TheFinancial Stability Board (FSB, 2012) defines shadow banking asa system of credit intermediation (Creditintermediation is a lending activity where the saver does not lend directly tothe borrower) that involves entities and activitiesoutside the regular banking system in other wordsshadow banking system refers to unregulated activities by regulatedinstitutions.According to European Commissionshadow banking activities consist in: i. Maturity transformation: refersto using short-term liabilities to fund long-term assets. ii. liquidity transformation: referstothe fact that a bank’s assets are less liquid than its liabilities. Assets are converted intocash then they use illiquid assets to create a more liquid one.
For example,mortgage is an illiquid asset that can be used to create an equity which iseasily sold and therefor get more liquid this process is called securitization.iii. Credittransformation:individual loan carries risk specific to a transaction, a bank diffuses itsoverall risk exposure by lending to a large number of borrowers. iv. using direct or indirect financialleverage: refersto capital lent or borrowed in order to boost gains/losses.There are significant benefits thatshadow banking offers to the financial system by reducing cost of credit andincreasing liquidity of the system through:1.Securization:is a process of supplying various debt contracts inorder to arrange them according to clients’ needs. Here securitizationtransforms illiquid underlying assets into liquid securities and therebyincreases the liquidity of the financial system.
For example, loans can be turnedinto liquidity. 2.MoneyMarket Funds: are investment funds that have the purpose to provideinvestor with protection of capital and daily liquidity, and that seek toachieve that objective by investing in a diversified portfolio of high-quality,low duration fixed-income instruments.
3.Repurchase Agreements: the borrower borrows money from the lenderfor the price difference between the repurchase and initial price and usestheir assets as collateral. highly liquid and low-risk characteristics ofsecurities led to their acceptance as collateral in repurchase agreements.4.Decentralization: the shadow bankingsystem is decentralized, enables specialization and hence further efficiencygains, it may prevent existence of too-big-to-fail institutions and it supportscompetitive environment which has a further beneficial effect on the price ofcredit.
If shadow banking is not properlystructured, it can represent a source of systemic risk that can easily affect boththe rest of the financial system and the real economy. Firstly, one of the characterof shadow banking is decentralization which can lead to long and difficult financialintermediation chains. The process of securitization can be in theory repeated withoutending and thereby creates specialized but augmenting opaque securities.
As a result,pricing of the products becomes very complex as the price should reflect boththe quality of the underlying loans and the risk structure at every singlelevel.Secondly, acceptance of securities ascollateral for repurchase agreement builds up leverage. Although leverage is fundamentally related to credit intermediation and itcan turn a non-systemic risk into a systemic one. Moreover, raise of leverage increasesthe procyclical nature of shadow banking and extend consequences of financialcrises.Thirdly, the reliance of shadowbanking on short-term liabilities acquired through repurchase agreements tofund illiquid long-term assets (loans) is inherently fragilesince it is susceptible to modernbank-runs. shadow banking institutions do not accept deposits, which is thereason why they are not currently regulated.
Moreover, Shadowbanks buy long term assets and finance them by selling short term securities.However, if investors become susceptive about a bank’s health, these long-termassets have to be liquidates with immediate effect. This creates a situation ofdistressed sales.Fourthly: Shadow banks are not defended by the centralbank.
They do not have any kind of reserves that would save them from troubleif the depositors suddenly wanted to withdraw their cash. It is true thatcommercial banks indirectly finance these shadow banking institutions. However,it is difficult for them to deviate cash towards their shadowy arm especiallyif a crisis is in progress.
This creates a situation where in shadow banks notonly face huge risks themselves but also produce systemic risk. This is becausetheir business creates the same amount of risk as that of banks. However, theydo not have the preventive regulations or the safety nets that banks haveaccess to in case things start going wrong. (No access to cash)QuestiontwoToo big to fail theory affirmthat certain corporations, particularly financial institutions, are so largeand so intercorrelated that their failure would be catastrophic to the greatereconomic system, and that they therefore must be supported by government whenthey face potential failure (Fein,2013, p.2).
Systemicrisk and moral hazard are a principal immediate cause of the existence oftoo-big-to-fail due to growth of bank in size which increases the moral hazardrisk of becoming too-big-to fail institutions.The failure of a largebank as HSBC can be an extensive failure of several financial institutions,first, HSBC have direct implication on the economy, in terms of high laborforce redundancy of a large bank, and interruption in provision of operationsdecisively important for smooth marketfunctioning.Just to name few aspects of bank operations, the undesirable outcome in this situation would be the interruptionof lending, payment processing, short-term funding, and cash management. Second,multiple failures have indirect economic effects as well. They cause entire financial marketinstability, which spills over real economic activity.
Because the financialinstitutions are perceived to have very important role in the functioning of real economy, theirfailure is perceived to represent a disaster. (Barth,2012, p.30)Large banks as HSBC are organized by a form system ofresponsibilities along product and regional lines. The product heads of the large divisions into which banks are organized.As in industrial companies, each division has its own management focusingexclusively on its own divisional business. However, given the size of HSBCdivisions and his reach into many countries and continents, a problem rises inthe collaboration of the many employees behind offices of the bank with a largeinternational network.
largest banks aretoo big and complicated to manage their operation through thousands ofsubsidiaries.In other words, top management cannot detect all widespread internal misconduct.The size defies the ability of any manager or management team to understand,manage and control all aspects of operations, or even keep them within legalboundaries.