The economic costs of imposing bank

regulations on shadow banking

By
Paul Kupiec
American Enterprise Institute
May 6, 2014

The opinions in this presentation are those of the author and do not necessarily represent the opinions of the
American Enterprise Institute.
What is Shadow banking?
Those seeking to impose bank regulation on shadow banking have
never clearly defined what they identify as shadow banking
Financial Stability Board, September 2013
non-bank credit intermediation for short.
the capacity for (some) non-bank entities and transactions to operate on a large scale in
ways that create bank-like risks to financial stability (long-term credit extension based on
short- term funding and leverage). Such risk creation may take place at an entity level but it
can also form part of a complex chain of transactions, in which leverage and maturity
transformation occur in stages, and in ways that create multiple forms of feedback into the
regular banking system.
This is broad; it could cover almost anything.



Artic Trucks (AT) purchases 4-wheel drive trucks and modifies
them for Artic conditions. For arguments sake, lets assume
AT borrows (leverage) by issuing commercial paper (shadow
banking, short-term debt) and builds trucks and inventory.
The trucks last many years (maturity transformation).

If the economy unexpectedly freezes (ha!), customers stop
buying trucks and other things in Iceland. AT cannot roll over
its CP and unexpectedly defaults. Investors default as a
wake-up call and avoid all new CP issues.
Icelandic firms using CP must draw on their bank lines of
credit, impacting all Iceland banks liquidity when they are also
facing market liquidity pressures as investors reassess the
banks risks from the unanticipated recession.
To recap, the story is that leverage and maturity transformation outside of the banking system creates negative
feedback and stress for the Icelandic banking system...

Bank regulators argue that corporate leverage and maturity transformation in the shadow banking sector
creates risk for the banking sector, and we need additional regulations to prevent it.

Lets take a closer look at these issues and also focus of the cost of regulations that would fix the problem.
Concrete example of systemic risk created by shadow banking
Bank Regulators Solution
Solution: Limit Artic Trucks and other firms ability to use CP (shadow
banking) which will push the firms to borrow from the banks instead.
Issues with this solution
Artic Trucks borrows less & make smaller investments, limiting economic
growth
Forcing AT and all other firms to borrow from banks pools all the economys
risk in the banking system
Bank solution only works if banks anticipate the coming recession and force Artic
Trucks and other borrowers to reduce borrowing (& inventory) in anticipation of the
recession

Do Bankers Impose Timely Market
Discipline?
Are bankers (or their regulators) better at disciplining borrowers?
Open issue
Banks are protected from deposit runs by deposit insurance & other government
backstops that are designed to make banks less likely to shut down customer credit lines
in a timely fashion
Bankers may be reluctant to shut off short-term credit because they loose other sources of
revenue from the firm (transactions fees, advisory)
It is also possible that bankers have client relationship information that may enable them
to nurse firms through recessions where as shadow banking markets might cut off credit
It is unclear whether the real economic costs of the recession (building too many artic
trucks and other products no longer in demand) would be better controlled by requiring
firms to finance with bank loans instead of through the shadow banking markets
Real economic losses could well be bigger if all finance is bank finance
Regardless, all the losses will be in the banking system

Bank regulators solution will raise credit
costs
Shadow banking arises because it is cheaper than bank finance
Markets favor efficient (cheapest) solutions
When investor access to firm information reaches a threshold, most firms migrate, at
least partially, from bank-sourced finance to market-based sources of funding
Bank credit includes the cost and restrictions of bank safety and soundness
regulations
Regulators argue that the shadow bank financing solution only appears
cheaper to issuing firms because externalities are not priced in when these
unregulated markets extend credit or engage in maturity transformation
Externalities include of potential fire sales and negative liquidity spirals when markets or
institutions are allowed to create excess liquidity and excess leverage
In a moment, I will build a case that the systemic risk in banking and
shadow banking financial intermediation are basically the same
When banks have guarantees and government support, the losses from systemic
events will be distributed differently with bank finance, but the losses are the same
Are bank regulations able to control excess credit
& liquidity?
Identifying the problem as excess credit and excess liquidity
created by the shadow banking system creates a misleading narrative
Creates the impression that regulators can separate credit and liquidity into
necessary & appropriate from excess credit and liquidity before a crisis
happens
Nothing could be farther from the truth
Before the financial crisis, bank regulators from G-10 countries embraced
securitization and credit risk transfer (both shadow banking activities) as
beneficial...
They concluded that they reduced risk in the banking system by transferring credit risk to
the investors that best understood it and could best manage it
Credit Risk Transfer, Committee on Global Financial System, Publications No. 20, January
2003

Credit + Maturity Transformation = Money
When economic agents are able to sell long-term (interest paying)
debt, and investors have confidence that the terms will be honored at
maturity regardless of who owns the paper, the debt can be traded
among investors and can function as money
This is so-called inside money, because it is created by the private sector
without government involvement
A systemic risk event destroys inside money in the shadow banking system,
and in banks, and central banks have to scramble to replace it to prevent
economic activity from collapsing
I am going to develop a Simple model with no math which will show
the economic value of maturity transformation, and show that
maturity transformation can occur equally well using banks, or using
securities in the shadow banking sector
I will introduce a systemic risk into this economy and show that
systemic risk has an identical effect on the economy, regardless of
whether maturity transformation takes place through shadow
banking, or in the banking system.
This model will also give us a concrete idea of how to control systemic
risk and the costs that will be involved in doing so.
Resources Misaligned with Consumption
Preferences
Timeline for apple ripening.
1 2
3
Type I : apples ripen date 3 preferred apple consumption date 1
Type II : apples ripen date 1 preferred apple consumption date 2
Type III : apples ripen date 2 preferred apple consumption date 3
time
Type II Type III Type I
Three different agents: each owns 1 unit of fiat money they hold to pay a tax in period 3, and an
apple tree that bears apples.
The apple trees are identical except they produce apples at different times
Contracting Allows Apples to be Consumed at the Best Time
Apple ripening schedule
1 2 3
Apple consumption profile is optimal after contracts are honored
1 2 3
Type I : preferred apple consumption date 1
Type II : preferred apple consumption date 2
Type III : preferred apple consumption date 3
time
time
Type II
Type III Type I
Type III Type I Type II
If each agent can write contracts to trade apples, and the contracts are
credible & enforceable .
Type I agent writes contract to receive Type IIs apples at
time 1 in exchange for Type Is apples at date 3.
Type II agent trades contract for time 3 apples
with Type III agent in exchange for date 2 apples.
But what if some contracts are not
credible?
If Type II agents contract to swap apples across time is not crediblethe
bilateral contracting solution falls apart and apples cannot be traded across
dates
Agents must consume their own apples when they ripen
Welfare in this economy falls dramatically because agents must eat apples on dates
when they would prefer not to the apples
But all is not necessarily lost.
Suppose Type I can write a credible contract to exchange date 3 apples for Type IIs
apples at time 1
Type II does not need credibility to enter into inter temporal contract; Type II executes a spot
transaction---delivers apples immediately in exchange for Type I apple bond
Type I issues long-term debt
So long as all believe that Type I will honor the terms of the debt contract no matter
who presents it for payment at date 3, the first best solution can be achieved even
though some agents cannot enter into credible contracts to trade apples across time
Contracting Allows Real Goods to be Traded Across Time
Apple production
1 2 3
Apple consumption after contracts are honored
1 2 3
time
time
Type II
Type III Type I
Type III Type I Type II
Type II agent buys Type I agents long-term apple bond only because it wants to resell it----Type II does
not want Type Is date 3 apple bond payoff.

Bond functions as inside money---a medium of inter temporal exchange
Type I agent issues long-term bond pays apples at time 3 .
Type II agent buys the apple bond in exchange for apples
at time 1.

Type II agent holds on to the bond until time 2

At date 2, Type II sells apple bond to Type III agent in a
spot transaction for apples at time 2.

At date 3, Type III eats apples from Type I apple bond

Shadow Banking Maturity Transformation
The ability of one agent to issue a credible long-term (apple) bond
allows others, who do not have the credibility to issue their own debt
contracts, to successfully trade apples harvested at different dates to
reach the best consumption profile for the economy
The long-term (apple) bond is traded to facilitate the reallocation of ripening
apples across time
Maturity transformation
Agent II buys the bond to re-sell it, not to hold it
Might look like excess liquidity or trading to a bank regulator, but
the trading serves an important economic purpose
Systemic Risk in Shadow Banking
Consider the effect of a rumor at date 2 that there is an apple tree
blight that may reduce the time 3 harvest
Type Is (apple) long-bond may not payoff as promised
If blight is severe, Type II, who owns the bond, cannot sell it. Type III would
rather eat apples at time 2 than trust the bond payoff at date 3
Type I has already eaten apples at date 1.
Type II is stuck with no apples at date 2 and Type Is bond that may default at
date 3, so Type II ends up with apple harvest (possibly reduced by blight) at
the wrong date
Type III may have to eat his apples at date 2
Cash transactions can be used to share
losses
Type I has already eaten apples at date 1.
Type II is stuck with no apples at date 2 and Type Is fallen-angel bond
Type IIIs apples ripen at date 2
Maturity transformation using financial securities has broken down
But agents can still use fiat money to trade in spot transactions
Type II could use cash to buy some date 2 apples from Type III and recover these
balances at date 3 (to pay taxes) by selling Type III apples at date 3.
Type III will not sell all of his time 2 apples for the cash, but will keep and eat some of them
Type II and III can negotiate a cash transactions at date 2 and date 3 to share the loss in apple
output at date 3.
Type II and Type III will not get as many apples in their preferred consumption dates and Type
III will end up eating some of his apples at time 2.
Still, economic well-being plummets when new information about the
long-bond disrupts maturity transformation in the shadow banking system
Bank Intermediation
Agents deposit cash balances with bank; have right to withdraw at any date
They have no need to withdraw until date 3 when they have to pay taxes.
The bank can lend this money and manage bilateral loan contracts
Type I pledges time 3 apples to bank as collateral, bank lends fiat money to Type I.
Type I agent uses the money to buy date 1 apples from Type II.
Type II agent holds money balances until date 2 and uses it to buy date 2 apples from
Type III agent.
Type III agent holds money until date 3, and uses it to buy apples from Type I agent.
Type 1 agent uses apple sales proceeds to pay off the bank loan.
Bank loan facilitates intertemporal trade (maturity transformation) instead
of long-term bond sales.
No bond trading with bank intermediation.


Bank intermediation when rumor hits
All agents have deposits of 1 unit of fiat money in the bank and know that banks
only collateral is the loan secured by date 3 apple production, which is now of
questionable quality because of the blight
Agents try to withdraw deposits; bank has no fiat money to payoff deposits. The
bank fails; Agents get ownership share in banks residual value---all share 1/3 of
lost apple output.
Type III agent has apples at date 2; Type II agent has fiat money.
All agents will need fiat money in date III to pay tax.
Cash will buy fewer apples in date 3 since production is smaller.
Type III and Type II will negotiate and Type III may sell Type II only some of the date 2 apples
for cash and Type III will eat the rest of his date 2 apples.
Type III uses all the cash to buy apples from the bank at date III.
How many apples get traded between Type II and Type III depends on the relative strength of
their preferences.
End results is the same as with shadow bank intermediation.
Losses are shared by Type II and Type III investors
Without government safety net (not modeled hereno one has a guarantee),
bank and shadow bank intermediation produce the same outcome
How to control systemic risk?
In these examples, systemic risk is the risk of disruption of the maturity
transformation process
If the financial system breaks down, it reduces agents ability to trade resources
(apples) between periods
The financial system disruption causes a large loss in consumer well-being because
consumers can no longer trade for and consume the goods they most desire
The only way to limit systemic risk (the risk of maturity transformation
breakdown) without utilizing a government safety net is to limit long-term
borrowing so that there is no risk that the long-dated loan will default
Regulators will have to estimate the worst possible date 3 apple harvest, and limit
long-term debt to less than that amount.
Investors must believe this limited amount of debt will be fully repaid
There are no government safety nets in this model, and without using a
government guarantee (the government bears part of any loss) , there is no
other way to reduce systemic risk but to lower the borrowing limit





Regulation to control systemic risk
Firms required to limit leverage --long-term bond issuance
EG: Type 1 agent can only pledge 50 percent of the expected date 3 apple
harvest as collateral for long-term bond or bank loan
So long as random developments (blight) do not reduce harvest by more than 50 percent
(from expected normal harvest), the bond or bank loan will perform
Intermediation will not be disrupted
But the cost of reducing systemic risk is LESS maturity transformation
All of the agents will be forced to consume half of their harvest at the wrong date!
Overall economic welfare will be much lower all of the time, not just on rare dates when
shock disrupts maturity transformation
So systemic risk regulation permanently lowers consumers level of
satisfaction to prevent an infrequent occurrence of lower satisfaction when a
systemic risk event disrupts intermediation
Regulations will Limit Economic Growth
While the example deals with maturity transformation in a model of
consumption alone, if the model included investment and
production:
a systemic shock would disrupt maturity transformation which would keep
firms from being able to borrow to invest
Output/economic growth would drop
Systemic risk can be controlled by limiting firms borrowings, but this
will permanently lower firm investment and economic growth
What level of leverage is too much?
Are bank regulators judgments about the acceptable level of
corporate leverage better or more accurate than investors
assessment?
Maturity Transformation in the shadow banking system relies on investors
ability to continue trading a high-quality bond whose market value is
insensitive to most new information
Investors will avoid using debt instruments with high price volatility for
maturity transformation because they face the risk that they cannot resell a
bond they are holding only because it is a temporary store of value
Are bankers or bank regulators going to be any better than market investors
at selecting the firms that get to issue long-term debt?