The economic costs of imposing bank regulations on “shadow

banking”By

Paul KupiecAmerican Enterprise Institute

May 6, 2014

The opinions in this presentation are those of the author and do not necessarily represent the opinions of the American Enterprise Institute.

What is Shadow banking?• Those seeking to impose bank regulation on “shadow banking” have

never clearly defined what they identify as shadow banking• Financial Stability Board, September 2013

• “…non-bank credit intermediation for short.”• “…the capacity for (some) non-bank entities and transactions to operate on a large scale in

ways that create bank-like risks to financial stability (long-term credit extension based on short- term funding and leverage). Such risk creation may take place at an entity level but it can also form part of a complex chain of transactions, in which leverage and maturity transformation occur in stages, and in ways that create multiple forms of feedback into the regular banking system.”

• This is broad; it could cover almost anything….

Artic Trucks (AT) purchases 4-wheel drive trucks and modifies them for Artic conditions. For argument’s sake, let’s assume AT borrows (leverage) by issuing commercial paper (shadow banking, short-term debt) and builds trucks and inventory. The trucks last many years (maturity transformation).

If the economy unexpectedly freezes (ha!), customers stop buying trucks and other things in Iceland. AT cannot roll over its CP and unexpectedly defaults. Investors default as a “wake-up call” and avoid all new CP issues. Icelandic firms using CP must draw on their bank lines of credit, impacting all Iceland banks liquidity when they are also facing market liquidity pressures as investors reassess the banks’ risks from the unanticipated recession.

To recap, the story is that leverage and maturity transformation outside of the banking system creates negative feedback and stress for the Icelandic banking system...

Bank regulators argue that corporate leverage and maturity transformation in the “shadow banking” sector creates risk for the banking sector, and we need additional regulations to prevent it.

Let’s take a closer look at these issues and also focus of the cost of regulations that would fix the “problem”.

Concrete example of “systemic risk” created by shadow banking

Bank Regulators’ Solution• Solution: Limit Artic Trucks and other firms’ ability to use CP (shadow

banking) which will push the firms to borrow from the banks instead.• Issues with this “solution”• Artic Trucks borrows less & make smaller investments, limiting economic

growth• Forcing AT and all other firms to borrow from banks pools all the economy’s

risk in the banking system• “Bank solution” only works if banks anticipate the coming recession and force Artic

Trucks and other borrowers to reduce borrowing (& inventory) in anticipation of the recession

Do Bankers Impose Timely Market Discipline?• Are bankers (or their regulators) better at disciplining borrowers? • Open issue

• Banks are protected from deposit runs by deposit insurance & other government backstops that are designed to make banks less likely to shut down customer credit lines in a timely fashion• Bankers may be reluctant to shut off short-term credit because they loose other sources of

revenue from the firm (transactions fees, advisory…)• It is also possible that bankers have client relationship information that may enable them

to nurse firms through recessions where as shadow banking markets might cut off credit• It is unclear whether the real economic costs of the recession (building too many artic

trucks and other products no longer in demand) would be better controlled by requiring firms to finance with bank loans instead of through the shadow banking markets

• Real economic losses could well be bigger if all finance is bank finance• Regardless, all the losses will be in the banking system

Bank regulator’s solution will raise credit costs• “Shadow banking” arises because it is cheaper than bank finance

• Markets favor efficient (cheapest) solutions• When investor access to firm information reaches a threshold, most firms migrate, at least

partially, from bank-sourced finance to market-based sources of funding• Bank credit includes the cost and restrictions of bank safety and soundness

regulations• Regulators argue that the “shadow bank financing solution” only appears cheaper

to issuing firms because externalities are not priced in when these unregulated markets extend credit or engage in maturity transformation

• Externalities include of potential “fire sales” and “negative liquidity” spirals when markets or institutions are allowed to create “excess liquidity” and “excess leverage”

• In a moment, I will build a case that the systemic risk in banking and shadow banking financial intermediation are basically the same• When banks have guarantees and government support, the losses from systemic events will

be distributed differently with bank finance, but the losses are the same

Are bank regulations able to control “excess” credit & liquidity?

• Identifying the problem as “excess credit” and “excess liquidity” created by the shadow banking system creates a misleading narrative• Creates the impression that regulators can separate credit and liquidity into

“necessary & appropriate” from “excess” credit and liquidity before a crisis happens…

• Nothing could be farther from the truth…• Before the financial crisis, bank regulators from G-10 countries embraced

securitization and credit risk transfer (both “shadow banking” activities) as beneficial...• They concluded that they reduced risk in the banking system by transferring credit risk to

the investors that best understood it and could best manage it • “Credit Risk Transfer”, Committee on Global Financial System, Publications No. 20, January 2003

Credit + Maturity Transformation = Money

• When economic agents are able to sell long-term (interest paying) debt, and investors have confidence that the terms will be honored at maturity regardless of who owns the paper, the debt can be traded among investors and can function as “money”• This is so-called “inside money,” because it is created by the private sector

without government involvement• A systemic risk event destroys inside money in the shadow banking system,

and in banks, and central banks have to scramble to replace it to prevent economic activity from collapsing

• I am going to develop a Simple model with no math which will show the economic value of maturity transformation, and show that maturity transformation can occur equally well using banks, or using securities in the “shadow banking” sector• I will introduce a systemic risk into this economy and show that

systemic risk has an identical effect on the economy, regardless of whether maturity transformation takes place through shadow banking, or in the banking system.• This model will also give us a concrete idea of how to control systemic

risk and the costs that will be involved in doing so.

Resources Misaligned with Consumption Preferences

Timeline for apple ripening….

1 2 3

Type I : apples ripen date 3 preferred apple consumption date 1Type II : apples ripen date 1 preferred apple consumption date 2

Type III : apples ripen date 2 preferred apple consumption date 3

time

Type II Type III Type I

Three different agents: each owns 1 unit of fiat money they hold to pay a tax in period 3, and an apple tree that bears apples. The apple trees are identical except they produce apples at different times

Contracting Allows Apples to be Consumed at the Best Time

Apple ripening schedule

1 2 3

Apple consumption profile is optimal after contracts are honored

1 2 3

Type I : preferred apple consumption date 1Type II : preferred apple consumption date 2Type III : preferred apple consumption date 3

time

time

Type II Type III Type I

Type IIIType I Type II

If each agent can write contracts to trade apples, and the contracts are credible & enforceable ….

Type I agent writes contract to receive Type II’s apples at time 1 in exchange for Type I’s apples at date 3.

Type II agent trades contract for time 3 apples with Type III agent in exchange for date 2 apples.

But what if some contracts are not credible?• If Type II agent’s contract to swap apples across time is not credible—the bilateral

contracting solution falls apart and apples cannot be traded across dates• Agents must consume their own apples when they ripen• Welfare in this economy falls dramatically because agents must eat apples on dates when they

would prefer not to the apples

• But all is not necessarily lost….• Suppose Type I can write a credible contract to exchange date 3 apples for Type II’s apples at

time 1• Type II does not need credibility to enter into inter temporal contract; Type II executes a spot transaction---

delivers apples immediately in exchange for Type I apple bond• Type I issues long-term debt

• So long as all believe that Type I will honor the terms of the debt contract no matter who presents it for payment at date 3, the “first best” solution can be achieved even though some agents cannot enter into credible contracts to trade apples across time

Contracting Allows Real Goods to be Traded Across Time

Apple production

1 2 3

Apple consumption after contracts are honored

1 2 3

time

time

Type II Type III Type I

Type IIIType I Type II

Type II agent buys Type I agent’s long-term “apple” bond only because it wants to resell it----Type II does not want Type I’s date 3 apple bond payoff.

Bond functions as “inside money”---a medium of inter temporal exchange

Type I agent issues long-term bond pays apples at time 3 .Type II agent buys the apple bond in exchange for apples at time 1.

Type II agent holds on to the bond until time 2

At date 2, Type II sells apple bond to Type III agent in a spot transaction for apples at time 2.

At date 3, Type III eats apples from Type I apple bond

Shadow Banking Maturity Transformation• The ability of one agent to issue a credible long-term (apple) bond

allows others, who do not have the credibility to issue their own debt contracts, to successfully trade apples harvested at different dates to reach the best consumption profile for the economy• The long-term (apple) bond is traded to facilitate the reallocation of ripening

apples across time• Maturity transformation

• Agent II buys the bond to re-sell it, not to hold it

• Might look like “excess” liquidity or trading to a bank regulator, but the trading serves an important economic purpose

Systemic Risk in Shadow Banking• Consider the effect of a rumor at date 2 that there is an apple tree

blight that may reduce the time 3 harvest• Type I’s (apple) long-bond may not payoff as promised• If blight is severe, Type II, who owns the bond, cannot sell it. Type III would

rather eat apples at time 2 than trust the bond payoff at date 3• Type I has already eaten apples at date 1.• Type II is stuck with no apples at date 2 and Type I’s bond that may default at

date 3, so Type II ends up with apple harvest (possibly reduced by blight) at the wrong date• Type III may have to eat his apples at date 2

Cash transactions can be used to share losses

• Type I has already eaten apples at date 1.• Type II is stuck with no apples at date 2 and Type I’s fallen-angel bond• Type III’s apples ripen at date 2• Maturity transformation using financial securities has broken down

• But agent’s can still use fiat money to trade in spot transactions• Type II could use cash to buy some date 2 apples from Type III and recover these balances at

date 3 (to pay taxes) by selling Type III apples at date 3.• Type III will not sell all of his time 2 apples for the cash, but will keep and eat some of them• Type II and III can negotiate a cash transactions at date 2 and date 3 to share the loss in apple output at date

3. • Type II and Type III will not get as many apples in their preferred consumption dates and Type III will end up

eating some of his apples at time 2.

• Still, economic well-being plummets when new information about the long-bond disrupts maturity transformation in the shadow banking system

Bank Intermediation• Agents deposit cash balances with bank; have right to withdraw at any date

• They have no need to withdraw until date 3 when they have to pay taxes.

• The bank can lend this money and manage bilateral loan contracts• Type I pledges time 3 apples to bank as collateral, bank lends fiat money to Type I.• Type I agent uses the money to buy date 1 apples from Type II.• Type II agent holds money balances until date 2 and uses it to buy date 2 apples from

Type III agent.• Type III agent holds money until date 3, and uses it to buy apples from Type I agent.• Type 1 agent uses apple sales proceeds to pay off the bank loan.

• Bank loan facilitates intertemporal trade (maturity transformation) instead of long-term bond sales. • No bond trading with bank intermediation….

Bank intermediation when rumor hits• All agents have deposits of 1 unit of fiat money in the bank and know that bank’s only

collateral is the loan secured by date 3 apple production, which is now of questionable quality because of the blight

• Agents try to withdraw deposits; bank has no fiat money to payoff deposits. The bank fails; Agents get ownership share in bank’s residual value---all share 1/3 of lost apple output.

• Type III agent has apples at date 2; Type II agent has fiat money. • All agents will need fiat money in date III to pay tax.• Cash will buy fewer apples in date 3 since production is smaller. • Type III and Type II will negotiate and Type III may sell Type II only some of the date 2 apples for cash

and Type III will eat the rest of his date 2 apples. • Type III uses all the cash to buy apples from the bank at date III.• How many apples get traded between Type II and Type III depends on the relative strength of their

preferences.

• End results is the same as with shadow bank intermediation.• Losses are shared by Type II and Type III investors

• Without government safety net (not modeled here—no one has a guarantee), bank and shadow bank intermediation produce the same outcome

How to control systemic risk?• In these examples, systemic risk is the risk of disruption of the maturity transformation

process• If the financial system breaks down, it reduces agents ability to trade resources (apples) between

periods• The financial system disruption causes a large loss in consumer well-being because consumers can

no longer trade for and consume the goods they most desire

• The only way to limit systemic risk (the risk of maturity transformation breakdown) without utilizing a government safety net is to limit long-term borrowing so that there is no risk that the long-dated loan will default• Regulators will have to estimate the worst possible date 3 apple harvest, and limit long-term debt

to less than that amount.• Investors must believe this limited amount of debt will be fully repaid

• There are no government safety nets in this model, and without using a government guarantee (the government bears part of any loss) , there is no other way to reduce systemic risk but to lower the borrowing limit

Regulation to control systemic risk• Firms required to limit leverage --long-term bond issuance

• EG: Type 1 agent can only pledge 50 percent of the expected date 3 apple harvest as collateral for long-term bond or bank loan• So long as random developments (blight) do not reduce harvest by more than 50 percent

(from expected normal harvest), the bond or bank loan will perform• Intermediation will not be disrupted

• But the cost of reducing systemic risk is LESS maturity transformation• All of the agents will be forced to consume half of their harvest at the wrong date!• Overall economic welfare will be much lower all of the time, not just on rare dates when

shock disrupts maturity transformation• So systemic risk regulation permanently lowers consumers’ level of satisfaction to

prevent an infrequent occurrence of lower satisfaction when a systemic risk event disrupts intermediation

Regulations will Limit Economic Growth• While the example deals with maturity transformation in a model of

consumption alone, if the model included investment and production:• a systemic shock would disrupt maturity transformation which would keep

firms from being able to borrow to invest• Output/economic growth would drop

• Systemic risk can be controlled by limiting firms’ borrowings, but this will permanently lower firm investment and economic growth

What level of leverage is too much?• Are bank regulators’ judgments about the acceptable level of

corporate leverage better or more accurate than investors’ assessment?• Maturity Transformation in the shadow banking system relies on investors’

ability to continue trading a high-quality bond whose market value is insensitive to most new information• Investors will avoid using debt instruments with high price volatility for

maturity transformation because they face the risk that they cannot resell a bond they are holding only because it is a temporary store of value• Are bankers or bank regulators going to be any better than market investors

at selecting the firms that get to issue long-term debt?