as a special purpose vehicle.
Then, SPVs (asset-backed commercial conduits) issue rated securities which are
backed by these assets (loan pools) and sell their shares to investors through
intermediaries. This structure allows banks to transfer risk to the investors who are
15
willing to hold it and eases banks’ balance sheet with regards to the minimum capital
requirements. Also, with the new funds raised through securitization, banks can
increase their lending and revenues.
According to Cetorelli and Peristiani (2012), under the securitization model, lending
(loan origination) constitutes not the end point in the allocation of funds, but the
beginning of a complex process in which loans are sold into legally separate entities,
only to be aggregated and packaged into multiple securities with different
characteristics of risk and return that will appeal to broad investor classes. And those
same securities can then become the inputs of further securitization activities. Below
figure demonstrates a simplified view of securitization process. As it can be observed
in the figure, securitization divides banks’ traditional role of credit intermediation into
several steps which can be summarized as pooling of assets (loans), transferring the
pools to SPVs, tranching of pools into several risk categories and distributing these
tranches to investors.
Figure 9. The Securitization Process
Source: Gorton and Metrick (2010a): Regulating the Shadow Banking System
Securitization process redistributes a bank’s traditional role of intermediation into
several specialized functions. These functions are performed by different entities in
several steps. In the first step, the bank –or the originator of loans- identifies the loans
(usually mortgage loans, auto loans, credit card receivables, student loans, consumer
loans etc.) that it wants to remove from its balance sheet and pools them together into
a portfolio. It then sells this asset pool –portfolio- to an external legal entity, often
called a special purpose vehicle –or the issuer-. At this point, since it’s a true sale,
pooled loans leave bank’s balance sheet and move to SPV’s balance sheet. The SPV
finances the purchase of the pooled loans by issuing tradable, interest-bearing
securities that are backed by those assets. In general, these securities are called asset
backed securities. If the underlying loan is a mortgage, then they are referred to as
mortgage backed securities. With the help of an underwriter and a rating agency, cash
flows of the underlying loan pool is split into different tranches, each representing
16
different risk level and rating. Then, the issuer sells these security shares to capital
market investors. The investors receive fixed or floating rate payments from a trustee
account funded by the cash flows generated by the loan portfolio. In most cases, the
originator services the loans in the portfolio, collects payments from the original
borrowers, and passes them on—less a servicing fee—directly to the SPV or the
trustee.
3.2. PRIMARY ROLES IN SECURITIZATION
There are several different parties involved in the process of asset securitization.
Originator, as the name suggests, is the bank who originates the underlying loan
portfolio. It is sometimes referred to as the sponsor. Originator is the initial owner of
the underlying assets. It pools together a selected portfolio of loans and transfers these
assets to a special purpose vehicle. Issuer is the special purpose vehicle who issues
security shares which are backed by the loan pool. Underwriter represents the issuer,
analyses investor demand and splits securities into tranches accordingly. It is also
responsible for marketing and selling the securities. Another role of the underwriter is
to provide liquidity support to the securitization in the secondary market. Rating
agencies publish ratings for different tranches of the issued securities. Servicer, is the
party who handles the payments and interaction with ultimate borrowers of the loans.
Servicer’s primary responsibilities are to collect and divert cash flows of loan
repayments, to monitor borrowers’ performance, and if needed, to liquidate the
collateral in the event of default. Originator bank can often be the servicer. Trustee, is
an independent firm responsible for the management of SPV, distributing payments to
investors and protecting the rights of the investors.
SPVs play a key role in the process of securitization. They are specifically designed to
move the assets from the balance sheet of the originator and convert them into
tradable securities. Gorton and Metrick (2010a) argue that in order to understand the
potential economic efficiencies of securitization, it is important to understand how the
SPV structure works. An SPV has no purpose other than the transaction or
transactions for which it was created; it can make no substantive decisions. SPVs are
set up specifically to purchase the assets and realize their off-balance-sheet treatment
for legal and accounting purposes. First important feature of SPVs is that they are
bankruptcy remote, meaning that if the originator bank goes into bankruptcy, the
assets of the issuer will not be distributed to the creditors of the originator. It also
means that the SPV itself can never become legally bankrupt. Bankruptcy remoteness
comes into effect by a –true sale- of the underlying assets. In a true sale, originator
bank surrenders the control of receivables and loans are transferred to the balance
sheet of the SPV. According to Cetorelli and Peristiani (2012), the transfer of the
assets to the SPV has the legal implication of obtaining a true sale opinion that
17
removes originator ownership and insulates asset-backed investors in the event of a
bankruptcy.
Another important feature of SPVs is slicing and transformation of loan pools into
different tranches of tradable securities such as asset backed commercial papers
(ABCP), residential mortgage backed securities (RMBS), and collateralized debt
obligations (CDO). As illustrated in the below figure, several classes (tranches) of
securities are issued each with different risk-return profiles.
Figure 10. Tranching of Securities in a Waterfall Structure
Source: Noeth and Sengupta (2011), Is Shadow Banking Really Banking? -
Brunnermeier (2008) explains that these tranches are then sold to investor groups with
different appetites for risk. The safest tranche -known as the “super senior tranche”offers investors a (relatively) low interest rate, but it is the first to be paid out of the
cash flows of the portfolio. In contrast, the most junior tranche -referred to as the
“equity tranche” or “toxic waste”- will be paid only after all other tranches have been
paid. The mezzanine tranches are between these extremes. The exact cutoffs between
the tranches are typically chosen to ensure a specific rating for each tranche. For
example, the top tranches are constructed to receive an AAA rating. The more senior
tranches are then sold to various investors, while the toxic waste is usually (but not
always) held by the issuing bank, to ensure that it adequately monitors the loans.
There is also the practice that banks keep some part of senior tranches on their
balance sheets to attract repo funding and through this to boost leverage.
3.3. WHY DO BANKS SECURITIZE THEIR LOANS?
Banks securitize their loan portfolios for various reasons. Primary motive of
securitization is regulatory capital arbitrage.
Suppose that a bank’s existing
regulatory capital can’t afford any additional loan issuance. In this case, in order to
provide new loans to clients, the bank either has to decrease its loan portfolio or
increase its equity. Both are costly and not practical. Instead of these two, by
18
securitizing a portion of existing loan portfolio, the bank can release some regulatory
capital and use it for new loans. According to Altunbas et al (2009), by removing
loans from their balance sheet, banks can obtain regulatory capital relief on account of
the transfer of credit risk, which allows for a positive net effect on the loan supply.
Jackson et al (1999) argues that banks in a number of countries are using
securitisation to alter the profile of their book. This may make a bank’s capital ratio
look artificially high, relative to the riskiness of the remaining exposures, and in some
cases may be motivated by a desire to achieve exactly this. According to Affinito and
Tagliaferri (2010), in order to meet both economic capital requirements linked to
market discipline, and mandatory capital requirements linked to regulation, banks
traditionally had two ways to choose from: Either they altered the numerator, for
instance by retaining earnings and issuing equity, or the denominator, by cutting back
assets and reducing lending or shifting into low risk-weighted assets. Securitization
allows a third way: banks can adjust their capital ratios by engaging in securitization.
Loan securitizations avoid the disadvantages of warehousing loans and then they
automatically decrease regulatory and market capital requirements.
Another important motive behind securitization is risk transfer or risk-sharing.
According to Stein (2010), when banks sell their loans into the securitization market,
the risks associated with these loans can be distributed across a wider range of end
investors, including pension funds, endowments, insurance companies, and hedge
funds, rather than being concentrated entirely on the banks themselves. This improved
risk-sharing represents a real economic efficiency, and lowers the ultimate cost of
making the loans. Moreover, as put out by Schwarcz (1994), a securitization
transaction can provide obvious cost savings by permitting an originator whose debt
securities are rated less than investment grade or whose securities are unrated to
obtain funding through an SPV whose debt securities have an investment grade rating.
Even an originator with an investment grade rating may derive benefit from
securitization if the SPV can issue debt securities with a higher investment grade
rating and, as a result, significantly decrease the originator's interest costs.
Securitization provides diversification of funding sources. According to Adrian and
Shin (2009), securitization opens up potentially new sources of funding for the
banking system by tapping new creditors. Claessens et al (2012) suggests that banks
accumulate, on their balance sheets or in affiliated investment vehicles, a significant
share of the long-term AAA claims produced by securitization. Banks used these
claims in part as collateral for repo funding. By pledging high-quality securitized
debt, banks could raise wholesale funds (and increase leverage) more cheaply and in
larger volumes than if they relied on traditional liabilities, such as deposits and
unsecured funding.
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3.4. SECURITIZATION’S ROLE IN SHADOW BANKING
Securitization of assets has been in use for a long time but only in the last 20 years
has it grown dramatically. As discussed in previous parts of this paper, growth of
securitization was a response to changing market dynamics, which are mainly the
increasing demand of cash pools for safe and liquid assets as well as increasing
competition and regulatory pressure in the banking sector. Securitization contributed
to the rise of shadow banking by moving assets of traditional banks off their balance
sheets and transforming these assets to tradable securities. This role of securitization
filled the gap between traditional banking and modern finance by building a bridge
where bank loans can be transformed into securities and transferred to the capital
markets. This allowed more efficient use of bank capital and supply of a new source
of assets to the investors. According to Claessens et al (2012), securitization caters to
two sources of demand. The first is the demand from corporations and the asset
management complex for what are perceived as safe, short-term, and liquid “moneylike” claims to invest their large cash balances. The second is the demand from banks
(especially European banks) that use securitized safe and long-term “AAA” assets to
attract repo funding (from institutional cash pools directly or money market funds)
and boost leverage. Gorton and Metrick (2010b) put out that with each level of
securitization, the SPV often combines many lower-rated (BBB, BBB-) tranches into
a new vehicle that has mostly AAA and AA rated tranches, a process that relies on
well-behaved default models. This slicing and recombining is driven by a strong
demand for highly rated securities for use as investments and collateral: essentially,
there is not enough AAA debt in the world to satisfy demand, so the banking system
set out to manufacture the supply. According to Brunnermeier (2008), securitization
allows certain institutional investors to hold assets (indirectly) that they were
previously prevented from holding by regulatory requirements. For example, certain
money market and pension funds that were allowed to invest only in AAA rated fixedincome securities could now also invest in a AAA-rated senior tranche of a portfolio
constructed from BBB-rated securities. These features of securitization make it an
important source of collateral within the asset management complex.
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PART 4. COLLATERAL INTERMEDIATION
Collateral is the lifeblood of today’s capital markets. Hedge funds, money market
funds, pension funds, asset managers, broker-dealers, investment banks, insurance
companies all rely on collateral for continuation of their investments and fundings.
Especially after the financial crisis in 2008, cash lenders’ growing risk-aversion
boosted the ever increasing need for collateral and policy makers supported this
increase and led the market to greater use of collateral based transactions. As put out
by Claessens et al (2012), collateral intermediation function is likely to become more
important over time.
Collateral, in its most basic form, is a protection against the counterparty risk. It is a
physical or financial asset that a lender holds in order to be secured against a credit
exposure taken. In finance, commercial banks usually take collateral from borrowers
in order to be covered in the event of a default. Defaulting means that the borrower is
unable to meet its contractual obligations, for example when the loan is not repaid in
maturity. In such an event, the bank can close the loan by selling/liquidating the
collateral that it holds. There are different types of collateral that is used in finance.
While cash is the most preferable one for lenders, many other types of collateral such
as treasury bills, corporate bonds, commodities, commercial papers, equities,
securities and credit claims also exist. Essentially, any liquid asset that allows
transferability of legal ownership and has a market price can in practice be used as a
collateral. For example, banks, who provide trade finance loans, hold physical
commodities such as steel, coal or grain as collateral. If a customer can’t repay the
loan, bank sells the commodity and closes the corresponding exposure. In collateral
based commercial loans like this, haircut is also a very common risk management
practice. It is a tool that lenders use to cover themselves against possible price/value
changes of the collateral. Back to the trade finance loan example, the bank is aware
that the commodity it holds as collateral has a market price that changes almost on a
daily basis. In order to prevent the collateral from not being sufficient to repay the
loan (a sudden price decrease in markets), bank either lends less than the value of
collateral it takes, or gets margin i.e. more collateral than the loan that customer asks
for. For instance, if a customer has 1 mn $ worth of nickel and asks for a loan, the
bank can apply a 10% haircut and either provides a loan of 900K $ or requires 1,1 mn
$ worth of nickel to be pledged against a 1 mn $ loan. This haircut also helps to cover
the interest and additional costs of the corresponding loan.
Collateral is not only used in commercial banking loans. Actually, commercial banks
do also borrow from each other or from non-bank financial institutions against
collateral. As mentioned in the very beginning of this paper, collateral use in capital
21
markets has become a very common practice in recent years. It’s emerged as one of
the key elements for functioning of the modern finance along with securitization. Not
only commercial banks use collateral for attracting additional funding, but also nonbank financial intermediaries like asset managers, hedge funds, money market funds,
insurance companies and broker-dealers heavily engage in secured financing
transactions (such as repo, secured loans and securities lending) for their investments
and fundings. A wide range of different assets such as cash, treasury bills,
commodities, bonds, securities and equities are used as collateral in capital markets.
After cash, government debt (such as US Treasury Bills) appears as the ideal type of
collateral since it is perceived as the safest and most liquid type of debt/claim
available. However, the problem is, there is not enough supply of government debt as
collateral in the financial world. Therefore, investors who are involved in collateral
transactions, need other liquid and safe sources of collateral3 . As discussed in the
previous part, securitization of bank loans is also one of the (imperfect) substitutes of
government debt as a collateral in secured transactions. Gorton et al (2012) suggests
that the demand for safe or information-insensitive debt exceeds the supply of U.S.
Treasuries outstanding. The private sector can produce substitutes for government
debt in the form of short-term instruments or long-term debt securities that can be
used as collateral or as safe stores of value. Consistent with the rise of the shadow
banking system, the main producers of safe debt are not commercial banks, whose
share of private safe debt has been shrinking. Of course, the government could
attempt to completely satiate the demand for safe debt by issuing more Treasuries. In
such a world, there would be no need for “safe” private financial-sector debt outside
of banking deposits. However, recent developments in sovereign debt markets suggest
that even governments cannot issue too much debt without such debt becoming
information-sensitive. Thus, if the demand for safe assets cannot be met in whole by
the government, near-riskless debt issued by the financial sector plays an important
role in facilitating trade.
4.1. PRIMARY DRIVERS OF COLLATERAL USE IN CAPITAL MARKETS
Different parties have different motivations for engaging in collateral based
transactions. While some use it as a secured investment instrument which allows
return enhancement for the excess cash they hold, others use it to obtain cash funding
or to get temporary access to specific securities.
Large institutional investors like pension funds and mutual funds are important users
of collateral based transactions. The main reason for their increasing use of repos and
3
IMF has an extensive review of safe assets in its 2012 Global Financial Stability Report’s 3rd chapter
called “Safe Assets: Financial System Cornerstone?”
22
securities lending transactions is the rapid growth of money under management and
the need of using this cash as a secured investment. These firms hold large amounts of
cash for various reasons and they would like to invest this cash in short-term, liquid
and safe –money-like- instruments. Even though asset managers invest households’
long-term savings into long-term instruments, their day-to-day management and
return mandates—absolute or benchmark— effectively requires them to transform a
portion of these long-term savings into short-term savings. This in turn drives the
money demand of asset managers (Pozsar and Singh, 2011). As discussed in previous
parts, institutional investors with large cash holdings can’t benefit from government
insured deposits as their cash pools exceed the maximum insurance amount. For large
cash holders like these, secured and collateral based transactions act as a substitute for
insured demand deposits. Therefore they invest their excess cash in instruments like
repos. They also use securities lending transactions to boost their profits without
being exposed to too much risk by lending out their securities against collateral and
generating additional income from their securities portfolio.
Another motivation is hedge funds’ need to cover their short positions. This type of
firms commonly engage in short sale transactions. Basically, they sell securities which
they don’t own, in the expectation that they can buy back same securities at a lower
price in the future. To cover these short positions, hedge funds need to obtain those
same securities that are sold short. They can do so by going into securities lending
markets and borrow the securities from another firm against posting either cash or
other securities as collateral. In such a market, it’s not easy to locate a specific
security which is available for borrowing. Therefore, hedge funds rely on prime
brokers who acts as an intermediary between security lenders and those who need
specific securities. Prime brokers are in continuous search for available securities in
the market. They locate available securities and service these securities to those who
need them for specific purposes like in the case for hedge funds. Another incentive of
hedge funds for involving in collateral transactions is to obtain leverage. Some hedge
funds are not creditworthy enough to attract unsecured funding. Therefore, they rely
on secured transactions to boost their leverage. They lend securities that they hold
through prime brokers and obtain funding from capital markets by using collateralised
transactions.
Investment banks and broker-dealers borrow securities for various reasons. Their
primary motives are to support their own proprietary trading, customers’ transactions
and finally their own market-making activities. Dealers trade with each other as well
as with their customers. To support these trading activities, they use collateral
transactions (mainly repos) to obtain funding. They use econonomies of scale by
pooling customers’ securities and source funding at the lowest cost available. They
23
also re-hypothecate their clients’ assets to originate additional secured financing
which in turn supports their own and clients’ funding needs.
4.2. MAIN PLAYERS IN THE COLLATERAL MARKET
The ultimate sources of collateral in the shadow banking system are asset managers.
Asset managers can be subdivided into two main groups: levered accounts and
unlevered (or real money) accounts. Broadly speaking, levered accounts refer to
hedge funds, and real money or unlevered accounts refer to exchange traded funds,
sovereign wealth funds, central banks, pension funds, insurance companies and
mutual funds (Pozsar and Singh, 2011). Mutual funds usually lend cash against
various type of assets as collateral. But they also do lend their securities with a
motivation to get additional revenue while minimizing the credit risk by taking
various types of eligible collateral. Hedge funds may also take role in both sides of
the transaction. They can either lend their securities to borrow cash, or lend cash to
borrow securities. They borrow cash to boost their leverage and expand their
investments. And they borrow securities to cover their short positions in the market.
Other important players in the market are intermediaries. The sophistication of
transactions and required infrastructure (administrative, operational, accounting, risk
management) to accommodate them are highly costly and necessitate third party
specialist institutions to be involved. These institutions are: agent intermediaries
(custodian banks), broker-dealers, prime brokers and central clearing counterparties
(CCPs). These intermediaries are sub-divided into 2 broad category: agent
intermediaries and principal intermediaries.
Agent intermediaries including custodian banks are employed by benefical owners to
lend their securities on behalf of them. These institutions are responsible for services
such as collateral management, trade settlement, risk management and operational
activities. They don’t assume counterparty risk. Therefore, deciding to whom the
securities will be lent (counterparty risk) is however still beneficial owners’
responsibility. Custodian banks are a type of agent intermediary with capability to
mobilise large pools of collateral. They usually have large numbers of institutional
clients and they act as a meeting point for the securities lending market. These
features of custodians allow their clients to benefit from economies of scale as well as
custodians’ advanced market and technological expertise.
Unlike agents, principal intermediaries assume principal risk, provide credit, liquidity
and take positions on behalf of themselves (proporietary trading). They perform credit
intermediation between beneficial owners and borrowers by taking a principal
position in the transaction. This feature offers beneficial owners a protection against a
24
counterparty they don’t know. Instead of assuming the risk of an unknown third party,
benefical owners assume principal intermediary’s risk who is usually a well-known
investment bank. Also this provides borrowers access to new resources. For instance,
some hedge funds may not be eligible or don’t have a proper credit rating to transact
with large cash pools like pension funds. But pension funds can engage in
transactions with principal intermediaries such as broker-dealers who are commonly
high rated and well-known investment banks. By intermediating such transactions,
broker-dealers act like a bridge between these institutions who don’t/can’t be directly
exposed to each other. Hedge funds heavily use prime brokers to source funding and
borrow securities. Brokers earn income from these services as well as their own
proprietary trading activities. To support their own activities, they also engage in repo
transactions among themselves as well as with third parties such as mutual funds.
4.3. COLLATERAL BASED TRANSACTIONS
There are two main types of collateral based instuments: securities lending and
repurchase agreements4. While these two transaction types have many similarities,
different motivations of market participants and specific characteristics of the
transactions divide them into two categories. A key difference between securities
lending and repo is that the first one is motivated by the need of temporary access to
specific securities (securities-driven), whereas the latter is mostly motivated by the
need to obtain cash financing (cash-driven). Repo is a key instrument for market
participants who are in search of liquidity. In a repo, the borrower borrows cash
against a collateral posted to the lender. In contrast, securities lending transactions are
motivated by the need to borrow specific securities and might not necessarily include
a cash exchange. It provides lenders of securities with low risk return enhancement,
while enabling borrowers to cover their short positions which requires specific
securities. Both markets are composed of lenders and borrowers of cash and securities
as well as intermediaries who organize and manage these transactions.
4.3.1 Repurchase Agreements
A repurchase agreement (repo) is the sale of an asset in exchange with cash, together
with an agreement to buy back the same asset at a higher price on a predetermined
future date. In such transctions, financial assets serve as a collateral for what is
effectively a cash loan. Following is a simple demonstration of a repo transaction. In
this example, a dealer gets into a repo transaction with a money market fund. Money
4 For
a detailed overview of repo and securities lending markets, please check “Adrian et al (2013),
Repo and Securities Lending” and “Financial Stability Board (2012), Securities Lending and Repos:
Market Overview and Financial Stability Issues”.
25
market fund lends cash to the dealer against receipt of securities as a collateral. At the
maturity, dealer pays back the cash plus a repo interest and money market fund
returns back the collateral.
Figure 11. Illustration of A Repo Transaction
cash
Opening+Leg
DEALER+
MMMF+
(seller&/&collateral&provider)
securities
(collateral)
(buyer&/&cash&provider)
cash
Closing+Leg
DEALER+
MMMF+
securities
(collateral)
From seller’s viewpoint, the transaction is called repo, whereas from buyer’s
viewpoint it’s called a reverse repo. Reverse repo is simply the mirror image of a
repo. Government bonds are the most common type of collateral used in repos. Repo
transactions are generally of a short maturity, changing between overnight to one year.
Banks, broker-dealers and cash-rich entities such as MMFs are involved in repo
transactions, each with different motives. During the term of repo, collateral value is
marked to market on a daily basis. Any negative change on the market value of the
collateral is effectively eliminated by margin maintenance. This is done by calling for
extra collateral or cash. Buyer gets the legal title of the assets received as collateral. In
case of the seller defaults, the buyer can liquidate the assets and recover its exposure.
In addition to that, buyer can re-use the securities during the term of the repo. This
practice is called re-hypothecation which will be analysed in detail in the following
sections. The buyer must return the securities by the end of the repo in order to
receive back the lended cash plus earned repo interest. Collateral used in repos has
two main categories: “general” and “specific” collateral. In general collateral repo
transactions, the lender accepts any of a variety of different assets as collateral. These
transactions are more common and general motivation for this type of transactions is
financing i.e. the need to obtain cash with lower cost of financing. It can also be used
to build up leveraged long positions by using the cash raised through a previous repo
transaction to buy new securities and lend them out again in a repo transaction. Repos
are also used to cover short positions. In that case, lenders of cash seek specific
security as collateral. In specific collateral transactions, a specific asset is identified
26
as collateral in the repurchase agreement. This allows institutions to sell an asset
which they do not own, by borrowing it from another party in the repo market.
Repo transactions take the form of either bilateral or tri-party repos. In bilateral
repos, only two parties involved, the seller delivering the securities to the buyer rather
than to a third party. However, in tri-party repos, collateral is delivered to and held by
a third party agent (such as a custodian) on behalf of the buyer. In such transactions,
tri-party agent acts as an intermediary for the administration of the transaction,
providing services such as collateral management, allocation, settlement, valuation
and marking to market.
Repo transactions are divided into two segments according to the parties involved:
inter-dealer repo segment and repo financing segment. Inter-dealer repo segment, as
the name suggests, primarily consists of repo transactions between broker-dealers.
The motivation of broker-dealers to engage in repo is either to cover their long
positions in a secured way by borrowing cash against collateral, or to cover short
positions by borrowing specific securities against cash for hedging and market
making purposes. Government bonds are the main collateral type used in these
transactions. Transactions are more commonly at an overnight maturity and typically
cleared by central counterparties (CCPs). Repo financing segment, consists of repo
transactions between bank, broker-dealers and cash-rich institutions such as money
market funds. Primary incentive of cash-rich institutions for involving in this type of
repo transactions is their demand to hold liquid and secured –money-likeinvestments.
4.3.2 Securities Lending
Securities lending is the transfer of securities to a borrower in exchange of a collateral
such as cash or other securities. As mentioned previously, primary motivation of
market participants for involving in securities lending transactions is to borrow
specific securities. In this sense, these transactions are similar to specific collateral
repos explained in the previous section. The difference between specific collateral
repos and securities lending transactions is that it’s not necessary to post cash as a
collateral in securities lending transactions. Other financial assets like securities can
also be posted as collateral. Institutional investors such as hedge funds, pension funds,
insurance companies and mutual funds lend their securities to investment banks and
broker-dealers against the collateral of cash or securities. According to Adrian et al
(2013), in U.S. equity markets, securities lending is driven primarily by the
prohibition on “naked” shortselling, which is a short sale by an institution that does
not hold the security and therefore cannot complete delivery. In a simplified example
as illustrated below, suppose that a hedge fund has a short position that needs to be
27
covered by a specific security. The fund can source that specific security from its
broker-dealer by getting into a securities lending transaction. In such a transaction,
according to the agreement, hedge fund can either post cash or other securities as
collateral. At the maturity, hedge fund returns the borrowed security and dealer
releases the collateral.
Figure 12. Illustration of A Securities Lending Transaction
securities
Opening,Leg
DEALER,
(collateral)provider)
HEDGE,FUND,
cash,/,securities
(collateral)
(securities)provider)
securities
Closing,Leg
DEALER,
HEDGE,FUND,
cash,/,securities
(collateral)
Securities lending involves complex operational and administrative activities which
are generally intermediated by third party specialist private firms such as custodian
banks and agents. These firms manage lenders’ securities lending business. Unlike
repo, this type of transactions are usually open ended with no predetermined maturity
date. So either the lender or borrower can exit the transaction at any time by recalling
or returning the collateral. If the collateral is not cash, the borrower pays the lender a
fee for the use of the borrowed securities. If there is cash collateral involved, the
securities lender pays the borrower an interest rate calculated on the cash collateral
received. Similar to repo transactions, collateral value is marked to market on a daily
basis to maintain sufficient levels of collateralisation. Collateral received through a
securities lending transaction can also be re-hypothecated. Securities lending market
has two main segments divided according to market participants. In the first segment,
which is called securities lending segment, lenders are institutional investors like
money market mutual funds. They typically lend their securities to broker-dealer
banks. In the second segment, which is called leveraged invetment fund financing
segment broker-dealers lend securities to investment funds such as hedge funds for
covering their short positions.
28
4.3.3 Re-hypothecation
Although re-hypothecation is not a different type of transaction, it is important to
discuss this segment separately since it plays a major role in collateral markets. Rehypothecation is simply a practice that allows assets received as collateral to be used
again as a collateral in another transaction. Basically, if permitted , a party who
receives a collateral can “re-pledge” the same collateral to another party for its own
funding. Bank for International Settlements (2013) argues that certain types of
collateral rehypothecation (and reuse) can play an important role in financial market
functioning, increasing collateral velocity and potentially reducing transaction and
liquidity costs. Rehypothecation decreases the (net) demand for collateral and the
funding liquidity requirements of traders, since a given pool of collateral assets can be
reused to support more than one transaction. This lowers the cost of trading, which is
beneficial for market liquidity.
Main users of re-hypothecation are investment banks who provide prime brokerage
services. Hedge funds generally give custody of their assets to prime brokers who
administer daily operations of hedge funds. Prime brokers, where legally allowed, rehypothecate hedge funds’ securities to obtain funding for their own transactions. For
example, a hedge fund who holds some securities in a primer broker account, can post
these assets as collateral and source funding from the broker to use it for new
investments. The broker then can re-pledge the same assets to another broker in a repo
transaction and gets funding for its own trades. The second broker who gets the
securities, may then use them as a collateral in a new repo transaction with a money
market fund. Re-hypothecation process can go on and on in a long chain where a
single security can be used as collateral by different parties in more than one
transaction. Below figure illustrates how a single collateral can support many different
transactions. A hedge fund may get cash financing from its broker Goldman Sachs
against posting collateral. Goldman Sachs may use the same collateral in a transaction
with another broker which is Credit Suisse in this case. Credit Suisse may then post
the collateral to a money market fund to acquire new financing. In such a scenario,
same collateral has been used three times from the hedge fund to the money market
fund.
29
Figure 13. An Example of Repeated Use of Collateral in a Dynamic Chain
Source: Claessens et al, 2013. Shadow Banking: Economics and Policy
Rehypothecation provides benefits both for prime brokers and hedge funds. Prime
brokers have an incentive to rehypothecate clients’ assets because it increases prime
brokers’ funding sources, lending capacity and revenues. On the other side of the
transaction, hedge funds’ primary motivation to allow rehypothecation of their assets
is mainly to obtain favorable funding rates and better terms of services from brokers.
Although rehypothecation provides benefits to both sides, possible risks are also
attached to these transactions. According to Bank for International Settlements
(2013), if collateral collected to protect against the risk of counterparty default has
been rehypothecated, then it may not be readily available in the event of a default.
This, in turn, may increase system interconnectedness and procyclicality, and could
amplify market stresses.
4.4. HISTORICAL EVOLUTION OF SECURITIES LENDING AND REPO
MARKETS
Although collateral based transactions are far more older than modern examples, first
developed repo market has been introduced by US Federal Reserve in early twentieth
century to provide funding to the member banks through open market operations.
Repos lost their attractiveness during the Great Depression due to banking panic and
historically low interest rates. Only after 1960s, they completely recovered and started
expanding in US. Especially during the high inflation environment of 1970s and
1980s, rising short-term interest rates made repos increasingly attractive to
institutional investors with large cash holdings. Instead of depositing their cash on
commercial banks who don’t pay interest on demand deposit, they increasingly
started using repos for investments. According to Garbade (2006), as time went on
and interest rates rose, an increasing number of corporations and state and local
governments initiated repo lending relationships. They were aided in their efforts by
brokers that arranged for school districts and other small creditors to lend to dealers in
regional and national repo markets.
30
Also emergence of securities firms accelarated the use of repo transactions on the
funding side, because it provided these firms to borrow with lower cost of funding.
Collateralised nature of repo allowed securities firms to benefit from lower cost of
borrowing and increase their leverage. During the same period, collateral based
transactions started to be imported to Europe and became a cross border instrument.
Another important development was the increasing volume of marketable Treasury
debt in 1970s. According to Acharya and Oncu (2010), this led to a parallel growth in
government securities dealers’ positions and financing, and the repo market grew by
leaps and bounds. As security dealers have grown by size, their economic importance
for the market also increased significantly.
In 1980s, three unfortunate events –collapse of Drysdale, Lombard-Wall and Lion
Capital Group- , had a profound impact on the securities lending and repo markets.
These dealer failures demonstrated the need for a mechanism which can provide
safety for parties involved in repo transactions and it finally led to the standardisation
of transactions and development of a new form, called tri-party repos which were
explained in previous sections.
Another significant consequence of Lombard-Wall’s bankruptcy was a court decision
that imposed automatic stay on the repo securities that Lombard-Wall had used as
collateral. In 1982, Federal Bankruptcy Court of New York decided that LombardWall’s repos were secured loans and repo securities were subject to automatic stay;
that is, creditors of Lombard-Wall could not take ownership of the repo securities and
sell them immediately. Until this event, the issue of whether repos are secured loans
and repo securities are subject to automatic stay was not so clear. In the aftermath of
Lombard-Wall’s bankruptcy, market participants favored the exception of repos from
the application of automatic stay, simply because automatic stay makes creditors
subject to the risk of fluctuations in the market value of the securities until the
bankruptcy court grant access to the securities. Finally in 1984, Congress announced
the Bankruptcy Amendments and Federal Judgeship Act of 1984, exempting repos
from the application of automatic stay.
Gorton (2009) argues that the repo market traditionally was confined to U.S. Treasury
securities, but in the last 25 years it has grown to accept a broad range of securitized
bonds as collateral. Asset classes that came to be eligible for repo included all manner
of securitized products, as well as tranches of structured products like collateral debt
obligations. The last significant change to the repo contracting conventions came in
2005, with Bankruptcy Abuse Prevention and Consumer Protection Act of 2005
(BAPCPA), which expanded the definition of repurchase agreements to include
mortgage loans, mortgage-related securities, and interest from mortgage loans or
mortgage-related securities (Acharya and Oncu, 2013) . This allowed exemption of
31
repo contracts backed by such securities from automatic stay and gave repos a
bankruptcy-remote status. According to Olson (2012), were it not for this legislation,
repos would likely not be the foundational transaction tool they are today because
being subject to the bankruptcy process would make them a far less sure form of
collateral.
4.5. BENEFITS ON MACRO AND MICRO LEVELS
On a macro level, collateral intermediation function of shadow banking is important
both for the whole financial system and for capital markets as it facilitates financial
lubrication and supports flow of credit from otherwise unavailable sources to where it
is needed. In micro level, collateral based transactions allow more efficient use of
financial assets which otherwise sit idle in institutions’ books. For example, a hedge
fund who buys some securities as an investment, can temporarily post these securities
to a dealer as a collateral, and attract additional funding to expand the investments of
its customers. By using collateral for their funding, these institutions can boost
leverage and also reduce cost of borrowing. Also collateral based transactions (most
commonly repos) act as a provider of insured deposit substitutes for large cash pools
like MMMFs. Such institutions engage in repo transactions as an alternative
investment since their cash holdings exceed the limits of deposit insurance that is
provided by the traditional banking system. These functions of collateral based
transactions have increased their popularity in recent years. Especially in the
aftermath of the financial crisis in 2008, institutions have become more risk-averse
and increasingly used collateral based transactions as it provides insurance-like claims
on the lender’s side and sustain availability of credits while reducing cost of funding
on the borrower’s side.
32
PART 5. TOPICS OF DISCUSSION
Previous parts of the paper presented an overview of the shadow banking system and
how market-based collateral intermediation functions within the shadow system. In
the following part, we will take a deeper look into the current issues in the market by
reviewing existing academic literature. While general shadow banking topics will be
touched upon, our main focus will be on its collateral intermediation function.
5.1. ROLE OF SHADOW BANKING IN THE 2007-2009 CRISIS
No any paper about shadow banking is complete without mentioning the 2007-2009
crisis. Because as Krugman (2009) mentioned, shadow banking is “the core of what
happened” in the crisis. In a nutshell, introduction of securitization of mortgage loans
started a new era which led to a credit boom and the U.S. housing bubble. Potential
home buyers with good credit history were able to get mortgage loans from banks
who pool, securitize and sell these loans to outside investors in the capital markets.
Due to competition and profit concerns, banks even started to provide mortgage loans
to buyers who had no or negative credit history (subprime mortgage market). Adrian
and Shin (2010) clearly summarizes this as “when all the good borrowers already
have a mortgage, the bank has to lower its lending standards to capture new
borrowers who were previously shut out of the credit market”.
Banks had little incentive for risk management as they were able to package and sell
these loans to third party investors through complex securitization mechanisms
involving SPVs, broker-dealers and rating agencies. These developments made
buying a house relatively much easier, and thus house prices skyrocketed. By the time
the mortgage securitization market became too big, mortgage-backed securities were
already a very common trading and collateral instrument in the capital markets.
Below figure represents the security issuance by U.S. non-government institutions. As
it can be observed below, asset backed securities (red) including subprime mortgage
backed securities had the highest portion of total securitization until the crisis.
33
Figure 14. U.S. Private Label Securitization Market, 2001-11
Source: Claessens et al, 2012. Shadow Banking: Economics and Policy
In 2006, deterioration of housing market started questions in the capital markets.
Because, at that time, a lot of institutional investors were holding mortgage backed
securities in their books. If house prices were to decrease, investors’ collateral would
also lose value. Moreover, many leveraged hedge funds and broker-dealers were
funding their transactions with short-term repos which were collateralized with these
asset backed securities. Repo lenders’ increasing concern about the downturn in
housing market led them to require more collateral for their repo transactions with
borrowers including Bear Stearns which failed to meet these margin calls and
collapsed in 2008. After Bear Stearns’ bankruptcy, Federal Reserve introduced
Primary Dealer Credit Facility (PDCF) which extends its lender of last resort support
to systemically important primary dealers. PDCF couldn’t prevent the run on Lehman
Brothers and its bankruptcy in late 2008. The shock in the housing market triggered a
systemic event in the capital markets. Following Lehman’s bankruptcy, almost all
capital markets including repo (even the ones collateralized with government bonds)
froze. Below figure, which compares the total assets of traditional banking with the
total assets of shadow banking, shows the growing weight of market-based credit
intermediation in the run up to the crisis. By the end of second quarter of 2007,
market-based assets were at least 14% larger than that of commercial banks.
34
Figure 15. Total Assets at 2007Q2
Source: Adrian T., Hyun Song S., 2010. The Changing Nature of Financial Intermediation and the
Financial Crisis of 2007-09
5.2. IMPORTANCE OF REPO MARKETS AND THE RUN ON REPO
Although there is no any official statistics available, unofficial guesses put the US
repo market at somewhere around $10 trillion which is close to the total assets of the
regulated US banking sector (see Gorton, 2009 - Hördahl and King, 2008). As
discussed previously, collateralized nature of repo makes it a very important tool for
the market participants. Although having been increasingly used until the crisis, it
became apparent that repos are susceptible to runs just like banks. Parallel to the event
log explained above, Gorton and Metrick (2010b) suggest that the panic of 2007-2008
was a run on the repo market. According to them, the location and size of subprime
risks held by counterparties in the repo market were not known and led to fear that
liquidity would dry up for collateral, in particular non-subprime related collateral.
According to Acharya and Oncu (2010) , if the underlying collateral is a mortgagebacked security and an economic downturn ensues, the risk of an already illiquid
market for MBSs get compounded; this is because many financial institutions’
portfolios are crowded with MBSs or have lost capital. In this scenario, repo lenders
run the risk of being forced to sell their collateral in illiquid markets. This forces the
price of the underlying collateral to further decrease and a complete market freeze can
arise, which happened during the crisis of 2007 to 2009. Gorton and Metrick (2009)
add that, in the current crisis repo depositors did not know which securitized banks
were most likely to fail (or whether the Fed would let them fail). More specifically,
the concern was not directly about the bank defaulting, because repo is collateralized,
but about being able to recover the collateral value when selling it in the market if the
bank did default. According to Acharya and Oncu (2010), unlike the liquidity risk that
unsecured financing may become unavailable to a firm (a risk largely specific to the
35
credit risk of the firm), liquidity risk that secured repo financing may become
unavailable to a firm is inherently a systemic risk, materializing in circumstances
where other financial firms are also experiencing stress and the markets for assets
held predominantly by the financial sector are rendered illiquid.
5.3. HAIRCUTS
Haircuts played an important role in the run up to the 2007-2009 crisis. Investors’
increasing concerns about the repo market (or the quality of underlying collateral they
received in repos) led to a jump in haircuts. Basically, repo lenders asked for more
collateral to rollover repos. According to Gorton and Metrick (2009), a haircut
addresses the risk that if the holder of the bond in repo, the depositor, has to sell a
bond in the market to get the cash bank, he may face a better informed trader resulting
in a loss (relative to the true value of the security). When everyone does this and the
haircuts are high enough, the securitized banking system cannot finance itself and is
forced to sell assets, driving down asset prices. The assets become informationsensitive; liquidity dries up. This is what exactly happened during the 2007-2009
crisis. Below is a figure of haircuts during the crisis period. Largest haircut jump
(especially in the subprime related market) happened in late 2008 with the collapse of
Lehman Brothers.
Figure 16. Repo Haircuts on Different Categories of Structured Products
Source: Acharya and Oncu, 2010. The Repurchase Agreement (Repo) Market
5.4. THE ROLE OF REHYPOTHECATION AND VELOCITY OF
COLLATERAL
In their 2010 paper, Singh and Aitken (2010) argue that the shadow banking system is
much bigger than previously documented due to the velocity of collateral in the form
of re-hypothecation.
36
Figure 17. Shadow Banking System in the U.S. (in billions of US dollars)
Source:
System
Singh and Aitken, 2010. The (sizable) Role of Rehypothecation in the Shadow Banking
As described in previous sections, rehypothecation occurs when the collateral
received is repledged in another transaction. Most commonly, hedge funds are the
main supplier of collateral. They pledge collateral to their prime brokers in exchange
for cash borrowing. Where allowed and agreed, prime brokers re-pledge received
collateral to third parties in their own funding transactions. Suppose that a hedge fund
pledged 1 mn $ worth of securities to its prime broker. And then prime broker used it
as a collateral in an inter-dealer repo transaction with another broker, who further
used the same collateral with a repo transaction with a money market fund. In this
simple example, with 1 mn $ of collateral, market players created 3 mn $ of credit
(also risk).
Singh (2011) estimated that the velocity of collateral in 2007 and 2010 are 3 and 2.4
times respectively. This basically means that from each dollar of collateral, shadow
system was able to create 2.4 dollars of credit by re-pledging the same collateral in
chains. He explains the decrease from 3 to 2.4 with “fewer steps” that a collateral
takes to reach from the primary source to the ultimate client. According to Singh, this
results from reduced supply of collateral from the primary source clients due to
counterparty risk of the dealers, and the demand for higher quality collateral by the
ultimate clients.
5.5. COLLATERAL SCARCITY
Many research and academic paper argue that <inancial collateral is a scarce resource and supply of collateral is not able to meet the demand coming from 37
capital markets5. Gorton et al (2012) have found that although the total amount of
assets in USA have grew from approximately four times GDP in 1952 to more than
ten times GDP at the end of 2010, the percentage of “safe” assets (U.S. government
debt and the safe component of private financial debt) has remained stable (close to
33%) in every year since 1952. They also documented that the demand for safe or
information-insensitive debt exceeds the supply of U.S. Treasuries outstanding. Thus,
near-riskless debt issued by the private financial sector plays an important role in
facilitating collateralized transactions.
Figure 18. The Safe-Asset Share (High Estimate)
Source: Gorton et al, 2012. The Safe-Asset Share.
Singh (2013) documented that the pledged collateral market shrinked from $10
trillion prior to Lehman crisis (end-2007) to about $6 trillion (end-2011). According
to him, the factors that are driving the collateral dynamics in the near-term are: (i)
central banks that remove good collateral from markets to their balance sheet where it
is silo-ed; (ii) regulatory demands stemming from Basel III, Dodd Frank, EMIR etc
that will entail building collateral buffers at banks, CCPs etc; (iii) collateral
custodians who are striving to connect with the central security depositories (CSDs)
to release collateral from silos; and (iv) net debt issuance from AAA/AA rated issuers.
5.6. OTHER ISSUES
5.6.1. ABCP Conduits and Securitization Without Risk Transfer
Acharya et al (2012) argue that ABCP conduits were a form of securitization without
risk transfer and outside investors who purchased ABCP very often suffered no losses
5
For further information on the topic, please check: “Credit Suisse (2012) When Collateral is King”
and “Singh and Aitken (2009) Counterparty Risk, Impact on Collateral Flows, and Role for Central
Counterparties”.
38
even when collateral backing the conduits deteriorated in quality. Traditionally,
securitization allows banks to transfer financial risks to outside investors. This is done
through bank sponsored ABCP conduits who purchase long term assets of banks and
finance them with short term commercial paper which are sold to investors. Conduits
are an important part of the shadow system. According to Acharya et al (2012) ,
ABCP outstanding grew from $650 billion in January 2004 to $1.3 trillion in July
2007. At that time, ABCP was the largest money market instrument in the United
States, compared to the second largest which was Treasury bills with about $940
billion outstanding. Transforming loan pools to ABCP allows banks to disperse the
risk and move the assets off-balance sheet. However, especially during the period
leading up to the financial crisis, banks have used some specific securitization
methods, which allowed retaining the risk on the balance sheet while reducing
regulatory capital. Banks’ main motivation of doing that was to provide investors a
safety net for the continuation of the securitization business while maintaining
reduction in regulatory capital. Since central banks and regulators don’t provide
public guarantee to the shadow system, in a stressed market, banks invented their own
guarantee. These guarantees were some sort of commitment to investors to repurchase
the ABCP at par in the event that it can’t be rolled over. So, although banks benefit
from the reduction of regulatory capital by securitizing assets, they retained exposure
to the “off-balance sheet” conduits and remained exposed to the rollover risk inherent
in ABCPs. According to Adrian (2011), from a regulatory point of view, the problem
with the off balance sheet funding via ABCP was that discount window and deposit
insurance guarantees were extended indirectly and sometimes implicitly via the
liquidity line to the conduit.
5.6.2. Asset Encumbrance
Collateralized transactions are a form of secured funding. Banks also use their assets
as collateral in various forms of secured funding transactions. This results in those
assets being encumbered6, meaning that, they become unavailable for unsecured
creditors in the event of a bank’s default. Especially, the involvement of haircuts (or
overcollateralization) makes the situation worse for the unsecured creditors. Because
haircut given to a secured creditor decreases the portion of assets that might be
available for unsecured creditors in the event of a default. Below figure demonstrates
the encumbrance of bank assets. Figure in the left is a balance sheet of a bank whose
assets are not used as collateral. If the bank bankrupts, all unsecured lenders can claim
a portion of banks’ assets to cover the funding that they provided to the bank. Since
the value of bank’s assets and liabilities should be equal, all unsecured lenders would
6 For
an extensive review about asset encumbrance, please check Bank for International Settlements’
May 2013 paper called “Asset Encumbrance, Financial Reform and the Demand for Collateral Assets”.
39
very likely to receive sufficient amount of assets to cover and close their loans. The
figure in the right side demonstrates what happens to the balance sheet of the bank if
it posts some of its assets (loans/cash flows/claims) as a collateral in a secured
transaction. The secured party who gets collateral and provides funding is likely to get
some haircut, which means that the value of collateral will be higher than the funding.
In case of a bankruptcy, secured lender will get its collateral (plus haircut) and cover
its loan. However, unsecured lenders will be left with the remaining assets which are
less than the amount of unsecured funding. So, unsecured lenders would most likely
to be unable to cover their claims.
Figure 19. Illustration of Asset Encumbrance
Houben and Slingenberg (2013) argues that asset encumbrance may have unfavorable
impacts on the financial system such as increasing procyclicality, less access to
unsecured funding and less monitoring of banks.
5.6.3. Key Frictions in the Securitization Market
Ashcraft and Schuerman (2008) studied important informational frictions that exist in
the securitization transactions such as predatory lending, predatory borrowing,
adverse selection and moral hazard. Predatory lending is a friction between the
borrower and the originator. Many products offered to borrowers are very complex
and subject to mis-understanding and/or mis-representation. Even if these products
are known, the borrower might be unable to make a choice between different options
that is in his own best interest. Predatory borrowing is an information friction
between the originator and the arranger. Originator has an information advantage over
the arranger with regard to the quality of the borrowers. Without safeguards in place,
originators can have the incentive to collaborate with a borrower and make significant
misrepresentations on the loan application. Adverse selection refers to the asymmetric
information problem between the arranger and third-parties (for example asset
managers who buy securities). Arranger has more information about the quality of
underlying assets than third-parties have and this creates an adverse selection
problem. In particular, the arranger can securitize bad loans and keep the good ones.
40
The information advantage of of the arranger creates a standard lemons problem.
Another friction is between the asset manager and the investor (principal-agent).
Investors provide funding for the securitization but they are typically not financially
sophisticated enough to conduct an investment strategy or due diligence. This services
are provided by asset managers who may not give sufficient effort on behalf of the
investors. Finally, another very important friction is model error which takes place
between the investor and the credit rating agencies. Credit rating agencies are paid by
the arranger and not investors which creates a potential conflict of interest. Their
rating decisions come from models which may be too sophisticated for investors to
understand and may contain honest or dishonest errors.
5.7. CONCLUDING REMARKS
Shadow banking system has been playing a key role in global finance in the last 30
years. It emerged as a response to bank competition, regulatory changes and
increasing demand for safe assets. To address these challenges, shadow system
resembles traditional banking in such a unique way that key banking functions of
credit, maturity and liquidity transformation are performed in a complex chain of
transactions in various balance sheets rather a single bank balance sheet. Each step in
the chain is performed by different specialist institutions who don’t have access to
public sector guarantees. Although being outside the regulated banking system,
shadow banking has a number of economically useful functions which are not
available in traditional banking system. First, securitization provides banks the ability
to disperse the risks which traditionally used to be assumed only by banks before the
emergence of shadow system. Also, moving assets off balance sheet, banks gain
regulatory capital easing and ability to increase the supply of credit to ultimate
borrowers; households. Moreover, securitization services a new type of investment
instrument which was previously unavailable in the capital markets. Different
tranches of securities offer variety of risks and rewards to investors. Asset backed
nature of these securities provides institutional investors a secured substitute of
insurance deposits and government bonds. These securities are multi-purpose tools.
They are either used solely as an investment instrument, or as a collateral for other
transactions. Since these securities are backed by claims on diversified asset pools
which are rated according to tranches, most senior tranches are perceived as the
safest, money-like instruments. This feature allows market participants to use these
securities as collateral in different transactions. Hedge funds use securities as a
collateral for backing their cash funding or for borrowing other securities to cover
their short positions. Dealers use collateral for their inter-dealer repo transactions or
for securities lending transactions with cash pools. Pools of collateral, collected in
dealers, provide utilization of economies of scale and benefit both investors and
dealers in terms of cost of funding and revenues. Receiving collateral in repo and
41
securities lending transactions, cash pools like money market funds enjoy money-like,
secured and collateralised investments. High-rated safe appearance of triple-A-rated
securities created information-insensitivity which supported liquidity increase and
credit boom. They were indeed informationally-insensitive, but not riskless.
Unarguably, benefits of shadow banking come with costs. Latest global financial
crisis proved that shadow banking is prone to shocks. Markets may benefit from
creating information-insensitive assets during quiet periods. But a shock may force
market participants to start producing negative information about the securities/
collateral, which then may lead securities to become informationally-sensitive. And as
we experienced in the crisis, especially in the repo segment of the market,
informationally-sensitive assets are vulnerable to bank-like runs. In such stressed
market conditions, increase in haircuts may further deteriorate the functioning of the
market and create rollover failures and market freezes. On the other hand, liquidating
the collateral would more likely to drive down the asset prices. Absence of
government backstops further worsen the situation. Therefore, difference between
perceived safety and effective safety of the asset/collateral is very important. This
requires production of transparent information about the underlying asset pools which
is very costly for investors to acquire. Therefore, market participants should find new
ways to produce transparent information in order to satisfy investors and sustain
liquidity. Governments may also introduce reforms to motivate and support
production of more transparent information and data about the assets. Because
shadow banking and its collateral intermediation role is surely and will continue to be
a significant part of the modern finance.
42
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