CHAPTER 1: INTRODUCTION

The emergence of a shadow banking system, providing the image of a conventional credit and
liquidity bank, has raised questions about the economic reasons for its appearance. Is it the
product of an avoidance strategy in response to a banking regulation that would have undermined
the competitiveness of banks or does it ensure a specific economic function? While there are
many empirical evidences of the existence of regulatory bodies involving the responsibility of
banking regulation in the development of this underground banking system, the latter assumes an
economic function distinct from a conventional bank. It allows for better diversification of risk
under the benefits theoretically related to securitization. The reality of this diversification has,
however, been empirically challenged in light of the 2007-2008 crisis. The economic role of the
shadow system also lies in the nature of its liabilities, which offers institutional investors looking
for safe short-term investments, and not eligible for retail deposit insurance, a form guarantee of
deposits via the collateralized debt issued by these structures, a protection which nevertheless
remains subject to variations in the financial value of the collateral property.

The shadow banking system is defined as a set of institutions that provide credit to the private
sector of the economy and as such operate a maturity transformation. These institutions do not
receive deposits from individuals, but rather from institutional depositors. These bodies are
poorly regulated and have no state guarantee on their liabilities such as deposit insurance. Nor do
they have access to central bank liquidity. Their balance sheet is highly dependent on the market.

These banks of the shadow (hedge funds, broker-dealers, investment funds, special purpose
entities securitization...) are financed by short-term debt collaterals, such as repurchase
agreements (repos) or ABCP (asset-backed commercial papers or treasury bills), and invest in
assets whose underlying loans securitized (asset-backed securities or asset-backed bonds, etc.).

The emergence of this shadow banking system is the result of combined forces whose
responsibility is difficult to disentangle: regulation undermining the competitiveness of banks
and a new economic role in its own right.

Empirically, there has been some weakening of the situation of the traditional banks. They have
faced competition from rival institutions on two fronts: on the asset side, their products have
been hard-pressed by commercial papers; and on the liability side, the money-market funds have
taken away a significant portion of their deposits, with the shares of money-market funds, liquid
and low-risk. They also lost their protected monopoly privileges and had to pay more
competitive rates to continue to attract deposits1.

As early as the 1990s, this notion of decline was challenged by a revival of banking activities
outside the traditional sphere. This approach already corroborates the idea of a rise of the shadow
banking system from the traditional banks.

It is important to distinguish the institutions and activities of the banking system from the
shadows. Some activities belong to it while being undertaken by conventional banks. The
banking system of the internal shadow thus covers the activities of the latter, while the external
shadow banking system includes the activities of the shadow institutions themselves.

Traditional commercial banks securitize part of their loans and this process is the original
constitutive phenomenon of the shadow banking sector. The emergence of securitization and the
emergence of the shadow banking system are inextricably linked. Any explanation of the
emergence of this shadow banking system requires an analysis of securitization and its economic
role.

Two explanations can be advanced to account for the emergence of securitization. Either the
banks sought to circumvent the legislation by establishing capital ratios, or thus this phenomenon
would have a purely legislative origin, i.e. the banks wanted to take advantage of the strong
demand for collaterals, used massively to reduce counterparty risk in many financial
transactions, which made the creation of securities from their receivables very profitable.

In other words, is it the force at work on the supply side, namely the degradation by the
legislation of the competitiveness of conventional banks because of the establishment of capital
ratios, or the force at work on the demand side, namely the need for collateral for new financial
transactions, which has prevailed in the expansion of shadow banking system?

1
Berger A. N., Kashyap A. K. and Scalise J. (1995), “The Transformation of the US Banking Industry What a Long,
Strange Trip It’s Been”; Wharton School Center for Financial Institutions, University of Pennsylvania, Center for
Financial Institutions, Working Papers, No. 96-06, November (last visited Mar 15, 2019).
The legislative explanation may be relevant if the emergence of new regulations binding
commercial banks has been accompanied by a decline in the value of the banking charter
(Gorton, 2010)2, that is, the set of advantages associated with bank status, including the existence
of barriers to entry into the banking sector. It is only the disappearance of the banking charter as
a whole, i.e. an accentuation of constraints through the appearance of capital ratios, coupled with
an erosion of profits through the dismantling of barriers to entry, and not only the regulation by
ratios that can explain the relative decline of banks.

If the shadow banking system assumes an economic role identical to that of a bank, it would be
purely redundant and its birth would be entirely dictated by too strict regulation on conventional
banks. However, if it assumes a role different from that of a conventional bank by assuming a
specific and distinct economic role, then it cannot be reduced to a mere anomaly emanating from
regulation.

1.1 IS THE EMERGENCE OF THE SHADOW BANKING SYSTEM A RESPONSE TO

OVERLY BURDENSOME REGULATION FOR COMMERCIAL BANKS?

In a micro-prudential approach, capital ratio regulation essentially aims to limit the moral hazard
arising from state Deposit Insurance. Under Basel regulations, banks are required to maintain a
minimum amount of equity proportionate to their assets. Assets are weighted differently in
calculating these ratios based on the associated risk: a risky asset requires more equity than a
non-risky asset.

The logic of the regulation establishing ratios is to force the banks benefiting from deposit
insurance to internalize part of the costs associated with this insurance. It aims to limit the moral
hazard which could lead banks to take on excessive risks, the consequences of which would be
borne by the public authorities, in the form of deposit insurance. When banks are forced to hold
more capital, this means that in the event of bankruptcy, they will contribute more to losses
because they will lose their own capital. In the case of deposit insurance, the more debt a bank
incurs, the less the cost of bankruptcy rests with the bank itself.

2
Dang T. V., Gorton G. and Holmstrom B. (2010), “Financial Crises and the Optimality of Debt for Liquidity
Provision”, mimeo Available at https://econresearch.uchicago.edu/sites/econresearch.uchicago.edu/files/ignorance-
crisis-and-the-optimality-of-debt-for-liquidity-provision.pdf (last accessed 15 Mar, 2019).
Capital ratios are thus designed to force banks to bear a share of potential losses and thus limit
the exposure of public funds to guarantee deposit Insurance.

DEFINITION OF A REGULATORY ARBITRAGE

If the ratios aim to reduce the distortions in terms of moral hazard created by deposit insurance,
they can absorb the shocks in case of losses. The fear of regulatory arbitrage existed from the
first Basel accord 3 and was defined as "an action that exploits the differences between a
portfolio's true economic risk and its regulatory obligations".

Regulatory arbitrage refers to “any distortion arising from a regulatory constraint. The regulation
may create an incentive for the securitization and transfer of the legal ownership of this asset to a
structure within the banking system”.

The existence of regulatory arbitrage refers to the notion of boundaries, delineating the regulated
and unregulated sector generated by financial regulation. While regulation is effective, it
constrains the bank in its choice of the optimal capital ratio, preventing it from maximizing
profits and return on capital, causing capital to be reallocated to the unregulated system, until the
marginal return on capital in both sectors is equalized4.

An extreme solution to this border problem may be either to regulate nothing (free banking
situation) or to regulate all institutions without distinction. The first solution is dangerous for the
stability of the system and the second is impracticable due to a financial innovation constantly
circumventing the regulation, any regulation is necessarily conducted within an intermediate
space and will always be confronted with the border problem.

WHY REGULATORY ARBITRAGE?

Regulatory arbitrage may be optimal for a bank when equity financing is at a disadvantage in
terms of debt financing and when, spontaneously, the bank chooses more debt. The regulation
then forces the choice of the bank and can reduce its profitability. Regulatory arbitrage requires
the existence of a market imperfection that would penalize equity financing. If the markets were

3
De Marzo P. and Duffie D (1999), “A Liquidity-Based Model of Security Design”, Econometrica, vol. 67, No.
1January, pp. 65-100.
4
Goodhart C. (2008), “The Boundary Problem in Financial Regulation”, National Institute Economic Review, 48,
pp. 206.
perfect, the debt and equity would be perfectly substitutable and the bank would be indifferent to
the various financing structures.

Several anomalies may explain a debt benefit, for example: asymmetry of information,
differential tax treatment etc. Therefore, imposing a certain financing structure on the banks, in
particular a fixed share of equity, can lead to a decrease in profitability and a flight to the shadow
banking system.

The theoretical question that arises is whether these regulations actually represent a cost for
commercial banks, which would justify a capital outflow to the shadow banking system? One
can thus question whether Modigliani and Miller's (1958) theory applies to banks, i.e. whether
the equity or debt financing structure has an impact on the value of the bank?5

This analysis requires identifying precisely which market anomaly (transaction costs, incomplete
markets, asymmetries of information...) is at the origin of this possible violation of the
Modigliani and Miller theory.

THE IMPORTANCE OF CHOOSING ASSET RATIOS

The choice of risk ratios assigned to different assets is crucial. Under the assumption of market
imperfections that make equity financing disadvantageous compared to debt financing, an
inherently biased definition of the ratios in favour of undervalued risk assets would mechanically
lead to economic arbitrage in favour of those assets. Such arbitrage would aim at reducing
regulatory capital by investing in undervalued risk assets in order to lower the cost of financing.

In particular, if the ratio attributed to banks’ off-balance sheet assets is lower than that attributed
to their traditional activities held on their balance sheet, banks will naturally and rationally
choose these first assets with a lower coefficient and put in place, for example, structures such as
special purpose entities. For example, under Basel I, the assets and capital ratios to be retained in
relation to the assets established by rather broadly defined asset classes. Within the same
category, the risk was assumed to be homogeneous. This allowed banks to invest in riskiest

5
Modigliani, Franco, and Merton H. Miller. “The Cost of Capital, Corporation Finance, and the Theory of
Investment: Reply.” The American Economic Review, vol. 49, no. 4, 1959, pp. 261-297 (last accessed 16 Mar,
2019).
assets within the same risk category in order to reduce their regulatory capital for the same
amount of assets. The legislation would thus have introduced a distortion in the choice of banks.

1.2 DOES EQUITY FINANCING PRESENT AN ECONOMIC DISADVANTAGE?

The object here is not to develop the classical arguments of debt theory, which are well known to
productive firms and which may apply to banks in some cases. All these arguments require
market imperfections: incomplete markets, transaction costs, tax distortions. Under these
approaches, debt would have a lower financing cost and the ratios would therefore be costly and
subject to regulatory arbitrage.

In the beginning itself, a distinction has to be made between inventory costs and flow costs of
equity financing. A cost of inventory implies a permanent cost differential between equity and
debt financing, while a cost of flow involves only an adjustment cost, the time to increase equity.

The first type of cost is, for example, a tax advantage of the debt because of its deductibility,
already mentioned by Modigliani and Miller, or even a lower cost of the debt because of its more
liquid nature or liquidity premium.

The second type of cost results from costs related to the raising of own funds attributable, for
example, to the unfavorable signal attached to a sudden rise in equity in the presence of
information asymmetry existing between the better-informed management and the investors6.

In the presence of information asymmetry between the management of the bank and its investors,
the debt represents the optimal mode of financing to guarantee liquidity, defined as the
possibility of rapidly exchanging a certain amount of assets without that there is an impact on
prices and that no misinformed party is harmed in favor of a better informed party. Debt is the
most insensitive instrument for the creation of private information and thus maximizes liquidity
in the market7.

6
Myers S. C. and Majluf N. S. (1984), “Corporate Financing and Investment Decisions when Firms Have
Information that Investors Do Not Have”, National Bureau of Economic Research, Working Papers, No. 1396, July
1984, Available at https://www.nber.org/papers/w1396.pdf (last accessed 15 Mar, 2019).
7
Dang T. V., Gorton G. and Holmstrom B. (2010), “Financial Crises and the Optimality of Debt for Liquidity
Provision”, mimeo Available at https://econresearch.uchicago.edu/sites/econresearch.uchicago.edu/files/ignorance-
crisis-and-the-optimality-of-debt-for-liquidity-provision.pdf (last accessed 15 Mar, 2019).
Of all the possible contracts, the debt minimizes the incentive to create private information
because it preserves a form of symmetrical ignorance between the agents. Because of its safe
nature, the possession of private information provides no advantage in the market. Information
asymmetry is not a hypothesis of the model, the creation of private information being
endogenous and giving birth to no asymmetry of information. Only debt minimizes incentives
for private information creation and thus resolves the problem of asymmetry8.

Banks thus have an advantage in operating at high levels of debt, and even at a higher level as
productive enterprises. The raison d'être of a bank lies in its ability to produce liquidity, unlike
productive enterprises.

EMPIRICAL OBSERVATIONS SUPPORTING THE EXISTENCE OF REGULATORY

ARBITRAGE

Two types of adjustments can be made by banks to comply with the ratios: either an increase in
equity, a reduction in assets. If the equity financing by banks will tend to reduce their assets, in
the opposite case, they will be indifferent to the ratios and will substitute without compromising
the own funds for the debt on their balance sheet. So, Asset reduction as a result of the enactment
of ratios is a regulatory arbitrage measure. The introduction of regulatory capital ratios for the
first time in the United States has involved a bank balance sheet adjustment9. From June 1985,
the latter are forced to maintain a primary capital of 5.5% of their assets and the adjustment of
their balance sheet mainly by slower growth in their assets. It can be deduced from this empirical
observation that, at in the short term, the introduction of capital ratios may imply a reduction in
assets from traditional banks to other structures, which implies that this mode of financing has a
cost in relation to the debt.

The existence of ad hoc securitization structures (SPVs) also supports the flight to the shadow
banking system in response to regulation10. The banks have created $ 1.3 billion of SPVs to

8
Ibid.
9
Awdeh, Ali & Moussawi, Chawki and Machrouh, Fouad. (2011). The Effect of Capital Requirements on Banking
Risk. International Research Journal of Finance and Economics. 66. pp. 133-146 Available at
https://www.researchgate.net/publication/257867017_The_Effect_of_Capital_Requirements_on_Banking_Risk (last
accessed 16 Mar, 2019).
10
Acharya, Viral V. and Schnabl, Philipp and Suarez, Gustavo, Securitization Without Risk Transfer (October 20,
2011). AFA 2010 Atlanta Meetings Paper. Available at http://dx.doi.org/10.2139/ssrn.1364525 (last accessed 16
Mar, 2019)..
which they have provided collateral, thus the fact the credit risk on their balance sheet, but not
holding regulatory capital in front of the assets. These authors show that the crisis revealed, after
the collapse of the ABCP market, main mode of financing, the extreme concentration of risks on
banks' balance sheets due to the granting of these liquidity guarantees to the SPVs, and not its
dispersion to outside investors.

The guarantees granted consisted of so-called liquidity guarantees, i.e. a legal commitment on
the part of banks to finance the SPVs, that is to say to buy the ABCP issued by them in case of
incapacity to refinance. Commercial banks thus assume the risk of non-refinancing of SPVs, the
rollover risk. The creation of such structures allowed commercial banks to contribute 10% of the
capital required in the United States if the loans had not been securitized, but on their balance
sheet, a huge savings in regulatory capital. Yet banks continued to assume the risk of these
structures: their creation seems to result from a regulatory arbitrage aimed at circumventing the
ratios. Other elements corroborate the idea of a regulatory arbitrage in favor of the shadow
banking system. The growth of the ABCP market has suddenly stopped after the announcement
in 2001 by regulatory increase in capital ratios for SPVs with liquidity guarantees. After the
withdrawal of this regulation in 2004, the ABCP market resumed very strong growth11. These
authors also note that in Europe, the only countries imposing identical capital ratios for an asset
held by a securitization structure with a liquidity guarantee only for an asset on the balance sheet
(Spain and Portugal) have not seen the development of such SPV benefiting from guarantees.

WHY DOES THE SHADOW BANKING SYSTEM EXIST?

The classic question raised by the theory of financial intermediation is to determine why
traditional banks exist. The emergence of the shadow banking system now leads us to ask the
following question: why do shadow banks exist alongside conventional banks? Do they assume a
particular function, distinct from that of conventional banks? Or do they have the same economic
function, or do they simply have certain comparative advantages over them?

AN ECONOMIC ROLE CLOSE TO THAT OF A TRADITIONAL BANK

To explain the existence of commercial banks, two main theories compete with each other. A
first approach focuses on the assets of traditional banks, i.e. the loans they hold in their balance
11
Ibid.
sheets. Their specificity would lie in the management of their assets: their ability to supervise
borrowers12, to produce credible information on investment projects, among others13.

However, the axiom underlying all of these theories is challenged by the existence of the shadow
banking system and the development of securitization. Indeed, in order for incentives to exist for
the production of information or for the supervision of borrowers, the assets must be retained by
the banks within their balance sheet. Their assignment destroys any incentive to operate, which is
their specificity under this approach. It therefore seems to have no explanatory power in the light
of recent financial developments. In this conceptual framework, shadow banks as we have
described them would not be banks.

Gorton and Pennacchi (1990)14 provide a different explanation for the existence of banks, which
remains consistent with the emergence of securitization and perhaps it is applicable to the
shadow banking system. Their definition of the role of a bank is distinguished by the emphasis
placed on the liabilities of institutions rather than on their assets. The essence of a bank's
function would be to create a particular short-term debt instrument, perfectly liquid, the value of
which would be insensitive to the holding of private information and thus immune from any anti-
selection phenomenon.

In the asset market, some agents have superior information to uninformed agents who are
unaware of their future liquidity needs and future returns on assets. In the presence of
information asymmetry of this type, a zero-sum game takes place in which informed agents can
extract a profit by abusing uninformed agents. Informed agents form coalitions for this purpose
and manipulate the price in such a way that it never reveals the state of the world that has
occurred. Only the creation of an asset that is not sensitive to the holding of private information,
such as risk-free debt, solves this problem. Commercial banks create deposits with these
characteristics. In the context of the shadow banking system, there is an equivalent, in particular

12
Diamond D. W. (1984), “Financial Intermediation as Delegated Monitoring” Federal Reserve Bank of Richmond
Economic Quarterly, Volume 82/3 Summer 1996 Available at
https://www.richmondfed.org/~/media/richmondfedorg/publications/research/economic_quarterly/1996/summer/pdf
/diamond.pdf (last accessed 17 Mar 2019).
13
Leland H. E. and Pyle D. H. (1977), “Informational Asymmetries, Financial Structure and Financial
Intermediation”, Journal of Finance, vol. 32, No. 2 February, pp. 371-387.
14
Gorton, Gary B. and Pennacchi, George G., Banks and Loan Sales: Marketing Non-Marketable Assets (December
1990). NBER Working Paper No. 3551. Available at SSRN: https://ssrn.com/abstract=226833 (last accessed 17 Mar
2019).
repurchase agreements or repos, but, more generally, any form of very short-term (usually one-
day) loan guaranteed by a collateral.

These repos can be analyzed as currency, as are commercial bank deposits 15 . The Federal
Reserve and the European Central Bank (ECB) now include repos in their calculation of the M3
monetary aggregate. Rest periods also has a form of monetary multiplier, the collateral can be
reused (remortgage) for another transaction, giving rise to a creation of ‘money’.

This approach, however, is not enough to explain why the shadow banking system fulfills a role
distinct from that of conventional banks and would have emerged even in the absence of banking
regulation.

1.3 DEMANDS FOR RISK-FREE DEBT BY INSTITUTIONAL INVESTORS

In the shadow banking system, savers are not individuals, but businesses or financial institutions.
They are institutional depositors realizing a ‘wholesale deposit’, as opposed to the traditional
‘retail bank deposit’ made by individuals. These institutional depositors raise funds from
individuals or companies to invest them in the liabilities of the alternative financial system.

The shadow banking system responds to a real need of these institutional investors, who seek a
form of paid and secure deposit that can be withdrawn at any time, economic role that the
conventional banking system cannot assume. These large companies or financial institutions, the
depositors, are reluctant to deposit their liquidity with conventional commercial banks, because
deposit insurance is exclusively reserved for individuals. A repo then provides them with a form
of insurance through the counterpart that constitutes the collateral received in exchange for the
deposit. A discount (a cut) is generally applied to the market value of the collateral in order to
guarantee an additional margin of safety for the depositor in the event of a fall in the market
value of the collateral.

In case of default of the shadow bank (that is to say if it does not buy the collateral as promised),
the sale of the collateral provides the depositor a form of guarantee that will depend on the
market value of this collateral. The price of this one is however subjected to phenomena of

15
Gorton, Gary B. and Metrick, Andrew, Securitized Banking and the Run on Repo (August 2009). NBER Working
Paper No. 15223. Available at SSRN: https://ssrn.com/abstract=1454939 (last accessed 18 Mar 2019).
discounted liquidation (fire sale) which can lessen, even extinguish the value of the insurance.
The collateral gives these deposits a form of private insurance, like state insurance offered to the
individual, but which nevertheless remains subject to market risks.

The securitized loan market is the market on which the shadow banks invest. The latter are not
the source of loans and have less information on future flows. Securitization, an essential
element of the shadow banking system, therefore allows less informed investors to invest in
riskier productive projects through the purchase of assets with underlying loans16.

In the presence of asymmetric information on the asset market, securitization allows risk
diversification and increases liquidity. The banking system of the shadow thus makes it possible
to solve a problem of asymmetry of information that a conventional bank cannot solve by its
traditional tools of deposits and loans held on its balance sheet. In the presence of asymmetric
information, the quantity offered by the informed agents is analyzed by the uninformed agents as
an index of their quality. Asset sellers (in our context, the conventional banks) have a superior
knowledge of future loan returns because they know the clients to whom they granted these
loans. If the quantity ceded is too important, the uninformed agents (the buyers) deduce that the
quality is bad.

This is a classic lemons problem, as described by Akerlof17. Since price plays a signaling role for
uninformed agents, demand for assets becomes a decreasing function of price, leading to a
significant liquidity problem. Sellers cannot sell too many assets, they are forced to keep some in
their balance sheet so that their offer does not lower the price and depresses the demand.
However, this retention of assets has an opportunity cost due to the existence of new and more
profitable investments18.

The securitization of loans, i.e. their transformation into assets, their assembly into asset pools
and their division into classes of different length, allow diversification. The securities thus
created correspond to ABS with different repayment priority rights: the assets are backed by the
yield streams of the underlying loans and have a different ranking in the order of creditors. The

16
De Marzo P. & Duffie D (1999), « A Liquidity-Based Model of Security Design », Econometrica, vol. 67, No. 1,
December 2003, pp. 65-100 Available at https://doi.org/10.1111/1468-0262.00004 (last accessed 19 Mar 2019).
17
Ibid.
18
Ibid.
top tier is almost debt-like as it is ranked first in the repayment hierarchy. This diversification is
optimal because of its beneficial effect on the liquidity of these assets19.

Conventional banks can build low-risk assets from their loans by establishing classes of different
length. The most senior class thus have a secure character which reduces the information
asymmetry prevailing in the market and thus improves liquidity.

However, while the specific economic role of the shadow banking system (and distinct from that
of a traditional bank) does exist due to the economic advantages of securitization, it is beneficial
to the economy only under certain conditions and can be a source of instability. For example,
when a bank invests in two assets with uncorrelated returns, assembles them into one portfolio,
creates two classes with different priority entitlements, and then transfers each of the classes to
two separate SPVs, these two SPVs must have different risk profiles for the operation to be
beneficial to the economy20. It is questionable whether this condition is respected in the real
world. It seems that very often, the commercial bank creates only one SPV and thus the
condition is not respected. In the case of re-sales of securitized loans to the external shadow
banking system, the risk profiles of these shadow buying jurisdictions should be examined and
compared. On the other hand, if asset returns are correlated, the additional welfare costs provided
by structural finances are reduced.

Similarly, when we assume a high demand for risk-free debt from investors, the shadow banking
system is beneficial to the economy when these investors take into account the extreme risks21.
Faced with strong demand for risk-free short-term debt (corresponding to a high wealth of
investors with infinite risk aversion), shadow banks diversify their portfolios by exchanging
risky assets with other entities, in order to eliminate idiosyncratic risks22. Indeed, the only return
on risk-free assets is not enough to meet the demand for risk-free debt. Shadow banks thus create
a low-risk asset from risky assets by eliminating characteristic risks. Securitization therefore
creates a risk-free asset from risky investments. Investors with infinite risk aversion agree to buy
these assets, which allow shadow banks to finance more productive projects.

19
Ibid.
20
Martin A. and Parigi B. M. (2011), “Bank Capital Regulation and Structured Finance”, Federal Reserve Bank of
New York, Staff Reports, No. 492.
21
Gennaioli N., Shleifer A. and Vishny R. (2011), “Neglected Risks, Financial Innovation and Financial
Fragility”, Journal of Financial Economics, vol. 104, No. 3, June, pp. 452-468.
22
Ibid.
However, when investors no longer form rational expectations and neglect extreme risks, the
system proves very unstable. In addition, the explanation in terms of risk diversification has lost
its strength in the light of the latest crisis, which revealed the extreme concentration of risk that
actually prevailed in the financial system. Thus, if securitization is traditionally represented as an
operation to disperse risk out of traditional banks, Acharya et al. (2010) show how securitization
actually took place without effective transfer of risk to the buyers of securities, including the
shadow banking system, as expected. These same authors describe this phenomenon of
"securitization without risk transfer" within the banking system of the internal shadow. Ad hoc
structures created by traditional banks purchased loans securitized by commercial banks and
financed by ABCP. They received from the commercial banks (called their sponsor) a set of
guarantees that effectively eliminated any transfer of risk. These guarantees took the form of
liquidity guarantees, i.e. legal commitments to repurchase the ABCP if the conduits were unable
to refinance themselves on the market. A refusal of investors to renew the ABCP was thus
observed during the crisis, forcing the sponsor banks that provided their guarantee to replace the
market for financing. 57.5% of the losses that should have fallen in theory to the SPV were in
fact assumed by the commercial banks.

The concept of the myth of diversification makes it possible to account for this paradox.
Securitization makes it possible to reduce the characteristic risk, but leads to greater
interdependence between the various authorities in the shadow and, as a result, to an increase in
the systemic risk of their portfolios. In case of unanticipated aggregate shock, the system proves
extremely unstable. The emergence of shadow banks is the result of several combined forces: a
need for wholesale deposits by institutional investors offering a form of private insurance
deposits, securitization through diversification, maximum liquidity, and regulatory arbitrage
favored by the dissolution of the banking regulation etc.

It is likely that the banking system of the shadow would have emerged in the absence of
regulation by ratios because it assumes a real economic role. However, banking regulation
necessarily had an impact on its size because it involved regulatory arbitrage that stimulated its
development. The high demand for risk-free debt from investors largely explains the emergence
of the shadow banking system. The origin of this demand is therefore essential in this context,
but remains debated in the literature. It is sometimes attributed to the existence of global
imbalances.

CHAPTER 2: ORIGIN OF SHADOW BANKING: THEORY AND PRACTICE

In the 1980s, at the time of the total liberalization of the financial markets - considered as "self-
regulating" - securitization developed, it was thought, to better cover foreign exchange and
interest rate risks. . Without a framework, these financial arrangements have become complex,
excessive and speculative and it becomes so risky and systemic. At each new crisis, bank
regulations are decided to ensure the liquidity and solvency of banks (thus, the viability of the
system). Problem: this regulation is losing margins of maneuver and profitability to banks.
Which drives them, systematically, to circumvent it?

By removing their most risky assets from their balance sheets (and thus regulatory radar screens)
by securitizing them and selling them as "derivatives" on the financial markets, through financial
institutions. From the 2000s, with the rise of the Internet and information, the actors of this
opaque and ultra-sophisticated finance have multiplied.

Shadow banking presents two major problems: its weight in the global financing of the economy
and the interdependence of shadow banking players with each other and with the traditional
international banking system. This means that if shadow banking is systemic: if it suffers, it
brings with it the "normal “banking system. The 2007 subprime crisis is concrete evidence of
this.

The recent crisis has corroborated the idea that some countries have financial systems that are
"too big" for the size of their national economies. Two years before the collapse of the US
subprime mortgage market, Rajan (2005) suggested that financial markets could fall victim to
their own success. The longer they appear to be reliable, the greater the demand. If markets could
not continue to improve, these demands would eventually exceed their delivery capacity and
reveal the vulnerabilities accumulated during periods of rapid growth. Having come to the
conclusion that large and complicated financial systems increased the likelihood of a
“catastrophic debacle”, Rajan has sparked controversy, but his discourse now seems almost
prophetic.

A large financial sector could also take hold of political mechanisms and push for policies that
would benefit the sector, but not society as a whole. This capture of politics is due in part to
electoral contributions, but also to the sector's ability to promote the widespread belief that what
is good for finance is also good for the country. In an article affecting the leverage of the U.S.
financial industry, Johnson argued that :

“The banking and stock exchange sector became one of the main contributors to the
political campaigns, but at the height of its influence it did not have to buy favors as
might have to do, for example, tobacco companies or armaments companies. On the
other hand, it benefited from the fact that policymakers in Washington already believed
that large financial institutions and free capital markets were key to America's position in
the world”. (Johnson, 2009)23.

According to Johnson, this political and intellectual influence is the basis of a set of deregulation
policies that have: 1. Encouraged the liberalization of capital accounts, 2. Excluded the
regulations that separated the activities of investment and investment banks, 3. Prohibited the
regulation of certain derivative instruments, such as credit default swaps, 4. Allowed banks to
increase their leverage and 5. Allowed banks to assess their own level of risk.

Examining the relationship between financial development and economic growth requires an
accurate assessment of financial development. Ideally, there should be a set of indicators.
Indicators of a financial system's ability to allocate credit, extract and use information, and
exercise governance are difficult to define, let alone quantify24. Certainly, the structure of the
financial sector is likely to be important, and a financial system with commercial banks that have
wide geographical coverage and are able to provide credit to small and medium-sized enterprises
can have a greater impact on economic growth than a system concentrated in urban centers.

23
Johnson, S., The Quiet Coup, The Atlantic, Available at:
https://www.theatlantic.com/magazine/archive/2009/05/the-quiet-coup/307364/ (last accessed 21 Mar, 2019).
24
Beck, Thorsten; Feyen, Erik; Ize, Alain; Moizeszowicz, Florencia. 2008. Benchmarking financial development
(English). Policy Research working paper Report no. WPS4638 Vol.1, Washington, DC: World Bank.
http://documents.worldbank.org/curated/en/621981468314984133/Benchmarking-financial-development.
It was in August 2007, when the subprime tornado was forming, that an economist from Pimco
(the world's first Bond Fund), Paul McCulley used the term "shadow banking" for the first time
and warned of the major risks of "this shadow finance indebted to the neck". A message then
passed unnoticed. However, a year later, in September 2008, The American bank Lehman
Brothers went bankrupt

Next year another attempt for describing ‘shadow banking’ was made by Pozsar, in a paper titled
as the “Rise and Fall of the Shadow Banking System”25. Pozsar relates the upward thrust of
shadow banking to structural adjustments in credit intermediation by using banks: from on-
balance intermediation to ‘originate-and-distribute’, which requires using off-balance sheet
intermediaries along with conduits and dependent investment motors (SIVs).

Ten years into the crisis that is far from over, it has become obvious that the tide of new
regulation has more or less run its course. Compared to the dramatic regulatory changes that
were enacted in the immediate aftermath of the Great Depression (Glass-Steagall, Government
Sponsored Enterprises, Deposit Guarantees, huge public infrastructure projects as well as the
establishment of crucial parts of the US welfare state), the political response to the Great
Recession has been notably practical.

The financial crisis that began in the summer of 2007 in the United States reveal that the shadow
banking system is the weak link in the international financial system. The mechanisms
underlying the sub-prime crisis are well known. The onset of the crisis is linked to the shift in US
monetary policy to fight the housing bubble. The rise in interest rates is leading to an increase in
household defaults. In an episode of traditional credit crunch, banks are experiencing losses,
short-term refinancing with the central bank, and recapitalization through recourse to investors.

But to the extent that bank claims had been transferred to the shadow banking system to be
transformed into structured products and then sold to investors in the United States and around
the world, the crisis took on a whole new dimension and spread internationally. One of the first
signs of the crisis was sent on 9 August 2007 by BNP-Paribas, which suspended two of its
investment funds, which declared that they were unable to add value to the structured products

Pozsar Zoltan, “The Rise and Fall of the Shadow Banking System” Moody’s Regional Financial Review / July
25

2008 , Available at: https://www.economy.com/sbs (last accessed 22 Mar, 2019).

acquired on the US market. The crisis accelerated in 2008 with the chain failure of many hedge
funds and large investment banks, which are the main players in the shadow banking system. In
March, the hedge fund Carlyle Capital defaulted on 16.6 billion debts and brought down the
American investment bank Bear Stearns, one of its main creditors. In September, two other
investment banks, Merrill Lynch and Lehman Brothers, are on the verge of bankruptcy. While
Bear Sterns and Merrill Lynch were bought by JP Morgan and Bank of America respectively
with the help of the US Treasury, Lehman Brothers went bankrupt on September 15, 2008. This
bankruptcy pushed the world's No. 1 insurance company, AIG (American International Group),
to the brink of bankruptcy, the latter not being able to meet the credit risk protection on Lehman
Brothers bonds sold to banks worth $ 460 billion, including French Societe Generale victims of
panic, the two independent American investment banks, Goldman Sachs and Morgan Stanley,
must transform into commercial banks to have access to the Federal Reserve's liquidity, offered
exclusively to banks with this status.

Banking failures are also increasing on the European continent, affecting Northern Rock in the
United Kingdom, Fortis in Belgium and Franco-Belgian bank Dexia, all of which have over-
consumed structured products. By the end of 2008, bank losses were estimated at $ 700 billion,
and stock prices in major financial centers had fallen by 50 per cent. Despite bank bailouts and
government stimulus policies, which led to a sharp rise in public debt, the recession began in
2009 in developed countries and affected some emerging economies. In 2013, the shock wave of
the financial crisis continued to be felt throughout the global economy.

2.1 TAX AVOIDANCE AND EMERGENCE OF SHADOW BANKING

Another probable reason for the development of shadow banking can be deeply linked to the tax
and regulatory flexibility they offer to companies, financial institutions and individuals. Indeed,
it has been suggested that investigating tax arbitrage in particular may perhaps help researchers
and policy makers to incorporate the so-called ‘endogenous’ and ‘exogenous’ explanations of
shadow banking26. Tax arbitrage helps to mobilize the ability to leverage financial innovations
within banking, and reduce taxation costs from forms of financialized assets and income streams,

26
Lysandrou, P. & Nesvetailova, A. (2014). The role of shadow banking entities in the financial crisis: a
disaggregated view. Review of International Political Economy, 22(2), pp. 257–279 Available at : doi:
10.1080/09692290.2014.896269 (last accessed 22 Mar, 2019).
which help to offer both fee income for shadow banking institutions and after-tax yield to bond
and securitized asset holders. It has also been suggested that taxation issues help to bridge
another open question about shadow banking whether these are mainly a monetary or financial
phenomenon. One of the key achievements of shadow banking is not so much just that their
activities are outside of prudential regulatory spaces, but that they have developed hybrid
institutions and instruments that bridge the older descriptive boundaries of money and finance.

There can a possible link between development of shadow banking and tax arbitrage. One study
in particular in respect of development of Irish SPV (Subprime Special Purpose Vehicle) sector
has indicated that ultra tax-efficient centers or tax havens have been breeding grounds for
shadow banking system 27 . The rapidly emerging body of literature on the shadow banking
industry, has generally tended to overlook the not insignificant fact that many security based
swap entities (SBSs), possibly even the majority of such entities, including hedge funds, SPVs,
structured investment vehicles, and money market funds are registered in jurisdictions known
colloquially as tax havens. Perhaps due to an understandable focus on speculative dynamics and
the complexity, opacity and fragility of global financial markets in general, the growing literature
on the financial crisis has tended to ignore that a good portion of the failed subprime loans were
held by SPVs, at least nominally, in jurisdictions such as Ireland and the Caymans 28 . The
problem here, however, is that the issue too readily becomes a policy-oriented challenge of how
to get this activity back inside the prudential scope of central banks, rather than an effort to
understand what was driving (and continues to drive) the growth of these activities in the first
place.

The U.S. Inland Revenue Service recently estimated that $100bn of tax is lost annually due to the
corporate use of derivatives in tax planning 29 . Although disputed, this is undoubtedly a
significant figure that questions the exclusive focus in orthodox finance literature on derivatives
as simply hedging and trading instruments. By way of comparison, the total tax paid by the top

27
Jim Stewart, Cillian Doyle, (2017), The Measurement And Regulation Of Shadow Banking In Ireland, Journal of
Financial Regulation and Compliance, Vol. 25 Issue: 4, pp.396-412, Available at: https://doi.org/10.1108/JFRC-02-
2017-0019 (last accessed 22 Mar, 2019).
28
Adrian, T. and A. Ashcraft (2012), Shadow Banking: A Review of the Literature, Federal Reserve Bank of New
York Staff Report, no. 580,Available at: www.newyorkfed.org/ medialibrary/media/research/staff_reports/sr580.pdf
(last accessed 22 Mar, 2019).
29
Donohue, M. (2012), Financial Derivatives in Corporate Tax Avoidance: Why, How and Who? AAA Annual
Meeting – Tax Concurrent Sessions. Available at: http://ssrn.com/ abstract=2097994 (last accessed 23 Mar, 2019).
30 European banks at the height of the financial bubble in 2007 was 33.9 billion Euros (ECB
2007).

There are clearly demands and supply issues that are fulfilled by the security based swap entities
(SBSs) as discussed in this chapter, but there is little doubt that one of the primary drivers of the
emergence of the entities, products and markets that make up the shadow banking industry is tax
avoidance. The author suggests that while tax and regulatory avoidance is not the only reason for
the growth of shadow banking, it has been critical to its structure and evolution in ways that are
often underappreciated.

2.2 AN ECONOMY OF DISPLACEMENT

For most of the twentieth century, economic paradigms and regulatory frameworks have been
built on the clear separation of national and international jurisdictional space, and within nations,
between fiscal and financial phenomena. Tax evasion and tax-avoidance are generally dealt by
municipal laws or bi-lateral treaties and recently through some international initiatives taken by
OECD. Global Financial supervision, on the other hand, was oriented towards market stability
and did not take the issue of complex inter-connectedness between financial and fiscal matters
into account.

This separation between the two realms is replicated in academic discourse as well. Financial
economists rarely devote much attention to fiscal considerations, whereas accountants and tax
lawyers usually profess to know very little about financial matters. This is not unreasonable
considering the diverging types of expertise needed to operate in the two realms. Yet, financial
entities are, as economists are fond of emphasizing, profit oriented businesses. Economists do
not pay sufficient attention to the blurring of the boundaries between the national and
international, or to the differences between the concepts of pre-tax and post-tax profit-orientation
of the firm.

On contrary, the theory seems to be that cross-border transactions have marginal implications
and do not affect the basic structure of the national–international divide. Governments are only
concerned about receiving of taxes and assumption is that the post-tax positions do not affect the
position of an entity. This view, if it were ever true, is increasingly obsolete. As businesses
operate in a world of notionally separate states, each with different treatments of different assets
and income streams, the ‘bottom line’ for companies, to all intents and purposes, is their post-tax
position in the jurisdictions in which they operate. As businesses increasingly operate across
multiple jurisdictional spaces (either directly or indirectly), they can and do structure their
corporate organization, costs, expenses and financial transfers in such way as to minimize
taxation – just like any other costs. And this means that however odd these resulting structures
may appear from a conventional productivity and methodologically nationalist economic
perspective, financial and organizational innovation has changed our understanding of national
and corporate juridical space. In conventional accounts the world of states consists of political
entities that are in control of landed territories, including adjacent waters, each of which are
sovereign independent states and have a right to regulate businesses located, domiciled or
licensed in their territories as well as levy tax on them. From an international businesses’
perspective, the world consists of easily traversed diverging sovereign platforms, each of which
offers a distinct bundle of regulatory, taxation and market attributes. There are no particular
reasons why business would tend to ensure that activities are recorded, and hence tax is paid
where income accrues, costs incurred or profits are made. On the contrary, business would aim to
structure activities in such a way that profits accumulate where tax is minimal, while expenses
are recorded where subsidies and deductions are maximized. Tax is therefore integral to
evaluating a spread, or how much above a risk-free rate a product must return. Modern systems
of taxation have developed on the basis of a relatively simple world where corporeal property is
exchanged in the provision of goods and services, where costs and income accrue and corporate
entities have a recognizable national home. Taxation is typically levied on an entity at the point
of assumed completion of the series of transactions. But two changes in economic activity have
changed these assumptions. First, the growth of the services sector activity has meant that more
and more of economic exchange occurs in or is based around incorporeal property, and these
activities make location, ownership and valuation issues far more fungible and mobile. Second,
in the inherently incorporeal world of finance and commerce, these simple attributes of
ownership, location, forms of capital can be unbundled, rearranged and relocated to achieve one
of the following:

 That the issuing business in charge of final transactions, or that the business that appears
to gain from the final transactions and hence where ‘profit’ is logged, happen to be
located in territories that levy minimal or no taxation on such entities. Hence, for
 instance, most hedge funds will be registered in territories known colloquially as tax
havens.
 Or that final transactions are structured in such a way that they are ‘logged’ or registered
in political platforms that levy minimal taxation on a particular form of final transaction
that is used for such cases – hence tax is minimized. Businesses set up ‘holding
companies’ and various types of ‘SPVs’ in offshore locations for that purpose. Financial
engineering is also one way of minimizing tax burden.
 Or that final transaction is structured in such a way that the maturity point of the
transaction that triggers taxation is deferred to some point in the future, but the future
never truly materializes, and/or the transaction is structured in such a way that it takes
place in a simulated realm that is not easily recognizable by the tax authorities, and hence
the transaction may disappear completely from their radar. That is where derivatives
come into play.

Indeed, it is not too much to argue that much of the financial innovation and corporate
restructuring, has involved fiscal arbitrage in which potential tax liabilities can be deferred or
displaced30. An economy of deferral and displacement has emerged, supported and sustained by
a large and sprawling army of accountants, lawyers and financiers, which according to a recent
estimate by a UK parliamentary committee (House of Commons 2013) 31 , is worth about
$US55bn a year, to consult businesses on how to take advantage of either strategy a, b or c, or
ideally, all three, to ensure their post-tax position is minimized. Importantly for this chapter,
author argues, tax arbitrage has been one of the key drivers for the emergence of the shadow
banking industry.

2.3 DERIVATIVES AND TAX AVOIDANCE

In the early phase of the development of derivatives, researchers seemed to be very aware of the
tax advantages offered by such transactions and their role in international capital flows. The
Structured Capital Markets division reportedly contributed as much as £1bn a year to Barclays’

30
Desai, Mihir A., The Decentering of the Global Firm, World Economy, Vol. 32, Issue 9, pp. 1271-1290,
September 2009. Available at http://dx.doi.org/10.1111/j.1467-9701.2009.01212.x (last accessed 23 Mar, 2019).
31
House of Commons Committee of Public Accounts, Tax Avoidance: Tackling Marketed Avoidance Schemes,
House of Commons, Available at: https://publications.parliament.uk/pa/cm201213/cmselect/cmpubacc/788/788.pdf
(last accessed 23 Mar, 2019).
profits by selling complex structured products which had the effect of reducing tax charges or
providing artificial deductions – accounting items that can be set against taxes due32.

A comprehensive study on tax planning and use of derivatives indicates that “derivatives are
attractive because they can imitate financial positions, blur economic substance, and introduce
considerable ambiguity in tax reports” and refers to an annual $100bn lost to the U.S. Inland
Revenue Service due to corporate use of derivatives in tax planning33.

Financial derivatives, which emerged in the immediate wake of the collapse of the Bretton
Woods System as a mechanism to harness and navigate the volatility of market driven finance,
are contracts the value of which derives from the performance of underlying securities prices,
interest rates, foreign exchange rates, commodities and market indexes.

The industry is the largest in the world. The notional value of all OTC contracts at the end of
December 2012 was $633 trillion, down from an all-time high of $706 trillion at the end of June
2011(BIS 2013). Derivatives challenge fiscal efficacy via the capacity to transform when a fiscal
claim is applicable (timing) where that fiscal claim should be applied (source) and to what the
fiscal claim is applied (income character or asset identity).

Derivatives provide a fancy position to contracting parties by allowing legal advantages of a

position without the same obligation. As a result, the transaction may go under the radar of tax
authorities or simply be misidentified. As mentioned earlier, tax rates vary across jurisdictions
and asset types. This legal-geographical differentiation is the grounds upon which the
transforming, synthesizing and switching functions of derivatives perform. As a result,
derivatives are, to borrow a phrase, potentially ‘fiscal weapons of mass destruction’ because they
afford the ability to replicate the commercial outcome of a transaction without entering into the
transaction and incurring the tax exposure associated with such a transaction.

Simply, a position on a bond can be synthesized through a position in equity options by entering
into put and call contracts. In this example, the value of the bond which will be replicated is 100.

32
ExecReview, Barclays Secret Tax Avoidance Factory That Made £1bn A Year Profit Disbanded,
http://www.execreview.com/2013/02/barclays-secret-tax-avoidance-factory-that-made-1bn-a-year-profit-disbanded/
(last accessed 22 Mar, 2019).
33
Donohoe, Michael P., 2015. The Economic Effects of Financial Derivatives on Corporate Tax Avoidance, Journal
of Accounting and Economics, Elsevier, vol. 59(1), pages 1-24.
The put and the call are written so that the investor has a right to sell at a given fixed price and
buy at a given fixed price at the same time. If the underlying equity moves below 100 the
investor can exercise the put at 100. If the equity moves above 100, the call written with a strike
price of 100 will be exercised and the investor will receive 100. In effect a position on a fixed
income asset (one that returns a predefined sum, such as the bond) has been replicated by a put
and a call. The put and call as opposed to providing fixed returns, provide the investor with
contingent returns. A position with fixed returns and one with contingent returns may be taxed
differently. Consequently, an investor can choose a preferred tax exposure. Further, a swap
allows an investor to switch between asset forms and where an asset is located providing the
investor with a choice of where tax is due and on what basis.

A core fiscal principle is the determination of when and where an item of income or expense
becomes subject to tax. This matters because of the time value of money. A taxpayer is likely to
prefer to pay €100 in two years time than pay €100 tomorrow. In a situation where a tax charge
arises on the basis of a triggering event, such as an asset sale, it is possible via a derivative
structure to replicate the payoff from the asset sale without making the sale. In effect, income can
be realized but tax will not be. This is a function of constructing a sale of some attributes of an
asset and postponing a transfer of direct ownership, perhaps almost indefinitely. An investor who
holds shares the price of which has increased may wish to realize that profit. If the investor sells
the shares, a capital gains tax will be imposed. On the other hand, an investor could, where
legally admissible, buy a put option on the equity from a bank with a strike price of 100 that
matures in two years. The current share price is 100. The investor then sells a call option with the
same strike price and maturity. Simultaneously, the investor borrows from the counterparty the
full value of all the shares owned using the shares as collateral for the loan. The end effect is
stark. The investor realizes gains in the present, but owes no tax now. Furthermore, due to the
options the investor is no longer exposed to changes in share value. If the share price is higher
than 100 when the option matures, the loss on the call offsets this gain. If the share price is lower
than 100, the gain on the put option offsets this loss. Eventually the loan will have to repaid, but
the contract could be renewed nearing maturity.

The transformation of source rules follows similar principles. A foreign investor in equities
subject to withholding tax on the sale of the equities may turn to an equity swap to alter where
the income is sourced for tax purposes. For instance, returns from an investment in US equity by
a foreigner will usually be subject to a withholding tax of 30 per cent. However, the investor can
receive the same returns through an equity swap in which she receives payments from a
counterparty if the value of the equity increases or dividends are paid, and makes payments to
that counterparty on the basis of interest on the value of equity referenced in the swap and in the
event that the value of the equity declines. The source of the income in a swap is based on the
residence of the investor, while a direct purchase of equity is sourced where that purchase is
made. If that investor is resident or registered in an offshore jurisdiction, income from the swap
may be subject to no tax at all. By artificially replicating a desired equity position, a foreign
investor can receive the economic benefits of direct ownership without the fiscal obligations
attached to it.
CHAPTER 3: RISKS ASSOCIATED WITH SHADOW BANKING: INVESTMENT
FUNDS AND GOVERNANCE

Credit intermediation; accepting deposits or other short-term funding from surplus agents and
lending it on to corporations, households and public bodies with borrowing needs – is typically
associated with banks. Traditionally credit intermediation has been provided through a business
model where banks act as single intermediaries, managing all stages of the credit intermediation
process. The role of other financial intermediaries, such as investment funds, has been limited.
However, in recent decades, the provisioning of credit has become increasingly segmented, with
the various stages of the intermediation process supplied by a variety of financial entities,
specializing on one particular or several stages in the intermediation chain. The potential benefits
from such segmentation are substantial. It allows for more efficient intermediation, provides
opportunities to diversify risk, improves pricing and allocation of risk as well as avoids its
concentration in (typically a few large) banks. It also increases supply of funding and liquidity,
thereby lowering costs for banks, their clients and the overall economy34.

Involvement in the credit intermediation process by non-bank financial intermediaries, either by

directly supplying credit or by taking part in one or more stages of the credit intermediation
process, has become known as shadow banking. It can hardly have escaped anyone with interest
in financial markets that the segmentation of the credit intermediation process, coupled with
various vulnerable business models of many shadow banks, contributed to the build-up and
manifestation of the global financial crisis. No wonder then that regulating and improving
oversight of these nonbank credit intermediaries have become a top policy priority. Since the
request from G20 in November 2010, the Financial Stability Board (FSB) has undertaken
considerable work in mapping and exploring possible regulatory reform to reduce systemic risk
and opportunities for regulatory arbitrage in the shadow banking system.

But despite this, it is fair to say that the understanding of shadow banking is still in its infancy.
As sound understanding is a precondition for appropriate regulation, there is a need for
exploratory studies that seek to unveil particular aspects of shadow banking. This can include
studying single stages in the credit intermediation process or looking at the involvement of one

Elias Bengtsson, Fund Management and Systemic Risk – Lessons from the Global Financial CrisisFinancial
34

Markets, Institutions & Instruments(2014), https://onlinelibrary.wiley.com/doi/epdf/10.1111/fmii.12016 (last visited

Mar 22, 2019).
particular type of non-bank entities. This chapter seeks to accomplish this by considering the role
of investment funds in the credit intermediation process and discussing various forms of
systemic risk it might give rise to. Based on these findings, it draws some conclusions on various
policy challenges facing authorities charged with overseeing and regulating shadow banking.

3.1 FUNDING CREDIT INTERMEDIATION: SUBSTITUTING MATURITY

TRANSFORMATION

While funds with fixed income exposures display large variation in the combination of ratings
and maturities in their asset allocation, money market and short-term credit funds in general
provide significant funding to the banking sector. For short- and medium-term money and credit
instruments issued by banks, these funds play a particularly important role.

In addition, a significant amount of these investment funds’ money travels across border. This
means that the total proportion of money and short-term debt instruments issued by banks and
held by investment funds is even higher. For example, in mid-2008, US MMFs placed around
half their assets under management with non-US banks. This funding corresponded to around
one-eighth of European banks’ US$ funding needs35.

In a shadow banking framework, the supply of funding by investment funds to banks

corresponds to a partial substitution of banks’ maturity and liquidity transformations. This relates
to the funding profile of investment funds. For open-ended funds, fund shares are withdrawable
at notice. This means that when such funds invest their immediately withdrawable funds in any
financial instrument that has a longer tenure, the funds are engaged in maturity transformation.
To the extent that banks replace deposit or other forms of short-term funding with funding with
longer tenure from investment funds, their maturity transformation has decreased. However, the
maturity transformation of banks has in fact been substituted by maturity transformation by
investment funds.

35
US dollar money market funds and non-US banks, https://www.bis.org/publ/qtrpdf/r_qt0903g.pdf (last visited
Mar 24, 2019).
3.2 INVESTING IN STRUCTURED CREDIT: REVERSING MATURITY AND
LIQUIDITY TRANSFORMATION

In the context of credit intermediation, reversals of maturity and liquidity transformations are
facilitated by investment funds investing in various forms of securitized loans. This includes a
wide spectrum of structured credit instruments, ranging from simple asset-backed securities
(ABSs) to various forms of more complex collateralized debt obligations (CDOs). Market data
on structured credit is very limited, but investment funds and hedge funds play important roles as
both buyers and sellers of these instruments36.

Estimates of global CDO exposures by the end of 2006 corroborate this picture; hedge funds’
share of total CDOs amounted to 47 per cent, whereas investment and pension funds together
held around 19 per cent 37 . In fact, hedge funds in particular played a decisive role in the
development of the CDO market from the early 2000s and onwards. By 2008, structured credit
represented more than half of total credit exposure to residential mortgages, and more than a
quarter of total credit exposure to commercial mortgages and consumer credit in the US (IMF,
2008). The fact that the importance of structured credit in the intermediation process has
diminished considerably since, is rather an illustration of the role of non-banks in strengthening
cyclicality in credit supply. From a shadow banking perspective, the role played by investment
funds in structured credit implies three things:

(1) Funds’ investment in structured credit substitutes the role of banks in taking on credit risk. It
also supports a continuous credit intermediation process by freeing (regulatory) capital of banks,
which then can be used to buttress additional loans.

(2) Structured credit enables banks to reverse their liquidity and maturity transformations, as
securitizing credit implies taking long-term illiquid loans and transforming them into short-term
liquid securities. By investing in these assets with short-term funding, investment funds reverse
and take over banks’ maturity and liquidity transformations.

36
Joint Forum final release of "Credit risk transfer" paper, The Bank for International Settlements(2008),
https://www.bis.org/press/p080731.htm (last visited Mar 24, 2019).
37
Elias Bengtsson, "Investment funds, shadow banking and systemic risk", Journal of Financial Regulation and
Compliance, Vol. 24 Issue: 1, pp.60-73, https://doi.org/10.1108/JFRC-12-2014-0051(last visited Mar 24, 2019).
(3) Just as for bank debt securities, the fact that investment funds frequently trade in structured
credit means that they contribute to market liquidity for these instruments. This in turn is a
precondition for the instruments to be effectively used as collateral in secured transactions.

3.3 THE INTERMEDIATION PROCESS OF THE SHADOW CREDIT

The shadow banks system is organized around securitization and wholesale financing. Under this
system, loans, financial leases and real estate loans are securitized and thus become negotiable
instruments. Financing is also provided in the form of negotiable instruments such as commercial
paper and repos. Investors hold money market investments rather than bank deposits.

Like the traditional banking system, the shadow banks system operates as a credit intermediation
system. But unlike the traditional banking system where intermediation takes place ‘under one
roof’ that of the bank, in the shadow banks system, it is done through a chain of non-banking
intermediaries in a multi-step process. These include: (1) the creation (origination) of loans, (2)
the stocking of loans, (3) the issue of ABS, (4) the stocking of ABS, (5) the issue of ABS CDO,
(6) the intermediation of ABS, (7) the wholesale financing38. The shadow banks system carries
out these credit shadow intermediation operations in a strict order, each step of which is carried
out by a specific type of shadow banks using a particular type of financing techniques:

1. The creation of loans (e.g. car loans and financial leases, non-conforming mortgage
loans) is produced by financial corporations which are financed by commercial paper
(CP-commercial paper) and medium - term notes (MTN-medium term notes)
2. The stocking of loans is done through mono or multivendor conduits and is financed by
ABCP
3. Pooling and structuring of ABS asset-backed securities is done by the ABS desks of the
brokerage firms
4. ABS storage is carried out through trading books and financed by repurchase agreements
(repos), total return swaps (TRS) or hybrid repos
5. The pooling and structuring of ABS in CDO are also carried out by the desks of the ABS
syndicates of the brokerage firms

38
Laura E. Kodres, What Is Shadow Banking?, Finance & Development, June 2013, Vol. 50, No. 2, IMF, Available
at: https://www.imf.org/external/pubs/ft/fandd/2013/06/basics.htm (last visited 25 Mar, 2019).
 6. ABS intermediation is handled by limited purpose finance companies (LPFC), structured
investment vehicles (SIV), securities arbitrage conduits and credit hedge funds that are
financed in various ways, such as repos, ABCP, MTN, capital and debt securities
7. All of these activities and entities are financed in wholesale financial markets through
fund providers, such as regulated and unregulated money market participants, and direct
money market investors. In addition to these liquid investors, who finance shadow banks
through short-term rest, CP or ABCP, fixed-income mutual funds, pension funds and
insurance companies participate in the financing of shadow banks by purchasing longer-
term MTN and bonds.

The process of credit intermediation by shadow banks fulfils an economic role similar to that of
credit intermediation by banks in the traditional banking system. The shadow banks system
breaks down the simple process of deposit-financed and mature loans implemented by banks into
a more complex process, based on wholesale financing and based on securitization. Through this
intermediation process, shadow banks convert risky long-term loans (e.g. subprime mortgage
loans) into seemingly risk - free, short-term, currency-like instruments, such as money market
shares with a stable net asset value39.

It should be noted that not all channels include the seven steps, and some may have more than
seven steps. For example, a supply chain may stop at the second stage if a pool of good quality
car loans is sold by a finance company to a multi-vendor conduit set up by a bank for long-term
storage. In another case, a CDO ABS can be rearranged into a CDO2 ("CDO Squared") that will
extend the intermediation chain to eight steps. Normally, the lower the quality of the underlying
loans at the start of the chain (for example, a subprime mortgage pool created in California in
2006), the longer the credit intermediation chain will be, in order to improve the quality of the
underlying loans at the levels required by the MMMFS and equivalents. In general,
intermediation of low quality long-term loans (non-compliant mortgages) includes all seven
steps, whereas intermediation of short-or medium-term loans (credit cards, car loans) usually

39
Governor Daniel K. Tarullo,Shadow Banking and Systemic Risk Regulation,Financial Reform and Economic
Policy Institute Conference, November 22, 2013, Available at:
https://www.federalreserve.gov/newsevents/speech/tarullo20131122a.htm (last visited 25 Mar, 2019).
includes three steps (and rarely more). The supply chain always starts with origination (creation)
and ends with wholesale financing, and each shadow bank only appears once in the process.

3.4 THE FRAGILITY OF SHADOW BANKING'S FINANCING STRUCTURES

Shadow banking has been and still is a vector of systemic risk and must therefore be regulated
from a macro-prudential point of view, that is to say, with the objective of the stability of the
global financial system and not of any particular category of financial intermediary. Liquidity is
at the heart of the systemic vulnerability of shadow banking in various interdependent forms, the
analysis of which provides avenues for regulation.

Money market funds are in a position of vulnerability to liquidity risk similar to that of banks:
they are dependent on the confidence of share-holders. In case of distrust, as was the case in
September 2008 in the United States after the bankruptcy of Lehman Brothers, a rush is possible,
comparable to a bank panic. All policyholders can choose to withdraw their savings from the
fund and recover their liquidity. The absence of a deposit guarantee increases the risk of a run
since, in the case of a money fund; no guarantee protects the savings placed. To meet the legal
obligation to fix the $ 1 share, the funds were forced to sell their securities in order to recoup
liquidity and meet the demands of their clients. As of September 15, 2008, sales of units
amounted to $ 300 billion (14 per cent of the outstanding under management). By the end of
September, the money market funds had sold 29 per cent of their portfolio of short-term
securities even though they were the main driving force behind this market (40 per cent held by
the money market funds). In the face of this earthquake, the US Treasury had to intervene by
guaranteeing the value of the share of the funds at one dollar and by creating facilities to support
the short-term market (statement of SEC president Mary Shapiro, August 22, 2012) 40 . For
example, while money fund policyholders equated this investment with a bank deposit, the
2007/08 rush highlighted the financial and non-monetary nature of their investment.

In the repo market, the danger arises from the temporary illiquidity linked either to an excess
demand for good quality securities in the face of an insufficient supply, or to a significant
increase in the spreads required for certain categories of securities. Both of these events occurred

40
Statement of SEC Chairman Mary L. Schapiro on Money Market Fund Reform, Washington, D.C., Aug. 22, 2012,
Available at: https://www.sec.gov/news/press-release/2012-2012-166htm (last visited 26 Mar, 2019).
in the repo market during the crisis. Many AAA rated securitized products (short-term and long-
term) were circulating in the repo market. All AAA securities had the same interest rate (Gorton,
2010). Starting in the summer of 2007, there was a differentiation of the rates according to the
securities, as securitized products received an increasingly high discount before virtually
disappearing from the market.

The securities traded in the shadow banking system, especially the securitized products that can
be used to support repo, give the illusion of being liquid. The opacity of asset valuation and risk
assessment models has been at the heart of the development of structured finance and shadow
banking. They have created an illusion of low-cost, high-yield and low-risk liquidity for complex
financial products for which market participants do not have the information necessary to value
these products. The more pervasive this illusion is in the period of financial euphoria, the less
prudent market participants are and the more they delegate to models - and rating agencies - the
assessment of the risks they take.

Since mistrust prevailed with securitized products, the demand was limited to sovereign
securities, but supply was very weak. The volume of transactions on the repo market collapsed:
Gorton speaks of panic over the repo. Crystallizing the mistrust, European banks were
particularly affected and could no longer refinance themselves on the US repo market. As a
result, there has been an increase in transactions on the European repo market between European
players41. It should be noted that this movement of mistrust on the repo market has occurred in
parallel with that observed on the inter-bank market. Bank refinancing could no longer operate in
the markets and it was the intervention of central banks that made it possible to escape a banking
crisis.

Hedge funds are also a potential source of systemic risk because of their level of indebtedness
and their intervention in illiquid markets42. However, during this crisis, even though bankruptcies
of hedge funds took place, they did not lead to a systemic effect. Hedge funds were more victims
of the crisis with the collapse of securitized products (first wave of credit default hedge fund

41
Klára Bakk-Simon et al., Shadow Banking In The Euro Area 1 An Overview, Occasional Paper Series No 133 /
April 2012, Available at: https://www.ecb.europa.eu/pub/pdf/scpops/ecbocp133.pdf (last visited 26 Mar, 2019).
42
M.Aglietta, S. Rigot, Crisis and Financial Renovation, Librale Publications.
failures in the spring of 2007) and then with the credit restrictions imposed by brokers' premiums
during the falling markets.

THE FRAGILITY OF A VERY PRO-CYCLICAL LEVERAGE

As we have analyzed, repos and securitization are instruments that favor the development of
credit and its uncontrolled diffusion via a myriad of unregulated organisms. In addition, the
illusion of the liquidity of these instruments allows these securities to benefit from an
underestimation of the real risks. They are therefore massively sought after in the high cycle and
rejected just as massively at the bottom of the cycle. They therefore feed the pro-cyclicality of
financial leverage and credit. The fall in the price of risk is a powerful momentum amplification
factor that feeds the vicious circle of debt/asset price increases in the euphoric phase of the cycle.
In derivatives, the amount of leverage is directly related to the value of the underlying assets,
with derivatives buyers investing very little capital43. This type of leverage is powerfully pro-
cyclical. It boosts the return on capital of banks and other securitization players in times of
financial euphoria, typically in the pre-crisis period the rise in real estate prices was a machine to
rake in profits but became a powerful mechanics to generate losses and deplete capital when
asset prices have turned.

The leverage effects of shadow banking entities can be explained by the cascading of the
leverage of different entities and the combination of economic and financial leverage. Economic
leverage is the best known form of leverage that comes from borrowing cash, financial leverage
is that incorporated into the use of derivatives. It does not appear in the balance sheet since it is
not the result of a loan. Thus the purchase of CDO's tranche equity by a hedge fund involves
considerable implicit leverage. Let's illustrate the lever stunts. The investment banks have a very
high leverage financed mainly on the markets rest i.e. by loans against securities. Very pro-
cyclical financing. These same investment banks as prime brokers finance the hedge funds and
thus fuel the growth of their leverage, hedge funds which themselves hold illiquid and risky
assets often resulting from securitization, financed by a hidden leverage because implicit. The
leverage of unregulated shadow banking thus increases faster than that of other lenders, notably

43
Tobias Adrian and Hyun Song Shin, Procyclical Leverage and Value-at-Risk, Federal Reserve Bank of New York
Staff Reports, no. 338, July 2008; revised August 2013, JEL classification: G21, G32 Available at:
https://www.newyorkfed.org/medialibrary/media/research/staff_reports/sr338.pdf (last visited 26 Mar, 2019).
because it combines economic leverage and financial leverage. As asset prices increase, the share
of this type of financing increases in the aggregate balance sheet of financial intermediaries. The
whole system is made more fragile. When the crisis breaks out, the shadow banks collateral
collapses, lenders withdraw, and the systemic liquidity crisis spreads.

3.5 THE LIQUIDITY PROBLEM

Liquidity is therefore the Achilles' heel of both banks and the shadow banking system. However,
liquidity risk is an inherently systemic risk: it generates chain reactions from bank or non-bank
financial intermediaries to liquidity stress.

The illiquidity spiral is explained by the increased interdependence between financing illiquidity
and market illiquidity in times of stress on liquidity. Access to market liquidity refers to the more
or less liquid nature of the assets, that is to say the possibility for a financial intermediary to sell
on the market without discounting assets to obtain liquidity. Financing liquidity refers to the
ability of financial intermediaries to easily borrow on the markets. These two forms of liquidity
are excessively interdependent because of the prevalence of securities lending in financing the
wholesale liquidity markets 44 . The intuition of this interdependence can be explained in the
following way: trading requires capital. When a trader (dealer, hedge fund or investment bank)
buys a security, he can use it as collateral and borrow on that basis but he cannot borrow the total
value of the collateral. The difference between the price of the security and the value of the
collateral is what is called the margin; it must be financed from the trader's capital. This creates
interdependence between market and financing liquidity. When the "financing liquidity" is
tightened, traders become reluctant to take positions in particular capital-intensive with high
margins. This reduces market liquidity and leads to increased volatility. Symmetrically, a
tightening of the market liquidity increases the risks of financing of the trading and thus
increases the margins.

These spirals of illiquidity are what are called self-fulfilling prophecies: this explains why
systemic risk is endogenous. As a result of the reaction of financial players to a liquidity shortage
or the mere anticipation of a tightening of liquidity that aggravates the lack of liquidity for

44
R. Christopher Small, Shadow Banking and Bank Capital Regulation, HLS Forum on Corporate Governance and
Financial Regulation, Available at: https://corpgov.law.harvard.edu/2014/10/27/shadow-banking-and-bank-capital-
regulation/ (last visited 26 Mar, 2019).
others. In other words, by their microeconomic and risk-protective rational behaviors, agents
create and amplify the risk against which they seek to protect themselves. This is what happened
from mid-September 2008 to mid-October 2008 in particular. The simultaneous attempt by many
banks to restore their liquidity positions by disengaging or tightening their holdings in the
interbank market has contributed to the general collapse of liquidity. The exit timing of the acute
phase of liquidity crisis has been totally conditioned by the public actions of governments and
central banks: there are no endogenous forces in the market allowing its recovery without
external support. Currently, the approach of regulation by the statute (bank, manager of OPC,
insurance, etc.) takes precedence over a regulation based on the activity. In other words, there is
a growing gap between the despecialization and segmentation of finance, i.e. the fact that the
same type of activity can be exercised by different legal entities (regulated or not) and with
different instruments and a European law conceived and built according to a logic of the silo. It
is not the activities that are regulated but the legal entities: there are "banking", "insurance",
"investment services" or "collective management" Directives45.

Thus, the intermediaries that have fueled the credit drift all have financial structures similar to
those of banks: they hold illiquid and risky assets that they finance with a liquidated short-term
indebtedness. The interconnection between all these financial entities generating a strong
leverage is very strong and in case of financial stress the counterparty risk becomes considerable.
It should be noted that the Fed in the United States and the Bank of England had to extend access
to the lender of last resort to investment banks and money market funds under conditions
announced as temporary. However, it is now known that in case of need this device can always
be reactivated. It would therefore be very pernicious, from the point of view of moral hazard,
that shadow banking entities are not regulated like commercial banks.

The scope of regulated institutions therefore needs to be revised by integrating all systemically
important financial institutions. Any entity that generates or transmits endogenous risk via credit
or derivative markets whether related to size, interconnections or leverage should be considered
systemically important and should therefore be subject to macro-prudential regulation. The

45
Skipper, Harold, Financial Services Integration Worldwide: Promises and Pitfalls, North American Actuarial
Journal 4 (2000).
calibration of the macro-prudential constraints imposed on it must be a function of its
contribution to systemic risk.

It is therefore necessary to implement a macro-prudential policy that transcends the

differentiations between financial institutions: banks and parallel banks must be regulated in the
same way as regards their exposure to liquidity risk. In other words, the regulation of shadow
banking requires switching from differentiated regulation by financial institutions to a unified
regulation by financing activity. A macro-prudential policy should focus on the liability structure
of the financial players to reduce the liquidity risk. It must therefore penalize the most vulnerable
financing structures by increasing securities lending transactions, irrespective of the financial
entities that use them. Such a unified approach to liquidity regulation could substitute for banks'
liquidity ratios.

Capital regulation of banks is based on the assumption that insolvency can only come from
deterioration in the quality of assets or capital charges, depending on the degree of risk placed on
banks' assets. Illiquidity and insolvency are treated as separable risks. The global financial crisis
has, on the contrary, underlined that illiquidity has led to the insolvency of banks and, more
generally, financial players being exposed to it. This porosity between these two types of risk is
increased by the "mark to market" accounting rules.

3.6 THE EXPANSION OF SECURITIZATION

In the last two decades, the financial system has shifted from an "intermediated" model (in which
banks played the predominant role by lending directly to their customers and keeping these loans
on their balance sheets) to a market system (in which the financial market provides the bulk of
financing to banks).

In this context, companies have tended to finance themselves increasingly directly in financial
markets by issuing bonds. But in recent years, financial institutions themselves have become
increasingly dependent on markets. The traditional intermediation model was gradually replaced
by the "originate and distribute" model. This mechanism consists of the banks securitizing the
loans they grant by transforming them into "securities" that are offered on the market to investors
looking for investments (pension funds, insurance companies.). These titles have taken various
forms. In particular, the collateralized debt obligations (CDO) - linked to the explosion of "sub -
prime" - have seen their outstanding amount increase considerably in recent years. This model of
activity that of investment banks has thus developed strongly.

This phenomenon played a major role in the credit boom referred to earlier. Indeed, banks are
limited in granting credit because they have to respect the International ratios (Basel rules)
between their own funds and their commitments. Securitization, which allows banks to release
insiders loans from their balance sheets, has effectively increased the credit multiplier by
accelerating balance sheet turnover.

This surge in Securitization has undoubtedly contributed to global economic growth in recent
years. Until the summer of 2007, it was also widely believed that this phenomenon, by spreading
risk among many investors around the world, would strengthen the soundness of the banking
system.

But securitization, which has been accompanied by a great sophistication of increasingly

innovative financial products, has been the subject of a number of abuses and deviations that
were hardly perceived at the time.

First, the ease with which financial institutions can sell credit to markets has the temptation to
pay less attention to the quality of the credit in question (since the institutions in question no
longer keep them on their balance sheets). In fact, the criteria for granting loans have
deteriorated in recent years. The example of the "subprime" in the United States is, in this
respect, almost caricatural. It cannot be explained why some financial institutions have been able
to grant such risky mortgage loans without even considering their clients ' income. It is likely
that they would not have done so to such an extent if they had had to keep these liabilities on
their books. The link between securitization and the deterioration in the quality of loans has,
moreover, been recently confirmed by scientific studies. This deterioration in credit quality has
played a major role in the rise of "subprime" borrower defaults, which were the ‘triggers’ for the
crisis.

Secondly, securitization contributed to the development of a large uncontrolled ‘parallel banking

system’ that played a decisive role in the crisis. Indeed, banks, by definition constrained by their
own capital obligations, have found financial partners willing to take advantage of higher
remunerations on risky loans. For their part, these partners are in no way limited by prudential
ratios. These are hedge funds and other specialized "vehicles" that have very little capital and are
not subject to control. These funds have therefore contributed, by borrowing heavily from the
banks to buy a massive and growing volume of financial products, to increase the "leverage" of
the system (if a bank can not lend for example only twelve times its funds the vehicles and funds
in question have often engaged twenty, thirty or even fifty times, or more, their capital), and this
in an environment of abundant liquidity, animated and arbitrated by the investment banks. It is
the excessive and opaque nature of this leverage that has been one of the most serious
weaknesses of the system. It is important to understand that the ‘non-banks’ have resorted to
credit granted by banks as well as to the very short-term effects market (largely fueled by
investors to finance their purchases of securitized products). The fall in the value (and ratings) of
the assets, as a result of the subprime defaults in 2007, led to a major shift in the growth of core
investors panic. All of them began to sell their shares in the funds and securities considered often
wrongly as suspects, which precipitated their decline. At the same time, these investors refused
to renew the short-term financing facilities on which shadow banking system depended.

But the problem goes beyond the fund-investor relationship. It also concerns the banks. Many
banks had, in fact, created and sponsored special off-balance-sheet conduits or vehicles to house
the financial products they had issued or assembled on behalf of third parties. They had to either
honor the credit lines they had agreed to with these conduits in order to replace the investors who
no longer subscribed to the refinancing instruments, or they had to directly include the
instruments in question in their balance sheets. Hence the problems of losses on the value of the
underlying assets and the problems of insufficient own funds faced by some institutions which
had gone too far in the path of off-balance-sheet operations.

It can be seen that the deterioration in the credit criteria promoted by securitization has weakened
the financial system as a whole. Those financial institutions that thought they had lost risky and
costly credit in terms of equity are now required - if only for reasons of reputation-to take over a
large part of their balance sheets. However, this re-intermediation, which is involuntary, has
obvious consequences for the banks’ ability to grant new loans.
3.7 HEDGE FUNDS

The hedge fund industry has managed to convince investors, regulators and economists of a
myth. These engineering managers would have found the philosopher's stone. They would be
able to systematically make exceptional profits without taking more risk than mutual funds that
are content to make "normal" profits. They would even be insubstantial to the worst financial
crisis in eighty years. It is high time that hedge funds make their activities more transparent to
investors and regulators.

It is noted that all of the arbitrage strategies on which hedge funds have established their
reputations because they are supposed to be independent of the avatars of the markets are the
most heavily affected the acceleration of the crisis in September and October caused a real
collapse of the performances. The convertible arbitrage strategy that deals with structured loans
is, of course, the most affected. Yields are falling completely. Only the equity market neutral
strategy is protective. But it is a strategy that never produces an exceptional return and that any
funds less. As for macro strategies, they will be heavily allocated to the mutual investment can
offer its clients with commissions well in 2009 with the transmission of the crisis to the
economy46.

As disastrous as the picture presented, it is far from representing reality. Because the
performance of the hedge funds collected in the indexes is much overvalued, because they are
biased, all in a flattering sense. Inflated performance and hidden risks result from the opacity in
which this profession operates with the indulgence of regulators. The voluntary disclosure bias
results from the license given to hedge funds to provide information. Only those who perform
well and need to attract capital communicate and are in the indexes. The selection bias arises
from the small part of the hedge fund universe that is covered by the databases. The survivor
bias, the most important, results from the removal of databases from hedge funds that have
stopped providing information, particularly because they have disappeared.

46
Fostel A, Geanakoplos J. 2008, Leverage Cycles and the Anxious Economy, American Economic Review 98(4),
1211—1244, Available at: https://ideas.repec.org/a/aea/aecrev/v98y2008i4p1211-44.html (last visited 26Mar, 2019).
WHY HEDGE FUNDS ARE VULNERABLE TO SYSTEMIC RISK?

The high performance that hedge funds post in good times is mainly due to the leveraged
leverage that allows them to acquire liquid assets cheaply. These performances enrich them
thanks to the commission’s excessive amounts they levy on investors. It must be understood that
hedge funds are similar to market banks that acquire more assets or less liquidity by borrowing in
the short term on the wholesale markets for liquidity against their assets put in collateral. As a
result, their profits and losses are amplified by the leverage lever. This lever is cumulative
because the hedge fund arbitrage operations lead them to operate on optional derivatives that
incorporate very high levers. Profiles risks of these operations are typical: rare and extreme
risks. As long as the risk has not come true, hedge funds can make us believe that they are able to
make high returns without risk. This was the case of the implication hedge funds in structured
credit.

Hedge fund leverage connects them to the shadow banking system, which has been the driving
force behind the financial crisis. Their reciprocal dependence on investment banks is a complete
endogamy. So Bear Stearns was sunk by one of the hedge funds it sponsored, Carlyle Capital. It
had invested heavily in MBS (mortgage-backed securities) with a leverage of 30 and was in
default on $ 22 billion per inability to deal with margin calls on its credit lines when the value of
this collateral is collapsed47.

General deleveraging, which is the dominant dynamic of the financial crisis, is particularly
deadly for hedge funds. Indeed, they are caught between the margin calls of their prime brokers
and withdrawals of investors' holdings. It is estimated that 15 to 25% hedge funds will have to be
sold in 2009 to deal with withdrawals. That is why, with no capital and no cash buffer, many
hedge funds will disappear.

Thanks to the diversification of their strategies, some were held longer during the destruction of
the shadow banking system. The Special Vehicles invented by the investment banks to handle
structured subprime loans were swept away first. Wall Street investment banks followed, causing
panic in the money market funds. Then it was the turn of high-leverage hedge funds, that is to

47
Lloyd Dixon, Noreen Clancy, and Krishna B. Kumar, Hedge Funds and Systemic Risk, MG-1236-CCEG, 2012,
146 pp., ISBN: 978-0-8330-7684-7.
Available at: https://www.rand.org/pubs/research_briefs/RB9680/index1.html (last visited 27 Mar, 2019).
say those who arbitrate and therefore can only perform through leverage. This process has
exacerbated the decline in bank stocks. It led to the destruction of their capital at a time when
their gigantic losses in structured credit required a recapitalization. Governments have had to ban
short selling to stop the killing game. The boomerang effect on hedge funds has forced them to
unravel their positions in catastrophe, thus selling bonds and Commodity Futures. This led to
heavy losses for hedge funds and spread the crisis from one market to another.

LIMITATION OF THE EXCESSIVE LEVERAGE OF HEDGE FUNDS

In addition to the lighter regulatory framework and the diversity of strategies, high leverage is
another structural feature of hedge funds. The latter make use of a double lever: financial
leverage (uncovered sales, counter-collateral credit and intensive use of credit derivatives)
provided by prime brokers and economic leverage via structured credit (the tranches). Through
this combination, hedge funds have contributed to the excess of leverage, which we have seen
beforehand as a factor that amplifies systemic risk. The need to control the leverage capacity of
hedge funds lies in a difficult trade-off between, on the one hand, the strengthening of indirect
regulation by banks and, on the other hand, the effective implementation of direct regulation of
hedge funds48.

While hedge funds played an active role in the spread of systemic risk in the crisis that erupted in
July 2007, they also fell victim to the effects of a sharp drop in their returns, capital withdrawals
from investors and margin calls from prime brokers. They end up in the same financial turmoil
as the investment banks with which they had previously had a symbiotic relationship. A year
after its beginning, the crisis has become systemic. The change of rules and incentives must aim
at both containing the excessive expansion of credit and encouraging the advent of a new mode
of financing, in which long-term investors would be the dominant players. These players with a
long horizon are the only ones capable of having and having an interest in using the stabilizing
forces of return to the average in the financial markets.

They can be the vectors of a new phase of globalization reversing capital flows for the benefit of
emerging countries where long-term investment opportunities lie ahead in future.

48
Frame WS and White LJ. 2005. Fussing and Fuming over Fannie and Freddie: How Much Smoke, How Much
Fire? Journal of Economic Perspectives 19(2), pp 159-184. Available at: DOI: 10.1257/0895330054048687 (last
visited 27 Mar, 2019).
CHAPTER 4: REGULATION AND SUPERVISION OF SHADOW SYSTEMS

Recent international reports have recommended strengthening the macro-prudential orientation

in the regulatory and supervisory systems49. This term is now so well accepted that, to quote
Milton Friedman, one could say that "we are all today adopting a macro-prudential approach".
And yet, ten years ago, the term was hardly used. It would have been difficult for the regulators
to recognize that their objective had a significant macro-prudential dimension, let alone that it
was desirable to strengthen it.

In fact, the term is not new. At the BIS, it has been used at least since the late 1970s to designate
a systemic orientation, or at the system-wide level, regulatory and supervisory arrangements, and
the link to macroeconomics, although publicly available references are more recent 50. It was
already recognized that if the focus was exclusively on the financial soundness of each of the
institutions, there was a risk of overshadowing an important dimension of the task of ensuring
financial stability. However, it was only at the beginning of the 21st century that an effort was
made to define the term more precisely in order to highlight its more specific implications for the
architecture of prudential arrangements 51 . The term was already more commonly used.
Subsequently, the macro-prudential perspective slowly gained ground until the current financial
crisis gave it considerable impetus.

At the same time, the use of this term remains ambiguous. Sometimes it is used as a synonym for
prudential approaches to limit the pro-cyclicality of the financial system, which is considered to
be a major cause of financial instability. Sometimes it continues to be used to unclear approaches
to address ‘systemic or system-wide’ risks more generally. Then what exactly does the term
‘macro-prudential’ mean and what are its implications for economic policy?

49
Report of the Financial Stability Board to G20 Leaders, Improving Financial Regulation, 25 September 2009
Available at http://www.fsb.org/wp-content/uploads/r_090925b.pdf (last visited 27 Mar, 2019).
50
Report Prepared By A Study Group Set Up By The Central Banks Of The G10 Countries , Recent Innovations In
International Banking (Cross Report), Basel, April 1986, Available at https://www.bis.org/publ/ecsc01.htm (last
visited 28 Mar, 2019).
51
Address by Mr. Malcolm D Knight, General Manager of the BIS, at the 14th International Conference of Banking
Supervisors, Mérida, 4-5 October 2006.
4.1 DEFINITION AND MAIN FEATURES

Define the term ‘macro-prudential’ with the help of its ‘micro-prudential’ antonym, and do so in
a deliberately stylized way is useful. Thus defined, by analogy with the opposite colors of black
and white, the macro and micro-prudential orientations should normally coexist in the more
natural shades of gray which characterize the regulatory and surveillance devices.

As defined by Gorton, G. B., and A. Metrick 52 , the three basic features that distinguish the
macro-prudential approach from the micro-prudential approach to regulation and surveillance
relate to their objectives, their end-point and the characterization of risk.

First, the immediate objective of a macro-prudential approach is to limit the risk of system-wide
episodes of financial crisis in order to control their macroeconomic costs. The micro-prudential
approach, on the other hand, is to limit the risk of failure at the level of individual institutions,
independently of any impact on the system as a whole. This approach is more easily justified in
terms of consumer protection (depositors or investors).

Secondly, and consequently, the purpose of the macro-prudential approach is the financial
system as a whole, while its micro-prudential counterpart is concerned with each institution at
the individual level. This essential difference can be illustrated by analogy. The financial system
can thus be compared with a portfolio of securities in which each security would represent a
financial institution. The micro-prudential approach would be concerned with the losses incurred
on each security; the macro-prudential approach would focus on losses across the portfolio. From
a macro-prudential perspective, it is the degree of diversification or concentration of risk, not at
the level of each financial institution, but at the level of the system as a whole that is essential.
What is important, therefore, is the common (correlated) exposures between financial
institutions, much more so than those found within the portfolios of each institution, which fall
under the micro-prudential approach.

Finally, a macro-prudential approach considers aggregate risk as dependent on the collective

behavior of institutions, or endogenous in technical terms. Indeed, collectively, financial
institutions can influence the prices of financial assets, the quantities processed (borrowed or

52
Gorton, G. B., and A. Metrick, Regulating the Shadow Banking System, Brookings Papers on Economic Activity
(2010).
Lent) and thus the dynamism of the economy itself. This, in turn, has important implications for
the soundness of financial institutions. On the other hand, insofar as it focuses mainly on
financial institutions considered at the individual level, the micro-prudential perspective takes no
account of this type of feedback, i.e. it considers the risk as exogenous. Individual financial
institutions will generally have little impact on market prices or on the economy as a whole. In
fact, they generally view risk as follows: asset prices, market/credit conditions and economic
activity are not affected by their decisions. For example, risk models and stress testing consider
the range of possible asset price changes, default probabilities and macroeconomics as variables.

4.2 IMPLICATIONS

Differences in targeting and risk Design have important implications for how both approaches
analyze the origins of the financial crisis.

From a macro-prudential point of view, the different institutions may appear to be strong while
the financial system as a whole is not. This would be the case, for example, if risk were more
diversified within the portfolios of the various institutions and thus more concentrated
throughout the financial system. Even by dispersing risks in their own balance sheets, financial
institutions could increase their exposures to common risk factors, especially if their portfolios
tend to be composed in a more uniform manner. This would mean that negative shocks would
simultaneously affect a larger number of institutions, and thus systemic and un-diversifiable risk
would increase.

In addition, the endogenous nature of the risk suggests that measures that are optimal from the
perspective of individual financial institutions may have undesirable consequences for the
system as a whole through negative feedback. For example, downturns during periods of
financial stress are rational and virtually inevitable from the point of view of individual
participants. However, if they become widespread, their consequences can be damaging to
everyone by causing catastrophic liquidations and tighter credit conditions. This possibility is
excluded, by definition, in the micro-prudential approach, where the risk is considered
exogenous.

This marked contrast between the two approaches is reflected in the fundamental disagreement
about the validity of the following micro-prudential principle: 'for the financial system to be
sound, it is necessary and sufficient for each institution to be sound'. From a macro-prudential
point of view, this is not necessary: the costs of the financial crisis in terms of output may not be
sufficiently high at the level of individual institutions, or even of a set of institutions. More
subtly, it is also not enough: by neglecting exposures common to financial institutions and the
endogenous nature of risk, a micro-prudential approach may not provide effective support for the
stability of the system as a whole.

The macro-prudential approach to financial regulation and supervision has two dimensions
which have different implications for the calibration of prudential tools. The distinction between
these two dimensions is often insufficiently made. The first concerns the way in which risk is
distributed in the financial system at a given moment, or 'cross-sectional dimension'. The second
is how risk evolves over time, the ‘temporal dimension’. The first is to take an instant
photograph of the financial system and the second to follow its evolution as in a film.

With regard to the transversal dimension, the key issue is the existence of common (correlated)
exposures. These exposures arise either because the institutions are directly exposed to the same
or similar asset classes or because of indirect exposures arising from links between them (e.g.
counterparty relationships). Going back to the analogy with the securities portfolio, the main
distinction is between systemic or non-diversifiable risk between financial institutions on the one
hand and idiosyncratic (or institution-specific) risk on the other.

Therefore, the guiding principle for calibrating prudential tools should be to develop them on the
basis of the contribution of individual institutions to systemic risk. Ideally, this should be done
by proceeding "top-down". The first step would be to measure the systemic risk of extreme loss,
assess the contribution of each institution to that risk and then adjust the tools (capital
requirements, insurance premiums, etc.) accordingly. This would require higher standards for
institutions with a larger contribution. This is in sharp contrast to the microprudential approach,
which would apply common standards to all facilities.

With regard to the temporal dimension, the key question is how systemic risk is amplified by
interactions within the financial system and between the financial system and the real economy.
This is the whole issue of pro-cyclicality53. Return effects are the essential element here. During
the expansion phases, the spillover effect between the decrease in risk perception, the increase in
risk tolerance, the relaxation of financing constraints, the increase in debt, the increase in market
liquidity, the soaring prices of assets and therefore of expenditure, feeds itself, which can lead to
excessive balance sheet growth. This process is then reversed, and more abruptly, when financial
tensions arise, exacerbating the financial crisis. The main question, therefore, is how to limit the
pro-cyclicality inherent in the financial system.

The corresponding guiding principle is to calibrate the instruments in such a way as to encourage
the formation of safety flywheels (buffers) in good times, which can be used when tensions
materialize. This would help to limit the cost of the nascent financial crisis by allowing the
system to better absorb the shock. In addition, the construction of safety flywheels, acting as a
kind of soft anchor or speed limitation, could also help to limit risk taking during the expansion
phase. In the first place, therefore, it would also reduce the risk of a financial crisis.

4.3 IMPLEMENTATIONS OF THE MACRO-PRUDENTIAL APPROACH

The above analysis has highlighted the necessary coexistence of macro-prudential and micro-
prudential perspectives in current financial regulation and supervision arrangements. For
example, adapting the degree of prudential supervision to the systemic importance of institutions
or limiting the concentration of risk within the system is a macro-prudential perspective. On the
other hand, the analysis in relation to a reference group (peer group) corresponds to a micro-
prudential perspective: the aim is to identify the outliers without questioning the average
performance. The usual practice of uniformly calibrating prudential tools relating to the risk
profile of individual institutions (e.g. the calibration of capital requirements to obtain a
probability of default common to all institutions) is also reflected in this approach. The main
challenge, therefore, is to find ways to strengthen the macro-prudential orientation of current
arrangements.

53
Markus Brunnermeier and others, The Fundamental Principles of Financial Regulation, Geneva Reports on the
World Economy 11, ICMB, Available at: https://cepr.org/sites/default/files/geneva_reports/GenevaP197.pdf (last
visited 28 Mar, 2019).
The urgency of this task has been highlighted by the current financial crisis54, which has brought
to the forefront the need for a system-wide risk assessment. It would have been impossible to
detect the threats if the exposures held outside the banking system had not been taken into
account. Just before the onset of the crisis, it was wrongly considered that the securitization of
mortgage portfolios, as well as the splitting and slicing of risk inherent in the process, made the
whole system more secure. Paradoxically, the misperception of a more diversified system has
encouraged institutions to take more risks. Moreover, the crisis was an excellent example of pro-
cyclicity at work. In an environment of low interest rates and aggressive risk-taking, the
favorable economic environment masked the gradual and excessive growth of private sector
balance sheets. Among the traditional signs of rising risk are credit and asset prices, particularly
in the residential real estate sector, and the exceptionally low level of volatility and risk premier
across a wide range of asset classes. Once these financial imbalances were reduced, the process
was radically reversed. It triggered the financial crisis and amplified it, before paralyzing the real
economy.

4.4 THE TRANSVERSAL DIMENSION: COMMON EXPOSURES

The current prudential frameworks already take into account, to some extent, the importance of
common exposures for all financial institutions. Supervisory authorities may, on a discretionary
basis, limit global exposures to sectors which they consider to be particularly risky at a given
time (real estate, leveraged loans, etc.). Moreover, the authorities of several countries have
already sought to adapt the prudential supervision of individual institutions to their systemic
importance, by devoting more resources to it. Progress in this direction has generated increased
interest since the recent financial turmoil. Switzerland is a case in point in this respect, as the
authorities have tightened regulatory and supervisory requirements for the country's two largest
international banks.

An emphasis on macro-prudential orientation would require more systematic efforts to measure

the contribution of different institutions to systemic risk using a top-down approach. These
contributions would be determined by several parameters characteristic of the institutions,

54
Borio, Claudio E.V. and Drehmann, Mathias, Towards an Operational Framework for Financial Stability: 'Fuzzy'
Measurement and Its Consequences (June 2009). BIS Working Paper No. 284. Available at
http://dx.doi.org/10.2139/ssrn.1458294 (last visited 28 Mar, 2019).
including their default risk, relative size, and exposure (direct and indirect) to systemic risk,
including the part that reflects the relationships between institutions, such as the relationships
between counterparties.

The main caveat in this regard is that the quantitative methodologies to support these
assessments are still in their infancy. Some tools, such as those used to estimate domino effects
through counterparty relationships, may provide an indication of the consequences of the failure
of one or more institutions. However, they have a number of disadvantages. They are too
mechanical, excluding behavioral reactions, they need information generally unavailable on
these links, except perhaps for specific markets (e.g. organized markets), and they do not provide
information on the probability of occurrence of a crisis55. Other approaches, which generally rely
on market prices, can provide measures of the extreme risk of loss to the system as a whole, at
least for sets of institutions. Indeed, they rely on the multivariate probability distribution
underlying asset price developments. Examples can be found in extreme loss risk measures based
on Extreme Value Theory 56 or Quantile Regression 57 . Nevertheless, it is either impossible to
break down these measures and allocate them to the various institutions, or, even if this
possibility exists in principle; the corresponding methodologies have not been sufficiently
explored.

From an operational point of view, three aspects are essential for the calibration of prudential
tools in terms of the contribution of different institutions to systemic risk: a.) the relationship
between the transversal and b.) The temporal dimension, the choice of institutions portfolios and
closely related problem of the scope of regulation.

Approaches that assess the marginal contribution of institutions on the basis of market prices
should take into account a fundamental limitation: these prices can be misleading measures of
the temporal dimension of risk. It is in fact one of the main manifestations of pro-cyclicity.
Measures of risk at market prices tend to be exceptionally low in the risk accumulation phase,
55
Christian Upper, Using Counterfactual Simulations To Assess The Danger Of Contagion In Interbank Markets,
BIS Working Paper, Available at: https://www.bis.org/publ/work234.htm (last visited 28 Mar,2019)
56
Geluk, J.L, de Haan, L.F.M, & de Vries, C.G. (2007). Weak & Strong Financial Fragility (No. TI 07-
023/2). Discussion paper / Tinbergen Institute. Retrieved from http://hdl.handle.net/1765/8747 (last visited 28
Mar,2019)
57
Tobias Adrian and Markus K. Brunnermeier, Federal Reserve Bank of New York Staff Reports, no. 348,
September 2008, Available at: https://www.newyorkfed.org/medialibrary/media/research/staff_reports/sr348.pdf
(last visited 28 Mar,2019)
reflecting aggressive risk-taking in the system: the level of risk premier, observed and implied
volatilities and correlations is unusually low. In other words, market prices behave more as
thermometers of financial crises, measuring their intensity when they occur, than as barometers
that predict their occurrence. Hence the paradox of financial instability: it is when the system
appears the most robust that it is, precisely, the most vulnerable. This can easily affect the
temporal measures of systemic risk as well as the contributions of individual institutions.

One approach to this problem is to follow procedures similar to those adopted for adjusting risk
measures in the context of treatment of pro-cyclicity. This implies the use of stressed parameters,
calculated from periods of financial stress, or long-term averages. More generally, the objective
would be to focus on the relative, rather than absolute, contribution of institutions to systemic
risk. The risk of estimation error could be further reduced by categorizing institutions into
different categories, as in a rating system.

It is not easy to define an appropriate ‘portfolio’ of institutions. Conceptually, what part of the
financial system must be taken into account in order for estimates to be considered reliable
indicators of systemic risk? And should the 'portfolio' cover domestic financial systems or the
institutions that make up the core of the global financial system? In addition, the data needed for
the calculations may not be available for important parts of the financial sector (e.g. stocks in the
case of savings banks and cooperative banks). Pragmatism is required in this respect. The
appropriate portfolio will depend on the priorities identified and the possibility of effective
international coordination. The practical limitations of not having data available can be
overcome by developing approximations or by requiring firms to issue instruments whose prices
in the secondary market could be used in the estimation.

This also raises the question of the scope of regulation. A macro-prudential framework should
address the risks generated by all financial institutions that are likely, in isolation, as a whole and
through interactions within the system, to cause significant systemic damage. To the extent that
an indirect approach based on restrictions imposed on regulated institutions has proven to be
insufficient, both for obtaining information and for taking corrective action, an extension of the
coverage of the prudential framework should be considered58.

Analytical efforts to address the cross-cutting dimension of the macro-prudential approach have
so far been more directly applicable to instruments such as equity or guarantee schemes. It is
important to note that they did not relate to liquidity. Certainly, a number of suggestions have
been made59; they primarily addressed pro-cyclicity, acting as a speed limiter during periods of
expansion or establishing safe flywheels to dampen tensions. However, these proposals are all
calibrated according to the characteristics of the institutions’ balance sheets on an individual
basis. They do not take into account common liquidity exposures between institutions. This
subject deserves more attention.

4.5 THE TEMPORAL DIMENSION: PROCYCLICALITY

Unlike the transversal dimension, to which few studies have been devoted, the temporal
dimension has given rise to important analytical efforts in recent years. It has already led to a
number of initiatives to mitigate the pro-cyclicality of the financial system60, with the aim of
limiting the possible contribution of the prudential framework and policies: accounting practices
and introduction of an element of counter-cyclicality into the devices. Rather than examining the
work in detail, this section presents five general principles that can guide current efforts and
revisits some debated issues that deserve special attention.

First, it is necessary to take a holistic approach. Many public policy measures affect the pro-
cyclicality of the financial system. Therefore, the necessary adjustments to the prudential
framework will depend on the characteristics of the other measures and the changes they have
been subjected to. Thus, the current trend towards fair value accounting probably increases
procyclicality by making valuations more sensitive to the economic cycle: this method
incorporates, in the accounting data, estimates of cash flows and future risk premiums of a
changing nature. Other examples relate to the characteristics of deposit guarantee schemes,

58
Ricks, M. (2010), Shadow Banking and Financial Regulation, Columbia Law and Economics Working Paper, no.
370. Available at: https://papers.ssrn.com/sol3/papers. cfm?abstract_id=1571290.
59
Stulz, R. M. (2011), The Squam Lake Group Comment Letter to the PWG’s Report on Money Market Fund
Reform, Comment Letter to the PWG’s Report on Money Market Fund Reform Options SEC Rel. No. IC-29497 (on
file with The Securities and Exchange Committee)
60
Global Shadow Banking Monitoring Report 2012, FSB, http://www.fsb.org/2012/11/r_121118c/ (last visited Apr
1, 2019).
resolution procedures and the existing monetary policy regime. The lack of pre-financing of
deposit guarantee schemes forces financial institutions to make payments at the precise moment
when the system is under stress. The failure to take account of systemic tensions in resolution
procedures of different institutions can lead to excessive liquidations. Finally, monetary policy
regimes that do not hinder the build-up of financial imbalances, resulting in unusually rapid
growth in credit and asset prices, in a context of weak and stable inflation, may inadvertently
process61.

Secondly, it is important to build on strong mechanisms. In particular, Basel II is a major

improvement over Basel I. Basel I significantly increases the ability to cross-differentiate
between borrowers, aligning capital requirements much more closely with the relative risk of
exposures. This tool has significantly strengthened the link between risk measures and minimum
capital requirements and reduces the scope for regulatory arbitrage. Basel II gives the
supervisory authorities more flexibility to require a level of own funds above the minimum
amount, allowing them to adjust the capital mix in line with the risk incurred by financial
institutions (prudential supervision) 62 . Basel III is a tool for Strengthening Financial Risk
information Procedures and market discipline. First and foremost, Basel II has helped to spread
and anchor good risk management practices in the banking sector. The challenge in this area is to
reduce the sensitivity of the system to the business cycle without affecting its ability to
distinguish between risks at a given point in time and to proceed by simple and transparent
adjustments.

Third, the range of possible regulatory capital options ranges from the reduction of their cyclical
sensitivity to risk to the deliberate introduction of countercyclical elements within the system.
There are different ways to do this63. These include reducing the sensitivity of the minimum
capital requirements to the cycle by the greater smoothing of the data needed for their calculation
and the introduction of transparent countercyclical adjustments allowing the constitution and use
of capital buffers. Adjustments could be applied to minimum capital requirements.

61
IMF (2001), International Capital Markets, Developments, Prospects and Key Policy Issues, Chapter 4 (‘The
Changing Structure of the Major Government Securities Markets’). Washington, DC: IMF.
62
Montes & Gabriel Caldas, Uncertainties, monetary policy and financial stability: challenges on inflation
targetingBrazilian Journal of Political Economy, http://www.scielo.br/scielo.php?script=sci_arttext&pid=S0101-
31572010000100006 (last visited Mar 29, 2019).
63
Danielsson, J., P. Embrechts, C. Goodhart, C. Keating, F. Muennich and H. S. Shin (2001), An Academic
Response to Basel II, LSE Financial Markets Group Special Paper No. 130.
Fourthly, while considerable attention has been paid to capital requirements, other prudential
tools must also be examined. ‘Prudential filters’ can be applied to the accounting data as a
preliminary step to compensate for undesirable features, such that the loan loss provisioning
rules are insufficiently forward-looking and prudent. Because of the pro-cyclical nature of
funding liquidity, the definition of funding liquidity standards based on invariant quantitative
minimum requirements, irrespective of the economic situation, could increase financial tensions
as they arise. In other words, like invariant capital requirements, they would amplify rather than
absorb shocks64. An increase in the margins of variation in a period of peak volatility may have a
similar effect. A high percentage of financing is likely to accentuate pro-cyclicality by increasing
the sensitivity of credit supply to assets used as collateral65. The mechanism could therefore be
adjusted in each of these areas.

Fifth, the operational framework should be based, to the extent possible, on integrated
(automatic) stabilizers rather than discretionary measures. This would overcome the limitations
of real-time aggregated risk measurement, and as a result of which discretionary measures are a
source of error. Certainly, the recent work of the BIS suggests that it is possible to develop
simple leading indicators of a financial crisis, likely to give fairly satisfactory results even
outside the sample. In particular, they constitute a warning signal of the current crisis. Despite
this, the margin of error remains significant. In addition, the use of automatic stabilizers would
limit the danger of any measure being taken, even though the risks have been properly identified.
Fear of going against market consensus can have a powerful inhibiting effect. Once in place,
automatic stabilizers can serve as an effective pre-engagement device, helping to rebalance the
burden of proof66.

On the other hand, automatic stabilizers and discretionary measures should not be regarded as
mutually exclusive. Discretionary measures can complement automatic stabilizers when they
encounter design limitations. In addition, it may be easier to tailor discretionary measures to the
nature of risk taking and vulnerabilities, provided they can be identified in real time. It is

64
C.A.E. Goodhart , Some New Directions for Financial Stability?, Per Jacobsson Lecture, London School of
Economics (2004)
65
Borio, C., Ten Propositions About Liquidity Crises (Bank for International Settlements (BIS), Working Papers
293, Available at https://www.bis.org/publ/work293.pdf (last visited 3 Apr, 2019)
66
FSB (2012), Global Shadow Banking Monitoring Report, Financial Stability Board Report, Available at:
www.financialstabilityboard.org/publications/r_121118c.pdf (last visited 3 Apr, 2019)
probably also more difficult to arbitrate as they are easier to circumvent in the long run. The
main difficulty lies in the way in which they are delimited and framed.

Automatic stabilizers can be considered in several areas. With regard to collateral practices,
these include requirements for cycle-length margins and the application of maximum funding
ratios that are low and/or based on valuations that are less sensitive to market prices. Similarly,
the supervisory authorities may consider that accounting standards do not provide for sufficiently
forward-looking or prudent provisions. A notable example is the obstacles to setting up
provisions for loan losses, over the life of the cycle and on the basis of average developments in
the past, also referred to as ‘dynamic provisioning’, which was in place in Spain until recently. In
such cases, the supervisory authorities may add to the minimum capital requirements the
difference between the amount they consider appropriate and the accounting data. Importantly,
adjustments to capital requirements as defined in the existing framework could be based on
specific rules and not on discretionary assessment.

However, it is not difficult to see how adjustments based on automatic stabilizers can be difficult
to achieve in some cases. Take, for example, the objective of setting countercyclical regulatory
capital buffers. It is not easy to define rules that are as effective in times of expansion as in
periods of contraction. For example, linking the minimum requirements to credit growth, as
suggested by Goodhart67, can be effective in times of expansion but can lead to an inability to
release capital buffers in a timely manner. As the current crisis shows again, credit tends to slow
down with a lag compared to the emergence of tensions, mainly because of the use of credit
lines. Similarly, linking the minimum capital requirements to credit spreads is certainly an
improvement from this point of view, but the behavior of these spreads has not been uniform
over the different periods of crisis68. Undoubtedly, these examples do not exclude the possibility
of defining rules. However, they emphasize that discretion and judgment are probably also
necessary.

67
C.A.E. Goodhart , Some New Directions for Financial Stability?, Per Jacobsson Lecture, London School of
Economics (2004)
68
Luxford, Karen (2016), First, Do No Harm’: Shifting The Paradigm Towards A Culture Of Health, Capital
Experience Journal: Vol. 3: Issue. 2, Article 2, Available at: https://pxjournal.org/journal/vol3/iss2/2 (last visited 4
Apr, 2019)
Any attempt to create and release credible capital buffers will have to solve the following
problem : as pressures materialize, the markets are likely to prevent the fund-raising appeals.
Recent history has shown that a sharp rise in risk aversion and uncertainty among investors in
turbulent times compels financial institutions to increase their capital flows.

There are different ways to reduce this risk. One is to have sufficiently high capital flows and
minimum capital requirements, backed up by a credible framework, so that the solvency of the
institutions cannot be seriously threatened. Another is to make the rules of the game clear, so that
their implementation is not seen as a departure from current practice, which could signal serious
concerns about the situation of banks. Even in this case, it is difficult at this stage to judge
whether these measures would be sufficient to allow the capital flows to function effectively.
CHAPTER 5: SOME REFLECTIONS ON NON-FINANCIAL MARKETS IN
DIFFERENT COUNTRIES

The financial crisis of 2007-2008 highlighted the driving role of the shadow banking system in
the excessive development of credit in the pre-crisis period.

It is true that there is no consensus as to the definition of shadow banking but the FSB defines
“all credit activities outside the traditional banking system as parallel banking”.

So we have a real credit intermediation including the transformation of liquidity and maturity as
the granting of loans financed in the short term.....that works independently of traditional
banking instruments. And this is where the whole fragility of shadow banking lies, because there
is a significant risk due to the mismatch between the characteristics of its assets (long, illiquid
and risky) and its liabilities (short, liquid and risk-free). This risk is all the greater because
shadow banking entities such as investment funds, leasing companies, and securitization
vehicles... have little equity and use a large leverage (debt /equity). Following a process of
financial innovation and regulatory arbitrage, shadow banking has now grown to a very large
size. This is inherently difficult to measure because of the imperfection of the available data and
definitional difficulties. The Financial Stability Board, however, has valued the assets of the
major countries involved (20 countries plus the euro area) at $ 75,200 billion in 2013,
representing 50% of the assets of the traditional banking system. In order to address possible
systemic risks due to the fragility of this parallel system, the authorities, like the Financial
Stability Board and the European Commission, have been proposing since 2010 a set of
regulatory measures to reduce these risks and ensure financial stability, which is necessary for
economic growth.

This discussion highlights the need for studying the development of shadow banking and Non-
banking firms around the globe and how this system is affecting different countries.
5.1 GROWING CAPITALISM IN CHINA AND SHADOW BANKING

The halcyon days of China’s financial expansion have witnessed something of a downturn. As a
consequence of the US Federal Register’s publication of US regulatory enactments concerning
shadow banking, there was a comparable result in part in China. China has become concerned
with the alleged undisciplined activities of its shadow banks that are composed of trust
companies, insurance firms, leasing companies, pawnbrokers, and other non-traditional bank
lenders. As in the USA and other nations, it had until this time avoided significant oversight. The
government noted that the rapid expansion of credit could lead to a debt crisis. In early June
2013 the People’s Bank of China began lessening the available funds for China’s interbank-
lending market by significantly raising the cost of funds that banks lend to each other and to
shadow banks. The fear was that unregulated lending practices could lead to risks such as had
occurred in the US subprime mortgage expansion and ultimate collapse69.

China’s traditional banks had begun to lend moneys to non-bank financial entities thus leading to
the expansion of shadow banks. During the period of 2010–2012, shadow bank lenders doubled
their lending to ¥36 trillion ($5.8 trillion) which constituted some 69 % of China’s GDP. The
China Banking Regulatory Commission (CBRC) has somewhat different numbers and
percentages, which stated that the shadow banking sector was some ¥33 trillion ($5.29 trillion) in
2013, equivalent to 80 % of China’s GDP. The expansion of shadow banking in China
commencing in 2009 might have been a symptom of the nation’s fear that the global financial
crisis would have serious effects. As a result, the government encouraged the increase in credit to
finance real estate construction and infrastructure.

Part of the difficulty in analyzing China’s shadow banking is that its governance is quite
different from other national entities. It may be viewed in a narrow or a broader sense, which
will lead observers to estimate its financing anywhere from ¥6 trillion to ¥27 trillion by the end
of the third quarter of 2013. Its total assets are about 20 % of total banking assets. Its risks are
mainly from an incomplete infrastructure and a lack of understanding of risks that may result
from the system’s lending through banks, trusts, securities firms, insurance companies, and other
financial entities. According to one scholar who has analyzed China’s system in depth, the

69
Lingling Wei and Bob Davis, China's 'Shadow Banks' Fan Debt-Bubble Fears, The Wall Street Journal, Available
at: https://www.wsj.com/articles/SB10001424127887324637504578563570021019506 (last visited 5 Apr, 2019)
regulatory authorities, including the ‘People’s Bank of China, the CBRC, the China Securities
Regulatory Commission (CSRC), the China Insurance Regulatory Commission CIRC), and the
State Administration Foreign Exchange’, have developed a framework for regulating interbank
financing, including that of shadow banks. It is an active member of the FSB and has been
attentive to the FSB’s toolkit discussed above, but making it applicable to China’s one-party
political system and its unique financial regulatory setup.

It is problematic to ascertain whether shadow banking may be an Achilles heel for China. The
chairman of the China Investment Corporation (CIC), which manages the currency reserves of
China, Ding Xuedong, stated to the cable news network CNBC that the issue of shadow banking
is exaggerated and that the overall financial system is sound.

Other commentators question whether shadow banking may lead to a Lehman type crisis in the
future. The government has allegedly indicated that it will not bail out non-bank financing
instruments. Banks that have extended credit to non-bank entities are able to withstand large
losses because of current sizeable profit margins. Another basis for absorbing non-bank
financing losses is the very high national savings, almost half of China’s GDP. Some
commentators fear that the biggest threat to China’s financial system is that the government will
curtail shadow bank lending too forcefully, which could precipitate a run on these entities and
lead to a drying up of moneys available while the domestic market regroups and reassesses the
risks arising there from70.

There is a great lack of data that are made public in China, and absence of information pervades
many types of shadow banking instruments, from money market funds to trust products. The
shadow banking system in China, however, is quite different from that in the United States or
Europe. Rather than being comprised of extensive numbers of asset-backed securities and a
widely used repo market, the Chinese shadow banking system contains a wide variety of
instruments that are less sophisticated and less liquid. In the section below, we review the types
of shadow banking instruments used in China. One should pay particular attention to the type of
market in which the instrument is traded and to the size of assets under management in each

70
BIS, Torsten Ehlers, Steven Kong and Feng Zhu, Mapping Shadow Banking In China: Structure And Dynamics,
BIS Working Papers No 701.
category, for both of these features impact the degree to which a presence or lack of data can
build risk.

SHADOW BANKING INSTRUMENTS IN CHINA

There are many types of shadow banking instruments in China, including asset backed securities,
money market funds, repurchase agreements, commercial paper, wealth management products,
trust products (including Real Estate Investment Trusts (REITs)), leveraged leases, negotiable
securities, and financial guarantee instruments. While some of these have been used for some
time, several products, including the wealth management and trust products, have grown up only
recently due to regulatory changes and dwindling sources of growth following the global
financial crisis. Below, we describe each of these instruments.

Asset-backed securities: The asset-backed securities market is small in scale in comparison to

that in the US. Asset-backed securities in China consist of mortgage securities approved by the
PBOC and the Chinese Banking Regulatory Commission, and enterprise asset securities
developed by securities companies and traded mainly through the interbank bonds market. The
trading scale of nonperforming asset securities is even smaller, but with the credit asset
securitization pilot restarting in 2012 it had increased to 20 billion RMB by the end of 2012. In
2013, the scale of loans for securitizing was 50 billion RMB. By 2015, the stock of asset-backed
securities reached 639.6 billion RMB; among them, enterprise asset securities reached 226.4
billion RMB.

Money market funds: China’s money market funds developed rapidly after 1998. The money
market consists of the repurchase market, the commercial paper market, and the bond and bill
market, among other instruments (including government issued debt). Aggregated data for
negotiable securities, repurchase agreements, commercial paper, corporate bonds, and medium-
term notes is available through the database built by the China Central Depository & Clearing
Co. Ltd under the guidance of the Ministry of Finance of China.

Repurchase agreements: China has two repo markets, the exchange-traded repo market and the
interbank repo market. Repo rates on identical types of transactions varied between these two
markets between 2000 and 2005, demonstrating market segmentation in this area (Fan and Zhang
2007). Two reasons for this segmentation in the repo market are given: high exchange repo rates
are linked to new stock market issues, while interbank repo rates follow the trends of the macro
economy. In addition, larger amounts of volatility in the exchange-traded repo market result in
the payment of additional risk premiums due to this uncertainty. China’s repo market began in
1993, using Treasuries as collateral. Interbank trading began in 1997 with Treasuries, policy
financing bonds, and central bank notes as collateral. Commercial banks were at that time
forbidden from trading in repurchase agreements on the stock exchange (Xie 2002).

The most common repo maturity type has been one week, although repos with maturities of less
than one week have been traded on the exchange market, and three-week and two-month repos
have been traded on the interbank market (Fan and Zhang 2007). With an increase in the speed
of financial market processing, the scale of repos traded grew quickly; They measure in at 2.67
trillion RMB (91.4 percent traded on the interbank market, and 8.6 percent on the stock exchange
market) in 2002 and it reached 566.18 trillion RMB (78 percent traded on the interbank market,
and 22 percent on the stock exchange market) in 2015, with an average annual increase rate
above 40 percent. Since 2010, the trading scale of the exchange market has grown rapidly
because individual investors were allowed to take part in repo trading.

Commercial paper market: The commercial paper market consists of bills issued by large
corporations including enterprises, listed companies, and securities companies in order to raise
funds. Large enterprises, such as state-owned enterprises, issue commercial paper in the
interbank bond market and the maturity is one year. By 2012, the stock scale of commercial
paper was 832.7 billion RMB, which had increased 65.7 percent over what it was in 2011. In
2012, securities companies began to issue commercial paper for liquidity management with
maturities of 90 days to 270 days. This broker-dealer commercial paper scale was 29.5 billion
RMB in 2012. Some large state-owned enterprises have issued super- and short-term commercial
paper in the interbank market since 2010. The scale reached 15 billion RMB in that year and 45
billion in 2011, but there was a big bang increase in 2012, reaching 353 billion RMB. Super
commercial paper is welcomed by large enterprises because its maturity lasts from 7 to 270 days,
which supplies a flexible instrument for managing financial liquidity. The total stock of
commercial paper, super commercial paper, and securities company commercial paper exceeded
1.5 trillion RMB in 2013 and increased to 2.47 trillion RMB in 2015.
Corporate bonds: Highly rated corporate bonds are very liquid instruments. The corporate bond
market measured in at 1.7 trillion RMB in total bonds outstanding at the end of 2015. Corporate
bond issuance is approved by the China Securities Regulatory Commission. Bonds can be issued
for any purpose and can amount to 40 percent of the corporation’s net assets at the end of the
previous accounting year.

Bankers’ acceptance bills: Enterprises also issue bankers’ acceptances for short-term financing.
This kind of bill became a debt instrument under the tight credit policy in China. At the end of
2005, the balance of undiscounted bankers’ acceptances was 2.4 billion RMB, but had reached
5.85 trillion RMB at the same time in 2015. Bankers’ acceptance bills have been used
increasingly outside of trade transactions in recent years. In 2015, with stock prices increasing
rapidly, some money from bill discounting went into the stock market. The bill case of
Agricultural Bank of China showed that 3.918 billion RMB went into stock trading and could not
be taken back after the stock crash.

Medium-term notes. Medium-term notes (MTNs) are debt securities offered to the public and
issued by corporations after they are registered and approved by the regulatory authorities. In
April 2008, the PBOC allowed state enterprises to issue RMB 39.2 billion in MTNs, and the
scale of issuance reached 167.2 billion. In the next four years, the issuance scale grew rapidly
and the outstanding volume was 2.63 trillion RMB in 2013. MTNs are the most important types
of collateral assets in repo transactions, and its market quota is 77 percent. By 2015, the balance
of MTNs had reached 4.16 trillion RMB.

Private placement notes, small- and medium-sized enterprises (SME) collective notes and asset-
backed notes. Non-financial corporations have issued private placement notes (PPNs) in the
interbank market since 2011. The private placement note maturity is from six months to three
years. By 2012, the balance of PPNs was 450.2 billion RMB, but only 89.9 billion RMB at the
end of 2011. By 2015, this had reached 2.1 trillion RMB.

Starting from 2009, SMEs were permitted to issue SME collective notes in the interbank market
and stock exchanges. This note requires two to ten enterprises to form a unified issuer under the
same note name. In past three years (2010–2012), the scale was 2.1 billion, 3.5 billion, and 4.3
billion RMB, respectively. Since 2012, enterprises can issue asset-backed notes (ABNs) in the
interbank market. Fourteen enterprises issued ABNs of 5.7 billion RMB in that year. By the end
of 2015, the number had grown to 15.9 billion RMB. Aggregated data for PPNs and credit
derivatives is available through the Shanghai Clearing House database.

Credit derivatives: In China, derivatives have developed slowly because regulatory authorities
are afraid of risks that may be brought about by the derivatives market. Commodity futures
appeared at the beginning of the 1990s. The top three categories of derivatives include interest
rate, currency, and stock market derivatives (Gao and Sun 2012). The derivatives market was
approved for operation by the State Council on October 12, 1990 (Gao and Sun 2012).
Unfortunately, a number of trading markets appeared and were not well organized, experiencing
breaches such as illegal trading and market manipulation. Therefore, in 1993, the State Council
reduced the number of actively trading markets to three, including the Shanghai Futures
Exchange, Dalian Commodity Exchange, and the Zhengzhou Commodity Exchange, and
reduced the number of instrument types that could be traded on these exchanges.

On December 29, 2000, the China Futures Association was established, creating a self-regulatory
agency for the futures market. The China Financial Futures Exchange was built on September 8,
2006, and the Stock Index Futures began on April 16, 2010. Now China has four exchanges and
agricultural, precious metals, energy, chemical, and financial futures are traded on the four
exchange markets. The futures market reached a trading volume of 171 trillion RMB in 2012.
China currently lacks an options market.

Credit derivative instruments include two types: credit risk mitigation warrants (CRMW) and
credit risk mitigation agreements (CRMA). The (CRM) product was established in 2010 as one
type of credit derivative. The CRMA is a nontraditional financial risk management instrument
that provides credit protection to the seller in a financial agreement. The first CRMA was set up
with a nominal capital of 1,840 million RMB. Debt types included short-term and medium-term
bills and bank loans. The CRMA was set with a one-year term period. On November 23, 2010,
the China Bond Insurance Co., Ltd, the Bank of Communications, and Minsheng Bank
established the first CRMW, with a nominal capital of 480 million RMB. Hence both types of
CRM products were established.
CRM business volume remains relatively low. Although CRM products have not grown rapidly,
they have played a vital role in China’s money market. This is because China’s money market
financial structure has created an extreme dependence by firms on bank credit. CRM tools are
playing an increasing role as other types of asset credit risks expand. In addition, CRM tools also
make it possible for SMEs to dilute credit risk.

Commercial banks comprise 75 percent of CRMW traders. Other trading companies include
negotiable securities companies and asset management companies. CRMA nominal capital was
1,990 million RMB as of February 2010, and there were no CRMA transactions in 2011. CRMW
nominal capital equaled 730 million RMB in 2010 and dropped to 130 million RMB in 2012.

Data on derivatives such as futures is available from the individual exchanges on a daily, weekly,
or monthly basis, and from the China Securities Regulatory Commission on a monthly basis, but
in aggregate form.

CHINA’S SHADOW BANKING INSTRUMENT DATA ISSUES

The modern financial sector is a whole system that includes securitization and repo markets in
the shadow banking sub-system. The core of the shadow banking system includes special
purpose vehicles (SPVs) used for conducting securitization and repo transactions. Both
traditional banks and most non-banks financial intermediaries are conducting shadow banking
transactions off balance sheet and out of the scope of monitoring and regulation. In China, the
central bank and China Banking Regulatory Commission are able to obtain all banks’ and most
non-bank financial institutions’ balance sheets and financial statements. But most of these
financial statements, except those of listed banks, trusts and leasing corporations, are not open to
the public. Listed financial corporations are relatively few in number. Hence scholars, analysts
and market participants cannot use these data for analysis. Only aggregate industry data can be
obtained through public channels.

Since the subprime mortgage crisis began, the shadow banking system became a very hot subject
in China. Data on shadow banking instruments are very important to financial regulatory
authorities. Most countries and international financial organizations such as the BIS and
European Securitization Forum started to gather statistics on shadow banking data. In China,
shadow banking instrument data are scattered across different departments and are not easy to
obtain. For example, data on securities, repurchase agreements, commercial paper, and ABNs are
issued by China Central Depository and Clearing Co., Ltd, Shanghai Clearing House, and China
Securities Depository and Clearing Corporation Limited. These institutions issue monthly or
quarterly reports, and the summary data are open to the public. But more detailed data cannot be
obtained—data such as asset holding structure information is viewable only by the government.

Chinese shadow banking instruments include WMPs issued by banks, negotiable securities
companies, and trust companies, but there is incomplete statistical data on these kinds of
products. The China Banking Regulatory Commission (CBRC) requests that all banks submit the
data through internal channels, but does not make all of the data open to the public. Some
individual pieces of data can be gathered from databases and research reports, but there is no
way to obtain certain types of data, such as negotiable securities’ wealth management product
data, at this time. It is necessary to build a unified database on the shadow banking system in
China. This should gather data on shadow banking instruments’ issuance and amounts
outstanding, shadow banks’ balance sheets and financial statements, credit sizing, and other
information. The data should also be made available to the public.

In China, the shadow banking system is different from that in the US and Europe in terms of the
size of securitization and length of existence. Shadow banking instruments have swelled in
variety and number from 2005 on. Types of shadow banking instruments include WMPs, trusts,
which developed very quickly after 2008, and repurchase agreements, among others. The scale
of repo trading is currently very large; it is an important liquidity management instrument for
banks, financial companies, and large enterprises. Data on shadow banking instruments are
scattered throughout different institutions and departments, and the most detailed data cannot be
obtained through public channels. Micro-level data, such as data on balance sheets and financial
statements, can be seen only by regulatory authorities for non-listed corporations. Therefore, it is
important to build a unified database on the shadow banking system in China, that is made
available not only to the government but to the public as well. A lack of data presents a threat to
shadow banking system stability and makes it difficult for investors to maintain confidence in
purchasing such instruments.

Since 2014, China has been gathering data on its shadow banking. This will enhance the public’s
access to financial information, although the details of the new data platform have not been
disclosed, and it is unclear whether the platform will encompass all aspects of shadow banking,
particularly at a disaggregated level. If it does not, the data issue will remain an ongoing
problem.

5.2 CANADA: A REGULATORY HYBRID APPROACH

In several developed countries, the volume of market financing is as large as the volume of
conventional loans provided by the regulated banking sector. In Canada, the main forms of
market financing are divestitures or repos, the securitization of government-backed mortgages,
the creation of asset-backed securities (or ABS) using consumer credit, and short-term wholesale
financing. Although growth in this sector slowed during the crisis and even became negative in
some countries, it has remained strong overall over the past fifteen years in the developed world,
especially in the United States and the United Kingdom, but also in Canada. Much of this
dynamism stemmed from financial innovation and the expansion and deepening of capital
markets.

Prior to the global crisis, direct-to-market financing operations were more widespread and
generally riskier in the United States than in Canada and were a major source of systemic risk. In
Canada, only one segment of the market finance sector, the non-bank ABCP, has been severely
affected by the turmoil, with the others (notably the repo and mortgage sectors) performing
relatively well.

In the face of the damage caused by the crisis, possible reforms of the market financing sector
are being examined by international bodies under the direction of the Financial Stability Board
(FSB)71. These efforts are also motivated by the risks of regulatory arbitrage that could result
from the regulated banks becoming subject to the stricter Basel III capital, liquidity and leverage
rules. This tightening of requirements could encourage the shift of financial activities away from
the regulated banking sector, which, if left unchecked, could partially offset the initial reduction
in systemic risk. The work of the FSB revolves around three themes: definition of the market
financing sector; development of methodology and data that will allow systematic monitoring of
the sector; review of possible means of action. Any revision of the regulation applicable to

71
In November 2010, at the Seoul Summit, the leaders of the G20 asked the FSB to make recommendations aimed
at to strengthen the regulation and supervision of the banking system parallel before the middle of 2011.
market financing operations must nevertheless ensure a balance between, on the one hand,
broadening the scope of the regulation in order to limit the risks associated with the operations in
question and on the other hand, maintaining an environment conducive to healthy competition
and innovation, and thus the efficiency and resilience of financial intermediation.

DOMINANT FEATURES OF FINANCING MARKET

Market financing has grown rapidly over the last 15 years. The forces that drive its evolution are
mostly beneficial, but some of them can increase systemic risk. Clearly, most financial
innovations are driven by efficiency gains in hedging, portfolio diversification and credit
intermediation. The focus must be on innovations that are driven by regulatory arbitrage, that is,
by the desire to circumvent the rules in place. In the United States, for example, the
securitization of mortgage loans that do not meet mortgage insurers ' criteria is due in part to the
capital requirements imposed on banks, which encouraged them to withdraw these assets from
their balance sheets while providing liquidity lines to securitization vehicles, resulting in an
imperfect transfer of risk. There are other cases where innovative products created for a specific
purpose were later repackaged, often in the form of leveraged securities, to increase the expected
return, which has also resulted in increased risk. For example, commercial paper was first
developed to allow companies to meet short-term financing needs, and then the issuance of
AFCP to finance the securitization of longer-term assets began. While the AFCP had a higher
expected return, it was also more risky. It is clear that the market finance system is constantly
changing, driven by financial innovation and regulatory changes72.

Although the game of competition in the markets normally results in an improvement of well-
being, it remains that the lack of oversight, safeguards, and a mechanism for liquidity support on
the part of public authorities can increase the vulnerability of the financing sector of the market
to shocks and lead, therefore, to situations of financial panic (analogous to bank runs), market
failures and, consequently, at systematic risk. This fragility is likely to be enhanced when
financial transactions are primarily driven by regulatory arbitrage.

72
Allan Crawford, Chris Graham, and Étienne Bordeleau, Regulatory Constraints on Leverage: The Canadian
Experience, Bank of Canada, https://www.bankofcanada.ca/wp-content/uploads/2012/01/fsr-0609-crawford.pdf (last
visited 5 Apr, 2019)
Another important feature of market Finance is its heterogeneity within and between countries.
In Canada, the major market financing activities are: (1) short-term borrowing and lending of
cash and securities in repurchase transactions; and (2) issuance of securitized debt instruments,
i.e. asset-backed securities (such as credit card balances, auto loans and student loans, or
residential and commercial real estate loans); 3) short-term loans and loans on the wholesale
market. These activities are carried out through various markets: that of pensions, the asset-
backed securities such as mortgage-backed and commercial paper and other debt securities short-
term issued by financial institutions and non-financial corporations (including bankers
acceptances and ABCP). Market-based institutions include regulated and unregulated institutions
that are directly involved in the market-based system, such as banks, securities dealers, hedge
funds and money market mutual funds, and those that facilitate such activities, such as financial
rating agencies and mortgage insurers. The profile of market financing also varies from country
to country depending on the structure and regulation of the domestic banking system73.

COMPARISON BETWEEN CANADIAN AND US MARKET FINANCING

The overall volume of direct market financing activity, as measured by the stock of liabilities,
has increased three to four times in Canada and the United States since 199574. Interestingly, in
Canada, market financing has generally grown at the same rate as traditional banking
intermediation and, since 1999, has been roughly on a par with it, reflecting the strong presence
of banks in this channel. In the United States, on the other hand, the volume of financing in the
market grew more rapidly, and by the time it reached its peak, before the crisis, it was roughly
double that of traditional bank liabilities. It is now only about 25% higher. The total stock of
market financing in Canada has remained roughly the same since 2007, but has declined by
about 25 per cent among its neighbors to the South.

In Canada, repo transactions dominate with a share of 55%. In recent years, the securitization of
mortgage loans as a source of financing has increased significantly, particularly the issuance of
NHA mortgage bonds, which have increased from about 5% of the outstanding residential loans

73
Dickson, J. 2009, Capital and Procyclicality in a Turbulent Market, Office of the Superintendent of Financial
Institutions Canada, 8 January
74
Étienne Bordeleau & Allan Crawford & Christopher Graham, 2009, Regulatory Constraints on Bank Leverage:
Issues and Lessons from the Canadian Experience, Discussion Papers 09-15, Bank of Canada.
in 1998 to almost 20% in 200775. In the United States, pensions and mortgage-backed and other
asset-backed securities had experienced strong growth prior to the crisis, but have declined
significantly since then.

While a number of regulated financial institutions - banks, insurance companies, pension funds
and mutual funds, as well as provincial credit unions - conduct market financing operations, they
are not the only ones. Other entities, not subject to regulation, are also active. These include
hedge funds, which can acquire TAA and use pensions, and finance and leasing companies,
which can issue TAAs to finance various loan portfolios. A particularity of the Canadian market
financing system, compared to the US sector, is that regulated financial institutions are much
more present. Indeed, almost all operators in the NHA mortgage securities market are federally
or provincially regulated. Similarly, regulated banks and brokerage firms are the main players in
the repo market.

A comparison of market financing in Canada and the United States helps to understand the
vulnerabilities of the Canadian system and the corresponding systemic risks and to assess
possible regulatory reforms. Because in Canada, market financing operations are conducted
primarily by the large regulated financial institutions and the assets pledged in these transactions
consist primarily of government securities or government guarantees, the vulnerability of this
sector is reduced. However, because of its dynamism and heterogeneity, it is important to follow
it closely to understand what effects it may have on systemic risk.

While some progress has been made to protect participants in the market funding circuit against
the specific risk to their counterparties, the entire system remains vulnerable to systemic shocks.
Vulnerabilities related to procyclicality may also encourage the transmission of systemic shocks
within this sector.

The first of these weaknesses is the formation of substantial financial leverage made possible by
the lesser degree of regulation to which financing operations in the market are subject. An
example of this pro-cyclicality is the link between the financial leverage that an institution can
obtain on the market, on the one hand, and the level of discounts required on guaranteed loans

75
Witmer, J. (2010), Trends In The Emission Of Titles: Origins And Implications, Bank of Canada Review Canada,
Fall, p. 21-33
that it enters into on the market, on the other hand76. While the regulatory cuts serve to protect
the lender against market volatility, they also have a direct impact on the leverage that a
transaction will provide to the borrower. As the level of cuts tends to vary with the business
cycle, the financial leverage obtained through guaranteed borrowing can be very pro-cyclical and
can be a destabilizing factor for the financial system as a whole. More broadly, fluctuations in
funding liquidity constraints (including rate cuts) faced by financial intermediaries can have a
significant impact on asset prices and market dynamics and, therefore, propagate and even
amplify shocks throughout the financial system77.

The systemic vulnerabilities in the Canadian market finance system are currently relatively low
for at least two reasons: the decline in unregulated activity that followed the non-bank ABCP
crisis and the fact that in Canada market financing operations are generally carried out by
commercial banks, which are properly regulated and supervised. In addition, ongoing domestic
and international work to strengthen both micro-and macro-regulatory regimes will further
mitigate vulnerabilities in this sector. However, because of the dynamism of financial
innovation, the sector must be constantly monitored, based on a systematic approach that allows
new vulnerabilities to be identified as they emerge.

Given the rapid growth in the volume and scope of financing in the marketplace over the past 20
years in Canada and around the world, it is imperative to understand the reasons for this growth
and the vulnerabilities it could bring. The growth in market finance, driven largely by
competition and the continued deepening of financial markets, enhances the overall efficiency
and resilience of intermediation activities. However, the rapid pace of financial innovation and
the ongoing evolution of operations raise concerns that some new developments may be driven
by regulatory arbitrage and, by escaping government oversight, amplify systemic risk. A more
systematic approach to monitoring and further research is needed to identify and assess the
impact of vulnerabilities emanating from the market finance channel and to determine whether
the degree and scope of regulation and supervision in place should be reviewed. It is important to
strike the right balance between the benefits of innovation and its effects on systemic risk.

76
Kamhi, N. (2009), Pro-Cyclicality And Prescribed Margins, Financial System Review, Bank of Canada, June, pp.
61-63.
77
Jean-Sébastien Fontaine and René Garcia, Bond Liquidity Premia, Working Paper No. 2009-28, Bank of Canada,
Available at: https://www.bankofcanada.ca/wp-content/uploads/2010/02/wp09-28.pdf (last visited 5 Apr, 2019)
The recent financial crisis has highlighted the weaknesses of the Canadian market finance sector,
in particular the lack of transparency that affects it and the accumulation of excessive financial
leverage that it allows. Domestic and global reforms are underway to address these weaknesses.
In Canada, this sector has proven to be relatively strong, thanks to the dominant participation in
its activities of Prudential-regulated institutions and the widespread use of government securities
as collateral. An important lesson, however, can be drawn from the collapse of the country's non-
bank ABCP market and the crisis in general: the Canadian financial system is not immune to
vulnerabilities in the market finance channel, whether they are domestic or imported from other
countries due to the globalization of markets and institutions. A concerted international
intervention is therefore required to formulate clear principles for the monitoring, evaluation and
regulation of market financing operations, principles which must accommodate the differences
between the systems of different countries and limit the unintended consequences as well as the
possibilities for regulatory arbitrage between countries.

5.3 RUSSIA: LEGAL AND ILLEGAL MARKETS

“While the definitions of shadow banking in Russia remain as vague as they are in other
contexts, in the post-command economic reality of Russia, where the official financial system
remains centered on the state and a handful of state-owned banks, the shadow banking industry
has assumed a rather distinct function. Unlike in more advanced economies, the activities of the
Russian shadow banking system are associated with the organisation and maintenance of the
partially illegal market of cash circulation”. In Russia, like in some other emerging markets, a
large part of the shadow financial system is centered on the turnover of illegal cash: money
laundering, legalization of ‘dirty’ cash flows, money in support of different types of the shadow
economy, the financing of terrorism, corruption, channeling profits to offshore havens, etc.
According to official data of Russia’s statistical agency Rosstat, the grey economy amounts to up
to 16–17 per cent of GDP. If one includes the corruption component, some experts estimate that
the shadow financial turnover in Russia can account for between 40 and 46 per cent of GDP,1 or
27–30 trillion roubles. This does suggest that the tension between the formal and the grey in
Russia is widespread across all major sectors of economic activity.

According to the BIS, Russia is one of three countries in the world with the highest proportion of
cash money in circulation (M0) in relation to GDP. According to the European Central Bank, the
rate of non-cash payments per capita in Russia is one of the lowest in Europe. More than half of
payments for retail goods and services in Russia are made in cash. According to the Ministry of
Finance of Russia, the amount of cash in the country’s monetary turnover is about 23 per cent,2
while in developed countries this figure is only 10.7 per cent and does not exceed 15 per cent
even in emerging markets.

Most monitoring agencies confirm that Russia remains a cash-based economy, with 89.6 per cent
of respondents using cash in daily payments and transfers. About 50.1 per cent of respondents
never use non-cash forms of money, and only 15.9 per cent prefer non-cash-based transactions.3
The use of electronic payment terminals in Russia lags far behind their use in economies at a
comparable level of development; the population coverage of electronic terminals is one of the
lowest in the world.

The large presence of the shadow economy entails the loss of tax revenue and an additional
burden on public authorities. Estimates suggest that in 2015, the loss of tax revenue due to the
shadow economy in Russia amounted to more than 5 trillion rubles, while the total direct costs of
the Russian economy associated with cash turnover amounted to about 1.1 per cent of GDP (or
more than 880 billion rubles in 2013). Currently, about 900 billion rubles ($15 billion) of illegal
cash turnover fall on the shadow payment system, or grey payment platforms, the activities of
which are opaque and not regulated. The national legislation4 allows entities with low equity
capital5 to undertake very opaque activities to receive cash (nobody knows who owns these
terminals, how they are cleared and whether the sums are deposited with a credit institution).
Moreover, these activities are typically conducted without licenses or any other authorization
documents.

Persistent capital flight is another perennial problem associated with the Russian shadow
economy. The year 2014 saw the peak of capital flight out of Russia ($153bn, equivalent to 13
per cent of GDP). In 2015, the outflow of capital decreased by 2.7 times to $59.6bn, which is
mostly accounted for by a substantial reduction in Russia’s foreign debt as a result of the ruble’s
devaluation and international sanctions.

According to the Central Bank of Russia, in 2013, net capital outflow from Russia amounted to
$62.7 billion, an increase of 14.8 per cent compared to 2012 (in 2012 – $56.8 billion). In 2011,
this figure reached $84.2 billion, up from $33.6 billion in 2010. In 2009 it amounted to $56.9
billion, and in the crisis year of 2008 it set the first record of $126 billion. Thus, in 2011 there
was an increase in the net outflow of capital to just over 4 per cent of GDP, compared to 2.3 per
cent in 2010. The record high figure of almost 9 per cent of GDP in 2008 exceeds the level of
capital flight of 2011. As a result, over the period of 2008–2015, capital outflow was more than
$693.8 billion, which exceeds almost twice the size of the annual budget of Russia in 2015 in
current prices and 59 per cent of GDP. It is also highly likely that the real amount of money
withdrawn from the country vastly exceeds the sums officially recorded by the Bank of Russia.

According to official statistics, almost half of capital outflows are associated with the private
sector’s interest payments on external debts that have been growing steadily recently, as well as
the purchase of foreign assets by Russian enterprises. The foreign debt of Russian banks and
other corporations amounts to over 92 per cent of the country’s total foreign debt.

Russia’s external debt includes government and private sector debts. Governmental foreign debt
totalled $50.9bn, with the debt of Russian banks at $148.92 billion (a 29 per cent decrease over
one year). However, the largest share of external debt falls on the non-banking sector, where it
amounts to $326.19 billion (a decrease of 23 per cent per year and a decrease of 26 per cent since
2014).6 At a rate of 5–7 per cent per annum, such debt service can cost up to $30–51 billion
every year, the equivalent to half of the total capital flight from the country. Russia’s external
debt (which increased to $529.70 bn in the first quarter of 2017 from $518.70 bn in the fourth
quarter of 2016) is high, and in the context of lower commodity prices, threatens the stability of
the economy.

A deepening of the internal capital market is a factor that may help sustain the trend of lower
foreign indebtedness. However, spare liquidity which can be directed to build such a market is
scarce. In the meantime, the shrinking taxation base in the country (due to demographic changes
and lower oil revenues) has precipitated a structural shift away from the extractive industries. In
the context of fiscal rigidities (most fiscal transfers include social and military expenditure which
are impossible to change without inviting political tensions), such structural shifts will inevitably
lead to higher internal and external borrowings in the countries that have not aligned with the
2014 sanctions regime.
The phenomenon of capital flight is so opaque and uncontrollable for Russia that some
government officials have recently suggested renaming the problem of “capital flight” as the
phenomenon of “transfer of funds”. Against the backdrop of chronic underfunding of the
economy and the infrastructure, the massive outflow of capital leads to an increase in the share
of foreign loans in the structure of foreign investment, which has jumped from 45 per cent in the
early 2000s to almost 90 per cent in 2011, effectively putting Russia in the situation of a debt
trap78.

Up to now, foreign borrowings remain the dominant form of foreign investment in the Russian
economy. Between 2000–2016, on average about 80 per cent of foreign investments were
directed towards the extractive industries, trade, finance and insurance sectors. The private and
the public sectors are equally exposed to the risks of the debt trap. A solution to the problem is
imperiled by the fundamental problems of the domestic economy: the impoverishment of the
population, failures of small and medium-sized enterprises against unfavorable conditions for
Russia’s core exports oil, gas and other raw materials.

Against this background, the Russian shadow banking industry includes four major levels of
activity:

 The legal shadow financial market (the so-called ‘white’ market), which in addition to
certain segments of the financial market operating outside the control and supervision of
the official bank regulators, also includes transactions in the captive bank clusters, micro-
financing operations, as well as government guarantees for loans extended to state-
affiliated financial institutions and other economic operations carried out by oligarchic
financial groups.
 The illegal shadow banking market (the ‘grey’ market) – operations and transactions
undertaken by financial institutions and other market actors that are legitimate in
principle, yet lead to, or facilitate, a semi-legal and unidentified export of capital, opaque
ownership structures, tax evasion, etc.
 Criminal shadow banking market (the ‘black’ market), including illegal activities of
financial institutions aimed at money laundering, movement of dirty money, etc.

78
Cillian Doyle, Russian Bank Collapse: Fictitious Assets, Hidden Losses And The Role Of The IFSC, The Journal.
  Fictitious shadow banking segment: various corruption schemes, involving corrupt ties
for obtaining preferences, privileges and subsidies from the state, etc.

Micro-finance institutions (MFIs) which are increasingly expanding their activity. In 2010, a new
law institutionalized micro-finance organizations and gave a new impetus for the development of
financial infrastructure in small cities and towns of Russia. This law is aimed at facilitating
control over the debt market, promoting competition in the micro-credit sector, while protecting
the rights and interests of borrowers from abuses by moneylenders. Official data suggest that the
number of MFIs has grown significantly since 2010. In the first half of 2013, there were 3,260
MFIs registered officially, or 29 per cent more than the previous year. The year 2012 saw a
twofold increase in the number of registered MFIs79.

In absolute terms, MFIs dominate the Russian financial system: they comprise 39 per cent of the
country’s financial institutions. As of July 2016, there were 3,560 MFIs, which is almost 4 times
the number of banks in the country. The micro-finance industry also grows much more
dynamically than the banking sector. This can be attributed to the high demand for loans by
small- and medium-sized businesses, together with the public appetite for consumer and payday
loans, as well as to significantly higher interest rates on the loans.

The volume of loans issued by MFIs is estimated at 60 billion rubles (an increase of 51 per cent
compared to 2015). In January-October 2012 the rapid growth of the micro-finance market
enabled several MFIs to successfully issue debt securities to raise funds, which created a
precedent. The potential for this credit segment is vast: some estimates suggest it can expand by
40 per cent a year to about RUR 350 billion ($6bn). The prognosis is based on the fact that about
70 per cent of the populations living in small urban centres are not served by banks, while the
crossover between the banking system and micro-finance is no more than 25 per cent. The
tightening of bank lending standards prompted an expansion of micro-finance lending to the
individual entrepreneurs. As of 2015, the share of loans to individuals was 84 per cent of the
total portfolio of MFIs (7.8 per cent was loans to individual entrepreneurs, 8.2 per cent to
corporate clients)80.

79
FSB, Global Shadow Banking Monitoring Report 2017, http://www.fsb.org/wp-content/uploads/P050318-1.pdf
(last visited 5 Apr, 2019)
80
Ibid
A large volume of arrears and overdue loans is a key issue of the micro-finance market. The
relative youth of the micro-finance market in Russia is mirrored in the lack of professional
practice of portfolio management in these companies, as well as to often ad hoc efforts to collect
debts. Currently, the Central Bank of Russia (CBR) is putting efforts into improving the
transparency and organisation of this segment of the shadow credit market. In particular, in 2015,
the CBR introduced reserve requirements for micro-finance companies that could count towards
tax obligations and the system of reporting was changed. This effectively makes MFIs de facto
equivalent to credit organizations, making the industry more transparent and regulated.

The dynamics of micro-finance companies show that this remains one of the most dynamically
growing areas of the financial system in Russia. And while there were some signs of saturation
of this market in 2015, lower numbers of new companies in this segment can be accounted for by
a much stricter regulatory approach by the authorities. At present, the micro-finance market in
Russia appears to be on the verge of being integrated into the official, regulated financial systems
of the country.

REGULATING THE SHADOW BANKING IN RUSSIA

From a regulatory point of view, there are two paradoxes of shadow banking in Russia. First,
although it accommodates most of the participants of the financial system, Russia’s shadow
banking system is anchored in the country’s banking system which, in turn, is rather
concentrated. At the same time, because the shadow financial sector operates outside the scope
of bank regulation, it complicates the overall assessment of risks in the financial system and
undermines the existing set of regulatory measures employed by the regulator. The evolution of
the shadow banking sector in Russia in recent years has been largely uncontrolled. This has
given rise to significant risks, the scope and level of which cannot be adequately assessed by the
business community and financial regulators. In the event of a sharp deterioration in the liquidity
of the Russian financial system, even the relatively small volume of shadow banking activity can
become a source of systemic risk at any given time because it is closely related to all entities
holding financial institutions. Continuous adequate monitoring and systemic oversight might
help to partially mitigate the risks posed by the shadow banking system and enable the regulators
to promptly identify them. It may also help further reduce the negative impact on the monetary
policy, while also aiding the collection of tax revenues into the federal budget.
Second, while there has been no or little systemic oversight of shadow banking in Russia, at
times localized regulation was excessive and disproportionate. It is important, therefore, to draw
lessons from the recent developments in Russia and other emerging markets, with the aim of
designing an effective system of regulation both globally and nationally. In Russia, it is only in
late 2013 that the idea of a mega-regulator, a financial supervisory authority on the basis of the
central bank, became feasible81. The new Russian mega-regulator combines the Russian Central
Bank and what used to be the Federal Service for Financial Markets. The major functions of the
new regulatory body include supervision of the commercial banks and control over non-bank
financial institutions, including insurance companies, asset management companies, pension
funds, brokerage firms and MFIs.

The size of the grey economy in Russia is an important indication of the quality of the official
regulatory regime in the country. The tightening of the regulatory stances observed over the past
few years tends to invite negative reactions from the market, while the grey economy appears to
be sufficiently adaptable to new regulatory standards. The cleansing of the financial system
launched by the CBR has not brought about the decrease in grey economic activity as such, but
rather led to an integration of the grey economy into the official system as business simply flows
over to the largest commercial banks and financial companies.

Therefore, while the specific contours and challenges of shadow banking in Russia are shaped by
the legacy of transition and the post-Soviet political economy, a path towards a more adequate
financial regulation and governance involves steps that are being developed and implemented in
more mature economies. Increasing transparency, fuller information, a reform of financial
reporting standards and fuller, systemic oversight of the dynamic networks that connect the
economy and the financial system constitute critical steps towards more efficient financial and
economic governance in the post-2009 Russia.

81
Reuters, Green light for financial mega-regulator in Russia, Available at: https://www.rt.com/business/russia-
megaregulator-banks-finance-697/
CHAPTER 6: CONCLUSION

The global crisis calls for a profound review of financial regulation and, in particular, of the
relationships between markets, players and products. Faced with this situation, the primary
objective of all regulators is to restore confidence in the financial system.

In such an environment, however, regulators have to cope with the current fragmentation of
responsibilities in institutional, functional, geographical and legal terms.

In institutional terms, the competence of regulators remains limited in many aspects of the chain,
which is now largely self-managed by the actors themselves, either bilaterally or through
multilateral agreements. Thus, all the legal parameters for international derivatives transactions
are laid down by a professional association, the International Swap and Derivatives Association
(ISDA), and the setting of essential market benchmarks such as the Libor rate or the ABX or
iTRAXX credit spread indices82, which have been the subject of very strong disputes, are the
responsibility of the British Bankers association and of a private, finally major bank supplier,
market, respectively.

In functional terms, when it comes to regulated sectors, the actors in the chain are subject to very
dispersed legislation and control procedures: from the large US banks subject to the Federal
Reserve System, local banks and insurers that do not have federal supervision but are subject to
the regulation of their state of incorporation83, to European financial institutions that are subject
to sectoral directives and each supervised by specialized supervisors from their home member
state84.

In Geographical terms, the credit market has become difficult to define in terms of territoriality:
where to place the regulatory jurisdiction for a credit swap contract involving underlying US
assets, concluded by private agreement between traders located in London but recorded, on the
one hand, by a hedge fund domiciled in Jersey or Grand Cayman and, on the other, in the books
of a French bank in Paris?

82
International Swaps and Derivatives Association, Inc, Markit Credit Indices A Primer, November 2008
83
Supervision Program, FDIC, https://www.fdic.gov/about/strategic/strategic/supervision.html (last visited 5 Apr,
2019)
84
Guide To Banking Supervision, European Central Bank, 2014
From a legal point of view, the credit markets are now intermingling securities, contracts or
guarantees: for example, banks can issue loan contracts (e.g. mortgage or consumer credit cards),
which they refinance by issuing securities (e.g. asset-backed securities/mortgage-backed
securities), which are enhanced by guarantees (e.g. insurers), but whose risks are then transferred
by derivative contracts (e.g. credit default swaps), which are themselves reformatted into
securities (e.g. collateralized debt bonds/collateralized loan bonds), then in turn re-classified
through commercial paper issuing instruments (e.g. asset backed commercial paper) or covered
again by contracts (CDS), and so on.

EXPANDING THE REGULATION PERIMETERES

In this context, market regulators are looking at ways to strengthen the traditional tools of
Prudential and macro-financial regulation with an alternative approach that takes into account
specific developments in financial markets.

This principle was clearly stated by the G20 in its November 2008 and April 2009 declarations85,
in which it committed itself to ensuring that all financial institutions, markets and financial
products of systemic importance be subject to an appropriate level of regulation and supervision.

The scope of regulation will thus have to be examined in such a way as to frame more strictly
certain aspects which until now have been left to the self-regulation of market participants. This
revision will require an adaptation of the regulation, particularly as regards the means of its
application to non-regulated entities and markets. The great disparity between them will make
the task more difficult. In this context, the regulator's tools will have to be reviewed in order to
make them more effective.

The lessons learned from the global crisis call for further coordination between market and
prudential regulators, in particular in terms of risk assessment. Indeed, Prudential Regulation is
essentially focused on the solvency of intermediaries, without intervention in the functioning of
the unregulated market segments in which entities other than intermediaries participate.
However, Market Regulation has focused on the functioning of regulated markets, Codes of

85
G20 Information Centre, Declaration of the Summit on Financial Markets and the World Economy, Washington
DC, November 15, 2008, Available at: http://www.g20.utoronto.ca/2008/2008declaration1115.html (last visited 5
Apr, 2019)
Conduct for market participants and mandatory financial information for market issuers. The
analyses of the crisis have demonstrated the impact of the activity of unregulated entities and the
trading of unregulated products on the global financial system and thus call for a review of the
scope of the supervisors.

BASIS FOR A NEW ARCHITECTURE

The need to evolve the international regulatory framework was clearly on the agenda of the G20,
which transformed the Financial Stability Forum (FSF) into a council, broadening its mandate,
strengthening, alongside the IMF, its authority in the global governance of regulation and
specifying its competences and objectives with regard to financial stability. The need for
increased coordination of market and Prudential Regulation emerged at the end of the 1990s
during the financial crisis in Asia and Russia (in 1997 and 1998 respectively). At the institutional
level, the creation of the Financial Stability Forum was the result of this new approach. To
enhance the global coherence of regulatory standards, the Financial Stability Forum, together
with key international standards-setting bodies such as the International Organization of
Securities Commissions (IOSCO) and the Basel Committee, is mandated to promote
international financial regulatory convergence based on high-level benchmarks. The members of
the Financial Stability Board (FSB) will be called upon to pursue financial stability, to improve
the openness and transparency of the financial sector, and to apply international financial
standards. They undertake to carry out periodic peer reviews on the basis of, inter alia, the
reports of the Joint Financial Sector Assessment Programme at the IMF and the World Bank.
The FSB should report regularly to the IMF's International Monetary and Financial Committee
(IMFC) on progress in regulatory reform to implement the crisis responses. The IMFC will have
to be transformed into a decision-making Council, in accordance with the provisions of the IMF
agreement.

At European level, the Larosière Group Report86 makes recommendations for strengthening the
European crisis management or surveillance system. It proposes the maintenance of a system of
supervision based on national authorities and recommends a consolidation of European
regulation in the hands of “reinforced level 3 committees”. The report thus recommends the

86
EU, High-Level Group On Financial Supervision, The Larosière Group, Available at:
https://ec.europa.eu/info/system/files/de_larosiere_report_en.pdf (last visited 6 Apr, 2019)
creation of a' European System of Financial Supervisors (ESFS)', consisting of a decentralized
network formed by the three reinforced Level 3 committees. The group proposes that the
authorities coordinate the application of supervisory standards and ensure strong cooperation
between competent authorities.

PRIORITIES TO RESTORE TRUST IN THE FINANCIAL MARKETS

The restoration of trust depends first and foremost on the solidity of the market players. It is
important that the balance sheets of the major institutions are rapidly purged of so-called toxic
assets. Secondly, the deep malfunctioning of the financial markets, and in particular the credit
market, must be remedied. Four major topics appear in this framework:

 Transparency Of The Credit Market

 Organisation Of Post-Market Infrastructures
 Hedge Funds
 The Role Of Rating Agencies

 Transparency of The Credit Market

Often criticized for its role in the early stages of the crisis, securitization has enjoyed undeniable
success for more than twenty-five years, based on indisputable merits. This technique has made
it possible to optimize the financing conditions of companies by legally isolating specific assets
of better intrinsic quality than the balance sheet from which they are extracted. Moreover, the
financial structure of vehicles allows the risk-return characteristics of each liability tranche to be
adapted to the demand of the different types of investors. Even the CDOs, now largely
demonized, were initially content to replicate relatively homogeneous portfolios of corporate
loans, which are fairly legible in terms of overall risk profile.

Nevertheless, the very securitization model has led market participants to relax some of their
control over the quality of investments. The crisis reports published in 2008 by the FSF and
IOSCO, among others, already called on the originators of securitized products to strengthen
their diligence and risk management of the underlying assets to ensure that the quality of the
assets securitized and sold is the same as that of the assets they keep in their own balance sheet.
This objective has been taken up by the European Commission in the context of the amendments
to the capital adequacy directive, through a provision requiring originators and sponsors of
securitized products to retain a significant proportion of the risks, which is in any case no less
than 5% of the total.

In the securitization process, it is important that investors have a sufficient level of information
about the initial nature and the evolution over time of the assets underlying the securitization
transactions. The outbreak of the crisis has revealed a lack of transparency in this area. On the
primary market, the documentation of the instruments most widely open to collective money-
market managers, using short-term instruments has proved insufficiently detailed or educational
to allow investors analyze the quality of the undertakings and understand their behavior in the
event of a market downturn.

On the other hand, secondary transactions in credit transfer instruments take place outside the
organized exchanges, making it difficult to assess the actual depth and liquidity of the market.
The prices and volumes of the transactions carried out are only brought to the attention of the
market in certain very limited segments or by means of indices. These trading systems also pose
operational problems due to the lack of a mutual clearing and settlement infrastructure for the
instruments. Moreover, the crisis has shown the lack of global information on the exact transfers
of risks.

Thus, greater transparency of the credit market in its primary and secondary components, the
dissemination of more appropriate information on complex financial products and the securing of
technical and legal trading systems for securities or contracts will enable investors to make
better-informed investment and risk management decisions in the future.

Internationally, IOSCO released a consultation paper in May 200987 to address the concerns of
the G20 expressed in November 2008 regarding the role of unregulated products and market
segments in the crisis and market development. Using securitization and CDS as examples,
IOSCO identifies areas where regulation could play an important role in restoring confidence in
financial markets. The proposed recommendations are intended in particular to strengthen
investor confidence in these markets and to improve the functioning and supervision of non-

87
IOSCO, Hedge Funds Oversight: Consultation Report, Madrid, 19 March 2009.
regulated products and markets. As far as securitization is concerned, these recommendations
concern, inter alia, transparency, the dissemination of information and the diligence of the actors
in the securitization chain.

At the European level, in December 2008 the Committee of European Securities Regulators
(CESR) published a consultation paper on the transparency of markets other than the equity
market, including the corporate debt market, structured financial products and credit derivatives.
With regard to the latter two areas, the CESR sought to examine the role of post-trade
transparency in price formation as well as in information on the extent of credit risk transfer.

The AMF has long advocated for greater post-trading transparency as a factor of market
efficiency. It supports the measures advocated by the European Commission and the European
Parliament, which will make it possible to minimize potential conflicts of interest between the
holders of the different tranches of securitized products and thus contribute to renewed
confidence in this market. The importance of the subject is undeniable and lies at the heart of the
regulator's objectives, which are to ensure the information of investors and the protection of
savings invested in financial markets. Nevertheless, it is difficult to see any progress in this area,
due to a still rather weak consensus among regulators on the efficiency of exploring a field
hitherto outside the scope of market regulation.

 Organisation Of Post-Market Infrastructures

The July 2005 report of the Counterparty Risk Management Policy Group II highlighted the
significant increase in the use of credit derivatives and highlighted the potential operational risks
related to the post-market infrastructure of these instruments. It was developing proposals to
minimize these risks, such as the automation of operational processes. The financial crisis has
highlighted the importance of finding solutions to manage these risks. The FSF report of April
2008 was among the first to call for the introduction of clearing services for OTC derivatives
market transactions to ensure better control of counterparty risks and the conditions for the
transfer of cash and securities between relevant actors. Several initiatives have already been
announced in the United States and Europe.
  Hedge Funds

The global activity of hedge funds has become too important not to raise questions about its
consequences for the financial stability and the efficiency of the market. If hedge funds are not
the cause of the current financial crisis, it should be noted that some of them, along with other
large investors, were able to feed the speculative bubble and then the spiral. In addition, hedge
funds have traditionally been opaque in order to protect their "factory secrecy", the strategies
they deploy. However, this opacity conceals the importance and distribution of systemic risks for
prudential regulators, both for the banking system (counterparty risk) and for the markets (risk of
inefficiency). Hedge funds should therefore be subject to reporting to supervisory authorities in
addition to the "indirect" regulation imposing transparency requirements on counterparties to
hedge funds, in particular their prime brokers.

Clearly, only international coordination is capable of defining appropriate rules to ensure the
effective control of risks, particularly systemic risks, at global level, taking into account the
models for the organisation of hedge funds. IOSCO and the FSB are the preferred forums for
developing such an approach.

 The Role Of Rating Agencies

As a result of their central role in the structured finance market, credit rating agencies have been
made partly responsible for the excesses and malfunctions considered to be at the root of the
subprime crisis. With ratings covering about $45 trillion in debt, agencies now perform the
centralized credit analysis function on almost as many assets as the total bank balance sheets.
They have achieved this position both through the economies of scale that their central function
of data accumulation, modelling and analysis for all emitters has enabled them, and through the
official recognition that they have received from the US regulation for more than thirty years. As
a result, the agencies have largely catalyzed the debates caused by the crisis. Their role in
assessing the credit risk of securitization vehicles has been questioned, and questions have been
raised about the reliability of the rating as such of structural finance products (problems in the
management of conflicts of interest, excessive volatility due to the poor quality of the models
used or the lack of hindsight, etc.).
At the international level, market regulators have reacted quickly to these dysfunctions. In
particular, after a thorough review of the role of credit rating agencies in the structured products
market, IOSCO has modified certain aspects of its code of conduct to take into account
specificities related to credit rating of structured financial products. It then analyzed the
implementation of this new code by the rating agencies. It is now focusing on strengthening
international coordination of agency regulation and oversight, an initiative promoted by the G20.
 BIBILOGRAPHY

REPORTS

Global Shadow Banking Monitoring Report 2017

Global Financial Stability Report, April 2012: The Quest for Lasting Stability

The Shadow Banking System: Implications for Financial Regulation (2009)

Strengthening Oversight and Regulation of Shadow Banking: An Integrated Overview of Policy

Recommendations (2012)

Shadow Banking: A Review of the Literature (2012)

The Fundamental Principles of Financial Regulation Geneva Reports on the World Economy 11

BOOKS

William Greider, One World Ready or Not: The Manic Logic of Global Capitalism, (Simon &
Schuster ISBN: 978-0684835549)

Susanne Soederberg, The Politics of the New International Financial Architecture, (Zed Books
ISBN:9781842773796)

S. Claessens, D. Evanoff, G. Kaufman, Shadow Banking Within and Across National Borders,
(World Scientific Publishing Company ISBN-13: 978-9814602709)

Lemma Valerio, The Shadow Banking System: Creating Transparency in the Financial Markets,
( Palgrave Macmillan UK ISBN: 978-1-349-57812-2)

Iris H.-Y. Chiu, Iain G. MacNeil, Research Handbook on Shadow Banking: Legal and
Regulatory Aspect, (Edward Elgar Publishing ISBN: 978 -1-78536-2620)

ARTICLES

Donohoe, Michael P., Financial Derivatives in Corporate Tax Avoidance: A Conceptual

Perspective (October 6, 2014), Journal of American Taxation Association, Forthcoming

Warren, Alvin C, Financial Contract Innovation and Income Tax Policy, Harvard Law
Review 107 (1993)
Dixon, L., Clancy, N., & Kumar, K., Hedge Funds and the Financial Crisis of 2007–2008.
In Hedge Funds and Systemic Risk (pp. 39-62): RAND Corporation

Claudio Borio, The Financial Cycle And Macroeconomics: What Have We Learnt? BIS Working
Papers 395, Bank for International Settlements

Moreira, Alan and Savov, Alexi, The Macroeconomics of Shadow Banking, Journal of Finance,
Forthcoming.

Rashmi U. Arora and Quanda Zhang, Banking in the Shadows: A Comparative Study of China
and India, Australian Economic History Review

Ji Huang, Banking and Shadow Banking, Journal of Economic Dynamics and Control

Guillaume Plantin, Shadow Banking and Bank Capital Regulation, The Review of Financial
Studies

Adi Sunderam, Money Creation and the Shadow Banking System, The Review of Financial
Studies

Mehrling, Perry and Pozsar, Zoltan and Sweeney, James and Neilson, Daniel H., Bagehot was a
Shadow Banker: Shadow Banking, Central Banking, and the Future of Global Finance,
Financial Stability Research Program

Luck, Stephan and Schempp, Paul, Banks, Shadow Banking, and Fragility (August 13, 2014).
ECB Working Paper No. 1726.

Meade, D., Biddle, L., & Merritt, H., Shadow Banking: The Growing Sector of Non-bank Credit
Activity, Business Law Today

Sherpa, D., Shadow Banking in India and China: Causes and Consequences, Economic and
Political Weekly

Tarullo, D., Financial Regulation: Still Unsettled a Decade after the Crisis, the Journal of
Economic Perspectives

Jiang, W., Li, K., & Shao, P., When Shareholders Are Creditors: Effects of the Simultaneous
Holding of Equity and Debt by Non-Commercial Banking Institutions, The Review of Financial
Studies