Understanding “Shadow Banking”: Benefits and Risks of the Asset Management Industry

Section I: Defining Shadow Banking

The term “shadow banking” has evolved considerably since economist Paul McCulley first used the phrase in 2007. At the time, McCulley was specifically referring to non-bank financial institutions in the US that had engaged in financial intermediation, such as maturity transformations, through which funding for long-term loans was being provided by short-term customer investments. ¹What Is Shadow Banking. International Monetary Fund. By this definition, shadow banks extended credit which was not financed through bank deposits. These non-bank institutions fulfilled similar functions to banks, but were not regulated as banks; rather, they conducted their activities in the “shadows” of the financial system, operating under less regulatory supervision than traditional lenders.

The risks posed by the banking industry’s financial activities were well-known during and after the 2008 global financial crisis. In the wake of the crisis, regulators around the world tightened oversight of the traditional banking sector. This bolstered the safety of one part of the financial sector. But lending—and risks—have since migrated to the non-bank credit industry, which has ballooned since the financial crisis, now managing over $75 trillion in assets, according to a recent report by the International Monetary Fund (IMF).

From global financial regulators’ perspectives, very little was understood after the 2008 crisis of how non-bank entities operated, whether they could contribute to systemic financial risks, and what could be done to regulate them. The Financial Stability Board (FSB) and other international agencies have been developing a strategy for strengthening regulation of the shadow banking system. ²Shadow Banking: Scoping the Issues. Financial Stability Board. FSB “cast a wide net” by defining shadow banking as “the system of credit intermediation that involves entities and activities outside the regular banking system,” ³Id. In its 2014 Global Shadow Banking Monitoring Report, the FSB classifies all of the following as Non-Bank Financial Intermediation, and by extension, part of the shadow banking system: Equity, Fixed-Income, and Other Funds; Broker-Dealers; Structured Finance Vehicles; Money Market Funds; Real Estate Investment Trusts and Other Trust Companies; Hedge Funds; and other funding companies. which included non-bank institutions involved in extending credit directly, or facilitating credit between investors and debtors. For the purposes of this paper, we consider the “shadow” banking sector to include mutual funds, exchange-traded funds (ETFs), hedge funds, private equity funds, and other institutional investors, commonly known as the asset management industry. ⁴Commonly referred to as the asset management industry. See 2014 Global Shadow Bank Monitoring Report. Financial Stability Board; as well as The 2015 Global Financial Stability Report. International Monetary Fund.

As depicted in Figure 1 below, until the late 1980s, non-consumer and non-government credit intermediation ⁵That is, lending to business entities. was typically split between the traditional form of financial intermediation, in which credit is intermediated by banks that are backed by central banks and the public sector to prevent destabilizing runs, and non-traditional credit market intermediation. Since then, however, growth of direct bank loans has not kept pace with the non-traditional credit market, which includes intermediation though corporate bonds, open market paper, and other forms of non-traditional lending. This has led to much more credit activity being conducted outside of the banking system.

While shadow banks do face their own set of regulatory standards and are likely to follow prudent internal risk management policies, as well as industry best practices, traditional banks face much stricter and more standardized regulations designed for minimizing risk and ensuring stability. Private equity funds and hedge funds are two types of financial institutions that generally face minimal regulatory oversight compared to the traditional banking sector. Figure 2 demonstrates the main differences in regulatory requirements faced by traditional banks and the asset management industry.

Shadow banks nonetheless have a variety of internal risk management measures that are designed to mitigate risks—specifically liquidity risk. Section II addresses funding benefits provided by wealth funds and risks facing asset managers, and how these so-called shadow banks manage such risks with relatively limited regulatory oversight.

Section II: Economic Benefits, Risks, and Risk Management

As highlighted above, the asset management sector has not been subject to the same regulatory constraints as commercial banks. Banks have relatively stringent capital standards set by the financial regulators, which are usually expressed as a capital adequacy ratio of equity that must be held as a percentage of risk-weighted assets. ⁶These requirements are put into place to ensure that these institutions do not take on excess leverage and become insolvent. The standards became even tighter after the 2008 financial crisis (see Basel III), with more rigorous requirements on capital provision, leverage ratios, and liquidity coverage. Consequently, in the post-financial crisis environment, banks scaled back on lending activities due to regulatory pressure to control their balance sheets, as well as the rising compliance costs. In the meantime, without the same regulatory constraints, asset managers are swiftly filling the lending void left by banks.

Asset managers are also migrating into the credit intermediation market, (mostly through bond funds), as a result of the desire to generate greater returns, commonly known as the “reach for yield.” Since 2008, interest rates have declined to a historical low, with short-term interest rates approaching zero. This is partly due to the loose monetary policy initiated by many central banks around the world to support the economic recovery, including the “quantitative easing” programs conducted by the Federal Reserve system in the United States. Asset managers are increasingly looking for high-yield investment opportunities in order to produce higher returns for investment assets under management. Lending directly to companies is certainly one of these opportunities for fund managers, specifically for bond fund managers.

Benefits of Shadow Banking Supported by Funds

In principle, lending provided by asset managers is an important aspect of efficient capital markets, as the additional credit provision can be crucial to borrowers, especially when commercial banks are distressed. Smaller, less capitalized companies are poorly served by the official banking system. On the other hand, hedge funds, private equity funds, and other funds will often loan money to higher risk businesses, such as startup companies. The decision to lend is usually made after some due diligence, but with greater flexibility than what is provided by conventional lenders. An additional benefit of hedge fund loans is that access to funds is usually quick. ⁷Funds also have advantages over banks from a financial stability point of view. The business model for traditional banks entails capturing a spread in interest rates between the money banks receive and the money banks lend. Therefore, banks are predominantly financed with short-term borrowing, while providing long-term credit to borrowers, as interest rates are typically lower in the short term (yield spread). However, when short-term interest rates are rising fast, banks’ profits may be squeezed and could disappear swiftly, forcing banks to either curtail funding or raising borrowing costs. On the other hand, most investment funds issues shares to investors to get capital. As long as investors do not redeem equity shares from the funds en masse, there are fewer concerns over adequate funding over a short period of time, as equity funding does not have a fixed timeline.

Risks Faced by Asset Managers

Fund-financed benefits of financing have their own costs, of course, as asset managers face risks arising from assets’ operational and regulatory structure. Shadow banks encounter many types of risks that may not typically affect conventional large banks. There are two main risk categories:

• Due diligence and credit risk: Do asset managers have the expertise to vet the companies they lend to? Do they know the background of packaged debt purchased by the fund?
• Liquidity risk: Banks have high capital reserves and access to an official liquidity backstop through central banks. Banks also have deposit insurance. The fund management community lacks these regulatory risk management tools. So what happens if there is a run on asset management funds, where investors withdraw money from the fund rapidly? Where can fund managers get temporary funding to cover liquidity needs?

Credit Risk

When extending a loan to a borrower, the process of accurately assessing the borrower’s credit risk requires the gathering and complete disclosure of financial information about the borrower. However, asymmetric information is constantly present, as borrowers almost never fully and voluntarily disclose all information. Incomplete and inaccurate information conveyed about the credit quality of a borrower may lead to inefficient pricing of the credit risk by lenders.

Banks have long-running and substantial experience in performing due diligence on borrowers. Shadow banks, on the other hand, may be relatively new to direct lending, and there are some concerns about their ability to perform detailed financial assessments of potential borrowers.

Liquidity Risk

Shares of open-end mutual funds and ETFs are usually redeemable or tradable daily, whereas invested assets can be much less liquid. Therefore, easy redemption options and liquidity mismatches between a fund’s assets and liabilities in theory can create run risks, when the suppliers of funds bail out en masse, leading to the threat of a fire sale of assets and further destabilization of the investment bases of funds. Adding to the risk of panic is the fact that investor funds held by asset managers are not insured by the federal government as bank deposits are under FDIC. Thus, investors faced with risk of losing uninsured funds may be less willing to stick with a struggling firm, elevating the potential for a large and rapid liquidity crunch. Large-scale asset sales made by funds to cover liabilities during a run may in turn exert significant downward pressures on asset prices, which could spread panic to other firms.

However, in practice, hedge funds, money market funds, mutual funds and ETFs very seldom experience industry-wide distress. Research by the IMF, however, shows that retail-focused mutual funds, which tend to be smaller in size, are more susceptible to runs on funds than funds tailored towards institutional investors, as retail investors tend to be more fickle with fund volatility. On the other hand, institutional investors are likely to be more sophisticated than retail investors, and they appear to be less influenced by recent past fund performance. ⁸2015 Global Financial Stability Report. International Monetary Fund.

Since shadow banking is mostly facilitated through issuance of debt securities to investors, it is interesting to understand how bond funds differ from equity funds in response to market volatility and returns. NERA performed an analysis of the effects of market volatility and total returns on aggregate fund flows (see Figure 3). Our analysis shows the impact of market volatility and returns on bond funds and equity funds, respectively. If the contemporaneous market volatility, as measured by the CBOE VIX Index, rises by 10%, both aggregate bond funds and equity funds experienced a slight decline in total net asset value, with the percentage decline for equity funds nearly twice as large as the percentage decline for bond funds. As the regression model controls for market returns, we can interpret the asset value decline as a proxy for aggregate fund outflows ⁹Conversely, economic literature also suggests the existence of price pressures related to contemporaneous mutual fund flows. The evidence is, however, only consistent with mutual funds flows affecting asset returns in smaller, less liquid markets, such as those in emerging markets. For mature markets such as the U.S. bond and equity markets, with high aggregate market liquidity, research shows that fund flows’ impact on asset returns is more limited and may not be statistically significant.. This is perhaps unsurprising, given that investors in general view bond funds to be safer than equity funds; in times of market turmoil, cautious investors turn to safe havens in a flight to quality.

By contrast, aggregate bond assets experience a larger decline in value after a relevant benchmark index decline one month prior than aggregate equity assets do, though both assets experience a decline in value after the respective asset class experienced poor market performance. This indicates that investors may be pursuing momentum strategies that increase allocation to past winners and away from past losers, which in turn could exacerbate a liquidity crunch in a period of market stress. Our findings are similar to what the IMF concluded in their study. ¹⁰2015 Global Financial Stability Report. International Monetary Fund.

Risk Management by Funds

When discussing risks posed by asset managers and other non-bank financial institutions, it is crucial understand how such non-bank firms implement a range of risk management strategies.

For example, hedge funds may charge high borrowing costs and impose prepayment penalties in order to offset potential credit risk posed by borrowers. While this may be subject to some pricing inefficiencies as a result of asymmetric information, as long as the hedge funds cover the hidden risks on average with cautious pricing, the likelihood of massive losses due to defaults by borrowers can be significantly reduced. Furthermore, in respect to liquidity risk, maintaining significant redemption fees for investors is one standard strategy used by asset managers to protect funds against a run. . Fees are effective to a varying extent in dampening redemption following short-term poor performance of the fund. ¹¹2015 Global Financial Stability Report. International Monetary Fund.

Additionally, non-bank financial institutions can tap into banks’ excess capital through borrowing as a type of liquidity risk management. Banks themselves have been shown to play an integral part in the shadow banking system as a whole. The latest Financial Risk Report released by the US Office of The Comptroller of the Currency (OCC) showed that US banks’ loans to non-depository financial companies have increased more than 230% in just three years. ¹²Normal Banks Are Helping Shadow Banks Grow A Lot. Jody Shenn. Bloomberg Business; Semiannual Risk perspective, Spring 2015. OCC. Furthermore, a study by the Federal Reserve Bank of New York on the full dynamics of mergers and acquisitions since the early 1990s shows that banks have been purchasing non-bank targets such as asset managers, insurance underwriters, and broker-dealers to diversify their own portfolios. ¹³Shadow Bank Monitoring. Adrian, Ashcraft, & Cetorelli. Federal Reserve Bank of New York.

Some credit and liquidity risks associated with intermediation activities have migrated into the shadow banking sector in recent years. As discussed above, tighter capital standards and liquidity requirements since the financial crisis will provide an increased incentive for credit intermediation activities to migrate from the banking system to the shadow banking system. However, this trend is counteracted by bank holding companies’ nimble adaptation to the new regulatory regime—vertical and horizontal integration between banks and non-bank financial institutions has accelerated since the financial crisis.

Systematic Risk and Shadow Bankers

Systemic risk, also known as aggregate risk or undiversifiable risk, can be defined as vulnerability to events which affect aggregate outcomes such as broad market returns. In the past, most of the focus for systemic risk was on the failures of large banking institutions. But there have also been recent, notable examples of collapses by wealth management funds that posed serious concern for the stability of the broader financial system.

The collapse of Long Term Capital Management (LTCM) in 1998 is an example of how a large, highly leveraged non-bank financial company could potentially disrupt the stability of the wider financial system. LTCM experienced massive losses due to the Russian sovereign debt crisis in August 1998. Fearing the market fallout if LTCM was forced to rapidly liquidate its remaining positions, the Federal Reserve stepped in to organize a large bailout. ¹⁴Near Failure of Long-Term Capital Management. Michael Fleming and Weiling Liu. Federal Reserve Bank of New York. There was controversy, however, over whether the bailout was necessary and the systemic risk of LTCM’s failure was overestimated. LTCM had received offers for effective bailouts from the private sector, ¹⁵Most notably from a group led by Warren Buffett’s firm Berkshire Hathaway. See Too Big to Fail? Long-Term Capital Management and the Federal Reserve. Kevin Dowd. CATO Institute. as other market players were prepared to absorb the funds losses. ¹⁶Further critics of the Federal Reserve claimed that the bailout exacerbated risky behavior in the years following, since other asset managers could now consider the possibility of a federal bailout in the event of a similar loss. See Bailout of Long-Term Capital: A Bad Precedent? Tyler Cowen. The New York Times.

The 2006 failure of Amaranth Advisors, another large hedge fund, serves as a convenient counterpoint to the chaotic collapse of LCTM. In 2006, Amaranth reported to its investors that it had lost $5 billion in one week. The firm was then forced to liquidate its assets and close the fund, leading to concerns that the market would be destabilized. ¹⁷Amaranth Natural-Gas Losses May Have Far-Reaching Effect. Henny Sender & Gregory Zuckerman. The Wall Street Journal. In the case of Amaranth, however, other market participants acquired Amaranth’s energy portfolio and there was no need for a government-backed bailout. ¹⁸The Amaranth Collapse: What Happened and What Have We Learned Thus Far. Hilary Till. EDHEC Risk and Asset Management Research Center. The lack of systemic impact of Amaranth’s decline has been connected to the fact that, on the macro level, their losses were cancelled out by significant gains for other market participants and other funds that had taken opposite positions. ¹⁹See citations 23 and 24.

Further concerns of systemic risk are highlighted by the recent episodes of “flash” crashes, such as the May 2010 stock market crash and the October 2014 crash in US Treasuries, where the combination of lower liquidity and flight-prone investors may have exacerbated the liquidity crunches, magnified price moves of underlying assets under management, and further destabilized asset bases.

The LTCM and Amaranth collapses show that neither size nor the mere status as a credit intermediary guarantees that a non-bank financial institution is systemically vital to the overall financial system. Both LTCM and Amaranth were large hedge funds that failed rapidly and without warning; however, in both cases the private sector showed the capacity for correcting for fund failure through emergency recapitalization.

In addition, research by the IMF confirmed that the size of a fund does not necessarily determine the systemic risk of that fund. Rather, a fund’s investment focus is more important. Furthermore, institutional investors appear to be less influenced by recent past performance and market volatility, as institutional investors are likely to be more sophisticated than retail investors. Hedge funds and private equity funds, therefore, may be less likely to experience run risks during a stress time, as they are primarily funded by institutional investors.

Section III: Regulatory and Litigation Risks

Uncertainty surrounding the shadow banking industry could have a large and sustained impact on both regulation and litigation trends in the near future. Regulators will continue to introduce stronger and possibly controversial measures of government oversight for non-bank financial institutions. At the same time, the migration of risk away from banks and into certain areas of the shadow banking sector will also pose difficult litigation challenges to non-bank credit intermediaries and government enforcers, which often operate in a regulatory gray area.

Regulatory Risks

US and international regulators have continued to push for increasing regulatory oversight of non-bank financial institutions. Specifically, regulatory agencies are considering an expanded use of the Systemically Important Financial Institution (SIFI) label to the asset management industry. Widespread use of SIFI would allow regulators to impose stricter and costlier regulations on mutual funds, hedge funds, private equity managers, and other asset management firms deemed systemically important. In the US, the Financial Stability Oversight Council (FSOC) has been focusing on the systemic risks posed by the asset management industry. ²⁰Hedge Funds as Systemicall
y
Important Financial Institutions. Sharpe Funds Law. ²¹The FSOC has thus far avoided designating any non-bank asset management firms as SIFIs, due to significant pushback from the SEC and industry experts. See SEC Commissioners push back against systemic designation for mutual funds; Why FSOC Should Not Designate Mutual Funds as SIFIs ; SIFI Designation for Funds: Unnecessary and Harmful. Internationally, the FSB has attempted to widen regulators’ scope for SIFI designations to asset managers including hedge funds and private equity managers. ²²SIFI rules to net more asset managers. Chris Flood. Financial Times; Assessment Methodologies for Identifying Non-Bank Non-Insurer Global Systemicall Important Financial Institutions. Financial Stability Board. In response, some of the world’s largest asset managers have criticized the new system of SIFI classification as flawed and ultimately convinced the FSB to withhold SIFI designations from the asset management industry. ²³Fidelity Berates Carney’s FSB on Too-Big-to Fail Fund Fix. Moshinsky & Katz. Bloomberg Business; Fund Managers to Escape ‘Systemic’ Label. Jopson. Financial Times.

The SEC’s new regulations for money market mutual funds (MMMFs) are a prime example of how the perception of systemic risk in the non-banking financial industry is leading to increased regulatory activity. Widely considered to be one of the safest investment vehicles available to investors, MMMFs typically maintain a net asset value (NAV) per share of $1, a sign of stability for their customers. The 2008 financial crisis, however, led to a series of liquidity crises for multiple MMMFs, including a large fund named Reserve Primary Fund, which was forced to lower its NAV per share to below $1, effectively “breaking the buck.” The panic that ensued forced the US Treasury to issue an emergency guarantee to investors that the value of certain money market fund shares would remain at $1 a share. As a direct consequence, the SEC imposed a long list of new compliance standards for MMMFs, including mandated stress testing and disclosure and liquidity requirements. While these regulatory requirements may enhance the level of government oversight and investor confidence in MMMFs, implementing and evaluating the effectiveness of new compliance measures will also impose significant costs on MMMFs, many of which may not present significant risk to the broader financial system. ²⁴Money Market Mutual Funds: Stress Testing and the New Regulatory Requirements. Dr. Jeremy Berkowitz, Dr. Patrick Conroy, and Dr. Jordan Milev. NERA Economic Consulting.

In spite of the recent attention on regulatory oversight, a series of complex questions about the current state and future of the credit intermediation landscape remains. Are banks better equipped to provide stable and responsible credit intermediation than non-bank financial institutions? Is the capital base of a mutual fund, hedge fund, or other intermediary less stable than loans backed by traditional bank deposits, do they therefore require increased regulatory oversight? Finally, are fund managers more likely than banks to follow risky, short-term lending strategies?

Litigation Risks

In conclusion, non-bank financial institutions operate within a complex and rapidly evolving regulatory environment. Regardless of whether asset managers and other credit intermediaries legitimately pose systemic risk to the financial system, the fact remains that such institutions will face serious litigation risks as the debate over increased oversight of non-bank lending continues. Significant litigation risks include:

• 1.  Redemption Disputes:Non-bank financial institutions are at significant risk for litigation dealing with fund redemption, specifically in disputes involving early redemption, redemption fees, and a wide range of other contractual obligations imposed upon both investors and asset managers.
• 2.  Suitability, Investment Objective, and Disclosure Disputes:In an industry built on strategic diversity and innovation, asset management corporations are subject to considerable litigation risk involving fund valuation; investment objectives; disclosure and transparency practices; fiduciary obligations; and other matters that often fall into regulatory gray areas.
• 3.  Securities Lending and Collateral Disputes:Non-bank credit intermediaries use a range of tools and strategies to collateralize lending, responsibly meet margin requirements, and maximize the returns of their portfolios. Disputes involving collateral eligibility and valuation, delays or failure to meet margin requirements, securities lending, repurchase agreements, and other complex transactions will remain an area of high risk for asset managers.