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«2011-2012 IT’S ALL SHADOW BANKING, ACTUALLY 593 IT’S ALL SHADOW BANKING, ACTUALLY JONATHAN MACEY* Introduction “Shadow banking” is a great term. ...»

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2011-2012 IT’S ALL SHADOW BANKING, ACTUALLY 599 insurable interest in the underlying asset. As a consequence of this “loophole,” institutions use CDSs for hedging occasionally, but, more commonly, for speculation. For example, a hedge fund or other investor who predicts that a default or other credit event, like a ratings downgrade, will occur in the market for a particular asset, like mortgage-backed securities, can buy a CDS and receive payments if and when the credit event occurs. If CDSs were considered insurance, then rules in the United States, Europe and Asia governing the sale of insurance products and requiring that purchasers hold an insurable interest would prohibit purchasing for pure speculation. In late 2011, the European Commission proposed such an application of these rules to the credit default industry by calling for a prohibition against “naked” CDSs, but limited the prohibition to sovereign debt.17 The goal of these rules, which went into effect in February 2012, was to protect financially troubled sovereign debt issuers like Greece and Italy from speculators such as hedge funds, but their efficacy remains unclear.

The second implication of treating CDSs differently than insurance relates to the pricing of the instruments and the disclosure made by the sellers. Insurance companies price insurance contracts on a statistical or actuarial basis. Insurance companies examine many factors to determine pricing, but primary factors include the frequency and conditions under which insurable events have occurred historically. CDSs relate to financial contracts, and CDS sellers therefore price contracts according to financial algorithms that examine the credit spreads and arbitrage relationships of the underlying asset. Additionally, regulations generally require companies issuing insurance contracts to make myriad disclosures pertaining to the solvency of the issuing company and further require that such companies maintain adequate reserves for future claims.

CDSs, on the other hand, are not subject to this same sort of burdensome regulation.

D. The Relationship Between Credit Default Swaps and Letters of Credit Just as financial institutions participating in shadowing banking can earn fees by issuing credit default swaps and other


Press Release, European Union, Regulation on Short Selling and Credit Default Swaps—Frequently Asked Questions (Oct. 19, 2011), available at http://europa.eu/rapid/pressReleasesAction.do?reference=MEMO/11/713.

600 REVIEW OF BANKING & FINANCIAL LAW Vol. 31   derivative financial instruments, traditional banks similarly can earn fees by issuing their functional equivalent, letters of credit. The apparent credit risk of the borrower largely drives the market for both traditional letters of credit and for CDSs. The financial institutions that issue these guarantees receive an initial one-time fee followed by periodic “premium” payments. Typically, a bank will issue a letter of credit, a customized financial contract, on behalf of a fee-paying client trying to establish credit with a third-party beneficiary, in which the bank promises to pay the beneficiary pursuant to the terms of the contract. In other words, letters of credit serve as a form of insurance to sellers, typically those who are reluctant to give credit to distant unfamiliar buyers. With a letter of credit, a corporation, for example, can obtain supplies in international markets or issue securities on the basis of their bank’s reputation and credit rating, rather than on their own.

In this way, letters of credit provide credit enhancement in precisely the same way as CDSs: a shadow bank that sells a CDS earns a fee from a buyer who wants protection against default on securities, just as a regular bank that sells a letter of credit earns a fee from a buyer who wants protection against default on securities, albeit on behalf of a third party. When a borrower purchases a letter of credit, the issuing bank agrees to make all of the principal and interest payments in the event the borrower defaults. This is just like when an institution purchases a CDS, the shadow bank issuing the CDS agrees to make all of the principal and interest payments on the bond if the borrower defaults. Bondholders and other lenders, whether Goldman Sachs or a small seller of industrial equipment, also use CDSs and letters of credit to improve their own balance sheets: assets backed by these sorts of guarantees will be valued more highly than the same assets if left unprotected.

II. “Traditional” non-Shadow Banking

The above-description of shadow banking has led many to conclude that shadow banking somehow is different than other sorts of banking and that shadow banks become insolvent in their own unique ways.18 Therefore, in order to determine the extent to which shadow banking is different from regular baking, one must first understand what regular banking is and what regular banks do.


DUFFIE, supra note 7, at 3-5.

2011-2012 IT’S ALL SHADOW BANKING, ACTUALLY 601 The classic economic conception of traditional banking begins with the notion that banks are rather unique in three ways.

While many sorts of firms extend credit, banks differ from other firms because they are much more highly leveraged and because their balance sheets feature a dramatic asymmetry between the liquidity structure and term structure of their assets and liabilities.19 In other words, when a traditional bank makes a commercial loan, the money it uses to fund that loan comes from a mixture of sources, but the largest source, by far, is deposits. This is because banks are much more highly levered than non-financial firms—meaning that they have much higher book value leverage than other sorts of companies—and because this debt comes from short-term depositors, not long-term creditors.20 To add to the problem, banks assets are relatively long-term.21As Maureen O’Hara and I have observed previously in the context of discussing the particular corporate

governance needs of banks:

What distinguishes banks from other firms is their capital structure, which is unique in two ways. First, banks tend to have very little equity relative to other firms. Although it is not uncommon for typical manufacturing firms to finance themselves with more equity than debt, banks typically receive 90 percent or more of their funding from debt. Second, banks’ liabilities are largely in the form of deposits, which are available to their creditors/depositors on demand, while their assets often take the form of loans that have longer maturities (although increasingly refined secondary markets have mitigated to some extent the mismatch in the term structure of banks’ assets and liabilities). Thus, the principal attribute that makes banks as financial intermediaries “special” is their liquidity production function. By holding illiquid assets and issuing


See Jonathan R. Macey & Geoffrey P. Miller, Deposit Insurance, the Implicit Regulatory Contract, and the Mismatch in the Term Structure of Banks' Assets and Liabilities, 12 YALE J. ON REG. 1, 2 (1995) (exploring the relationship between deposit insurance and the mismatch in the term structure of commercial banks’ assets and short-term liabilities).

Id. at 3.


602 REVIEW OF BANKING & FINANCIAL LAW Vol. 31   liquid liabilities, banks create liquidity for the economy.22 In other words, banks have three distinguishing features, all of which make them particularly vulnerable to failure: (1) they fund long-term assets (loans) with short-term liabilities; (2) their assets are highly illiquid (i.e., difficult to transform quickly into cash at a price resembling the real value of those assets in economic terms); and (3) they are highly levered with very little equity cushion, meaning that they are not able to withstand significant fluctuations in the value of their assets without collapsing.

The dominant model of the traditional banking industry from a societal perspective was created by Douglas Diamond and Philip Dybvig.23According to the Diamond and Dybvig model, banks satisfy the market’s demand for liquidity by providing “transformation” services that provide depositors “with a pattern of returns that is different from (and preferable to) what depositors could obtain by holding the assets directly and trading them in a competitive exchange market. Explicitly, this means the conversion of illiquid loans into liquid deposits or, more generally, the creation of liquidity.”24 In this model, banks convert illiquid assets into liquid assets on both the asset and the liability side of the balance sheet.25 On the liability side of their balance sheets, banks convert cash into deposits. Bank deposits in this model are akin to liquidity insurance.26 Depositors do not know when they will need cash, so they benefit by loaning it to banks in the form of demand deposits, savings accounts and certificates of deposit. These deposits are then pooled together by banks and invested in much the same way that


Jonathan Macey & Maureen O’Hara, The Corporate Governance of Banks, 9 FED. RESERVE BANK N.Y. ECON. POL’Y REV., 91, 97 (2003); see Douglas Diamond & Philip Dybvig, Bank Runs, Deposit Insurance, and Liquidity, 91 J. POL. ECON. 401, 405 (1983) (“Banks have issued demand deposits throughout their history, and economists have long had the intuition that demand deposits are a vehicle through which banks fulfill their role of turning illiquid assets into liquid assets.”).

See generally Douglas Diamond & Philip Dybvig, Banking Theory, Deposit Insurance, and Bank Regulation, 58 J. BUS. 55, 55 (1986).

Id. at 58.

Id. at 62.

See Diamond & Dybvig, supra note 22, at 405 (“In this role, banks can be viewed as providing insurance that allows agents to consume when they need to most.”).

2011-2012 IT’S ALL SHADOW BANKING, ACTUALLY 603 insurance companies invest the premiums that they receive from the companies and people that they insure. Those depositors who have unexpected short-term liquidity needs, in effect, “file claims” for insurance payouts by withdrawing their funds.

In traditional insurance markets, those who do not file claims subsidize those who do by paying premiums but not filing claims, or by filing claims long after they began paying premiums whose present value is more than the present value of their claims.27 In traditional banking markets, those who put money in CDs and continuously roll them over or who keep money in savings or demand deposit accounts for long periods of time subsidize their fellow depositors who park their funds in the bank for very short periods of time, quickly find themselves in need of cash, and avail themselves of the bank’s promise to repay the money on or nearly on demand. Banks’ need to hold cash reserves in anticipation of such ‘early redemptions’ makes it necessary and prudent for banks to hold sufficient cash reserves and potentially limits their profitability and ability to offer meaningful rates of return.

III. Banks and Shadow Banks: They Make Money the Same Ugly Way

Banks make money in the process described above by earning “the spread”, or differential, between the relatively high rate of interest earned on the loans they make and the relatively low rate of interest paid on the deposits they receive.28 Shadow banks make money in exactly the same way, except that instead of taking deposits they take the functional equivalent, whether by issuing commercial paper or ‘selling’ securities into the repo market on an overnight basis.

To maximize profits, both shadow banks and regular banks try to reduce their cost of funds and increase the returns on their assets. There are several ways of doing this. The traditional economic model of lending posited that banks’ specialized skills in identifying and monitoring borrowers gave banks a comparative advantage over other lenders by reducing banks’ incidence of loss on loans. The theory was that banks were highly efficient lenders because they tend to be more sophisticated, skillful and alert than the depositors whose


Jonathan R. Macey, The Business of Banking: Before and After GrammLeach Bliley, 25 J. CORP. L. 691, 699 (2000).

Id. at 695.

604 REVIEW OF BANKING & FINANCIAL LAW Vol. 31   funds they were lending. The theory suggests that, for example, a bank making a loan will know its borrowers very well because it will have constant, real-time access to very high-quality information about the borrowers’ financial condition due to their role as depositors and their other relationships with banks that generate information.29 Similarly, issuers of credit default swaps are thought to have a highly sophisticated understanding of the underlying securities that they guarantee—in theory.

As I have pointed out elsewhere, however, as technology improves, as markets have better, faster and cheaper access to information, and as the quality of such information improves, the relative informational advantage of banks over markets declines.30 Thick securities markets replace thin lending markets as the primary means for obtaining financing, at least for the largest and best customers. In other words, loans become securitized, and financial instruments, like CDSs, trade in efficient markets.31 As banks’ informational advantage declines, and as the very best loans and other assets on banks’ balance sheets are stripped away, profits decline, forcing banks to make riskier loans at lower prices. Both regular banks and shadow banks must engage in increasingly risky behavior in order to make money. Banks must do this because high-quality borrowers can issue securities rather than taking loans. Shadow banks must do this because as markets become more efficient, spreads narrow, decreasing profits.

As banks’ and shadow banks’ comparative advantage in the market for information declines, banks must develop other ways to


See id. at 708 (“When firms who borrow from banks also maintain checking accounts at the banks from whom they have borrowed, banks have access to a wealth of information about their lending clients.”).

See Macey & Miller, supra note 19, at 5-6 (“[A]dvanced technology has made it possible for firms that compete with banks for commercial loans to obtain virtually the same timely credit and market information that was once available only to banks.... Current evidence indicates that banks generally do not have an informational advantage over other lenders.”).

Cf. Nicole Jenkins et al., The Extent of Informational Efficiency in the Credit Default Swap Market: Evidence from Post-Earnings Announcement Returns 30 (July 2011) (unpublished manuscript), available at http://www.nd.edu/~carecob/Workshops/11Workshops/Jenkins%20Paper.pdf (“Our results suggest that the CDS market is generally efficient with respect to accounting information during periods of relative economic stability but call into question its resilience during less stable periods.”).

2011-2012 IT’S ALL SHADOW BANKING, ACTUALLY 605 profit. In an enduring, albeit risky, maneuver to secure profit, banks and shadow banks creep farther out on the yield curve. The “yield curve” describes graphically the relationship between the interest rate on an asset, like a bond or other fixed-income security, and the maturity of that security.32 Typically, yield curves exhibit positive slopes, which show that the rate of return on financial assets increases as the maturity of that instrument increases.33 The steeper the slope of a yield curve, the greater the gap between short-term rates of interest and long-term rates of interest.

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