Here's a riddle. What looks like a bank sort of operates like a bank but is not a bank. That's right, a shadow bank in the world of finance, where the high-stakes game of money is played their lurks and often misunderstood. Yet surprisingly, powerful player, shadow banking.
These are non-bank, financial companies or nbfcs that provide banking services without a banking license blatantly breaking banking laws and regulations. It also refers to unregulated activities conducted by licensed institutions such as using financial instruments like credit default swaps, and who are these shadow bankers? You might be surprised their hedge funds, money, market funds, insurance companies, private equity, funds, mortgage lenders and even some of the world's largest investment banks. These shadowy players can perform many of the same functions of traditional banks yet slip under the regulatory radar because they don't classify themselves as banks. For this reason, they do not follow the same strict regulations as banks unseen and unchecked. They have the power to create credit, with no oversight and with it potentially devastating ripple effects that can shake our financial system to its very core. Most people have this misconception that only banks have the power to completely crash the entire financial system, but that's far from the truth, you see if we go back in time to 1998, we find a cautionary tale starring, a notorious shadow banker long-term capital management. It had its roots, deeply entrenched in the economy and its potential failure threatened to tear apart the fabric of the financial ecosystem.
As a result, under the watchful eye of the federal reserve, no fewer than 14 financial institutions were mobilized to rescue this rogue hedge fund. So why should we care? Because we stand on the precipice of a profound realization? The power to trigger a financial meltdown does not reside solely with the banks. The shadow banking sector, often disregarded, is capable of a similar if not more devastating threat. Therefore, it's time we cast our eyes over this elusive sector, a world that thrives in shadows, but can be illuminating in its impacts before we delve further into this discussion. Let's first understand what shadow banking really means. The shadow banking system comprises non-bank, financial companies which are regulated by the dodd-frank wall street reform and consumer protection act. This act describes nbfcs as companies that derive more than 85 percent of their yearly consolidated gross revenues or consolidated assets from financial sources.
These shadow banks offer a bunch of services. They can lend money, offer credit exchange, currencies plan, retirements, help in underwriting managing money markets and even helping companies merger, though non-bank, financial companies existed long before the dodd-frank act. The term shadow banking was invented in 2007 by an economist named paul mccully. Best definition of shadow banking is an entity that is engaged in maturity, credit and liquidity transformation, old-fashioned banking activity. He used it to describe the growing number of institutions that gave out easy loans. Unfortunately, this trend led to the subprime mortgage disaster in the 2008 financial crisis. So what differentiates shadow banks from traditional banks, shadow banks and traditional banks are like twins, but with their own unique quirks and differences.
First, off traditional banks can create new money based on customer deposits, a trick that shadow banks can't pull off next regular banks are like kids on a short leash, with a lot of rules and regulations, keeping them in line while shadow banks have fewer rules to follow, and their activities are anyone's guess third, regular banks usually get their money from people's deposits, while shadow banks often sell things like long-term securities, commercial papers or other credit instruments on the market to raise funds. Fourth, money and regular banks usually has a safety net. The government ensures it up to a certain amount, but when it comes to shadow banks, your money is at high risk with no guarantee or insurance. Lastly, if regular banks get into trouble, they can turn to the central bank for emergency funds. Shadow banks, however, don't have that lifeline. So where do shadow banks get the funds for their investments? Well, here's the thing about shadow banks. They can't accept money from you and I as regular banks and credit unions, who are deeply regulated do now, since they don't accept money from the public they're exempted from the typical scrutiny of federal and state financial regulators. So, instead of taking deposits, shadow banks focus on other financial activities, such as maturity, transformation, which means they take short-term funds and invest them for more extended periods.
They also engage in liquidity transformation where they convert cash or similar assets into investments that are harder to sell. Like loans, another thing they do is credit risk transfer where they pass on the risk of loan defaults to someone else and finally, they used leverage, which means they borrow money to potentially increase their profits. Look there's nothing shady about getting money from different investors who might want it back within a short period and then investing those funds and assets that mature in the future. It's all good business as long as everyone understands what's going on and doesn't put the whole financial system at risk, but here's where it gets tricky when investors start doubting the value of those long-term investments and they all try to pull out their money. At the same time, it can quickly destroy an institution and cause devastating effects on the economy, which is, in fact, what happened during the 2008 global financial crisis.
You see leading up to the global financial crisis. Some investors became concerned about the value of their long-term assets with non-bank, financial companies and opted to withdraw all their money, and since shadow banks can't issue new currency, they were forced to liquidate their assets. To pay back these investors, however, because they sold these assets, in a hurry, their value, dropped significantly, causing other shadow banks and even some traditional banks to hastily reduce the value of those same assets on their books to match the reduced market price. When the crisis peaked, many investors either took out their money or refused to reinvest. As a result, many financial institutions, both banks and non-banks, face significant difficulties. I'll talk more about the financial crisis further on in the video, but first you need to know what really prompted the growth of shadow banks after the 2008 global financial crisis, traditional banks based more scrutiny from regulators, which made them more cautious about lending money as the government regulations became more stringent, most banks tighten their requirements for loans and credit, and they became selective with whom they would extend these services, given the precarious state of today's financial markets and their vital importance to the daily lives of the american people. Government intervention is not only warranted, it is essential. As a result, people started looking for other funding alternatives, which led to the growth of non-bank institutions, since they could operate without being bound by stringent banking regulations.
Also, in the last two to three decades, massive growth in innovations changes in the regulatory structure and increased competition from non-bank entities have caused banks to shift some of their activities outside the regular regulatory framework furthering the growth of the shadow bank sector over time. Shadow banking activities have evolved, focusing on areas where they could take advantage of loopholes in the newer set of regulations and guidelines, but that alone does not account for their growth. Shadow banking also grew out of the market's need for new and different ways to make money that was less risky and gave better results. In other words, people were looking for financial solutions that were safe places to invest and didn't lose value, while increasing their bottom line. What role do shadow banks play in the global financial market non-bank? Financial companies play a valuable role in fulfilling the increasing need for credit loans and other financial services. Their customers include businesses and people, especially those who might not be able to get loans
because they don't meet the strict requirements set by traditional banks nbfcs not only provide an alternative option for obtaining loans, but they also offer more efficient ones, unlike traditional banks shadow banking entities, allow clients to directly engage with them, eliminating the need for intermediaries. This direct interaction helps reduce costs, fees and interest rates for customers for an economy to function effectively. There should be a constant flow of money, and this can only be accomplished through the provision of financing and credit, a supplementary role nbfcs play. Although non-bank financial companies play a crucial role in the global economy, their lack of transparency and accountability to regulators is a concern.
Critics worry that they are not closely monitored and scrutinized since they operate outside the conventional banking rules and regulations. In some cases, nbfcs may occasionally fall under the jurisdiction of other agencies such as the securities and exchange commission. If they are public companies or the financial industry. Regulatory authority, if they are brokerages, however, in different situations, they may be able to operate without being completely forthright about their operations. As a result, this could place significant strain on the financial system, making it highly vulnerable. Let me explain why some people are concerned about unregulated shadow banking. This situation happened in china which has one of the largest economies in the world, so after the global financial crisis, the chinese government was hell-bent on reviving the economy. To achieve this, they injected money into the economy through tax cuts and easy loans, mainly distributed through shadow banks affiliated with traditional banks. By 2009, eight percent of china's financial sector was made up of the non-bank sector, which includes shadow banks and by 2016 its size had increased by a third. At that time, the chinese government didn't make a big fuss about it. In fact, they supported this trend. As a result, the shadow banking sector exploded- this happened as banks tried to find ways around regulations to provide loans to restricted sectors. There was also a general misconception that the central or local government would step in to cover any losses incurred.
However, this was not the case. Instead this sector's expansion came at a cost, as the system became more reliant on debt. Problematic loans started piling up, posing a severe threat to the stability of china's financial markets. Additionally, many inexperienced individual investors started getting involved in the local stock market, increasing the risks and complexity of the situation in 2015, like a house of cards, it all came crumbling down due to a big crash in the financial market within just a month. The value of many significant stocks dropped by about a third. It was then that the chinese authorities realized that the fast-growing non-bank sector could harm the stability of the country's financial system in response, the regulators acted swiftly and implemented reforms to limit the lending activities of shadow banks.
One of the main changes was reducing the interest rates. They could charge these reforms had a significant impact, as the total value of shadow banking assets in the country dropped for more than 100 percent of the country's economic output to about 80 percent. The reforms put in place successfully shrank the sector and reduced bank's exposure to risks. However, there were also some drawbacks to these changes. One of the outcomes was that the level of credit risk increased significantly on the asset side of the balance sheet for affected institutions, because they could no longer secure financing the crackdown on the non-bank sector also undid. The progress made in making the financial system more accessible to those who were underprivileged like low-income households, this also went against the government's goal of creating a fairer economic growth model. The chinese government dubbed common prosperity, small and medium-sized enterprises, were hit the hardest because they were back to dealing with banks that turned down their credit requests and prioritized giving loans to major state-owned corporations. Instead, real estate was another heavily affected sector. This is because several property developers were obtaining money from the shadow banking system, since that was restricted. They had no other means of funding. It was a big deal because at that time real estate comprised about 30 percent of the country's economy. So when the crackdown happened, the sector was in a severe crisis and some of china's top real estate developers were on the verge of bankruptcy.
Since the funds from shadow banking were being restricted, property developers had no option but to rely more on pre-construction sales as their primary source of funding.
As a result, there was a significant increase in the number of homes being built and put on the market, even though fewer people were actually looking to buy them, even though the west does not have a system, that's identical to china's shadow banking system, there are lessons to be learned. The other disastrous situation, partly fueled by the unregulated activities of the shadow banking system, was the 2007-2008 global financial crisis. The 2007-2008 financial crisis was a disaster that had been building up for a long time. It crazy to think that, even though there were warning signs, not many investors suspected that the worst crisis in nearly 80 years was about to rock the global financial system. It even brought down the big players on wall street and set off what we now call the great recession. It was a catastrophic financial and economic meltdown that wiped out many people's savings and left them unemployed and homeless found 1.7 percent here, a loss of 37 points or so apple shares were just getting hammered this morning, we're down by between three and four and a half percent generally across these markets, let's talk about the speed with which we are watching this market deteriorate. We read everywhere, essentially down by four five percent were down over 16 percent. Dow at the same time has fallen about 18 percent. The stock market is now down 21 this was a really devastating time, for so many people. The financial crisis taught us a harsh lesson that it's not just traditional banks that pose a threat to the global economy.
This is because the economic meltdown was severely intensified by the failure and near collapse of non-bank financial into institutions like the american international group, lehman, brothers and general electric capital. Before the crisis hit, these non-bank financial companies were not subject to the same level of regulations and restrictions as traditional banks. The regulatory oversight of these shadow banks mainly focused on protecting consumers, investors and policyholders, rather than ensuring the overall stability of the financial system. The main regulatory tools applied to these firms were disclosure registration and ethical requirements, in other words, there weren't enough precautions to prevent these firms from becoming a significant threat to the economy. Policymakers didn't regulate non-bank, financial firms as aggressively as they did banks because they thought that their operational structures were more stable. In addition, they assumed that, because these entities did not rely on deposit insurance, their failure would not have a significant impact on the economy, but the financial crisis proved them wrong the signs were everywhere, but now it's official we are in a recession.
The research group that makes that determination made it today and said the recession actually started a year ago, but the question now: when will it end? It showed that non-bank, financial companies and their activities could present severe threats to the financial system in the economy. Even though these shadow banks hadn't caused major stability problems before the crisis, there were still warning signs that policymakers should have paid more attention to. We had the greatest asset bubble in history and now that bubble is bursting, the single biggest piece of the bubble is the u.s mortgage market and we're probably about halfway through the unwinding and bursting of that bubble halfway, it may seem like all the carnage out there. We must be almost finished, but there's still a lot of pain to come. For instance, when a high risk hedge fund called long-term capital management went bankrupt in 1988. The federal reserve bank of new york had to step in to save it discreetly, so that the financial system wouldn't be thrown off balance. Despite this warning sign the shadow banking industry remained under regulated in the years leading up to the great recession.
The role shadow banks played in the recent global financial crisis. Non-bank financial institutions such as aig and lehman brothers were significant contributors to the 2007-2008 financial crisis through their roles in the creation, packaging and widespread distribution of subprime mortgage-backed securities. Here is what happened: aig financial products, a subsidiary of the american international group, issued credit default swaps. On subprime mortgage-backed securities to their customers, if a customer purchased these swaps and the investments they were protecting, deteriorated aig would compensate them to cover their losses. The idea was that, if everything went well with the mortgages backing, these investments aig would profit from the premiums they received. However, if the market for subprime mortgage is declined, so would aig's financial position, because aig had a lot of investments connected to subprime mortgages and in a program where they lent out securities related to residential mortgages. The company had to liquidate some of its assets to cover the losses because of this, their cash flow declined and they
lost the funds they needed to keep operating as a result, aig's credit rating plummeted effectively indicating that their financial reputation had been damaged, which caused investors to hesitate in conducting business with them as aig's financial situation, worsened more people who had borrowed securities from them started to panic and liquidated their positions. The problem was that aig was a massive company with ties to many other businesses. The government was concerned that, if aig collapsed, it would trigger substantial stress and difficulties for these other businesses in the global financial markets. In response in 2008, the federal reserve stepped in. To save aig, they bailed the company out with an astonishing 182 billion dollars of taxpayers. Money to this day, this remains the largest bailout in u.s history aig, wasn't the only entity ensnared in the financial crisis at the time, just one day before aig's bailout, another major player, layman brothers, an investment bank worth an astounding 600 billion dollars declared bankruptcy. This event was a catastrophic disaster as it triggered immense panic in the global financial system.
Much like aig. The value of layman's housing related assets declined when the subprime housing market collapsed. Investors and organizations that had partnered with them began demanding their money and halted further lending in an effort to meet their creditors demands lehman brothers had to liquidate their hard to sell assets at a significant loss, putting them in a terrible position. The layman brothers bankruptcy sent shockwaves throughout the financial markets and the larger global economy. Creating a domino effect, the flow of money in the capital markets froze which resulted in businesses and individuals struggling to secure loans promptly, and if they were able to get a loan, they were required to have good credit and prove that they did not pose much risk to the lender, as lehman brothers spiraled downward investors reacted with panic withdrawing their money from other investment banks with similar business structures. Even though those banks had no direct ties to layman brothers, lehman brothers is going bankrupt in financial markets from asia to europe are doing their utmost to prevent monday from turning from dark to black employees of america's.
Fourth largest investment banks saw the writing on the wall. Late sunday after talks to pull them back from the abyss, collapsed british, firm, barclays bank said no thanks, while bank of america decided instead to help another struggling bank merrill lynch in a merger deal worth over 50 billion dollars. It was essentially in every bank for themselves scenario due to this pressure. Merrill lynch ultimately sold itself to bank of america goldman sachs and morgan stanley in a bid to assuage their creditors, fears altered their status to become bank holding companies. This change meant that they would be subject to stricter regulations and oversight, but to assure investors this was a price they were willing to pay.
Unlike aig lehman brothers received no assistance from the government. This whole situation proved that shadow banks and their risky activities harbored the potential to disrupt the entire financial system and inflict significant damage on the economy. It was a harsh lesson to learn, but it made it clear that we need to pay attention and monitor these kinds of institutions and their operations to avert similar problems in the future. In the aftermath of the 2008 global financial crisis, regulators primarily targeted the traditional banking sector, which also drew significant criticism from the public. You may recall the occupy wall street movement, where large crowds protested, expressing their fury at large banks. Surprisingly, no such campaign targeted the shadow banks, which were in fact significant contributors to the crisis in an interesting turn of events, while banks faced stricter rules and limitations on their lending capacities, the non-bank, lending sector grew twice as large. In other words, they emerged from the crisis unscathed and expanded their lending activities. It appears they managed to fly under the radar, while banks were under increased scrutiny and had less freedom. Why do I say this? You see? Recent data from the financial stability board indicates that the shadow banking sector has thrived since the crisis, the bank for international settlements estimates that the shadow banking industry currently makes up over half of the global financial market.
Furthermore, the total value of their assets is surged to an astonishing 52 trillion dollars worldwide, marking a substantial increase of 75 percent since 2010 the year after the crisis ended and, of course, the u.s dominates the market with 29 percent or an estimated 50 trillion dollars in assets, however, their share of the global market has slightly decreased due to china's robust growth with assets worth eight trillion dollars, which accounts for 16 percent of the total share you might be wondering if the sector poses such a threat to the economy. Why have the authorities allowed it to grow? Let me explain why, after the global crisis, authorities around the globe recognize the need to regulate all previously unregulated entities. Consequently, the u.s introduced a law known as the dodd-frank wall street reform and consumer protection act often referred to as the dodd-frank act. This legislation granted the federal reserve more authority to regulate all major institutions in the country. The goal was to monitor any activities that could jeopardize the entire financial system, including shadow banking. The european union also took measures to prevent shadow banking operations from spiraling out of control. They established policies and guidelines to ensure that transactions such as securitization the packaging of loans into investments and credit rating agencies were properly regulated.
Additionally the g20 countries, a group of leading economies, called for international cooperation to address the risks emanating from shadow banking. As a result, the financial stability board was formed following the g20 london summit at april 2009. This board was set up to enhance oversight and regulation of global financial institutions, including the shadow banking system, the organization, was established to mitigate dangerous activities that could jeopardize the global economy since its inception. It has worked to curb some of the risks posed by the shadow banking sector, such as financial stability and systemic rise. You see regulatory arbitrage was used to create shadow banking entities. All over the world by this I mean that during their formation, these entities exploited loopholes in the regulatory systems to circumvent rules that were unfavorable to their operations.
For example, some banks established special subsidiaries to engage in shadow banking activities. Banks also invested their funds into financial products crafted by other shadow banks, but here's the thing: shadow banks are vulnerable to shocks because they're so big and interconnectivity with other parts of the financial system. Any problem in the shadow banking sector can reverberate significantly posing a risk of the entire system. We saw this happen during the global financial crisis, particularly with the collapse of lehman brothers. This ripple effect is called a systemic risk. Another risk worth noting is regulatory arbitrage spread across geographical jurisdictions. This occurs when different countries have varied rules and regulations, making it challenging to control shadow banking activities that span across borders. Allow me to elaborate you see. In some countries, taxes on financial activities are high, so some financial institutions look for ways to evade these high taxes and they do this by transferring their operations to countries with more favorable tax policies, particularly those with low tax rates and lax policies.
These countries are commonly referred to as tax havens. Meanwhile, these tax havens maintain their low taxes to lure foreign investors and businesses, attract foreign capital and create jobs for their local economies. But here's the problem when firms from high tax nations move their operations to low tax countries, it causes a significant influx of money coming in and going out these sudden money movements, known as hot money flows, can create instability in both the source and recipient countries. It's like a seesaw effect that can jeopardize financial stability, especially in an era like today, where the global economy is more integrated than ever. The best example of a tax haven is the cayman islands. Most companies employing regulatory arbitrage often choose the cayman islands as their new home. This is because the cayman islands government allows companies to establish operations there and exempt taxes on earnings generated outside of the country so, instead of paying taxes, companies located in the cayman islands pay a licensing fee to the local government.
Similarly, in the united states, many companies choose to set up their businesses in the state of delaware due to its more favorable taxation and regulatory requirements. Regulatory arbitrage can sometimes be legal, but not necessarily ethical. For instance, if a country has weak regulations against money laundering, a company operating there could exploit this loophole to engage in wrongful activities. So while it may be legal, it goes against the intended purpose and can lead to devastating effects and consequences. So, what's the way forward, the dodd-frank act passed in 2010 introduced a suite of new laws aimed at mitigating the probability of another great recession by closely regulating key financial institutions to limit systemic risk. However, since its implementation debates have emerged, suggesting that maybe the laws are too stringent and need to be relaxed a little while the financial stability board persists in advancing financial stability by coordinating the development of regulatory supervisory and other financial sector policies.
There is a need for authorities to cross various nations to re-evaluate and update the regulations governing their shadow banking industry. This is necessary to address potential risks and ensure the system remains stable and secure. The shadow banking sector may seem inconsequential enough to pose a threat, but lessons learned from, the 2008 global financial crisis suggest otherwise so to be on the safe side. Countries like the united states should draw inspiration from india. India has been regulating its non-banking finance companies under the auspices of the reserve bank of india, since 1963 long before this issue gained global attention.
That said, thank you for watching. If you enjoyed this video I'm sure you're gonna love this next one
0 Comments