Case Study 1: Shadow Banking 1
Shadow banks are financial entities that perform the same functionsas traditional banks although they are subject to little or noregulation. According to Financial Stability Board (FSB), the shadowbanks makes up to 25 – 30 percent of the financial system acrossthe world (Pozsar, Adrian, Ashcraft & Boesky, 2013). It should benoted that this kind of practice is carried out in various countriessuch as the United Kingdom (U.K.), United States (U.S.), Middle East,and Asia, among others. The Global Financial Crisis (GFC) put theshadow banking in the limelight (Gennaioli, Shleifer & Vishny,2013). The financial stakeholders were able to comprehend thecontribution of the system in the global finance. Although the name“shadow” suggests otherwise, the banking system carries out awide range of secured funding techniques and securitization (Pozsaret al., 2013). Some of the securities that are traded on thisplatform include asset-backed commercial paper (ABCP), asset-backedsecurities (ABS), repurchase agreements (Repos), and collateralizeddebt obligations (CDOs) (Adrian & Ashcraft, 2016). The system hasspecialized bank intermediaries bound along a chain where thesecurities are exchanged. Over the years, shadow banks were taskedwith the provision of funding by converting the risky and long-termassets into liquid and short-term liabilities (Pacurar, 2016).However, the growth in the sector saw the emergence of unscrupulousinvestors whose objective was to make profits. In this regard, theGFC in 2007 – `09 severely strained the system leading to collapse.Their mode of operation began to be questioned both by the governmentand other stakeholders because their fragile activity was prone toruns (Pacurar, 2016). The government saw that there was a need toshield shadow banks from future risks through access to liquidity andestablish options (Pozsar et al., 2013). The funds were done throughdiscount window access and deposit insurance (Gennaioli et al.,2013).
There is no significant difference on the shadow business model withthat of traditional banking system. The primary players in bothindustries comprise of lenders and borrowers. However, thecomplexities of the conventional system such as timing, liquidity,and information make it hard to acquire capital (Pacurar, 2016). Theshadow banking system filled this discrepancy by pooling the requiredfunds and finding the creditworthy individuals who can put them toproductive and profitable use (Gennaioli et al., 2013). Uncertaintieshave been a primary challenge because runs and fire sales wouldresult in the closure of the entity. For example, if the depositorswithdrew all their money at the same time, it would mean that theshadow bank may need to liquidate their assets immediately,irrespective of the current market prices (Adrian et al., 2016). Theeffect would be adverse as it would spread to other financialinstitutions whether traditional or not. Shadow banks heavily rely onthe originate-to-distribute model of administering funds, and theyhave no exposure to government legislation such as safety nets andoversight (Pacurar, 2016).
Types of Institutions Comprising This Industry
Shadow banking industry consists of distinct organizations. Theyinclude government-sponsored, internal and external shadow bankingsystems. The government is widely attributed to the creation ofgovernment-sponsored enterprises (GSE) which included Fannie Mae,FHLB (Federal Home Loan Bank) system and Freddie Mac (Pozsar et al.,2013). Through the GSEs, the funding and credit transformationframework has been substantially changed. FHLBs system was the firstprovider of warehousing of loans while Freddie Mac and Fannie Maewere the founders of the originate-to-distribute model (Adrian etal., 2016). GSEs are funded through capital markets and providesecurity portfolios and loans by a maturity mismatch. Internal shadowbanking system is where there is credit intermediation throughoff-balance sheet activities, broker-dealers within a particularcompany (Pozsar et al., 2013). External shadow banks comprise ofdiversified broker-dealers (DFDs) and standalone financecorporations. Other shadow banking institutions include investmentbanks, special-purpose and structured investment vehicles (SPVs,SIVs).
Why Shadow Banking Exists
FSB argues that shadow banking existence forms a significant role inthe real economy. It provides the much-needed alternative to thetraditional banks (Adrian et al., 2016). In the long-run, everyone inthe financial sector is satisfied because of their ability to findand support economic activities. People prefer shadow banks becausethey provide accessible and economic cost funds in the financialsystem. Additionally, the industry provides a valuable source andchannel for diversification, market competition and financialinnovation (Pacurar, 2016). When an individual or institution iscash-strapped, the banks ensure that there is access to credit toenhance operation and remain afloat in the market (Adrian et al.,2016). The increased government legislation such as the FDICinsurance limits and prohibitions from offering interest on checkingaccounts have been a challenge to cash-rich entities or large capitalholders (Pacurar, 2016). The shadow banking system has emerged as anappropriate channel for this kind of clients. They provide an avenuewhereby the wealthy store their money through investment in elementssuch as Repos, and commercial papers. Moreover, the unserved andunderserved individuals from the traditional system have a chance toacquire credit from the shadow system (Pozsar et al., 2013).
Gaps They Fill in the Economy
Shadow banks fill an enormous gap created by the traditional bankingsystem. Limitations such as timing, information constraints, andliquidity issues are a thing of the past with the shadow system.Furthermore, it funds the traditional banks without which they couldnot lend money which in turn slows down the rate of economic growth.Shadow banking institutions such as hedge funds have the ability totake risks that cannot be made by mainstream facilities (Pacurar,2016).
Regulation of Shadow Banking Industry
Shadow banking industry should be regulated more comprehensively. Theindustry contributed largely to the GFC. There was a need to create abackstop in shadow banking by implementing requirements such assecuritization, and money market funds (Pozsar et al., 2013). Throughinitiative such as this, there would be more transparency and avert acrisis in the future. The failure in the industry would adverselyaffect the economy because of legitimate individuals andinstitutions, directly and indirectly, depending on the shadowindustry.
GE Capital, a Shadow Bank
I believe that GE Capital is a shadow bank. The company emerged fromthe parent firm as a result of low return-on-equity (RoE). Itoperated in fields that had no or little aspects to do with the coreor traditional business line (Pacurar, 2016). The company faced noscrutiny from the government which is a primary characteristic ofshadow banks. Moreover, the annual reports had been scrapped. Otherfeatures of the shadow banking include high liquidity and short-termlending. GE Capital is a form of an internal system because it wascreated with an objective of improving the competitive advantage andenhancing the RoE of the parent company (Pacurar, 2016).
GE Capital’s Historical ROE Regarding the Profit Potential forNonbank Financial Institutions Vis-À-Vis Traditional CommercialBanks
GE Capital’s historical RoE suggests a lot regarding the profitpotential of nonbank financial institutions vis-à-vis traditionalcommercial banks. Due to its shadow banking initiatives, GE Capitalwas able to complement the parent company in term of financing andexpanding the market for their products (Pacurar, 2016).
In conclusion, the engagement between GE Capital and Nonbankfinancial institutions was more profitable at the asset managementtechniques which made the parent company more stable through support.GE Capital provided the much needed low cost of funding than thetraditional banking institutions. It means that GE Company preferredand relied on the short term lending since it was able to increasethe share of profitability. The Dodd-Frank legislation regulated itsactivities prompting the exit plan.
Adrian, T., & Ashcraft, A. B.(2016). Shadow banking: a review of the literature. In BankingCrises (pp.282-315). Palgrave Macmillan UK.
Gennaioli, N., Shleifer, A., &Vishny, R. W. (2013). A model of shadow banking. TheJournal of Finance, 68(4),1331-1363.
Pacurar, M. (2016). Financial Institutions (1st ed., p. 105).Virginia: Darden Business Publishing.
Pozsar, Z., Adrian, T., Ashcraft, A. B., & Boesky, H. (2013).Shadow banking. Economic Policy Review, (Dec), 1-16.