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May 18, 2011

Shadows No More: The Shadow

Banking System Steps Into The
Primary Credit Analysts:
Nik Khakee, New York (1) 212-438-2473;
Jeffrey Zaun, New York (1) 212-438-2739;
Joel C Friedman, New York (1) 212-438-5043;
Rian M Pressman, CFA, New York (1) 212-438-2574;
Robert Chiriani, New York (1) 212-438-1271;
Chris C Cary, New York (1) 212-438-1894;

Table Of Contents
What Could Fuel Shadow-Banking Growth?
Regulatory Changes Create New Opportunities
Differences In Liquidity Support
Transparency Is Uneven In The Shadow Sector 1
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Shadows No More: The Shadow Banking
System Steps Into The Spotlight
The recent financial crisis shined a light on shadow banking that has grown brighter as the economic and political
aftershocks of the crisis reshape the banking industry. In the absence of one financial regulator harmonizing the
shadow-banking and traditional-banking sectors, Standard & Poor's Ratings Services believes shadow banking may
be well positioned to take on a greater role in lending vis-à-vis the banking sector; it may try to advance the
emerging opportunity to finance more assets that banks either can't or won't fund because of new regulation. This
regulation includes the Dodd-Frank Act, the Basel III capital guidelines, and yet-to-emerge governance for the
government-sponsored entities (GSEs) Fannie Mae and Freddie Mac. Here, we focus primarily on the U.S., but the
two-tier system of banking and shadow banking is a global condition.

We define shadow banking as the system of finance that exists outside regulated depositories, investment banks, or
bond funds. It includes bank-sponsored intermediaries such as asset-backed commercial paper (ABCP) conduits,
money-market funds, collateralized loan obligations (CLOs), finance companies, private investment funds, business
development corporations (BDCs), asset managers, and hedge funds. The market determines the level of leverage
and access to funding for participants in the shadow-banking system, which results in market-driven cost of funds.
Given that, in our view, shadow-banking players differ from traditional banks in three important ways. They don't
typically operate under bank regulatory supervision and thus often operate under differing capital, leverage, and
liquidity guidelines. They don't normally benefit from government capital support, such as deposit insurance. And
they don't benefit from the liquidity support available to regulated banks, such as the ability to borrow from the
Fed. This lack of oversight and support was a factor in the difficulties some shadow-banking players experienced
during the financial crisis.

The trade-offs between shadow banking and traditional banking lending occur in areas of capital requirements,
liquidity requirements, and reporting transparency. These differences create opportunities for borrowers and lenders
to pursue the cheapest-cost, least transparent source of capital, and results in incentives to concentrate debt leverage
that has led and may lead again to systemic events. Because traditional bank lenders have been busy building and
maintaining capital, other funding avenues, including the public and private capital markets and the
shadow-banking system, have begun to fill the void and may continue to do so. We also believe the shadow-banking
system will grow because we expect some investors to continue to seek high returns by backing shadow-banking
lenders. Some of that growth may be tied to capital sizing being focused on specific portfolios of assets, which we
believe can be a positive if it is transparent to investors and regulators. Some of that growth may be tied to
innovation that may focus more on regulatory arbitrage of capital, liquidity, or transparency as opposed to
enhanced asset-and-liability management.

Although there may be some benefits from growth in the shadow-banking system, such as financial innovation and
lower-cost financing to corporate borrowers, we also see potential risks in this trend: If shadow banking isn't
monitored rigorously, consistently, and transparently, the global financial system, in our view, could perpetuate the
already entrenched two-tiered approach, with different regulatory, capital, and reporting requirements for
traditional commercial banks and the components of the shadow-banking system. Under certain circumstances, that
might destabilize the financial system. In addition, we believe shadow banks will likely have to overcome investor
concerns about their access to capital, liquidity support, and transparency.

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A two-tier environment encourages regulatory and capital arbitrage, as borrowers compare and seek out the best
possible terms. Shadow banks can have a low cost of funding that compares with banks'. For example, when
shadow banks borrow in the commercial paper market, their cost of financing is comparable to banks' costs. In
addition, shadow banks' capital may be less than bank requirements because of regulatory differences or
market-driven differences in capital requirements. Traditionally, for instance, banks have had a lower cost of
funding thanks to their base of deposits. The shadow-banking system can sometimes lend more cheaply at certain
risk levels when it has less-stringent capital and regulatory requirements or lower market-driven capital
requirements. This is what we observed leading up to the 2008 financial crisis. When the crisis was at its worst and
asset values began to tumble, some large funds and investment vehicles could only stay in business by selling assets
at steep discounts. At the same time, a number of banks that had warehoused billions of dollars worth of assets in
various segments of the shadow-banking system found those assets hard to sell. But many banks globally ultimately
received liquidity support from central bankers, including the Federal Reserve, while some shadow-bank players,
ineligible for this support, collapsed. The danger, in our view, is that a two-tier regulatory system could, under
similar conditions, lead to another cycle of failed financial institutions, depreciating asset prices, and losses.

The share of corporate lending from the shadow-banking system is, we understand, still low relative to that coming
from banks and when compared to the universe of shadow banking. Nevertheless, parts of the shadow-banking
system will, we believe, continue to play a role in the fixed-income securities markets.

What Could Fuel Shadow-Banking Growth?

The Dodd-Frank legislation aims to strengthen traditional banks and help protect the U.S. financial system by
boosting capital-adequacy standards, restricting certain of the more-risky bank activities, and increasing consumer
protections and transparency. These regulations are likely to influence lenders (banks) heavily as they decide which
activities they'll continue to finance. We believe that banks will seek to measure the profitability of
noninvestment-grade corporate loans, other high-risk or complex loans, and financial contracts such as derivatives,
and consider the evolving capital, liquidity, and transparency standards before deciding whether to continue these
business lines. This may perpetuate the existing two-tier regulation, as some of this activity is likely to move into the
shadow-banking system.

Thus, we believe disintermediation of the banking system, which began decades ago, is likely to resume as resurgent
shadow-banking firms bolster their balance sheets to take on business that the banks discontinue. Nobody yet
knows what the new "normal" returns for traditional banks will be--just that they are likely to be lower than they
are today. We believe investor appetite for higher risk-adjusted returns will likely spur growth in the
shadow-banking system. A BDC, for example, is limited by regulation to no more than 50% debt leverage and
typically operates with less leverage than banks do. A commercial bank typically can leverage assets up to 90% or
95% with debt financing (which for a bank is in the form of deposits). The amount of leverage available in other
shadow-banking segments typically runs between these extremes. But shadow-banking participants could benefit
from tougher bank capital requirements if their capital guidelines are less stringent than banks' and if they can
generate higher risk-adjusted returns (reflecting the higher risk levels) for their investors.

A limited number of BDCs, for example (see chart 1), and distressed-debt investment funds were able to expand
their balance sheets during the financial crisis while many banks were shrinking theirs. That growth allowed them to
diversify their investments and typically earn higher risk-adjusted returns for their investors than banks did, despite 3
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employing lower leverage. BDCs provided their investors with one of the few opportunities to be a part of a
conservatively leveraged lending strategy during this period. Now that banks have started to lend once again, the
competition between regulated and unregulated lenders has heated up and begun to help reduce borrowing rates on
high-yield loans, which in turn makes them less attractive to firms outside of the traditional banking system unless
such entities 'innovate' a way to be more cost efficient.

Chart 1

During the financial crisis, banks' balance sheets made lending a secondary objective to rebuilding capital, thus
lowering firm-wide leverage. Loan demand has also been weaker during the crisis. In the absence of a supply of
loans from banks and in the weakened economic environment, the yield on corporate loans climbed between 2008
and 2009. In that environment, we understand that shadow lenders were able to increase lending. However, in
2011, bank lending has resumed and lending in the shadow-banking system has slowed. In our view, one
implication is that banks are able, once again, to lend at rates that start to crowd out shadow lending, while pricing
that risk differently.

However, despite the potentially tougher competition from banks, we have observed that some segments of the
shadow-banking system have been growing recently, reflecting, in our view, a demand for certain levels of credit risk
that banks aren't willing to fill. In addition, rising investor demand for higher yields has spurred rapid growth in
various nonbank credit investment vehicles. In particular, private equity companies such as Blackstone/GSO,
Fortress, and KKR have been aggressively growing credit-related business segments. Nonbank credit has met the
general financing needs of corporations and specialty projects in the energy and pharmaceutical industries, among
others. Many shadow-banking players are still smaller than they were before the financial crisis--notably the

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money-market funds, whose assets fell to $2.7 trillion at the end of 2010, from a high of $3.8 trillion in December
2008, as their low yields have made them less attractive to investors. But other components of the shadow-banking
system that shrank during the crisis have begun growing in line with the economic recovery. For example:

• BDC assets under management are still lower than they were in 2007, but are growing and neared $12 billion by
year-end 2010.
• CLO origination is much less than in 2007 but has resumed, and the prices of existing securities are recovering.
• Banks have sold billions of dollars in assets they warehoused when structured finance markets seized in 2007, and
have started again to finance asset-backed securities (ABS) receivables.
• ABS issuance has increased since the credit crunch, though it's at lower levels than in 2007.
• Finance companies are slowly starting to lend--and some have returned to the ABS markets to finance assets such
as auto and credit card receivables.
• Global hedge fund assets, which fell about 25% from their peak to $1.4 trillion in 2008, rebounded to $2 trillion
in first-quarter 2011, mostly because of gains and inflows from credit funds.

At the height of the financial crisis, the aggregate shadow-banking sector ("Other" in chart 1) accounted for almost
40% of total financial assets (as measured by the Federal Reserve). By December 2010, shadow banking had started
to stabilize and rebound from its low of 30% (see table 1). Commercial banks' share of total financial assets fell
gradually from its peak of almost 75% in the years following World War II to its low point in 2008, and has only
recently begun to recover. An uptick in the quarterly share of shadow banking from 29.91% to 29.99% as reported
by the Federal Reserve as of December 2010 may be small, but it is the first increase in shadow banking market
share since December 2007 (see chart 2).

Table 1
Financial Assets Of Category/Total Financial Assets
Monetary authority 6.42
Commercial banking 37.67
Savings institutions and credit unions 5.64
Money-market mutual funds 7.21
ABS 6.42
Finance companies 4.17
Security brokers and dealers 5.43
Funding corporations 6.06
Other 21
Data as of December 2010. Source: Federal Reserve Flow of Funds Guide 5
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Chart 2

Regulatory Changes Create New Opportunities

We believe that changes in capital and regulatory requirements will prompt some banks to restructure their existing
business lines. The Volker rule, which curtails proprietary trading, hedge-fund investing, and similar activities, in
our view influences the ability to service trading demand but does not necessarily curtail demand for these activities.
Therefore, it is likely to cause banks to off-load these activities into the shadow system. The derivatives business, for
example, where banks issue interest rate, currency, or credit-default swaps, is a high-profile area of finance in which
the shadow banking system might gain at the expense of banks. If that happens, the impact of such a shift, in our
view, could be counter to the regulatory objective of increasing the transparency of potentially risky financial

Some banks will also likely decline to make riskier loans because they are anticipating that they will have to increase
the level of capital required to do so under the coming Basel III guidelines. They could decide that they prefer
lending to companies with stronger credit profiles, including alternative asset managers, private equity firms, or

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other shadow-banking lenders who then, in turn, might finance the companies no longer financed by commercial
banks. We can see this already happening in the bank financing of BDCs. Riskier loans are not disappearing, just
moving from banks to firms in the shadow-banking system with different capital guidelines.

The residential mortgage-servicing business, for example, may also be pushed farther into the shadow-banking
system. For banking institutions that need to be Basel III compliant, the capital requirements for holding mortgage
servicing on their balance sheets will become costly. Therefore, we believe that banks may cede this business to
companies that are separately capitalized and specialize in this business, even through they might fall outside of
bank regulation. In addition, regulatory pressure on the GSEs, higher guarantee fees on Federal Housing Authority
loans, and the emerging requirements for banks to hold a certain share of the home loans they originate may lead
some banks to reduce mortgage lending sharply. Some of this lending could end up in the shadow-banking system,
with banks lending through real estate investment trusts, separate nonconsolidated subsidiaries, or utilizing
repurchase agreements to place home loans in nonbanks.

Dodd-Frank has already led to the creation of the Consumer Financial Protection Bureau. That new bureau may end
up regulating consumer finance products that until now have been either lightly or not regulated on the federal level.
These include payday and other short-term small-balance consumer loans, private student loans, subprime auto
loans, money transfers, debt collection, and prepaid debit cards. Finance companies are a good example of entities
that may wind up partly in and partly out of the shadow banking sector.

During the financial crisis, liquidity support from the government enabled banks to avoid selling their holdings of
these assets at the bottom of the market. But that support wasn't available to the shadow-banking system. Although
most areas of shadow banking appear to be on the mend, the segments most closely linked to mortgage lending,
such as residential mortgage-backed securities, remain depressed. We don't expect to know how the
shadow-banking system will end up participating in the housing market until the future of the GSEs is clear and new
bank mortgage-lending guidelines are in place.

Differences In Liquidity Support

Banks generally operate with liquidity support that the shadow banking system lacks, and in our view, this makes a
big difference when the financial system comes under stress. U.S. banks having access to the discount window at the
Federal Reserve enabled them to avoid realizing losses through asset liquidation that money funds or other nonbank
entities without such access could not avoid. A notable example of this took place in the fall of 2008, when the
Reserve Primary Fund, a money-market fund that had invested in Lehman Brothers' commercial paper only returned
$0.99 of every dollar investors had put into it.

Table 2
Short-Term Financing
Private investment Money-market
Banks investment funds ABCP vehicles funds Hedge funds
Primarily short-term deposit Yes No No No Yes (in form of Varies with redemption
financed shares) restrictions
Primarily short-term No No Yes Yes No Varies, but often done
commercial paper financed using prime broker
(liabilities, not assets) financing 7
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Table 3
Liquidity Support
Private Structured Money-market
Banks investment funds ABCP investment vehicles funds Hedge funds
Source of Federal Reserve Liquidity facilities Liquidity Liquidity facilities Cash reserves Cash reserves,
liquidity support Discount Window facilities liquidity facilities
Liquidity support All eligible assets, Limited Full Limited None Limited
coverage insurance for

Transparency Is Uneven In The Shadow Sector

Not all shadow-banking activities are equally transparent. How varying levels of transparency will affect the
operation of these institutions and investors' willingness to buy their debt remains to be seen. There are also
differences between the transparency available to investors and to regulators (see table 4).

Table 4
Private investment Special-purpose Hedge
Banks funds vehicles Money-market funds funds
Reporting period Quarterly Quarterly Monthly or Quarterly Monthly Quarterly
Specific portfolio assets reported to No Varies Varies Yes No
investors or depositors
General asset description reported to Yes Yes Yes Yes Yes
Disclosure of current prices for portfolio No Yes No Yes No

There is no one measure of transparency. Even large, complex banks, which may release tens of thousands of pages
of financial reporting each year, rarely reveal every corporate exposure they have to their investors. But that can
happen with some shadow-banking participants, who offer a range of transparency. Some will provide data on
specific assets and their prices to every investor, while others save that level of detail for major equity investors.

At the same time the level of transparency available to regulators also differs, with banks receiving the most
regulatory oversight and special-purpose vehicles--trusts or other entities set up to hold assets off balance sheet--the
least (see table 5).

Table 5
Regulatory Oversight
Banks Private investment funds Special-purpose vehicles Money-market funds Hedge funds
FDIC Yes No No No No
SEC Yes Varies No Yes No
CFTC Yes No No No Yes

In our view, one factor in determining an entity's financial strength and capabilities is its level of capitalization. The
transparency of capitalization in the financial system's segments can differ greatly. But we believe transparency in
this area is important if regulators are to improve their understanding of the assumptions behind an institution's
lending activity and investors are to better evaluate the balance of potential risk and rewards. The ability to get the

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data needed to analyze the capital position of companies in the shadow-banking system, however, remains a mixed
bag to investors, regulators, and the public alike. Transparency is already a focus of the Dodd-Frank Act, and the
efforts to direct over-the-counter derivatives to exchanges and clearinghouses is representative of that initiative.
Money funds, too, have increased existing transparency and adopted changes in accord with SEC 2a-7 in 2010,
which include monthly portfolio disclosures to investors, among other increased disclosures.

The recent financial crisis caused a run on the shadow system that forced many players out of business and
significantly affected the economy. We believe that fuller transparency in segments of the shadow system could
alleviate the potential for this to happen again. One way we see this happening would be if financial entities were
regulated by function rather than institutional charter, so that a build-up of risk in any given product is not
overlooked. An example is in corporate lending: Because loans do not trade through a central exchange, there is no
"place" to observe the activity. Making bank and shadow-banking corporate lending disclosure more consistent and
comparable could reduce the transparency trade-off that exists in the two-tier system. We believe such a paradigm, if
achieved, could help reduce the risk of major financial dislocations.

Writer: Robert McNatt 9
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Copyright © 2011 by Standard & Poors Financial Services LLC (S&P), a subsidiary of The McGraw-Hill Companies, Inc. All rights reserved.

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