March 8, 2014

The Rise of Shadow Banking

Financial crisis of 2008 was a landmark on the history of financial regulations. The collapse of large investment and commercial banks was an alarm for the banking sector. Since then every regulator turned their attention to find a solid structure for the financial sector. We’ve observed a rise in the financial regulations. Starting with Dodd Frank Reform and Volcker Rule in United States, Ring Fencing in United Kingdom and ongoing debates in European Union, there is a strong drift towards more regulated markets and financial institutions. And there is no predictable reason in the near future to change this direction.

Since the global financial crisis, regulators become even more anxious about the high leverage that banking sector employed. Regulatory pressure on bank lending and request for deleveraging is increasing since then.

In order to comply with regulations Banks had to change their models and reshape their balance sheets by reducing their risk weighted assets. Basel 3 is a game changer. RBS’s August 2013 report states that across Europe complying with Basel III rules will require banks to reduce assets by 3.2 trillion Euros.
Central Banks all over the world responded to the financial crisis by loosening the monetary policy. Since 2008, the biggest six central banks have spent 7.5 trillion US Dollars on quantitative easing programs. This increased the market liquidity and promoted lending.

As expected, asset allocations also changed in post crisis era. Equity allocations fell and fixed-income allocations rose. (Mercer 2013 European Asset Allocation Survey)

All these developments cause an unprecedented rise in shadow baking. Traditional banks and non-bank lenders switched hats. The demand for borrowing satisfied more and more by non-bank lenders. A recent research from DC Advisory shows that LBO (leveraged buyout) deals including non-bank lenders has been increased from 17% in 2011 to 46% in 2013.

Some experts claim that shadow baking absorb some of the risks that traditional banks took and constitute a market friendly solution to the “too big to fail” problem. However cases like the fail and following bail out of Long Term Capital Management (LTCM) reinforce the skepticism towards these arguments. On the contrary one might argue that heavily reliance to shadow banking was one of the reasons that triggered the last global financial crisis.

In conclusion, massive quantitative easing kept interest rates all time low and substantially increased the demand for assets with yield. On the other hand new regulations restrained banks appetite for lending. Somebody had to fill the void. Therefore we have seen a boom in shadow banking. 

The effects of this process is still not clear but it is certain that the financial system is increasingly changing and our models can’t keep up the pace to explain the situation.

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