ssay 1 Shadow Banking

In th traditional banking framwork, crdit intrmdiation btwn savrs and

borrowrs happns in a singl ntity. Savrs ntrust thir cash to banks as dposits,
which th institution uss to fund th xtnsion of advancs to borrowrs. Banks also
issu dbt and quity to undrwrit thir intrmdiation activitis. Rlativ to dirct
loaning, banks issu saf, dmandabl dposits, in this mannr uprooting th
rquirmnt for savrs to scrn th risk-taking conduct of ths institutions.
Th shadow banking systm rfrs to th financial intrmdiaris involvd in
ncouraging th formation of crdit ovr th global financial framwork, but ar not
subjct to rgulatory ovrsight of th cntral bank. Shadow banks lik convntional
banks attmpt diffrnt intrmdiation xrciss similar to banks, howvr thy ar
fundamntally distinct from commrcial banks in diffrnt rgards. Convntional
banks, ar comprssivly and tightly rgulatd, th rgulation of shadow banks is not
that broad and thir businss oprations lack transparncy. Scondly, commrcial
banks, driv funds through prparation of public dposits, shadow banks howvr
rais funds through markt basd instrumnts for xampl, commrcial papr,
dbnturs, or othr structurd crdit instrumnts. Bsids that, th liabilitis of th
shadow banks ar not insurd, whil commrcial banks ar guarant to a limitd
xtnt. At any tim of mrgncy th convntional banks, will hav dirct accss to
cntral bank liquidity whras th shadow banks wont hav such rsourcs.
Lik convntional banks, shadow banks giv crdit and by larg incras th
liquidity of th financial sctor. Yt not at all lik thir mor controlld rivals, thy
lack accss to cntral bank funding or in othr words safty nts such as dposit
insuranc and dbt guarant .In comparioson to traditional banks, shadow banks
don't tak dposits instad, thy dpnd on short trm funding providd ithr by asst
backd commrcial papr or by th rpo markt, in which borrowrs ar offrd
collatral as scurity against cash loan, through th componnt of offring th scurity
to a lndr and agring to rpurchas it at a concurrd tim in th futur at an agrd
pric.
Shadow banks can b includd in th provision of long trm loans lik mortgags
and facilitating crdit across th financial systm by matching invstors and borrowrs
individually. Du to thir part in this particular structur, shadow banks can
somtims provid crdit mor cost fficintly than convntional banks. A study by
th Intrnational Montary Fund charactrizs th two ky lmnts of th shadow
banking systm as scuritization to rduc countrparty risk saf asst and facilitat
scurd transactions.
In th US , prior th 2007-2008 financial crisis, th shadow banking systm had
ovrtakn rgular banking systms in providing loans to various sorts of borrowrs
including businss , hom and car buyrs, studnts and crdit usrs. As thy ar oftn
lss risk avrs than rgular banks, ntitis from th shadow banking systm in som
cass provid loans to borrowrs who may som way or anothr b rfusd crdit.
Mony markt funds ar considrd mor risk avrs than convntional banks and
thrfor do not hav this risk charactristic.

Figur 1.1: Th Growth of th US Shadow Banking Systm

Sourc : Pozsar t.al
(2012)
Th financial crisis of 2007 was a rsult of a numbr of factors affcting th
global conomy. Th crisis that bgan off as a mony and intrbank markt liquidity
sizur was changd into a univrsal crdit crunch and ultimatly a crisis of th ntir
banking systm whos lingring ffcts on ral conomis mad it th most noticabl
conomic crisis sinc th Grat Dprssion in th 1930s.

The development of shadow banking is expressed to be an inescapable consequence

of financial advancement. Financial development hastened the movement to shadow
banking and was, thus, fortified by it. In endeavoring a proficient utilization of the
financial capital, traditional banks depended on making creative items, empowering
them to go out on a limb permitted by the controllers . Not just that, they additionally
required an advancement to stay above water in the financial division because of the
expansion in aggressiveness between the banks, brought about by the regulations .
The advancement was securitization and it had been developing following the 1980s .
The instilled weakness of shadow banking gets to be clearer when the emphasis is on
the amplification of securitization and the funding exercises in money market
wholesale . Securitization is so widespread to the modern financial system that
economists sometimes refer to is as shadow banking system. As an way to give credit
intermediation, securitization empowers the shadow banks to change loan portfolios
or long haul illiquid loans into assets backed bonds which are then sold to investors
like mutual funds or insurance agencies. Like shadow banks, traditional banks
additionally practice securitization as it decreases the size of their balance sheet and
capital requirements. This is due to when they offer their securities to investors, the
record of the transaction is not considered their asset because of the regulations.

Bankrs cratd th mortgags in th fac of th consumr, but soon aftr sold thm
off into th scondary mortgag markt. Th xistnc of ths two ntitis
consquntly st up a liquid markt to sll mortgags and allowd banks to rmov
ths mortgags from thir balanc shts. Th Govrnmnt Sponsord ntitis
(GSs) scuritiz th mortgags crating Mortgag-Backd Scuritis (MBS) and sll
thm to invstors with a 100% guarant against loss of intrst or principal (Jaffee,
2010). To fund this guarant th ntitis chargd a guarant f somwhr
btwn 15 and 25 basis points (Jaffee, 2010). Ths ntitis also rtaind a portfolio
of ths scuritis that incrasd immnsly ovr th yars, fundd primarily through
dbt issud at xtrmly low yilds rsulting from th implicit govrnmnt guarant
(Jaffee, 2010). Ths actions alon incrasd risk but whn combind with xtrmly
low capital rquirmnts, .45% for loan guarants and 2.5% for loan portfolios, th
ntitis took on xcssiv amounts of risk.