Economics of Financial Regulation

Session 5: Regulatory Dialectics 辩证法

- Shadow Banking -
Prof. Jean-Edouard Colliard, HEC Paris
2023

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Introduction

Regulatory dialectics:
I Market failures ⇒ new regulations.
I Regulations ⇒ bypassing, or regulatory arbitrage.
旁路
I Arbitrage ⇒ new market failures.
I New market failures ⇒ new regulations

Two views of this process:

相交
I We converge to an equilibrium with efficient financial system
and regulation.
I Endless increase in unnecessary complexity and distortions.

Example: Shadow banking.

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Road map

1 Shadow banking

2 Regulatory Arbitrage

3 Crisis

4 Regulatory intervention

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Definition

Traditional banking: credit intermediation and maturity

transformation under one roof. Access to deposit insurance,
central bank liquidity. Licensed, regulated and supervised.
Shadow banking: same activity, no regulation, no DI.
Mechanism: split the banking process in specialized parts,
conducted by separate unregulated entities. Generates a complex
market with:
I Finance companies
I Structured investment vehicles (SIV)
I Money-market mutual funds (MMF)
I etc.

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A shadow banking chain

Borrowers

Cash Loans

Loans ABS CDO Repos

Special Special
Commercial Credit Money
Purpose Purpose
bank Hedge Fund Market Fund
Vehicle 1 Vehicle 2
Cash Cash Cash Cash

Cash Shares

Institutional
investors

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Origination and securitization

Firms or entities specialized in extending new loans (typically

mortgages, auto loans):
I Commercial banks, typically small subsidiaries of large BHCs.
I Independent “finance companies”.

The originator sells the loans to a Special Purpose Vehicle.

The SPV finances itself with asset-backed securities (ABS),
structured by broker-dealers and backed by the loans.
Other SPVs collect the ABS, which are repackaged as
Collateralized Debt Obligation (CDOs).

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Dissemination to investors
传播

CDOs are bought by Structured Investment Vehicles (SIVs) and

credit hedge funds.
SIVs / hedge funds borrow on the wholesale funding market via
repurchase agreements (repos).
Typical buyer = money market (mutual) fund (MMF).
Special type of fund investing in short-term debt (e.g.
overnight), hence “money market”. Only allowed to invest in
very safe assets, hence collateralized debt.
Final element in the chain: institutional investors or large
companies with a short-term surplus of cash invest in the MMF.

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To conclude

In the end: intermediation between long-term borrowers and

investors who can withdraw from an MMF at short notice.
Exactly what the bank does, but all the components of the
process are separated.
In principle, a good thing: allows specialization and
diversification. E.g. a small bank present in one region only can
get rid of local risk.
Entire “map” of shadow banking more complex: Pozsar et al.
(2010).

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The picture so far
SB = maturity transformation without DI, little regulation.
Many intermediaries linked by short-term collateralized debt.
Benefits: specialization, diversification.

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Map

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Zooming in

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Size and scope
Total “other financial intermediaries” assets worldwide: USD
100 trln in 2018 (FSB).
Narrow definition of shadow banking: 45 trln.
Particularly high in U.S., U.K., continental Europe. Growing in
other regions.

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Other example: China in the late 2000s
2008 government asks Big 4 Banks to lend massively.
Loans must be backed by 75% deposits
⇒ aggressive deposit collection.
Small banks cannot offer higher deposit rates (by regulation).
Instead, they issue more “wealth management products”:
I Trust company invests in risky loans, financed by WMPs with
high yield.
I WMPs marketed by banks to their customers (sometimes only
senior tranches), seen as an alternative to deposit account.
I About 10 trln yuan in 2014.
I No regulation, worries about fragility and some examples of
fraud and embezzlement.
See Acharya, Qian, Su, Yang (2020), as well as Acharya,
Khandwala and Oncu (2014) on India.
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From Acharya, Qian, Su, Yang (2020).

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Road map

1 Shadow banking

2 Regulatory Arbitrage

3 Crisis

4 Regulatory intervention

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Regulatory Arbitrage - MMFs

Regulation Q: ceiling on bank deposit rates, binding from 1965.

MMFs appear as unregulated substitutes: funds invest in safe
short-term assets and deliver market rate.
Seems as convenient, liquid and safe as a deposit account,
higher return.
Ceilings on interest rates typically generate regulatory arbitrage.
Very inefficient, but regulators’s goal is to reduce risk (see the
high rates in Cyprus before the bank-runs).
Drechsler, Savov, and Schnabl (2021) see Regulation Q as the
cause of US inflation over 1965-1980.

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Regulatory Arbitrage - Basel I

Basel I: same weight for all mortgages.

I Keep bad loans on balance sheet.
I Securitize and sell the good loans.

The bank is arbitraging between the market price of loans and

the marginal cost of capital ratios.

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Regulatory Arbitrage - Basel II
Basel II: finer risk weights.
Entirely avoid capital requirements as follows.
Create an SIV legally distinct from the bank, hence off-balance
sheet.
SIV buys the loans from the bank. Financed mostly with debt
(ABCP etc.).
Officially, the bank is not exposed to the loans. Downside risk
absorbed by the SIV’s creditors.
In practice, SIV “sponsored” by the bank with a credit line and a
guarantee (often unwritten).
Regulatory capital associated with credit line lower than for on
balance sheet loans, even though in some cases risk is the same.
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Example

Shadow banking and capital regulation arbitrage.

[See Exercises Sheet #6]

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The picture so far
SB = maturity transformation without DI, little regulation.
Many intermediaries linked by short-term collateralized debt.
Benefits: specialization, diversification.
Also a way to bypass regulation for investors and banks.

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Road map

1 Shadow banking

2 Regulatory Arbitrage

3 Crisis

4 Regulatory intervention

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Moral hazard 危险

Securitization ⇒ the firm checking the quality of the loan

applicant does not keep the loan on its balance sheet.
Issue bad loans and sell them at a high price to an intermediary,
who sells to another one and so on.
The agents bearing the risk are very remote from the decision
⇒ moral hazard.
Difficult to prove empirically: not enough to compare the default
rates of securitized and non-securitized loans.
Keys, Mukherjee, Seru, Vig (2008): use the fact that loans with
a FICO score above 620 are easier to securitize.

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Keys, Mukherjee, Seru, Vig (2008)

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The picture so far
SB = maturity transformation without DI, little regulation.
Many intermediaries linked by short-term collateralized debt.
Benefits: specialization, diversification.
Also a way to bypass regulation for investors and banks.
Underlying assets less good than expected due to moral hazard.

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Run on hedge funds

June 20, 2007: two hedge funds owned by Bear Sterns collapse.
Hedge funds with leverage of 10, invested in CDOs used as
collateral in repos.
2007: deterioration of the subprime market, creditors require
higher haircuts. 恶化 次级

Funds cannot meet higher constraints, Merrill Lynch seizes USD

850 mln of CDOs and auctions them.
Buyers found for only 100 mln. Illiquidity of CDOs apparent
⇒ other repos are not rolled-over.
Run on the repo market.

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Contagion

General distrust of repos with subprime related collateral.

August 2007: run on the SIVs of BNP Paribas, funded by ABCP
backed by subprime products.
赎回
BNPP announces suspension of redemptions on August 9.
General freeze of the ABCP market: −75% volume from 2006q3
to 2010q3 (Krishnamurthy, Nagel and Orlov, 2012).
Contagion to all short-term debt market.

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The picture so far
SB = maturity transformation without DI, little regulation.
Many intermediaries linked by short-term collateralized debt.
Benefits: specialization, diversification.
Also a way to bypass regulation for investors and banks.
Underlying assets less good than expected due to moral hazard.
Doubts on collateral quality triggered run on repo in 2007.
附带的

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Runs on MMFs
Reserve Primary Fund: one of the largest MMFs, USD 65 bln in
AUM.
Market learns that RPF holds 785 mln of Lehman’s commercial
paper, just after Lehman’s failure.
Immediate run on the fund on 16 September 2008: 10.8 bln
redemptions, additional 28 bln withdrawal requests.
Within a week, 172 bln withdrawn from all MMFs (Kacperczyk
and Schnabl, 2011).
Surviving MMFs reduce commercial paper holdings from 24% to
17% in one month, substitute with government debt.
Conclusion: shadow banks have short-term liabilities and
long-term assets, but no deposit insurance. A run on the shadow
banking sector was a matter of time.
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The picture so far
SB = maturity transformation without DI, little regulation.
Many intermediaries linked by short-term collateralized debt.
Benefits: specialization, diversification.
Also a way to bypass regulation for investors and banks.
Underlying assets less good than expected due to moral hazard.
Doubts on collateral quality triggered run on repo in 2007.
Run generalized to entire financial system in 2008.

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Diamond and Kashyap (2015)

Modern bank runs occur in shadow banks.

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Road map

1 Shadow banking

2 Regulatory Arbitrage

3 Crisis

4 Regulatory intervention

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Bail-outs
2008: temporary deposit insurance extended by the US Treasury
on MMFs.
Liquidity injection to help banks buy ABCP from MMFs.
Troubled Asset Relief Program: puts 700 bln on the table to buy
or guarantee toxic assets based on mortgages and subprimes.
Then reduced to 450 bln.
Idea: take out the worst assets from the market, so that the
collateral pool is safer.
Successful policy to stop a huge bank run, but:
I That this was a run and not fundamental crash was unclear ex
ante.
I Increase of moral hazard: even the shadow-banking sector will
be bailed-out.
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The picture so far
SB = maturity transformation without DI, little regulation.
Many intermediaries linked by short-term collateralized debt.
Benefits: specialization, diversification.
Also a way to bypass regulation for investors and banks.
Underlying assets less good than expected due to moral hazard.
Doubts on collateral quality triggered run on repo in 2007.
Run generalized to entire financial system in 2008.
Short-term solution: massive bail-outs.

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MMFs

New regulation issued by SEC in March 2010:

I 30% of MMF assets must be liquid.
I Max 3% invested in second tier securities.
I Monthly disclosure of exposures.
I Periodic stress-tests.

Problem: now unofficial government guarantee, less market

discipline but weak regulation.

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Origination

Dodd-Frank Act, 2010.

5% of the loans must be retained by the issuer.
Amount and form of retention must be disclosed to the market.
保留
Idea: avoid incentives for lax screening.
不严谨的
Furfine (2018) shows significant risk reduction (for the 40% of
the market that is not exempted).
被免除的

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Closing regulatory arbitrage

SPVs/SIVs consolidated with the bank if there is a guarantee

(Dodd-Frank, Financial Accounting Standards, Basel III).
Precise rules on when such vehicles can be kept off balance
sheet.
These structures are still used, but not for regulatory arbitrage
reasons (it seems).

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The picture so far
SB = maturity transformation without DI, little regulation.
Many intermediaries linked by short-term collateralized debt.
Benefits: specialization, diversification.
Also a way to bypass regulation for investors and banks.
Underlying assets less good than expected due to moral hazard.
Doubts on collateral quality triggered run on repo in 2007.
Run generalized to entire financial system in 2008.
Short-term solution: massive bail-outs.
Long-term solution: more regulation of shadow banking.
Closure of regulatory loopholes leading to arbitrage.
漏洞

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New regulations on banks
彻底检修
Post-crisis overhaul of bank regulation moved more business to
the shadow banking sector.
Buchak, Matvos, Piskorski, Seru (2017):
I Market share of shadow banks in new mortgage originations
doubles from 25% in 2007 to 50% in 2015.
I Effect 70% due to regulations on banks, 30% to new
technologies.

However, today’s shadow banking system seems less prone to

runs (e.g., credit funds).
General decrease in maturity transformation. Socially costly?

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Adrian (2017)

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Take-away points
SB = maturity transformation without DI, little regulation.
Many intermediaries linked by short-term collateralized debt.
Benefits: specialization, diversification.
Also a way to bypass regulation for investors and banks.
Underlying assets less good than expected due to moral hazard.
Doubts on collateral quality triggered run on repo in 2007.
Run generalized to all short term debt markets in 2008.
Short-term solution: massive bail-outs.
Long-term solution: more regulation of shadow banking.
Closure of regulatory loopholes leading to arbitrage.
Today: part of the financial system with low maturity
transformation, complementary to banks.
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 Thank you!

Suggested additional readings:

Adrian and Ashcraft (2012).
Gorton and Metrick (2012).
Acharya, Cooley, Richardson, and Walter (2011). Part III.

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