Liabilities of shadow banks, or institutions without access to central bank loans or permanent federal guarantees, still exceed the traditional banking system’s three years after the financial crisis began, according to a report from the Federal Reserve Bank of New York.
The shadow banking system had about $16 trillion of obligations in the first quarter, compared with $13 trillion for banks, the report said. The gap has narrowed from 2008, when obligations were $20 trillion and $11 trillion, respectively.
The U.S. had to lend, spend or guarantee $11.6 trillion to bolster financial markets and fight the longest recession in 70 years, according to data compiled by Bloomberg as of last September. That included agreeing to backstop obligations such as asset-backed commercial paper, collateralized debt obligations and money market funds that helped finance home mortgages, credit card borrowing and auto loans.
“The shadow banking system was temporarily brought into the ‘daylight’ of public liquidity and liability insurance -- like traditional banks -- but was then pushed back into the shadows,” Fed researchers including Zoltan Pozsar and Tobias Adrian wrote in the report issued earlier this month.
Given the size of this parallel banking system and its vulnerability to further panics, “it is imperative for policy makers to assess whether shadow banks should have access to official backstops permanently, or be regulated out of existence,” the researchers wrote.
The report is being released in stages for comment and is intended to aid regulators and policymakers in considering how much oversight is required for financial markets.
Shadow banking, which converted risky assets such as subprime mortgages into seemingly risk-free, short-term securities, began to break down in August 2007, requiring a near-complete government backstop, the Fed researchers wrote. This included measures to prop up American International Group Inc. and funding for investors to buy asset-backed securities such as bonds backed by car-loan payments.
“Their most powerful observation is that such protection had to be provided ex post, in order to prevent Depression 2.0,” said Paul McCulley, a managing director at bond fund manager Pacific Investment Management Co., in an e-mail. McCulley coined the term shadow banking in 2007 to describe the web of financing sources outside the traditional network of deposit-taking banks.
The transformation of high-risk, 30-year mortgages into AAA rated securities held by money market funds involved multiple transactions along an interconnected chain as shadow banks were highly specialized, according to the report. The typical transformation required seven steps, the report said.
“Over the past decade, the shadow banking system provided sources of inexpensive funding for credit by converting opaque, risky, long-term assets into money-like and seemingly riskless short-term securities,” according to the report’s authors, who also included Adam Ashcraft and Hayley Boesky.
The shadow banking system also helped to finance a significant part of the U.S. current account deficit by creating trillions of dollars of top-rated securities that were purchased by foreign investors, according to the researchers.
Traditional banks are shielded from bank runs by access to loans at the Federal Reserve and through the Federal Deposit Insurance Corp.’s protection of deposits.
Before the crisis, the shadow banking system was protected by promises from banks to be buyers of last resort if investors couldn’t sell their securities, and by companies such as bond insurer Ambac Financial Group Inc. and AIG Financial Products to cover credit losses in loan pools. That allowed the securities to get AAA ratings, considered risk-free to many investors.
“Once private-sector put providers’ solvency was questioned, even if solvency in some cases was perfectly satisfactory, confidence in the liquidity and credit puts that underpinned the stability of the shadow banking system vanished, triggering a run,” according to the report.
“It’s an interesting historical document, but if anything it’s a great illustration of what the Fed did wrong,” said Christopher Whalen, managing director at Institutional Risk Analytics. The Fed, along with the Securities and Exchange Commission, allowed banks to create virtually unlimited securities via shadow banking, he said.
Rule changes by the Financial Accounting Standards Board and the SEC are requiring banks to bring many of these obligations onto their own balance sheets. As that happens, the shadow banking system will disappear, according to Whalen.
“The report is a reminder that we’ve taken trillions of dollars of financing out of the economy,” said Whalen. “It’s going to run off in four to five years and it’s not being replaced.”
A diagram detailing the entities that make up the shadow banking system requires enlargement to read.
“We recommend printing the accompanying map of the shadow banking system as a 36” by 48” poster,” the report said.
“When you look at the confused mess of transactions on the map, you have to ask how this was allowed to exist in the first place,” Whalen said.