Shadow Banking

The Rise, Risks, and Rewards of Non-Bank Financial Services

Roy J. Girasa

• Publisher: Palgrave Macmillan
• Year: 2016
• ISBN:
  9783319330266
• Topic: Betriebswirtschaft
• Subtopic: Finanzdienstleistungen

This comparative study explores how shadow banking differs from the traditional banking system. It discussesthe origins, history, purposes, risks, regulatory constraints, and projected future evolution of both financial sectors of the world economy. This thorough examination of non-bank financial intermediaries follows the migration of services from traditional banks to less-regulated alternative banking products, as well as the evolution of regulations and the Financial Stability Oversight Council to monitor these new entities. Three chapters explore in depth the major financial structures newly designated assystemically important financial institutions (SIFIs), with particular attention to insurance companies such as MetLife, which seek exemption from the designation. Finally, the focus shifts to international financial institutions' efforts to protect consumers and curtail irresponsible shadow banks, with an eye toward the effects of these actions on future banking practices.

© The Author(s) 2016

Roy J. GirasaShadow Banking10.1007/978-3-319-33026-6_1

Begin Abstract

1. Traditional Banking in the United States and Its Evolution as Bank Holding Companies

Roy Girasa¹

(1)

Lubin School of Business, Pace University, Pleasantville, New York, USA

End Abstract

1.1 Traditional Banking

There are essentially three methods by which individuals, businesses, other entities, and even governments who require financial support for household goods, mortgage loans, business loans, and innumerable other purposes may secure funds: (1) direct lending from one person to another, (2) “traditional banking,” and (3) “non-bank” or “shadow bank” financing. The simplest method of lending is by a direct loan of money given by one person to another, which typically occurs between individuals who are related to one another without the use of a third party (Fig. 1.1). The second method, whereby money is lent to borrowers, is traditional banking. By traditional banking we refer to the process known as financial intermediation whereby depositors place their money into a checking or savings account in a bank, which then acts as an intermediary between the depositors and borrowers to whom the bank lends the money deposited at a predetermined interest rate. The money deposited generally does not earn interest for the depositors if placed in a checking account, but may receive interest if placed in other accounts such as a savings account, certificate of deposit, or other interest-bearing accounts (Fig. 1.2). The third method is shadow bank financing (non-bank financing), which is the focus of this text.

Fig. 1.1

Simplest form of financing

Fig. 1.2

Traditional banking

Traditional banking depositors are legal persons who may be individuals living in households, partnerships, corporations, or other legally recognizable entities. Borrowers may consist of similar persons, ranging from individuals requiring automobile loans or mortgage loans for the purchase of homes to businesses needing money to further their interests. Of course, borrowing and lending may be accomplished under the first method without the third party intermediary by direct lending from the lender to the borrower; this often takes place between relatives or friends and even between anxious sellers of homes and buyers who are unable to obtain mortgage financing from mortgage lenders, usually in times of financial distress.

Traditional banking, as stated in the historical evolution discussed hereafter, has evolved well beyond ordinary lending to households and businesses to a third method of financing, whereby banks act as financial intermediaries accomplishing maturity and credit transformation, often using the vehicle of bank holding companies. The rise of shadow banking was due to a number of circumstances, the most important of which was to avoid significant governmental regulation (regulatory arbitrage). Through subsidiary entities, banks may engage in diverse investments from insurance to securities, repurchasing agreements, and other financial transformations.

Banks were once divided into commercial banks, which accomplished what was discussed above, and investment banks, which were engaged in providing financial capital for business entities by acting as underwriters, as agents in the securities market, and in other related activities. The larger banks later expanded to interstate banking and, thereafter, became international in scope, providing means for global payments and credits and engaging in a complex relationship with other local, national, and international banks. Central banks, such as the US FED, play a major role in monetary policy, keeping inflation and deflation under control, adding liquidity to the banking system when needed, and fostering well-being in the overall economy in a number of other ways.

1.2 Role and Types of Transformation of the Financial System

1.2.1 Role

The role of the financial system is to serve the economic well-being of business entities and their consumers. It does so by the performance of a variety of functions, namely financial intermediation whereby lenders, such as individual, corporate, or government investors, provide the funds that are ultimately utilized by businesses and individuals in the form of business loans to operate or expand enterprises and consumer loans, including home mortgages and automobile loans; risk transformation and insurance to protect against devastating losses; organization of the payment system; provision for payment and transaction services that permit consumers to make purchases through a variety of means such as automated teller machines (ATMs), checks, credit cards, and other such means; and the creation of markets that permits trade and pricing of financial instruments and their risks. ¹

1.2.2 Transformations

The banking system is not perfect, as witnessed by the many bank failures and panics that have gripped the USA and other nations. The problem is that banks and other financial intermediaries, such as savings and loan associations and credit unions, engage in activities that inherently encompass potential risks over an extended time frame, namely a qualitative asset transformation or maturity transformation whereby banks take short-term deposits and then convert them into long-term loans, an example being mortgage loans; liquidity transformation, where a bank’s assets are less liquid than its liabilities; and credit transformation, wherein banks spread their risk by providing loans to a variety of persons, individuals, and businesses, each having a varying degree of quality. It can readily be understood that banks and other mortgage or other long-term loan lenders may become subject to financial distress if depositors, for a variety of reasons, decide to withdraw their deposits suddenly, as in a so-called “run” on a bank. The long-term lender may be unable to immediately satisfy the lenders’ demand for immediate withdrawals. ²

As a result of negligence, malfeasance, and incompetence, it became necessary that banks be regulated by governmental entities, such as the requirements that they maintain minimum capital reserves, have diligent loan policies, and maintain customer confidence to prevent a sudden run on bank deposits. Fortunately, at least in the USA and the European Union (EU), there are supportive systems such as the US FDIC (Federal Deposit Insurance Corporation), which insures all deposit accounts up to $250,000 per depositor per insured bank, including checking and savings accounts, money market deposit accounts, negotiable order of withdrawal (NOW) accounts, cashier’s checks, money orders, and certificates of deposit; and in the EU a Directive that provides €100,000 comparable coverage. ³ Not insured in the USA, even if purchased through a bank, are mutual funds, stocks, bonds, life insurance policies, annuities, or municipal securities. ⁴ Depositors in the USA have no legitimate reason to fear that their deposits will not be honored up to the insured sums.

1.3 Historical Development of the US Banking System

Traditional banking has had a checkered history, having commenced at the inception of the new Republic with the creation of the First Bank of the United States (1791–1811) under the leadership of Alexander Hamilton, named the first US Secretary of the Treasury under President George Washington. The bank expanded with branches in a number of cities which, along with state banks, flourished in competition with each other. The Second US Bank was created in 1816 following the end of the War of 1812 with Great Britain. The issuance of bank notes was performed by state banks because of the lack of a national currency, which led to problems of redemption because of the varieties of state currencies, which often could not be redeemed at face value, particularly in other states.

The War of 1812 illustrated the weakness of the system, and events culminated in the Panic of 1819. In the seminal case of McCulloch v. Maryland, ⁵ the State of Maryland sought to impose a tax on the federal bank. The US Supreme Court, in a decision by the famed Chief Justice John Marshall, determined that Congress had the right to create a bank under its delegated power under Article I of the US Constitution to make “all laws which shall be necessary and proper, for carrying into execution.” Thus, the Maryland tax was declared by the Court to be contrary to the US Constitution. ⁶ There were continual debates concerning the powers of the federal bank vis-à-vis state banks primarily led by President Andrew Jackson (term of 1829–1837) who believed that the expansion of the US Bank was destructive of states’ rights. His actions in attempting to negate the federal bank’s jurisdiction and power led to another of the many financial panics that occurred in US history. In the midst of the Civil War of 1861–1865, however, Congress enacted the National Banking Act, ⁷ which established standards for banks including minimum capital requirements and issuance of loans, as well as the imposition of a 10 % tax on state banknotes, which effectively removed them from circulation. ⁸

1.3.1 The Federal Reserve System

The Federal Reserve Act of 1913, ⁹ whose statutory objectives for monetary policy were to maximize employment, stabilize prices, and moderate long-term interest rates, created the national system of banks known as the FED that has existed to the present day. Its structure consists of a seven-member Board of Governors of the Federal Reserve System (Board) who serve 14-year terms and whose duties include overseeing and supervising the 12 Federal Reserve Banks; the US payments system; the financial services industry; the guidance of monetary action; the setting of reserve requirements for depository institutions; the conduct of studies of current financial issues affecting the nation; and the approval of changes in discount rates recommended by the Federal Reserve Banks. The Board’s most important responsibility is participating in the Federal Open Market Committee (FOMC), which determines the direction of the nation’s monetary policy. ¹⁰

Additional organizational elements of the FED include the following: (1) 12 Federal Reserve Banks and 24 branches serving their respective regions, storing currency and coin; processing checks and electronic payments; supervising commercial banks in their regions; managing the US Treasury’s payments; selling government securities; and assisting with the Treasury’s cash management and investment activities; (2) member banks (about one-third of all state banks and all national banks); (3) three statutory advisory councils: the Federal Advisory Council, the Consumer Advisory Council, and the Thrift Institutions Advisory Council, which advise the Board on matters of current interest; and (4) some 17,000 other banks, savings and loan associations, and credit unions that are subject to the FED’s regulations.

The Act required all national banks to be members of the Federal Reserve System and to maintain levels of capital reserves with one of the 12 Federal Reserve Banks. The member banks must deposit a percentage of their customers’ savings account and checking account deposits in a Federal Reserve Bank. State banks are also eligible to become members of the Federal Reserve System with all the attendant benefits thereto, including federal protection of deposits. The FED conducts monetary policy; supervises and regulates banks; protects consumer rights; provides financial services to the government and financial institutions; and makes loans to commercial banks.

The Great Depression that commenced in 1929 and ended with the entry of the USA into World War II led to a congressional inquiry concerning its causes. It was noted that there were bank panics almos...