Shadow Banking, Low interest
Rates, and Financial Stability
Nellie Liang*
Financial Market Adaptation to Regulation and Monetary Policy
Stanford Graduate School of Business
Mar. 21, 2015
*Federal Reserve Board. Views expressed are mine and not necessarily those of the staff or the Board.
Outline
• Size and scope of shadow banking
• Structural regulatory reforms since the crisis
• Cyclical developments in a low interest rate environment
• Risk-taking channel of monetary policy leads to a buildup of financial
vulnerabilities
• Affects shadow banking through credit intermediation and provision of safe
assets, which depend on collateral values
• Case study: Speculative-grade debt and macroprudential policies for
shadow banking
Regulatory reforms for shadow banking
• Strengthened regulatory and accounting requirements for bank
support of nonbank intermediation
• FSOC designation of nonbank SIFIs
• MMF reforms
• Tri-party reforms
• Securitization rules – enhanced disclosure and risk retention
• New data for repo and sec lending
• Clearing for standardized derivatives, and margining for OTC
Low interest rates and financial vulnerabilities
• Risk-taking channel of monetary policy
• Loose policy can ease financial conditions, but in expansions can also fuel risk
taking and lead to a buildup in financial vulnerabilities
• Financial vulnerabilities – compressed risk premiums, excessive
leverage -- arise in:
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Asset markets
Banking sector
Shadow banking
Nonfinancial sector
• Financial vulnerabilities increase future downside risks to real activity
and financial stability
Tobias Adrian and Nellie Liang (2014), “Monetary Policy, Financial Conditions, and Financial Stability,” FRB New York
Staff Report, No. 690, September.
Monetary policy, financial conditions, and
financial stability (Adrian and Liang, 2014)
(1) Asset markets
(2) Banking sector
Financial conditions
Financial stability
Risk free term structure
Compressed risk premiums
Higher asset prices
Low volatility
Credit channel
Pro-cyclical leverage of banks and dealers
Risk-shifting reduces credit quality
(3) Shadow banking
(4) Nonfinancial sector
Credit channel
Pro-cyclical dealer intermediated leverage
Liquidity creation
Regulatory arbitrage
Securitization
Neglected tail risks
Balance sheet channel
Deterioration in underwriting standards
Excess leverage
Low interest rates and financial vulnerabilities
Banking sector and shadow banking
• Pro-cyclicality in leverage (Adrian and Shin, 2010)
• Risk shifting and neglected tail risks (Rajan, 2005, 2006; Gennaioli, et
al, 2013)
• Shadow liquidity – created by levering up collateral value of
their assets (Moreira and Savov, 2012)
• But liquidity creation comes at the cost of financial fragility
• Run on shadow banking during the financial crisis
• Runs on repo and ABCP that created amplification mechanism
(Gorton Metrick, 2012; and Covitz, Liang, Suarez, 2013)
• Theory of runs in repo markets (Martin, Skeie, von Thadden, 2012)
Case study:
Speculative-grade corporate debt
• Rapid growth of high-yield bonds and leveraged loans
• Poor underwriting quality
• Low risk spreads
• Leveraged loans originated by banks, but large amounts distributed
• Bonds and loans are relatively illiquid, and increasingly held by ondemand investment funds
• Case for intervention?
• Tools?
Speculative-grade debt markets
Note: Leveraged loans are defined broadly as senior secured loans rated BB+ or lower, loans to borrowers rated as a non-investment grade company (below BBB) or to loans without credit ratings and
an interest rate spread of 125 basis points over LIBOR. High-yield bonds are bonds rated below BBB. Ratings are referenced to S&P.
Investors for leveraged loans and high yield bonds
Speculative-grade debt and tools
• FINRA Investor Alert July 2011
• “prompted by significant recent inflows into investments like high-yield bond funds, floating-rate loan funds, and
structure retail products.” “Investors should never make an investing decision solely by looking at an investment’s
return, whether past or projected. Higher returns come with higher risk.”
• 2013 Supervisory guidance for leveraged loans
• Safety and soundness of the bank originator: pipeline management, concentration risk
• Minimum underwriting standards: due diligence of financials, payback capacity, debt multiples
• Same underwriting standards whether held or distributed
• DFAST / CCAR 2015 scenarios with a business bust, to build resilience
• Risk retention for CLOs (effective 2016)
• Possible:
• Exam authority for investment advisors that sponsor the CLOs
• Exam authority for liquidity requirements for investment funds
• Guidance for insurers
Macroprudential intervention
• Potential vulnerabilities
• Nonfinancial sector: Severe boom-bust credit cycle from higher business defaults,
negative investor returns, and reduced access to credit and recession
• (Greenwood and Hansen, 2013; Stein, 2013; Schularik and Taylor, 2012)
• Bank and shadow banks: Leveraged financial institutions suffer losses, with fire-sale
spillovers
• Asset markets: Negative investor returns spur large redemptions and high liquidity
risk premiums
• Macroprudential considerations
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First line of defense, targeted, unlike monetary policy
Reach of tools (investor demand)
Leakages to shadow banks (as originators)
Timing
Political economy
Appendix slides
Macroprudential authorities
• Sec. 165 grants the Board the ability to adopt standards to mitigate
risks to financial stability of the United States
• Requires a showing that an ongoing activity could cause risk to the financial
stability of the United States
• FSOC “comply or explain”
• May confer greater authority on the primary regulator, such as authority for
enforcement for financial stability purposes.
Macroprudential Policy for Vulnerabilities
Financial Vulnerability
Macroprudential Policy
(1) Asset markets
· Compressed risk premiums
· Low volatility and low risk premiums
(2) Banking sector
· Pro-cyclical leverage of banks & dealers
· Risk-shifting channel reduces the quality of
credit
(3) Shadow banking
· Pro-cyclical dealer intermediated leverage
· Excessive maturity transformation
· Regulatory arbitrage
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(4) Nonfinancial
sector
· Deterioration in underwriting standards
· Excess leverage
Underwriting standards for debt
Sectoral risk weights at banks
Countercyclical capital or liquidity buffers
Margins and haircuts
Limits on short-term collateralized funding
Higher capital and liquidity requirements
Countercyclical capital requirements
Sectoral risk weights
Supervisory guidance, exposure limits
Supervisory stress tests
Monitor for regulatory arbitrage
· Reduce regulatory and accounting incentives to move
activities from regulated sector
· Higher minimum haircuts or margins
· Tighter standards on securitizations
· Limits on underwriting standards, such as LTVs and DTIs
· Limits on adjustable rate loans for borrowers, stress test
borrowers for rising rates