«2011-2012 IT’S ALL SHADOW BANKING, ACTUALLY 593 IT’S ALL SHADOW BANKING, ACTUALLY JONATHAN MACEY* Introduction “Shadow banking” is a great term. ...»
2011-2012 IT’S ALL SHADOW BANKING, ACTUALLY 593
IT’S ALL SHADOW BANKING, ACTUALLY
“Shadow banking” is a great term. Although the term fails to
impart much meaning, it manages to convey the impression that,
whatever it is, it must be nefarious, somewhat clandestine and of
dubious legality. To those who have some familiarity with shadow banking, the term seems an apt label for a financial world that, albeit legal, sometimes is nefarious and somewhat clandestine.
Since the shadow banking system is, at times, even larger than the regular banking system, it is important to understand what the shadow banking system actually is and does. Determining whether the shadow banking system imposes “negative externalities,” i.e. costs on innocent third parties, like taxpayers, also seems like a worthwhile endeavor.
In this article, I intend to show that shadow banking is no different than regular banking. Although some commentators suggest that shadow banks escape the stringent regulation that regular banks are subject to,1 I will show that this is often not the case. More importantly, the shadow banking system produces the same economic benefits as those that come from the traditional banking system. In fact, as a matter of economic substance, there is no difference between the shadow banking system and the traditional banking system. That is the good news. The bad news is that, properly understood, we should worry about traditional banking at least as much as we worry about shadow banking—probably even more.
* Sam Harris Professor of Corporate Law, Corporate Finance, and Securities Law, Yale Law School.
See, e.g., Bill Gross, Beware our Shadow Banking System, CNN MONEY (Nov. 28, 2007, 10:58 AM), http://money.cnn.com/2007/11/27/ news/newsmakers/gross_banking.fortune/ (“My... colleague Paul McCulley has labeled it the ‘shadow banking system’ because it has lain hidden for years, untouched by regulation, yet free to magically and mystically create and then package subprime loans into a host of three-letter conduits that only Wall Street wizards could explain.”).
594 REVIEW OF BANKING & FINANCIAL LAW Vol. 31 I. Shadow Banking: A Concise Description Despite the fact that its exact contours remain unclear, the sheer size of the shadow banking system is astounding. In June 2008, Timothy Geithner, then the Chief Executive Officer of the Federal Reserve Bank of New York, estimated that in early 2007 the assets held by all institutions in the entire banking system, including holding companies, was “about $10 trillion,”2 while the assets in the shadow banking system were about $10.5 trillion.3 Given how opaquely the term shadow banking is often defined, it is hardly a wonder that shadow banks are shrouded in mystery. For example, a Federal Reserve Bank of New York report
defines shadow banks as:
[F]inancial intermediaries that conduct maturity, credit, and liquidity transformation without access to central bank liquidity or public sector credit guarantees. Examples of shadow banks include finance companies, asset-backed commercial paper (ABCP) conduits, limited-purpose finance companies, structured investment vehicles, credit hedge funds, money market mutual funds, securities lenders, and government-sponsored enterprises.4 Simpler definitions are often no more reassuring. According to Investopedia, an online resource whose self-stated goal is to “empower the individual investor” through education,5 the shadow banking system consists of “the financial intermediaries involved in
Timothy F. Geithner, President and Chief Exec. Officer, Fed. Reserve Bank of N.Y., Remarks at The Economic Club of New York: Reducing Systemic Risk in a Dynamic Financial System (June 9, 2008).
Id. Mr. Geithner reached this $10.5 billion figure by adding the value of asset-backed commercial paper conduits, structured investment vehicles, auction-rate preferred securities, tender option bonds, variable rate demand notes, assets financed through overnight tri-party repurchase agreements, assets in hedge funds and the assets on the balance sheets of the major investment banks.
ZOLTAN POZSAR ET AL., FED. RESERVE BANK OF N.Y., STAFF REPORT NO.458,
to SHADOW BANKING (2010), available at http://www.newyorkfed.org/research/staff_reports/sr458.pdf.
About Investopedia, INVESTOPEDIA, http://www.investopedia.com/ corp/about.asp#axzz1nOIMu000 (last visited Feb. 25, 2012).
2011-2012 IT’S ALL SHADOW BANKING, ACTUALLY 595 facilitating the creation of credit across the global financial system, but whose members are not subject to regulatory oversight. The shadow banking system also refers to unregulated activities by regulated institutions.”6 Yikes. That sounds bad.
I propose an alternative way to understand shadow banking.
Imagine that a financial institution sells $250 million in securities, on a very short-term basis, to a large investor. The buyer, who only wants to invest on a short-term basis, demands and receives a contractual guarantee from the selling financial institution that obligates that institution to buy those securities back the next day.
Imagine further that the financial institution takes the $250 million that it receives in this one day “sale”, and uses it to fund a long-term project, like the purchase of an illiquid investment that does not mature for eight years or the construction of a power plant. Finally, imagine that the financial institution is counting on selling another $250 million—or more—in securities tomorrow, and using the proceeds of that sale to repurchase the securities it sells today.
A repurchase agreement, or “repo”, like the kind of transaction described above is the paradigmatic example of the sort of transaction that takes place in the shadow banking system. Other transactions in the shadow banking system may take a different form, but the basic idea is the same. For example, if a corporation sells commercial paper, which is simply a short-term promissory note that matures within ninety days or less, and uses the proceeds to fund longer-term projects, that corporation participates in the shadow banking system.
B. Special Purpose Vehicles and Special Purpose Entities
In addition, what is known colloquially as “off-balance financing” also plays a major role in the world of shadow banking.
Off-balance sheet financing, as the name implies, allows a regulated entity to ignore certain assets and debts for regulatory and accounting
Shadow Banking System, INVESTOPEDIA, http://www.investopedia.com/ terms/s/shadow-banking-system.asp#axzz1jwYGKow1 (last visited Feb. 25, 2012).
596 REVIEW OF BANKING & FINANCIAL LAW Vol. 31 purposes. The term describes lending and borrowing activity that takes place through “remote entities”, or subsidiaries, which treat the assets and debts used in the financing as their own, thereby moving the assets and debts off the balance sheet of the regulated entity. If a financial institution, for example, were to keep an asset on the balance sheet, the financial institution would have to allocate precious, costly capital to cushion itself against the possibility that the asset could decline in value. Likewise, when a financial institution keeps a liability on its balance sheet, the bank’s capital would be reduced by the amount of the debt obligation, thereby reducing the amount of its lending and trading and other profitable activity, and possibly pushing the bank’s capital levels closer to or above regulatory minimums. In extreme cases, allowing a liability to fester on an institution’s balance sheet could even push the institution into bankruptcy.
To facilitate off-balance sheet financing, a bank or other financial institution generally will form a “special purpose vehicle” (“SPV”) or a “special purpose entity” (“SPE”). The SPE issues debt to investors and uses the proceeds of the debt issue to buy assets from the sponsoring financial institution, like home mortgages or, as in the case of Enron, other troubled or worthless products. Large financial institutions regularly use SPEs to remove assets and liabilities from their own balance sheets. Economist Darrell Duffie observed that “in June 2008 Citigroup reported over $800 billion in off-balance sheet assets held in [what the bank called] ‘qualified special purposes entities.’”7 A special kind of SPE known as a “structured investment vehicle” (“SIV”) sells debt, such as short-term commercial paper, to financial institutions and uses the proceeds to buy residential mortgages or other long-term assets. Many SIVs suffered during the 2007 and 2008 financial crisis, as home prices fell sharply and the number of mortgage defaults and foreclosures rose drastically.8 Needless to say, the money market funds and other financial companies that had purchased short-term debt from the SIVs also suffered losses.9 Although they were not legally required to honor the
DARRELL DUFFIE, HOW BIG BANKS FAIL AND WHAT TO DO ABOUT IT 20(2011).
See Eric Dash, Investor Safe Haven Becomes a Concern, N.Y. TIMES, Nov. 14, 2007, at C1 (“In another sign of turmoil in the credit markets, large investment firms, having sought out the high-yields for their money market 2011-2012 IT’S ALL SHADOW BANKING, ACTUALLY 597 debts of these remote juridical entities, financial institutions such as HSBC, Rabobank and, most notably, Citigroup bailed out their SIVs by putting the SIVs’ assets and liabilities on their own balance sheets.10
A credit default swap (“CDS”), an example of a shadow banking transaction utilized by both regular banks and shadow banks and pioneered by J.P. Morgan in 1997, is the most widely used credit derivative.11 An institution that buys a CDS enters into a contractual agreement that gives it the right to receive a cash payment upon the occurrence of a specified event, such as default, downgrade by a credit rating agency or any other “credit event” that would otherwise negatively affect the institution. Some institutions use CDSs to “hedge” against the effect of an event that negatively impacts the credit-worthiness of the issuer of debt that the institution holds as an asset, such as sovereign debt issued by developing countries, corporate debt or mortgage-backed securities. For example, Goldman Sachs prodigiously purchased CDSs on its portfolios of mortgagebacked securities and other real-estate related assets from the insurance company American International Group (“AIG”), likely a source of great solace to Goldman and of great aggravation for AIG12 Goldman received even more solace when the U.S. Treasury ensured
funds, are being forced to protect the funds from losses brought on by investments that no longer seem safe.... Bank of America said yesterday that it would provide as much as $600 million to prop up several Columbia Management funds, which bought large amounts of debt issued by structured investment vehicles, or SIVs, that is now worth less than it paid.”).
Liz Moyer, Citigroup Goes it Alone to Rescue SIVs, FORBES.COM (Dec.
13, 2007, 11:24 PM), http://www.forbes.com/2007/12/13/citi-siv-bailoutmarkets-equity-cx_lm_1213markets47.html.
A credit derivative is simply a contract that enables one party to an agreement to manage its exposure to credit risk. Swaps, forward contracts and options are all used as credit derivatives.
See Gretchen Morgenson, Behind Insurer’s Crisis, Blind Eye to a Web of Risk, N.Y. TIMES, Sep. 28, 2008, at A1 (explaining how A.I.G.’s CDS exposure and “its relationship with firms like Goldman offers important insights into the mystifying, virally connected—and astonishingly fragile— financial world”) 598 REVIEW OF BANKING & FINANCIAL LAW Vol. 31 a further windfall to Goldman when it awarded Goldman 100% of what it was owed on these CDSs despite AIG’s financial collapse.13 In essence, CDSs function like insurance contracts. They are called “swaps” because the buyer of these contracts makes both initial and periodic payments to the guarantor, who obligated itself to pay in the event of a credit event, and because the seller, who accepts payment for assuming certain risks on the buyer’s behalf, must deliver the value of principal and interest payments that the underlying asset would have paid to the buyer if no credit event occurs. In addition, if and when the person who bought the CDS begins receiving payments from the seller, the agreement usually requires the buyer to deliver to the seller either the current cash value of the underlying security or the security itself.
While CDSs function much like insurance, CDSs are not called insurance for a rather technical reason.14 Unlike pure insurance contracts in which a policy seller does not pay unless the beneficiary incurs an actual loss, CDS contracts do not require an actual loss as a condition of payment (although an actual loss of principal will result in payment).15 Nevertheless, while outside this narrow definition, CDS contracts have many characteristics of insurance.
The very controversial implications of the fact that CDSs generally are not considered insurance are two-fold. First, since the mid-eighteenth century, insurance contracts have been subject to the requirement that only someone with an “insurable interest,” an interest in the continued existence of the insured property, may purchase protection on that interest.16 Because CDSs are not considered insurance contracts, they are not subject to the requirement that they can only be purchased by those with an
See generally Louise Story & Gretchen Morgenson, Inside the U.S.
Bailout of A.I.G.: Extra Forgiveness for Big Banks, N.Y. TIMES, June 30, 2010, at A1.
For an overview of the difficulty of classifying CDSs, see Stacy-Marie Ishmael, Repeat After Me: CDS are not Insurance, FT.COM/ALPHAVILLE (Mar. 9, 2009, 8:59 PM), http://ftalphaville.ft.com/blog/2010/03/09/ 169811/repeat-after-me-cds-are-not-insurance/.
Id. (quoting Sec. Indus. & Fin. Mkts. Ass’n, Frequently Asked Questions About CDS, SIFMA, http://www.sifma.org/issues/regulatory-reform/otcderivatives/resources/ (follow “Frequently Asked Questions About CDS” hyperlink) (last visited Apr. 7, 2012)).
See generally Kyriaki P. Noussia, Insurable Interest in Marine Insurance Contracts: Modern Commercial Needs Versus Tradition, 39 J. MAR. L. & COM. 81 (2008) (discussing the concept of insurable interest).