What is shadow banking?
Bringing the dark corner of finance into the light.
September 28, 2022

In the 2006 James Bond film Casino Royale, the villain Le Chiffre makes his living as a banker for the world’s terrorists. Le Chiffre provides his clients with global access to their ill-gotten cash, and earns handsome fees for doing so. Ask a layman what ‘shadow banking’ describes, and you are likely to get an answer evocative of a Bond villain’s profession. The term brings to mind images of backroom deals, crooked characters, and legally questionable behavior. But in reality, shadow banking is no more villainous than the rest of the financial industry, and shadow banks perform very similar functions to traditional banks.

As one’s financial needs approach moderate complexity, having access to reliable banking services becomes essential. People need a place to park cash when the money is not actively being used for consumption or investment. This cash has to be redeemable at par and, ideally, available for withdrawal on a daily basis. For certain institutions, especially those with over a billion dollars in cash, traditional banks are unable to offer the safety and liquidity requirements that these institutions need. The shadow banking industry developed specifically to meet the demands of these institutional cash pools, which today control an estimated $5 trillion. While traditional banks serve retail depositors, shadow banks serve the largest corporations and financial institutions in the world.

The two most prominent types of shadow banks are dealers and money market funds. Dealers operate as market makers for a huge range of financial assets, earning a spread between bid and ask prices in exchange for providing liquidity. To finance their activities, dealers borrow money in the overnight lending market, secured by their inventory of assets. These overnight loans are typically rolled over by lenders, making them look very similar to deposits held at a bank. Money market funds operate an even simpler business. They take investor cash and make short-term loans to low risk borrowers, while offering investors daily withdrawal rights at par.

The shadow banking business has been criticized for being an industry of regulatory arbitrage, which exists to allow traditional banks to conceal risks in off-balance-sheet vehicles. There are merits to these arguments, as traditional banks can utilize the shadow banking infrastructure to take the same risks for lower capital requirements and leverage ratios. For instance, financing a special purpose vehicle to engage in a capital intensive activity like underwriting moves the assets off the balance sheet, but nonetheless exposes the bank to a similar risk profile. These critiques, however, miss vital demand-driven reasons for why shadow banking exists.

Suppose the portfolio manager of a $1 billion cash pool at a large company is considering what do to with the funds. The manager’s primary mandate is not to lose money; safety first, yield second. Given the FDIC insurance limit of $250,000, putting the money in a bank account means the company is doing almost a billion dollars of unsecured lending, an unacceptable amount of credit risk. The manager’s next idea is to park the money in short-term US Treasuries, which are guaranteed to be paid back at par. While this eliminates the credit risk, it introduces withdrawal constraints. Unexpected cash needs could force the manager to sell Treasuries prior to their maturity for an unknown market price. Further, the manager will have to continually reinvest their maturing holdings, and the Treasuries available for purchase may not suit the company’s cash flow needs.

Shadow banks solve the credit problem and the liquidity problem with overnight collateralized loans. The portfolio manager can either make overnight loans to dealers directly, or invest the cash with money market funds, who hold large quantities of such loans. Money market funds also hold short-term Treasuries, but they can manage liquidity needs better than an individual cash pool can due to economies of scale. Under normal conditions, this system operates smoothly, and satisfies the liquidity and safety needs of institutional cash pools. But just like traditional banks, shadow banks can be subject to runs in times of crisis.

Dealers and money market funds offer their lenders daily liquidity terms, but operate as if most lenders will choose to keep their money invested. The traditional banking parallel is how banks let depositors withdraw their money at any time, but do not actually have enough cash on hand to service a mass of requests. In times of crisis, like the 2020 Covid market crash, investors’ urgent need for cash causes them to withdraw from money markets and stop making new loans to dealers. To repay the withdrawal demands, shadow banks have to rapidly sell their assets, often exacerbating market turbulence. Similar withdrawal-related fire sales can occur if the value of the underlying collateral is called into question, much like what occurred during the 2008 credit crunch.

In crises, traditional banks are backstopped by their ability to borrow at the Fed’s discount window. Since no such public liquidity put is conventionally offered to shadow banks, they are often much more fragile during market dislocations. In light of this risk and the importance of shadow banking, the Fed has begun to offer the wider financial system the type of support that was previously restricted to traditional banks. Look to the creation of the Money Market Liquidity Facility and the revival of the Primary Dealer Credit Facility in March 2020 for two such examples.

Ultimately, shadow banks should be happy they are not in the same business as Le Chiffre. When he struggled to repay his depositors, they tracked him down and threatened to chop his hand off. When shadow banks struggle to repay their depositors, the Fed steps in to provide them with ample liquidity. Given the legitimate economic demand for shadow banks and the vital services they provide, the industry could certainly do with a less villainous name.

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