Topic 4 - Lecture - FINA1153

Shadow banking refers to financial intermediaries that carry out maturity, credit, and liquidity transformations without having access to central bank liquidity or public sector credit guarantees.
This structure has created the "originate-to-distribute" banking model, distancing the default risk on loans from their originators.
Contrasts with the traditional "originate-to-hold" model where lenders keep the loans on their books.

Securitisation is a key process in shadow banking where illiquid assets are transformed into liquid, tradable instruments.
This technique enables banks to offload loans from their balance sheets and distribute risk to other financial entities, enhancing liquidity and risk management.

Main investors in Asset-Backed Securities (ABS) include hedge funds, broker/dealers, and Asset-Backed Commercial Paper (ABCP) conduits.
Indirect funders of ABSs are typically money market funds (MMFs) and securities lenders.

Investors provide funding through:
- Asset-Backed Commercial Paper (ABCP): Issued by Special Purpose Vehicles (SPVs) created usually by commercial banks to buy long-term ABS.
- Repurchase Agreements (Repo): Broker/dealers utilize repos to finance their inventory of ABS and provide loans to clients like hedge funds.

Commercial banks (the originators) decide to securitise a part of their loans.
The pooled loans are sold off to administrators who establish SPVs that purchase them for a fee.
Securities created by SPVs are sold by an underwriter, typically an investment bank.
Broker/dealers, hedge funds, or ABCP conduits turn ABS into ABCPs or repos.
MMFs or securities lenders buy the securities.

A "repo" involves selling securities with an agreement to repurchase them later at a higher price, functioning akin to a collateralized loan.
In this transaction, the seller enters a repo agreement while the buyer enters a reverse repo.

Repo Rate: Illustrates the cost of the loan represented by the difference in selling and repurchase prices.
- Example: If collateral is sold at £80 and repurchased at £88, the repo rate is 10%.
Haircut Rate: Represents the difference between market value and purchase price of collateral.
- Example: For collateral valued at £100 sold for £80, the haircut rate is 20%.

The financial crisis was triggered by rising subprime mortgage defaults, first noted in February 2007, leading to significant pressure on investment banks like Bear Stearns in March 2008.
The contraction in the repo market was linked to the failures of shadow banking entities, specifically ABCP before affecting the broader repo market.
Lehman Brothers' failure resulted from significant write-downs owing to its exposure to mortgage-backed securities (MBS), triggering a bank run on money market funds after its bankruptcy in September 2008.

As of October 2018, the Financial Stability Board (FSB) shifted from the term "shadow banking" to "non-bank financial intermediation" (NBFI).
NBFI now accounts for 47.2% of global financial assets, with banks holding the majority of assets in emerging markets (57.9%).

The primary sectors within NBFI are:
- Insurance Corporations (ICs)
- Pension Funds (PFs)
- Other Financial Intermediaries (OFIs) including MMFs, investment funds, hedge funds, broker-dealers, and structured finance vehicles.

The growth of NBFI in China has exceeded the decline observed in total NBFI assets compared to GDP.
This sector has expanded significantly since 2009, contributing to the financing of firms and households, reflecting the unique economic functions that shadow banking fulfills in the Chinese market.