Good definitions of shadow banking -- the ominously-titled corner of the financial system -- are hard to come by.
One of the more broader definitions used by the Financial Stability Board includes any vehicle that provides credit and leverage and which falls outside the realm of traditional regulated banking. That would mean anything from hedge funds and private equity to non-bank mortgage lenders. A more narrow definition suggest that shadow banks are entities engaged in particular types of financial activities or transformation. By this definition, the repo market, where banks and big investors essentially pawn their assets in exchange for short-term cash, was the biggest component of shadow banking. It was also ground zero for the 2008 financial crisis.
As big investors in the repo market fretted about the risk of lending to Lehman Brothers, even on a short-term secured basis, the firm found itself unable to fund itself and was soon on the brink of collapse. It was the equivalent of a good old-fashioned bank run, but one that took place in the hidden corners of the shadow banking system instead of on the streets of New York. Funding long-term assets with short-term loans, it turned out, could be tricky; the repo market was prone to sudden and violent withdrawals.
Since then, regulators have cracked down on the repo market and instituted new rules that require banks to hold more capital and cut back on riskier activities such as trading for their own books. While that has taken a lot of leverage out of the banking industry and arguably made the financial system much safer, it has also caused a few problems. Traders, investors and regulators now regularly warn that liquidity -- or the ability to buy and sell securities without severely impacting their prices -- has deteriorated in the bond market. At the same time, a host of new vehicles have stepped up to the plate to fill the hole left by retreating banks and a shrinking repo market.
Exchange-traded funds and mutual funds specializing in bonds and loans are two examples of such new vehicles. Just as the repo market performed its nifty trick of "maturity transformation" by using short-term financing to fund longer-term assets, these funds do a similar thing for liquidity by creating a liquid wrapper around illiquid assets. But, just like repo, they are prone to a similar risk and that is that one day, investors try to flee en masse.
Here's Jeffrey Meli, head of credit research at Barclays, making the point in a 27-page presentation published late yesterday.
The interesting thing here is that the funds themselves know this weakness.
Exchange-traded funds that track highly illiquid leveraged loans, for instance, retain big cash buffers to make up for potential outflows. Plenty of mutual funds have also been increasing their credit lines with banks in an effort to prep for possible outflows and redemptions, and Bloomberg's Sridhar Natarajan reports today that leveraged loan ETFs in Canada, of all places, are boosting their borrowing limits to help meet potential redemptions.
For more, read this QuickTake: Shadow Banking