Research Summary
The report discusses the evolution and impact of the shadow banking system in the United States and China. It highlights the role of government-sponsored enterprises in the development of the U.S. shadow banking system and the subsequent financial crisis. The report also examines China’s success in deflating its shadow banking system without causing widespread turmoil, but warns of potential resurgence as the global economy stalls.
Key Takeaways
Origins and Evolution of the U.S. Shadow Banking System
- Emergence of Market-Based Finance: The report traces the origins of the U.S. shadow banking system to the 1970s, when market-based finance, or the intermediation of credit outside the traditional system, began to supersede the original banking model. This shift led to the creation of “deposit-like” instruments by private entities to evade regulatory hurdles.
- Role of Government-Sponsored Enterprises: The report highlights the role of government-sponsored enterprises (GSEs) like the Federal Home Loan Bank System in the development of the U.S. shadow banking system. These GSEs provided “loan warehousing” and “credit risk transfer,” similar to big banks providing “backstops” to shadow entities engaging in dubious activities.
- Impact of Regulatory Measures: The report discusses how the Basel Framework, a regulatory banking standard, inadvertently led to the rise of collateralized debt obligations (CDOs). Banks found ways to game the system by pooling mortgages into securities and reducing risk via CDO and credit default swap (CDS) products, requiring less capital than traditional lending to generate similar returns.
Transformation of the U.S. Shadow Banking System Post-Lehman’s Bankruptcy
- Shift to Repos and Asset-Backed Securities: Following the bankruptcy of Lehman Brothers, the U.S. shadow banking system transformed to consist primarily of repos (repurchase agreements) and asset-backed securities (ABS). The report notes that the securitized loans, leases, and mortgages packaged into tradable instruments have never been allowed to reach “CDO-cubed levels” of toxicity.
China’s Shadow Banking System
- Deflation of China’s Shadow Banking System: The report discusses China’s success in deflating its shadow banking system without causing widespread turmoil. However, it warns of a potential resurgence of financial alchemy in the shadows as the global economy begins to stall.
Actionable Insights
- Monitoring Regulatory Measures: The report suggests that regulatory measures, while intended to curb risk, can sometimes lead to unintended consequences, such as the rise of CDOs in response to the Basel Framework. Therefore, it is important to monitor the impact of such measures and adjust them as necessary.
- Understanding the Role of Government-Sponsored Enterprises: The report highlights the significant role of GSEs in the development of the U.S. shadow banking system. Understanding this role can provide insights into the dynamics of the shadow banking system and inform future policy decisions.
- Examining China’s Approach to Shadow Banking: The report suggests that China’s success in deflating its shadow banking system without causing widespread turmoil could provide valuable lessons for other countries grappling with similar issues.
