Shadow banking wins from latest straightjacket
Higher capital and liquidity requirements for traditional banks globally could make the parallel banking system, financed partly by insurers, more prominent and competitive, says a new report from US regulators. The July 2010 Federal Reserve Bank of New York staff report, entitled "Shadow Banking", recommended that US policy discussions on parallel banking should happen alongside those on traditional banking. As things stand, the new US financial reform legislation will restrict banks' proprietary trading and will require them to put swaps activity into a non-bank subsidiary. But outside traditional banking, the new legislation will largely ignore credit intermediation.The report queried whether parallel banking - defined as long-term, viable shadow banking - would have constant stability without the backstop of official credit and liquidity puts. If not, the question was whether puts and associated prudential controls should be extended to parallel banks, or whether parallel banking should be severely restricted.Securities lending activity of insurance companies, pension funds and certain asset managers is "unenhanced" shadow credit intermediation, meaning it is unsupported by official liquidity. Insurers invest in the shadow banks' longer-term medium-term notes and bonds.According to the report, credit intermediation of independent specialists depends on financial holding companies and diversified broker-dealers, both highly reliant on private credit risk repositories providing credit transformation services in the external shadow banking sub-system. The repositories include mortgage insurers, monoline insurers and certain subsidiaries of large diversified insurance companies, as well as credit hedge funds and credit derivatives product companies. Of these, mortgage insurers have specialised in insuring, or wrapping, whole mortgage loans. Monoline insurers have wrapped asset-backed security tranches, or the loans that back specific ABS tranches. Large diversified insurance companies, as well as credit hedge funds and credit derivatives product companies, have specialised in taking on the risks of ABS collateralized debt obligation tranches through credit default swaps. There has been overlap, as with some monolines wrapping both ABS and ABS CDOs.The report found that credit put options from private risk repositories absorbed the tail risk from loan pools processed through shadow banking, turning the securities enhanced by them into credit-risk free securities, at least as investors perceived them. Any liability issued against these assets to fund them was similarly perceived as credit-risk free.According to the report, the perceived credit-risk free nature of traditional and shadow banks' liabilities stems from two different sources. For traditional banks' insured liabilities, meaning deposits, the credit quality is driven by the counterparty, the US taxpayer. For shadow banks' liabilities, perceived credit quality is driven by a collateral seen as "credit-risk free" when enhanced by private credit risk repositories. Traditional banking relies on deposits for funding, but shadow banking relies on money market instrument issuance and longer-term medium-term notes and public bonds issued to investors such as securities lenders, pension funds and insurance companies. As the crisis showed, private credit repositories were ineffective substitutes for deposit insurance, given that they became themselves contaminated.Only after the breakdown of commercial banks' and broker dealers' ability and willingness to provide "lender of last resort"