A Model of Shadow Banking
01 Aug 2013-Journal of Finance (Wiley Blackwell (Blackwell Publishing))-Vol. 68, Iss: 4, pp 1331-1363
TL;DR: In this paper, the authors present a new model of shadow banking and securitization in which a financial intermediary can originate or acquire both safe and risky loans, and can finance these loans from its own resources as well as by issuing debt.
Abstract: We present a model of shadow banking in which banks originate and trade loans, assemble them into diversified portfolios, and finance these portfolios externally with riskless debt. In this model: outside investor wealth drives the demand for riskless debt and indirectly for securitization, bank assets and leverage move together, banks become interconnected through markets, and banks increase their exposure to systematic risk as they reduce idiosyncratic risk through diversification. The shadow banking system is stable and welfare improving under rational expectations, but vulnerable to crises and liquidity dry-ups when investors neglect tail risks. SHADOW BANKING TYPICALLY DESCRIBES financial activities occurring outside the regulated banking sector. In recent years, the most important such activities took the form of rapidly expanding provision of short-term safe debt to financial intermediaries through money market funds and other sources outside of the regulated banking sector (Coval, Jurek, and Stafford (2009a), Gorton and Metrick (2010, 2012), Pozsar et al. (2010), Shin (2009)). Much of that debt was collateralized through the process called securitization, which involves origination and acquisition of loans by financial intermediaries, the assembly of these loans into diversified pools, and the tranching of the pools to manufacture safe pieces. While regulated banks played a key role in securitization and held large amounts of securitized assets, a large share of the ultimate financing of securitized assets was provided by the shadow banking system. The collapse of shadow banking in 2007 to 2008 arguably played a critical role in undermining the regulated banking sector, and in bringing about the financial crisis. In this paper, we present a new model of shadow banking and securitization. In the model, a financial intermediary can originate or acquire both safe and risky loans, and can finance these loans from its own resources as well as by issuing debt. The risky loans are subject to both institution-specific idiosyncratic
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TL;DR: In this article, a preliminary assessment of whether the growth of active asset management, household credit, and shadow banking has been socially beneficial has been provided by the US financial services industry.
Abstract: The US financial services industry grew from 49 percent of GDP in 1980 to 79 percent of GDP in 2007 A sizeable portion of the growth can be explained by rising asset management fees, which in turn were driven by increases in the valuation of tradable assets, particularly equity Another important factor was growth in fees associated with an expansion in household credit, particularly fees associated with residential mortgages This expansion was fueled by the development of nonbank credit intermediation (or “shadow banking”) We offer a preliminary assessment of whether the growth of active asset management, household credit, and shadow banking—the main areas of growth in the financial sector—has been socially beneficial
393 citations
TL;DR: In this paper, the authors review the extensive literature on systemic risk and connect it to the current regulatory debate, and identify a gap between two main approaches: the first one studies different sources of systemic risk in isolation, uses confidential data, and inspires targeted but complex regulatory tools; the second approach uses market data to produce global measures which are not directly connected to any particular theory, but could support a more efficient regulation.
Abstract: We review the extensive literature on systemic risk and connect it to the current regulatory debate. While we take stock of the achievements of this rapidly growing field, we identify a gap between two main approaches. The first one studies different sources of systemic risk in isolation, uses confidential data, and inspires targeted but complex regulatory tools. The second approach uses market data to produce global measures which are not directly connected to any particular theory, but could support a more efficient regulation. Bridging this gap will require encompassing theoretical models and improved data disclosure.
269 citations
TL;DR: In this article, a model of credit cycles arising from diagnostic expectations is presented, in which agents over-estimate future outcomes that have become more likely in light of incoming data.
Abstract: We present a model of credit cycles arising from diagnostic expectations – a belief formation mechanism based on Kahneman and Tversky’s (1972) representativeness heuristic. In this formulation, when forming their beliefs agents overweight future outcomes that have become more likely in light of incoming data. The model reconciles extrapolation and neglect of risk in a unified framework. Diagnostic expectations are forward looking, and as such are immune to the Lucas critique and nest rational expectations as a special case. In our model of credit cycles, credit spreads are excessively volatile, over-react to news, and are subject to predictable reversals. These dynamics can account for several features of credit cycles and macroeconomic volatility.
239 citations
TL;DR: Macro-prudential policies, such as caps on loan to value ratios, limits on credit growth and other balance-sheet restrictions, countercyclical capital and reserve requirements and surcharges, and Pigouvian levies, have become part of the policy paradigm in emerging markets and developed countries alike as discussed by the authors.
229 citations
Cites background from "A Model of Shadow Banking"
...Other sources appear more behavioral, as when investors chase similar investment opportunities (Shleifer 2000, and Barberis, 2013, review) or ‘neglect’ the possibility of rare but large shocks (Gennaioli et al., 2013)....
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TL;DR: In this paper, the authors argue that banks are subject to capital requirements because their privately optimal leverage is higher than the socially optimal one, and that banks fail to internalize all costs that their insolvency creates for agents who use their moneylike liabilities to settle transactions.
Abstract: Banks are subject to capital requirements because their privately optimal leverage is higher than the socially optimal one. This is in turn because banks fail to internalize all costs that their insolvency creates for agents who use their money-like liabilities to settle transactions. If banks can bypass capital regulation in an opaque shadow banking sector, it may be optimal to relax capital requirements so that liquidity dries up in the shadow banking sector. Tightening capital requirements may spur a surge in shadow banking activity that leads to an overall larger risk on the money-like liabilities of the formal and shadow banking institutions.
225 citations
Cites background from "A Model of Shadow Banking"
...Gennaioli, Shleifer, and Vishny (2013) develop a model of shadow banking in which banks pool their idiosyncratic risks, thereby increasing their systematic exposure, and use the safe part of these recombined portfolios to back the issuance of safe debt....
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TL;DR: In this paper, the authors present a critique of expected utility theory as a descriptive model of decision making under risk, and develop an alternative model, called prospect theory, in which value is assigned to gains and losses rather than to final assets and in which probabilities are replaced by decision weights.
Abstract: This paper presents a critique of expected utility theory as a descriptive model of decision making under risk, and develops an alternative model, called prospect theory. Choices among risky prospects exhibit several pervasive effects that are inconsistent with the basic tenets of utility theory. In particular, people underweight outcomes that are merely probable in comparison with outcomes that are obtained with certainty. This tendency, called the certainty effect, contributes to risk aversion in choices involving sure gains and to risk seeking in choices involving sure losses. In addition, people generally discard components that are shared by all prospects under consideration. This tendency, called the isolation effect, leads to inconsistent preferences when the same choice is presented in different forms. An alternative theory of choice is developed, in which value is assigned to gains and losses rather than to final assets and in which probabilities are replaced by decision weights. The value function is normally concave for gains, commonly convex for losses, and is generally steeper for losses than for gains. Decision weights are generally lower than the corresponding probabilities, except in the range of low prob- abilities. Overweighting of low probabilities may contribute to the attractiveness of both insurance and gambling. EXPECTED UTILITY THEORY has dominated the analysis of decision making under risk. It has been generally accepted as a normative model of rational choice (24), and widely applied as a descriptive model of economic behavior, e.g. (15, 4). Thus, it is assumed that all reasonable people would wish to obey the axioms of the theory (47, 36), and that most people actually do, most of the time. The present paper describes several classes of choice problems in which preferences systematically violate the axioms of expected utility theory. In the light of these observations we argue that utility theory, as it is commonly interpreted and applied, is not an adequate descriptive model and we propose an alternative account of choice under risk. 2. CRITIQUE
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TL;DR: In this paper, the authors developed a theory of financial intermediation based on minimizing the cost of monitoring information which is useful for resolving incentive problems between borrowers and lenders, and presented a characterization of the costs of providing incentives for delegated monitoring by a financial intermediary.
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TL;DR: This Time Is Different as mentioned in this paper presents a comprehensive look at the varieties of financial crises, and guides us through eight astonishing centuries of government defaults, banking panics, and inflationary spikes.
Abstract: Throughout history, rich and poor countries alike have been lending, borrowing, crashing--and recovering--their way through an extraordinary range of financial crises. Each time, the experts have chimed, "this time is different"--claiming that the old rules of valuation no longer apply and that the new situation bears little similarity to past disasters. With this breakthrough study, leading economists Carmen Reinhart and Kenneth Rogoff definitively prove them wrong. Covering sixty-six countries across five continents, This Time Is Different presents a comprehensive look at the varieties of financial crises, and guides us through eight astonishing centuries of government defaults, banking panics, and inflationary spikes--from medieval currency debasements to today's subprime catastrophe. Carmen Reinhart and Kenneth Rogoff, leading economists whose work has been influential in the policy debate concerning the current financial crisis, provocatively argue that financial combustions are universal rites of passage for emerging and established market nations. The authors draw important lessons from history to show us how much--or how little--we have learned. Using clear, sharp analysis and comprehensive data, Reinhart and Rogoff document that financial fallouts occur in clusters and strike with surprisingly consistent frequency, duration, and ferocity. They examine the patterns of currency crashes, high and hyperinflation, and government defaults on international and domestic debts--as well as the cycles in housing and equity prices, capital flows, unemployment, and government revenues around these crises. While countries do weather their financial storms, Reinhart and Rogoff prove that short memories make it all too easy for crises to recur. An important book that will affect policy discussions for a long time to come, This Time Is Different exposes centuries of financial missteps.
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