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maturity and liquidity transformation

maturity and liquidity transformation

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maturity and liquidity transformation.18 In the absence of backstops, market uncertainty could result in bank runs and fire sales. As an example, if a significant number of depositors withdrew their money at the same time, banks might need to liquidate assets to meet redemptions, which they may only be able to do at suppressed prices. This could ripple throughout the financial system, causing widespread asset price declines. To prevent such market panic, many countries established certain financial stability protections, such as deposit insurance, central bank liquidity backstops, and consolidated supervisory structures geared toward preserving the safety and soundness of banking entities.

Although the nature of shadow banking appeared similar to traditional banking, a few significant differences stuck out to Reddy. First, while both traditional and shadow banks were in the business of extending credit, it certainly seemed that the shadow banking industry was averse to holding loans to maturity, relying instead heavily on securitization and the originate-to-distribute model of lending. The second difference revolved around shadow banks’ exposure to government oversight and safety nets: they seemed to have little to no exposure in either of these areas. To be sure, some were regulated for various aspects of their business, particularly to the extent that they were dealing in securities. However, only commercial banks were subject to a comprehensive, prudential bank supervision regime. Critically, shadow banks also did not have access to deposit insurance that could help prevent runs and fire sales. The other major difference existed in shadow banks’ funding models. Nearly every resource Reddy consulted highlighted shadow banks’ reliance on short- term wholesale funding markets. Bernanke, for instance, posited that shadow banks relied on “various forms of short-term wholesale funding, including commercial paper, repos, securities lending transactions, and interbank loans.”19 Reddy knew that traditional banks used these funding sources as well, but it seemed that the shadow banking system was particularly reliant on them, given its inability to take on deposits. To think more clearly about these distinct funding arrangements, Reddy gathered her thoughts into a diagram illustrating an example of a repo transaction, which she viewed as a common example of these short-term wholesale funding streams (Exhibit 9). Clearly, there seemed to be risks involved in all of this, and Reddy would soon investigate those. However, she was still not convinced that she fully understood why these institutions existed in the first place—a matter that lay at the heart of her analysis.

Why Do Shadow Banks Exist?

The FSB suggested that “non-bank financing provides a valuable alternative to bank funding and helps support real economic activity.”20 To Reddy, it seemed that the shadow banking industry could indeed be a highly valuable source of financial innovation, competition, and diversification, with the ability to lower costs across the financial system.21 Perhaps most importantly, the industry appeared to fill significant gaps in the financial system with both sides of its balance sheet. Certainly she understood the enhanced access to credit the shadow banking system could provide, but the benefits of the industry’s funding model seemed less obvious. Thus she began her analysis there.

In many economies, cash-rich entities, such as corporations and pension funds, have relatively few safe and logical places to store their excess funds. Using the United States as an example, deposit insurance limits often

18 Maturity and liquidity transformation involve the use of shorter-term and more liquid funds, such as deposits, to finance longer-term and more

illiquid assets, such as loans. 19 20 “Transforming Shadow Banking into Resilient Market-Based Finance: An Overview of Progress,” Financial Stability Board, November 12, 2015, (accessed May 17, 2016). 21

For the exclusive use of s. kapoor, 2018.

This document is authorized for use only by shivam kapoor in FIN315 Fall2018 taught by Victor Jarosiewicz, Bryant University from Nov 2018 to Dec 2018.