Notes from the Vault
Paula Tkac
December 2014
Throughout the financial crisis the Federal Reserve and financial regulators undertook a wide variety of innovative measures to battle liquidity crises, potential bank failures, systemic financial stress, and recession. Emergency facilities extended lending outside of the banking sector, asset purchase programs grew central bank balance sheets, and banking and financial market regulations were rewritten en masse. Now that the U.S. recovery seems to have gained its footing and major new regulations are being phased in, the question of the day is: Where to now? Should monetary policy return to a state of scarce excess bank reserves and, in the United States, a vibrant federal funds market? How far, and in what way, should macroprudential policy extend beyond the banking sector? How should a central bank fold in financial stability concerns particularly those related to nonbanks, if at all, as it formulates monetary policy? What this central bank of the future should, or will, look like remains a very open question and many of the potential answers involve more interaction with the large and growing shadow banking sector. Is traditional banking likely to become less central to central banking? Is it time for central banking to move into the shadows?
These questions have become a key line of inquiry here in the Atlanta Fed’s Center for Financial Innovation and Stability (CenFIS). We hosted an academic conference in November 2014 to bring exposure to detailed research on particular aspects of the shadow banking sector and its impact on financial stability. And in March 2015, CenFIS will host the 20th annual Financial Markets Conference to explore these policy questions more deeply. We’ve assembled a top-notch program of policymakers, practitioners, and academics to take on these issues from a variety of perspectives. We are eager to get the ball rolling, so this Notes from the Vault provides some background on these topics to feed what we hope are many future discussions.
Just how important are shadow banks anyway?
One of the first questions that needs to be asked is just what do we mean by “shadow banks”? Although defined in various ways, for our purposes a good definition is those institutions and markets that intermediate credit using maturity, liquidity, and credit transformation. This definition includes securitizations, finance companies, money market mutual funds, broker dealers, repo markets, and so on. Given this definition, how important in size and scope is the shadow banking sector relative to traditional banks?
Two of the best sources of detailed information on the shadow banking sector are “Shadow Banking” (by colleagues at the Federal Reserve Bank of New York) and the Financial Stability Board’s recent Global Shadow Banking Monitoring Report 2014. The former provides a detailed look at the involvement of nonbanks in the credit intermediation process, from loan origination to wholesale funding. As shown in this map, the shadow banking sector includes a variety of financing structures at each step of the intermediation process.
The authors report that, in the United States, the decade prior to the financial crisis was one of rapid growth for shadow banking liabilities relative to that of traditional banks. Shadow liabilities first exceeded traditional banking liabilities in the mid-1990s and peaked at $22 trillion in June 2007, half again as large as traditional liabilities at the time. During the crisis, however, shadow liabilities fell by $5 trillion while traditional banking liabilities continued to grow; as of December 2013, the traditional banking sector is now larger than the shadow sector by $2 trillion to $3 trillion.
The Global Shadow Banking Monitoring Report 2014 provides both a global perspective on these figures as well as some additional data on more recent growth rates.1 As the following chart shows, this analysis finds that the United States is somewhat anomalous in the relative size of its shadow banking sector as a percentage of gross domestic product (GDP); OFI is the shadow banking sector. Only the Netherlands has a larger shadow sector relative to the size of deposit-taking institutions (banks). In terms of overall size, the United States and the euro area account for roughly 67 percent of global shadow banking assets. However, the report also notes that growth rates of the shadow sector in many developing economies as well as China and Japan were over 10 percent (and as high as 30 percent) in 2013, after controlling for foreign exchange effects. Thus, while the Federal Reserve may currently face some unique challenges as it assesses its interaction with shadow banking, other central banks may not be far behind.
Well-designed policy is anticipatory and not just reactionary, which implies that it is the future evolution of the traditional and shadow banking sectors that may perhaps be most on policymakers’ minds. In this regard, the impact of the regulatory response to the financial crisis is likely the biggest driver of change, though its ultimate impact is far from certain. Dodd-Frank significantly changes the regulatory system for both traditional banks through capital and liquidity regulation, the Volcker rule, new Federal Deposit Insurance Corporation assessment base, etc. The new regulations still have not been fully implemented; for example, the liquidity coverage ratio goes into effect on January 1, 2015, while the Volcker rule conformance period for covered funds has been extended to July 2017, and similar timelines exist for disclosure and compliance with the supplementary leverage ratio. In addition, as recently as this month the legislation itself was amended to narrow the “swaps push-out provision” (Section 716) to apply only to certain asset-backed securities swaps.
While much of Dodd-Frank is targeted at the traditional banking sector, other aspects of the regulatory response (including Dodd-Frank) directly affect markets and entities that have been a part of shadow banking, including credit risk retention, securitizations, swaps activity, and new registration and examination of private equity and hedge funds. Altogether, financial activities across both the traditional and shadow banking sectors will be greatly affected. Activity is likely to flow to those financing vehicles where the benefits of the safety net subsidies net of regulatory costs are the greatest, with Boston College Professor Ed Kane predicting the evolution and expansion of “shadowy banking” as inevitable.2 Already we are hearing reports of shifts in even the most fundamental of bank activities: deposit-taking. As banks face greater balance sheet costs, some large corporate deposits are apparently not worth holding on to. Where will these deposits go? Almost by definition, many of them will migrate into current or new products in the shadow banking sector.
Potential impact on central banking, Federal Reserve style
So, if we conclude the shadow banking sector is economically significant and likely to grow and change in the United States, what impact could shadow banking have on how the Federal Reserve fulfills its responsibilities as a bank/systemic institution regulator and monetary policy authority?
The most obvious way in which the Federal Reserve could be, and has already been, affected by shadow banking is via its role (under Dodd-Frank) as the regulator of designated systemically important financial institutions (SIFIs). In late 2013, the Financial Stability Oversight Council designated AIG and Prudential as SIFIs and just last week added MetLife to the list. The Federal Reserve will now have the responsibility to regulate these institutions from a systemic risk perspective. However, the insurance business model is not just a tweak of the bank model, it is a wholly different animal and as such, effective regulation will require deep analysis of the fundamental framework presently in place for SIFI bank regulation. A Quantitative Impact Survey is currently under way to gather the necessary data from firms involved in insurance underwriting to begin such an analysis.
The next frontier in nonbank SIFI designation seems to be consideration of asset management products and activities, as opposed to an earlier study of asset managers as institutions. Douglas J. Elliott of the Brookings Institution provides a nice overview of some of the issues related to asset managers and some thoughts on how a regulator might proceed. And the New York Fed’s Nicola Cetorelli presented new work at our November conference on hybrid intermediaries with an example of how securities lending activity by a large asset manager can be part of the shadow banking sector. Even more so than insurance companies, asset managers do not operate on a bank business model (that is, the assets in a mutual fund are owned by investors and are not assets of the sponsoring asset management firm). Industry objections to designation are correct in that any assessment of systemic risk needs to be built from the ground up, not merely by extension of a bank-centric framework. Among the issues up for debate are how to gauge the risk of exchange-traded funds or securities lending agent services and the extent to which funds investing in bank loans are engaged in credit or maturity transformation.
Even more controversial, however, is the idea of extending lender-of-last-resort access beyond the banking sector into the shadows. As the U.S. Treasury’s Zoltan Pozsar and coauthors document, the menu of facilities and actions taken by the Federal Reserve in the financial crisis provided a liquidity backstop to the shadow banking sector. Is this part of optimal policy going forward? Thorvald Moe (Norges Bank and Levy Institute) took on this question in a presentation at our November conference. As with all policy, there is no riskless or costless alternatives here, but as the Fed embarks on its second century, it seems like a good time for a robust discussion of the pros and cons.
Turning to monetary policy, six-plus years at the zero lower bound shifted policy action into the realm of asset purchases and increased emphasis on forward guidance. Once the Federal Open Market Committee (FOMC) determines that it is appropriate to move interest rates up off of 0–25 basis points, the shadow banking sector may play an important role in managing monetary policy. As the FOMC indicated in September 2014, when normalization begins the Committee will continue to target the federal funds rate and intends to achieve this goal primarily through use of its ability to pay interest on excess reserves (IOER). In addition, however, the Committee affirmed that it will use the overnight reverse repurchase facility (ON RRP) and other supplementary tools as needed (such as the term deposit facility, or TDF). The large amount of excess reserves in the system means that small open-market operations will no longer be effective in moving the federal funds rate, as they were precrisis. Instead, the Committee will rely on setting an opportunity cost of funds through administered movements in the IOER and, if needed, the supplementary facilities. IOER and the TDF involve interactions with depository institutions (banks—banks are paid interest on the balances in their reserve accounts on an overnight or term basis). The ON RRP facility, in contrast, extends the Fed’s counterparties to include shadow banks, specifically money market mutual funds and government-sponsored entities (GSEs such as Fannie Mae and Freddie Mac).
It is unclear how much of a role this facility may play in the conduct of normalization, but some have argued that it should be a fundamental part of monetary policy in the future. The Peterson Institute for International Economics’ Joseph Gagnon and Brian Sack of D.E. Shaw Group advocate for the FOMC to maintain a large balance sheet and use IOER and the ON RRP facility to provide a firm floor under short-term market rates that “have much larger volumes of activity than the federal funds market and hence are presumably more important for determining overall financial conditions in the economy.” Jamie McAndrews and colleagues at the New York Fed contribute to this debate by theoretically analyzing how the portfolio of tools available to the FOMC may be most effectively utilized to manage rates and reserves when banks face balance sheet costs and the economy is subject to liquidity shocks. Their analysis also finds a role for the RRP and identifies situations in which the use of both the RRP and the TDF are optimal. Again, it seems that in our modern U.S. financial system, it is a good time to confront exactly how central banks are to central banking and monetary policy, and if there is a role for their shadow counterparts.
Looking ahead
We hope you find these questions as interesting as we do. As we have done in the past, in April we will be posting the papers, presentations, and videos from the upcoming Financial Markets Conference, Central Banking in the Shadows.
Paula Tkac is a vice president and senior economist at the Atlanta Fed. The views expressed here are the author's and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. If you wish to comment on this post, please e-mail atl.nftv.mailbox@atl.frb.org.
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1 Note that the data sources and definitions used in these two papers are not necessarily comparable along every dimension.
2 Indeed, Stephan Luck and Paul Schempp model how the safety net and regulatory costs influence the size and stability of a shadow banking sector, and John V. Duca provides empirical evidence that regulatory costs have contributed to the precrisis growth of the shadow banking sector.