AG213 FINANCIAL

MARKETS &
BANKING
Individual

The role of
securitized
lending and
shadow
banking in
the 2008
financial
crisis
By Indre Gauciute (Registration
Number: 201232277)

Contents
What is shadow banking?..........................................................................................................................
Size of Shadow Banking............................................................................................................................
Reasons for Shadow Banking....................................................................................................................
Shadow Banking and the 2008 Financial Crisis........................................................................................
Shadow Banking in China.........................................................................................................................
Trusts......................................................................................................................................................
Regulation..............................................................................................................................................
Conclusion.................................................................................................................................................
References................................................................................................................................................
Appendices...............................................................................................................................................

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The role of securitized lending and

shadow banking in the 2008
financial crisis
Financial crisis of 2007 2008, which originated largely in the United States (Coffee, 2009), is
considered to have been the worst financial crisis since the Great Depression of the 1930s. The
main reasons of this crisis include widespread failures in financial regulation and supervision, the
failures of credit rating agencies, failures of corporate governance and risk management at many
systematically important financial institutions, a combination of financial institutions excessive
borrowing, risky investments, and lack of transparency, and collapsing of mortgage-lending
standards and the mortgage securitization pipeline (The Financial Crisis Inquiry Commision,
2011). This report will focus on the role of securitized lending and shadow banking in the 2008
financial crisis and discuss the shadow banking sector in China.

What is shadow banking?

According to International Monetary Fund report (2014) shadow banking can be described as
financial intermediaries or activities involved in credit intermediation outside the regular banking
system, and therefore lacking a formal safety net. Because shadow banks are not subject to
traditional bank regulations, they cannot borrow in emergency from central banks and do not
have traditional depositors whose funds are covered by insurance (Kodres, 2013). Traditional
banks and shadow banks have two similar functions securitization and collateral intermediation
which means that they both assist in intermediating funds from savers to investors, and involve
risk transformation (Claessens et al, 2012). However, traditional banks make and hold loans with
insured demand deposits as the main source of funds, while securitized banking is the business of
packaging and reselling loans, with repo agreements as the main source of funds (Claessens et al,
2012). In addition, the key difference between bank based intermediation and securitization is
that traditional banks transform risk on a single balance sheet and in securitization the risks are
supported by a chain of multiple balance sheets and different sources of capital and puts.

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The Global Financial Stability Report (GFSR) (2014) states that shadow banking complements
traditional banking by expanding access to credit or by supporting market liquidity, maturity
transformation, and risk sharing. Shadow banks contribute to the financing of the real world by
enhancing the efficiency of the financial sector by enabling better risk sharing. However, they
can also become a source of systematic risk, especially when they are structured to perform
bank-like functions, such as maturity and liquidity transformation, and leverage, and when their
interconnectedness with the regular banking system is strong (FSB 2014).

Size of Shadow Banking

The largest shadow banking systems are usually found in advanced economies. According to
FSB data, the US, the euro area and the UK have the largest shadow banking systems (GFSR,
2014).
Two-thirds of shadow banking now occurs outside the U.S., as mentioned in the euro area and
the U.K, however, there is a rapid growth in many emerging markets, offsetting the decline in the
United States (Claessens et al, 2012). This is confirmed by Global Shadow Banking Monitoring
Report 2014 (FSB, 2014), which shows that in 2013 the U.S, the United Kingdom and China
had by far the largest shadow banking sectors in USD terms, meanwhile Argentina, Singapore
and Indonesia (emerging markets) had the smallest systems. Based on the MUNFI estimate
(FSB, 2014), non-bank financial intermediation, which can provide a conservative proxy of the
global shadow banking system, grew by $5 trillion in 2013 to reach $75 trillion. Globally, it
represents on average about 25% of total financial assets, approximately half of banking system
assets, and 120% of GDP. However, these estimates are very approximate as the concept of
shadow banking is interpreted differently across the globe. In addition, a number of studies have
attempted to estimate the size of the shadow banking sector, however, the size varies
significantly from one estimate to another (Jeffers and Plihon, 2013).

Reasons for Shadow Banking

Key drivers behind shadow banking growth include tightening of banking regulations and ample
liquidity conditions, as well as demand from institutional investors (GFSR, 2014). According to
Adrian, Ashcraft, and Cetorelli (2013), the growth of shadow banking is motivated by the
confluence of specialization by financial intermediaries, financial innovation, and regulatory cost
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avoidance. Specialization by credit providers allows possibilities for gains including superior
knowledge due to specialization in a single area of the market and possible economies of scale
by specializing in particular credit intermediation functions (Stanley, 2013).

Financial

innovation refers to the composition of money supply through shadow credit intermediation
(Gorton and Metrick, 2011), while by regulatory cost avoidance it is meant that private actors
can avoid both regulation and taxes by intermediating outside of the traditional banking system
(Adrian, Ashcraft, and Cetorelli, 2013).

Another growth of securitization driver prior the

financial crisis was the demand from banks for securitized debt to use as collateral to attract repo
funding, this way boosting their leverage and returns (Claessens et al, 2012).

Shadow Banking and the 2008 Financial Crisis

As it was mentioned in the introduction, shadow banking can pose serious systematic risks which
were highlighted by the 2007 - 2008 financial crisis. The securitization function which creates
private safe assets broke down before the crisis as financial institutions and investors realized
that it ignored some aggregate risks (Claessens et al, 2012). The 2007 2008 financial crisis was
a system wide bank run, which occurred in securitized-banking system and was driven by the
withdrawals of repurchase agreements (Claessens et al, 2012). According to Whitney (2011), the
run on repo started in France, when Paribas Bank (BNP) announced that it could not value the
toxic mortgage assets and that the liability holders, who thought they could get out at any time,
were frozen. The actual problem was that these toxic assets were used by the banks to secure
funding in the repo market. As the value of the assets was declining, the banks were becoming
increasingly less liquid. Therefore, the crisis was caused not only by the $1.5 trillion worth
subprime mortgages, but the trillions of dollars in the complex securitized bonds that had been
traded through shadow intermediaries (Whitney, 2011). Full-value for securitized bonds was
provided by financial firms that got worried that those bonds might contain toxic subprime loans;
therefore they reduced the amount of money they would lend on the bonds. These reductions also
called haircuts set-off a slow-motion panic that lasted over a year and drained almost $4
trillion from the shadow banking system (Whitney, 2011). In general, if repo lenders lose faith in
the collateral or in the borrowers, as they did in the 2007-08 financial crisis, they will demand
more collateral or repayments, which may drive the repo borrowers into bankruptcy
(RepoWatch, 2011). When investors became nervous about the worth of these long-term assets,
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they decided to withdraw their funds at once. Shadow banks needed to repay these investors and,
therefore, had to sell assets. At that time shadow intermediaries were highly leveraged or had
large holdings of illiquid assets and were vulnerable to runs when investors withdrew large
quantities of funds at short notice (GFSR, 2014). It resulted in fire sales, which generally
reduced the value of these assets. It forced other shadow banking institutions and some banks
that had similar assets to reduce these assets value to reflect the lower market price, creating
further uncertainty of their health (Kodres, 2013). At the peak of the crisis, many financial
institutions, both banks and nonbanks, ran into serious problems as many investors withdrew or
would not reinvest their funds.
The crisis revealed an extreme instability in the private supply of safe assets which resulted in a
run on prime money funds (Claessens et al, 2012). Prime money funds, which contained some of
the problem assets, started to be perceived as risky. It was reflected by the outflow of more than
$300 billion between August and September 2008. According Claessens et al (2012) the
systematics risks in collateral intermediation include the liquidity exposure of dealer banks in
collateral chains. This is due to dealer banks routinely using some collateral obtained from
customers for their own funding and, therefore, customer withdrawal may have liquidity
implications for the dealer bank. Claessens et al (2012) conclude that the breakdown had
significant real and financial spillovers. In addition Duarte and Eisenbach (2013) state that firesale externalities, which were mostly caused by large firms as well as the contribution of high
leverage and the illiquidity linkage of firms, are a key component of overall systematic risk for
the financial system.
Lastly, the financial crisis of 2007-2008 revealed widespread regulatory arbitrage as well as a
high procyclicality of shadow banking, and fiscal risks associated with crisis management in
shadow banking sector (Claessens et al, 2012). The financial crisis has revealed the need of the
alignment of all financial institutions under the regulation and the supervision of the Federal
Reserve System and other central banks. According to Farhi and Antonio (2009), the adoption of
a broader system of regulation and supervision becomes more and more inevitable, as the
systematic risk of a breakdown of the entire financial system imposed by the shadow banking
still exists.

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Shadow Banking in China

As it was mentioned before, China has the third largest shadow banking system in the world.
According to the Economist article Battling the darkness (2014), a decade ago traditional
banks, which in China are almost all state-owned and tightly regulated, accounted for virtually
all lending in China. However, nowadays, credit is available from a range of alternative financers
including trusts, leasing companies and money-market funds, which collectively are known as
shadow banks. Lending from the traditional banks is still far bigger than from the shadow banks,
and is still expanding; however, its rate of growth has recently stabilized. On the other hand, the
growth of some forms of shadowing banking is accelerating (Appendix A). Last year shadow
banks in China accounted for almost a third of the rise in lending, growing by over 50% in the
process (The Economist, 2014).
90% of the shadow lenders in China are State-owned enterprises (SOEs). These companies are
cash rich and are more capable than private enterprises in terms of their capability to sneak
around rigid regulatory requirements (Shen, 2013). Large state-owned enterprises such as China
Mobile, PetroChina, China Railway Group, Cofco and Yangzijiang Shipbuilding Holdings use
their excess cash to make direct loans to other companies making great profits out of the shadow
baking business.
Chinas shadow banking system is receiving increasing attention not only because of its rapid
growth, but also for its new products and practices that both develop financial system but at the
same time have increased risk. Some products contribute positively to financial development;
other products (credit guarantees and trusts) have proven to be far riskier (Lia, Hsub and Qina,
2014). Due to rapid expansion of the shadow banking system over the past few years, it became
impossible to regulate and monitor all aspects of the system.
Chinas shadow banking system consists of non-bank financial products and credit creation
products. Non-bank financial products include bank-trust cooperation financial products,
products issued by trust companies and financial leasing companies, and Q-REITS and credit
risk assets. Credit creation products are often produced by small loan companies, investment
companies, credit guarantee companies, insurance brokerage firms, pawn shops, private equity
investment funds, and venture capital funds (Lia, Hsub and Qina, 2014). Chinas shadow
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banking system is dominated by commercial banks (in off balance sheet transactions), insurance
companies, and trusts. The report will now discuss trusts in more detail.

Trusts
Trust sector in China is the third largest financial subsector (after the banking and insurance
subsectors) and is considered to be the riskiest (Lia, Hsub and Qina, 2014). Financial trusts are
not subject to the same regulations that banks are subject to, and it is the primary reason why
trusts have encountered problems. Trusts are often engaged in very risky activities such as
investing in undisclosed or highly risky projects. The recent example of poor real investments
that the trusts are based on is the product called Golden Elephant No.38. It was based on
investment in a near-empty housing project in poor, rural area of Taihe (Lia, Hsub and Qina,
2014). At the same time another investment in a coal company called Zhenfu Energy was at risk
of default because the owner of the coal company was unable to repay loans. Additional,
possibly questionable, real investments include investment in oil paintings or white liquor.
Trusts offer returns as high as 10% and this way they raise money from businesses and
individuals frustrated by the low cap the government imposes for interest rates on bank deposits
(The Economist, 2014). Trusts usually lend to firms that are unable to borrow from banks due to
the fact that they are in frothy industries (such as property or steel), where regulators have
instructed banks to curb lending because of signs of overinvestment.
Total outstanding trust product assets in China rose 8 per cent in the first quarter from the
previous quarter to reach Rmb11.7tn, a fourfold increase from the total at the end of 2010
(Anderlini, 2014). As much as $400 billion-worth of trust products will come due this year and
borrowers will want to reinvest many of those loans (The Economist, 2014). Many analysts and
observers worry that investors will lose faith in trusts, prompting a run, which as discussed
previously can seriously damage parts of the financial system. Trust products lie at the heart of
Chinas shadow banking sector, which has provided more than $4.8tn worth of loans to the
countrys riskier enterprises since 2007, and helped to create the biggest credit boom in history
(Anderlini, 2014). As discussed previously, the last shadow banking bubble which started in the
US in the run-up to 2008, compounded the global crisis that followed. Markets and regulators are
now concerned that the rapid build-up of risk in Chinas shadow banking sector may cause
similar damage.
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In addition, as a crisis in shadow banking could spread to the real economy, a sharp downturn in
some sectors could cause trouble for shadow banks (The Economist, 2014). The majority of trust
loans are secured with property, and many developers are reliant on shadow finance, however
Chinas raging property market is cooling, especially in smaller cities. Therefore, the fear that the
pricking of the property bubble leads to a panic in shadow finance, which reduces access to
credit, pushing property prices and economic growth down further, continues to grow.

Regulation
Chinese shadow banks are different from their Western counterparts, because they are still in an
infant form without being integrated into a long intermediation chain (Shen, 2013). Because
Chinese shadow banks disconnections with a wide range of securitization and secured funding
techniques, the regulatory measures addressing the shadowing banking system can be less
complicated than those in more advanced financial markets.
According to Lia, Hsub and Qina (2014), currently supervision focuses on Chinas commercial
banks, while attention is not given to property securities and other non-loan assets. Regarding
trusts, both trust financing companies and trust issuing commercial banks are regulated, even
though some trust companies have engaged in high risk project investment (Lia, Hsub and Qina,
2014). Despite that fact that the regulatory authority has introduced a series of laws and
regulations to bring about the healthy development of trust financial products, the trust
companies continue to engage in speculative investment. Therefore, the severity of the shadow
banking system forces the Chinese Government to reform the lending system so it offers more
investment incentives to create regulated bonds and other financial products, thus preventing the
spillover of systematic risks in the banking sector (Shen, 2013). According to Shen (2013), other
policy options may include the introduction of properly functioning private sector long-term
savings, mutual fund or pensions markets as well as a standardized and unified bond market.
On the other hand, it is very important to emphasize that in the Chinese context the shadow
banking performs a vital dual function channeling much-needed capital to a private sector, which
is starved of debt financing, and allowing savers to earn higher returns than through conventional
bank deposits. Transforming, instead of absolute destruction of shadow banking system may help

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to liberalize Chinas financial sector, which would involve liberalization of interest rate so that
depositors can earn more returns on their savings to spend (Shen, 2013).

Conclusion
The report discussed the significant role that shadow banking played in 2007-2008 financial
crisis. Despite the advantages of shadow banking which include complementation of traditional
banking by expending access to credit or by supporting market liquidity, maturity transformation,
and risk sharing, at the same time they impose high systematic risks as well. By representing
approximately 120% of GDP, shadow banks are very important in the whole financial system.
The problems that shadow banks may create were highlighted in 2007-08 financial crisis which
was a system wide run on repo. As discussed in the report, the crisis revealed extreme instability
in the private supply of safe assets and the worldwide financial spillovers that were created by
the issues in shadow banking. Chinas shadow banking system, which is the third largest in the
world, had recently become a primary concern for many analysts, investors and other market
participants around the globe. Being a key contributor and component of the world economy,
Chinas financial sector, which allows the number of risky and questionable banking activities,
puts the global economy in danger of a future financial crisis. Only well-functioning, aligned,
supervised by central banks regulation system in China and the rest of the world can prevent the
financial world from another crisis.

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Adrian T., Ashcraft A., and Cetorelli N. (2013), Shadow Bank Monitoring, Federal Reserve
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Appendices
Appendix A

The Economist (2014), Shadow banking in China: Battling the darkness, Available at:
http://www.economist.com/news/finance-and-economics/21601872-every-time-regulators-curbone-form-non-bank-lending-another-begins (Last accessed 23.11.2014)

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