Crisis and Sustainability by Alessandro Vercelli

Author:Alessandro Vercelli
Language: eng
Format: epub
Publisher: Palgrave Macmillan UK, London

6.3 The Genesis of Shadow Banking

Shadow banking gradually emerged since the early 1970s as cause and consequence of deep structural changes in the financial system. The main specific drivers of this ongoing process were, from the supply side, a continuous flow of flexibility-enhancing financial innovations and deep regulatory changes that aimed to liberalise banks and financial markets from any form of pressing regulation, control, and supervision. 19 A second impulse came from the demand of collateral for financial transactions that incentivised the surge of securitisation and the systematic use of repurchase agreements (repos) as a money-like instrument for big financial institutions. Supply and demand forces found a benign support from the visible hand of court decisions and regulatory innovations that allowed securitisation and gave repos a privileged treatment under the bankruptcy code.

This complex of factors produced a progressive decline of the traditional banking model as shaped by the containment laws of the 1930s and by the Bretton Woods policy rules. Federal Reserve flow of funds data confirm that the ratio of off-balance-sheet to on-balance-sheet loan funding grew from about zero in 1980 to over 60 % in 2007. 20 However, we should not interpret this evolutionary change as a mere process of substitution between old and new banking model, because the relationship between these two models is a very complex one that is based at the same time on competition and complementarity. Commercial banks increasingly suffered from a growing competitive challenge exerted by non-banks and their products both from the asset side of their balance sheets (junk bonds, commercial paper, exotic derivatives, and so on), as well as from their liability side (in particular money-market mutual funds [MMMF]). 21

Commercial banks reacted to the progressive fall of their deposits and declining profitability by seeking new profit opportunities in the emerging shadow sector contributing to its further development. On the other hand, strong complementary links developed between commercial banks and shadow institutions. Commercial banks started to manage short-term liquidity through shadow banking (securitised repo market), while the shadow institutions relied on commercial banks as ultimate source of liquidity (see Appendix A1). This complex interaction between commercial banks and shadow institutions is what makes so difficult to understand the impact of shadow banking on financial fragility and contagion. For the same reason, the control, regulation, and supervision of such a system is an unsolved problem. 22 A way out in the right direction requires a radical change of perspective.

The collapse of the Bretton Woods system started a process of transformation of finance in the direction of a growing importance of financial markets. This determined the progressive success of market-based financial institutions such as institutional investors, pension funds, and mutual funds. The focus of this chapter is restricted to a particular category of market-based financial institutions often called shadow banks since they perform banking functions outside the regulatory purview of banks, so to say in the shadows. 23 This terminology immediately caught up also in academic circles notwithstanding reiterated criticisms. The success of this

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