• “Shadow banking" is a term used to describe banking institutions, practices and instruments that operate beyond the reach of regulation – including hedge funds and money market fund that handles trillions of dollars.

What is Shadow Banking System (ii)
• A new kind of semi-banking system that emerged in the 21 st century.
• Shadows banks are acting like Commercial banks but technically they are not CB because they are not regulated.
– Such as Country Wide, a big shadow bank organization.
– They make all kinds of loans, like credit card loan, car loan, home loan, boat loan, merchandise loan, etc

What is Shadow Banking System(iii)
• Investment banks are taking the roles of
Shadow banks, such as Lehman Brothers.
– Investment banks may conduct much of their business in the shadow banking system (SBS), but most are not SBS institutions themselves
• Convergence of banks creates big banks that have both CB and SB (IB)
– JP Morgan Chase
– Citi group
– Bank of America

• Both make loans for borrowers, such as homeowners.
• CB receive deposits as resources for loans, not
SB
• CB get money @ 1% from depositors
• CB loan them out @6% to homeowners as mortgage.
• CB makes 5% of profits.
• CB are insured by FDIC and CB can borrow at
Fed discount window, not SB

• So how do SB make money?
• Repo market to borrow for short term @ low rate
– Repo is like short term loan but with collateral such as
TB.
• Use the borrowed short term fund to lend out for long term @ higher rate
• Bundle the loans as securities (such as mortgage backed security) and sell them to
– Hedge funds
– Pension funds, etc

• Definitely.
• When short term loan provider (repo investor) does not renew the loan, there is no liquidity for SB.
• When you think this tends to occur?
• We have seen this type of running happening in the crisis.
• Why bank run does not occur in CB anymore?

One Example of How SB operates (I)
• Imagine you can get loan from Wells Fargo @8%.
• You found that Nationwide is charging 6%, all else equal.
• You chose Nationwide’s loan.
• After the deal is closed, what tends to happen with your loan?
– Securitization of loans of yours and tens of thousands of others.
• AAA bond, AA bond, A bond, and lower ranking ones
– Securities were sold to investors
• Eg., Pension funds invest in AAA bond and get 2% rate
• Hedge funds invest in AA bond and get 3% or in BBB bond and get 4%, etc.

One Example of How SB operates (II)
• But are those mortgage backed securities as safe as loans from CB?
– CB’s loans are much safer
• Fed is CB’s lender of last resort
• CB has to meet capital adequacy ratio required by Fed
• CB is insured by FDIC
• CB has checks and balances from depositors
– SB has no safe net from the government and thus is much riskier.

One Example of How SB operates (III)
– So “bank run” would be more likely for SB
• Leverage of SB is much higher than CB
• No lending in repo market or short term market
– One cause of the failing of Lehman brother and Bear Stern
– Economist Paul Krugman described the run on the shadow banking system as the "core of what happened" to cause the crisis.
Reference http://en.wikipedia.org/wiki/Shadow_banking_system

Why SB is still running
• Before the crisis, about 60% of mortgage was issued by SB, and the rest is by CB
– Demand is higher than that can provided by CB
• So SB is a key component of our economy
• Without SB, many homeowners could not buy their dream houses.
• However, the assets (bonds) of SB (such as mortgage backed securities) are considered as toxic assets
– too hard to price them to find investors.
• Banks are becoming too big to fail.

Lehman Brothers Failed due to “Run on Repo” (i)
• Lehman Brothers is a pure IB
• It is acting as a SB as well
• Lehman Brothers heavily involved in repo market to get access to short term capital
– Repo is similar to deposit which is short term loan
• Then invested the borrowed capital in subprime securities and other securities

Lehman Brothers Failed due to “Run on Repo” (ii)
• So if repo investors (like depositors) fear of failure of Lehman Brothers
– Due to housing market value declined and subprime securities’ value declined
– They would not renew repo when it was due
– The “run on repo” occurs.
– The values of securities (subprime securities) held by Lehman Brothers declined
– Lehman Brothers could not rescue itself
– Government bailed out Bear Stern and Merrill
Lynch and did not bail out Lehman Brothers.

Debate about Regulations on Shadow Banking (i)
.
• Fed should regulate both CB and IB (SB)
• Regulate hedge funds with assets over 150m
• Formalize over-the-counter derivative trading
• Dodd Frank Act provisions

Debate about Regulations on Shadow Banking (ii)
• The G20 is still trying to stop banks becoming
"too big to fail", which covers banks the markets believe would be bailed out in a crisis.
• Instead, the Institute of International Finance, a global association of financial institutions, has asked world leaders to adopt shadow banking regulations tailored to individual banking sectors, rather than imposing blanket regulations