An Exploratory Report on Shadow Banking

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  • Topic: Collateralized debt obligation, Bank, Bank run
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  • Published : April 24, 2013
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An Exploratory Report on Shadow Banking

Neal Edmonson
University of the District of Columbia

Money and Banking
Professor Muhammad Samhan
March 4, 2013

Table of Contents
Executive Summary3
Findings4
Risk10
Regulation11
Conclusion12
Bibliography13

Executive Summary

This paper documents the institutional features of shadow banks, discusses their economic roles, and analyzes their relationship to the traditional banking system. It utilizes the print and web resources supplied in its bibliography to focus on institutional details of the shadow banking system, including information on the system’s collapse. It raises the question of whether the Shadow Banking System should be more regulated due to its inherent and systemic risks to our current financial system. Shadow banks are financial intermediaries that conduct maturity, credit, and liquidity transformation without explicit access to central bank liquidity or public sector credit guarantees. Within the market-based financial system, “shadow banks” have served a critical role. The rapid growth of the market-based financial system since the mid-1980’s changed the nature of financial intermediation. In the US, prior to the 2008 financial crisis, the shadow banking system had overtaken the regular banking system in supplying loans to various types of borrowers; including businesses, home and car buyers, students and credit users. As they are often less risk averse than regular banks, entities from the shadow banking system will sometimes provide loans to borrowers who might otherwise be refused credit. The 2008 financial crisis exposed the systemic risk associated with Shadow Banking and the world’s financial system. In this paper, I documented the specialized financial institutions of the shadow banking system, and demonstrated that these financial intermediaries played an important role in the run-up to the financial crisis of 2008. The two most important positions described in this paper are made around the need for the shadow banking system to provide liquidity to those institutions that have less than stellar credit and to be able to provide it in a more efficient manner, when needed, than through the regular banking systems; and secondly, the need to provide greater regulatory accountability to the shadow banking system, to avoid any further systemic crashes of the world’s financial system, in the future. It is my opinion that more such regulations must be established, because of the funding correlations that are established by the shadow bank and regular banking systems. Findings

Shadow banking institutions are typically intermediaries between investors and borrowers. Like regular banks, shadow banks provide credit and generally increase the liquidity of the financial sector. Yet unlike their more regulated competitors, they lack access to central bank funding (liquidity) or safety nets such as Federal Reserve’s discount window, or public sources of insurance such as Federal Deposit Insurance. Shadow banks conduct credit, maturity and liquidity transformation similar to traditional banks. Credit intermediation involves credit, maturity, and liquidity transformation. Maturity transformation refers to the use of short-term deposits to fund long-term loans, which creates liquidity for the saver but exposes the intermediary to spillover and durational risks. Liquidity transformation refers to the use of liquid instruments to fund illiquid assets.

In the traditional banking system, financial intermediation between savers and borrowers occurs in a single entity. Savers entrust their savings to banks in the form of deposits, which banks use to fund the extension of loans to borrowers. Savers furthermore own the equity and debt issuance of the banks. In contrast to traditional banks, shadow banks do not take deposits. Instead, they rely on short-term funding provided either by asset-backed commercial paper (ABCP), asset-backed...
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