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Shadow Banking: A European Perspective

Papers

Below are abstracts of papers selected for presentation at the conference, arranged by panel topic.
It is envisaged that a selection of conference papers will be published as a special issue of a journal, with an introduction edited by Michel Barnier, European Commissioner for financial services.

Panel 1A. The Anatomy of Financial Innovation

The Macroeconomics of Shadow Banking

Full Title

The Macroeconomics of Shadow Banking: The Anatomy of the US and European Crises

Author

Daniela Gabor

Abstract

Calls to regulate shadow banking have focused on the bank-like risks for financial stability, powerfully demonstrated in the US crisis. In turn, policy makers have so far ignored the implications for monetary or fiscal policies, thus implying that the current institutional architecture – premising an inflation-oriented independent central bank and a fiscally-prudent government – should remain in place, strengthened by a revamped prudential framework. But shadow banking activities respond to, influence and create new forms of interconnectedness between, monetary and fiscal policies. The paper analyzes the mechanisms underpinning interconnectedness, and in doing so, it argues that shadow banking renders the current macro-institutional architecture obsolete, if not outright damaging to macroeconomic stability. This perspective is useful to understand how and why the European crisis is a crisis of shadow banking, different in manifestations and timing from the US crisis.

Fund Management and Systemic Risk

Full Title

Fund Management and Systemic Risk: Lessons from the Global Financial Crisis

Author

Elias Bengtsson

Abstract

Asset managed by professional fund managers have experienced impressive growth during the last decade. In Europe, the assets under management by investment funds alone increased by 76% or over EUR 3.4 trillion in the decade of 2000-2010. Given the role of fund managers in increasing efficiency and stability in financial markets, this development should be welcomed. They pool resources and reduce risk by achieving diversification at a lower cost. And through their investment decisions, fund managers contribute to price discovery, liquidity and improved corporate control. But research also indicates that fund management in certain circumstances may contribute to the buildup of systemic risk and severity of financial crises. In this article, we focus on the lessons that can be drawn from the global financial crisis regarding the potential ways in which fund management can contribute to systemic risk. We distinguish between three sources of systemic risk in the financial system that may arise from fund management: insufficient credit risk transfer to fund managers; runs on funds that cause sudden reductions in funding to banks and other financial entities; and contagion through business ties between fund managers and their sponsors. There is a current intense debate on the role the so-called shadow banking system played in the global financial crisis, and several regulatory initiatives have been launched or suggested to reduce the systemic risk arising in non-bank financial entities in the future. We also seek to analyze the likely impact of these regulatory initiatives on systemic risk, in the light of prior research and ongoing structural developments in the fund management industry.

European Money Market Funds

Full Title

European Money Market Funds: A Comparative Analysis of US and European De Facto and De Jure Micro-Processes

Authors

Viktoria Baklanova & Joseph Tanega

Abstract

This article presents European money market funds from multiple dimensions and shows the diversity of these funds that is rooted in the historical developments of diverse European financial markets. The events of the financial crisis and liquidity squeeze confronting European money market funds in the fall of 2007 have moved the subject of the money markets high up on the list of financial regulatory agenda in Europe. The fragmentation of the European money market fund industry has been viewed as not only a source of confusion for investors, but also as a significant challenge in fostering a single market for financial services.
Thus, the near future of the European money market fund industry rests on the outcomes of two divergent trends: further harmonisation of investment products toward convergence of investment and regulatory practices and a desire for product differentiation driven by local nature of collective investments especially in regard of retail investors’ preferences. These two trends underscore two different types of transformations related to the development of money market funds in Europe: (1) from the very market practices that exist de facto to their capture and replication de jure; and (2) from the de jure ideals of fair rules that encourage further and deeper de facto market developments.
These transformations from de facto to de jure and from de jure to de facto present a continuous isomorphic dynamic that if balanced properly can result in both the creation of new products under fair rules of transparency and fair rules that drive new and more resilient markets. At the ground level, these trends will be shaped by their respective costs and benefits for asset managers and investors seeking optimal efficiency in the contest between national laws including applicable tax regulation. Lastly, the European sovereign debt crisis and the on-going problem of high risk political dis-resolution have profound consequences for money market funds in the US and Europe. These unquantifiable intangibles mark the major unknowns with respect to the future state of Europe, and in turn, impact the continued existence and development of the money market fund sector.

Panel 1B. Financial Innovation, Fragility, Crisis

Financial Fragility in the Current European Crisis

Full Title

Financial Fragility in the Current European Crisis

Author

Domenica Tropeano

Abstract

The paper defines financial fragility in relation to structural conditions on financial markets, as argued by Minsky. Fragility would not depend on the microeconomic balance sheets of agents or banks only (f.e. hedge, speculative or Ponzi positions) but also on their mutual relations and the characteristics of the environment. Thus changes in regulation and monetary policy stance matter. In Europe financial fragility has increased though the financial sector’s debt may be lower because of recapitalizations and massive deleveraging. The new regulatory framework, only partially implemented but anticipated by banks in their plans, has indeed favored the growth of transactions linked to shadow banking activities such as over the counter derivatives. The accommodating monetary policy pursued by central banks after the crisis has also allowed shadow banking activities to prosper. Basel III capital requirements rules have indeed maintained the discount on capital for banks that buy protection on their risky assets through derivatives. A new market for derivatives on European private and public debt has flourished. The regulation trying to improve the quality of collateral in transactions among financial institutions has increased the demand for safe assets lowering their yields and conversely increasing the yields of the risky ones. The very disturbed environment created by the economic and political crisis makes volatility increase, so more protection is demanded . I am arguing that the institutional changes that have followed the financial crisis have contributed to making the financial system more fragile. In this context, the growth of shadow banking may be explained.

The Interconnections Between the Shadow Banking System and the Regular Banking System

Full Title

The Interconnections Between the Shadow Banking System and the Regular Banking System: Evidence From the Euro Area

Authors

Esther Jeffers & Claudia Baicu

Abstract

One of the most important lessons of the global financial crisis has been the deep interconnectedness between the shadow banking system and the regular banking system. These two systems are linked through several channels, of which the most important is the financing provided by regular banks to the shadow banking system and vice versa. In addition, regular banks can originate loans that are securitized. Subsequently, part of the securitized instruments may remain on the balance sheet of the originating banks or be found on the balance sheet of other regular banks and shadow banking entities. These links between the two systems can increase contagion and systemic risks, which in turn may affect financial stability. The financial crisis has acutely revealed the negative effects these interconnections can generate. Within this framework this paper will examine the role of the European banking system in the shadow bank intermediation of credit flows from US savers to US borrowers, as well as the fact that US MMMFs provided sizeable funding to European banks, which may have affected the resilience of the EU banking system to external funding shocks.
The interconnections are underestimated by the available data because of the difficulties in gathering information on the euro area. Within this context, our paper tries to evaluate and analyze the interconnections between the shadow banking system and the regular banking system within the euro area and on both sides of the Atlantic, both in the pre-crisis period and currently. Finally, some proposals to regulate these two systems are put forward.

OTC Trading and Hunger

Full Title

OTC Trading and Hunger: A Second Look at the 2007-08 Food Price Crisis

Author

Luigi Russi

Abstract

This paper offers an alternative to the conventional explanation of the 2007-08 food price crisis in terms of escalating demand or dwindling supply. Instead, its focus is on the legal-institutional structure of commodity futures markets, which has witnessed a drastic alteration in the role of speculators after the opening of OTC trading in commodities. Speculators have transformed from “market makers” (that keep commodity futures markets liquid by arbitraging on price fluctuations) to “market breakers”. Index speculation, in particular, has had the effect of muddling information about market “fundamentals” because of the need – brought about by commodity index swaps – for swap dealers to hedge the fluctuations of an index of commodity prices by opening and periodically rolling over long-only positions. This periodical rollover to comply with contractual obligations, rather than in response to anticipated fluctuations in the availability of a commodity in the future, can induce a “contango bias” in the commodity futures market that, in turn, might have given the wrong signals to market operators, leading to a condition of induced (rather than pre-existing) scarcity and to an increase in spot prices in the 2007-08 crisis.

Panel 2A. Governing the Black Holes of the Global Economy

Shadow Banking, Offshore Banking and the Crisis

Full Title

Shadow Banking, Offshore Banking and the Crisis

Authors

Nicholas Shaxson, John Christensen & Sara Hsu

Abstract

The Great Recession that struck the global economy in 2008 and continues to reverberate stemmed significantly from “innovations” in the so-called shadow banking sector, involving a range of exotic entities that escape formal regulation, but exists in a symbiotic relationship with the regulated financial sector. The limited research on shadow banking has tended to ignore the crucial question of how and why the entities involved structured themselves across different jurisdictions, especially offshore jurisdictions. In this paper we explore the offshore shadow banking roots of the crisis, by examining the roles both of widely recognized offshore centres such as the Cayman Islands, Jersey, and Luxembourg; and of less recognized “offshore” centres such as Ireland, Delaware in the United States, and, most importantly of all, the City of London. We find and discuss a number of proven connections between the shadow banking sector, offshore banking, and the crisis, and discuss a number of suspected connections that we are currently investigating. We discuss the ‘competitive’dynamics between jurisdictions that impact the financial regulatory framework of both offshore and onshore jurisdictions, and which provide incentives for ever-increasing tolerance of criminality that contributed to the crises. Finally, we discuss proposed regulation that seeks to regulate shadow banking, and explore its impact on activity in offshore centres. Finally, we propose a methodology for quantifying shadow banking in offshore jurisdictions.

Governance Convergence of Tax Havens and the Shadow Banking System

Full Title

Governance Convergence of Tax Havens and the Shadow Banking System in Light of the Crisis

Authors

Ronen Palan & Anastasia Nesvetailova

Abstract

Transparency, convergence and efficiency have been at the centre of the regulatory agenda for tax evasion, secrecy and financial reforms. Yet, until recently there was little overlap between global corporate governance reforms and regulation of tax havens and international financial architecture. The article argues that this is changing. We analyse ongoing shifts in the two domains that include the largely unilateral policies of the USA, centred o Foreign Accounts Tax Compliance Act (FATCA), variants of which are adopted by the UK and EU, and G-20 ‘too-big to fail’ proposed regulations. Our study suggests that these national-level policy measures, while unfolding independently of each other, are generating a convergence of the regulatory frameworks of the corporate and the financial systems. Intriguingly, we find that this convergence is a result of national-level policy initiatives introduced by individual states in the wake of the crisis, rather than of a top-bottom approach to global governance advocated by many international forums and academic literature.

Democratic Diversity in Financial Market Regulation

Full Title

Democratic Diversity in Financial Market Regulation: Banalisation, Difference and the Global Public Good

Author

Nicholas Dorn

Abstract

This paper claims that the political, cultural and epistemic detachment of financial market regulation stimulates rule-convergence, market connectedness, herding and systemic instability. By contrast, democratic steering of public policy on financial markets would result in greater diversity of regulatory regimes, which in turn would induce greater variety within the market. Similarity of business models, common vulnerabilities and trans-border shock-transmissions would all be reduced, so alleviating bank/non-bank/sovereign connectedness and the propensity to bail out creditors at public cost. Within that perspective – diversity supporting robustness of the international system as an ensemble – regulatory arbitrage should be positively valued. However, and needless to say, any proposal for democratic steering and diversity directly contradicts the current international drive for greater convergence of regulatory regimes. The latter agenda is understandable in terms of presentational pressures to cooperate with peers in the face of crisis, and the interests of the largest transnational firms. Furthermore, and germane to the EU context, convergence within the single market remains the overarching agenda for the European Commission. Finally, coming to citizens, an extension of democracy to policy-making on financial markets opens up questions of political responsibility that are rather challenging: ‘leaving things to the experts’ may still the default public mood, even as the crisis deepens. Thus, technocratic governance seems set to become further institutionalised, deepening regulatory convergence and exacerbating market connectedness and instability. This paper situates these issues in relation to three historical tendencies in financial regulation: (i) its pre-crisis tendency to act as an arms-length representative of collective private interests (operationalised in terms of ‘models’ borrowed from the market); (ii) its current claims for greater autonomy, constructing a single level game (operationalised as a precautionary, prudential, judgement-led approach); (iii) its potential, but currently weak, democratic side. The paper draws on ongoing work on banalisation of financial markets as a policy goal (see Economy and Society 41(3); Law and Financial Markets Review 6(4); Journal of European Integration 34(3); and Cruz et al, eds, in preparation).

Panel 2B. Structures and Politics of Shadow Banking

Do Politicians Serve the One Percent? Evidence in OECD Countries

Full Title

Do Politicians Serve the One Percent? Evidence in OECD Countries

Author

Pablo Torija

Abstract

Present social movements, as “Occupy Wall Street” or the Spanish “Indignados”, claim that politicians work for an economic elite, the 1%, that drives the world economic policies. In this paper I show through econometric analysis that these movements are accurate: politicians in OECD countries maximize the happiness of the economic elite. In 2009 center-right parties maximized the utility of the 100th-98th richest percentile and center-left parties the 100th-95th richest percentile. The situation has worsened from the seventies when politicians represented, approximately, the median voter.

Privatized Returns and Socialized Risks

Full Title

Privatized Returns and Socialized Risks: CEO Incentives, Securitization Accounting and the Financial Crisis

Authors

Michele Fabrizi & Antonio Parbonetti

Abstract

The paper investigates the role of CEO’s equity and risk incentives in boosting securitization in the financial industry and in motivating executives to reduce the perceived risk while betting on it. Using a sample of US financial institutions over the period 2003-2009 we document that CEOs with high equity incentives have systematically engaged in securitization transactions to a larger extent than CEOs with low incentives. We also show that CEOs with high equity and risk-related incentives have engaged in the securitization of risky loans and have used securitization for transferring risks to outside investors. Finally we show that highly incentivized executives have provided outside investors with low quality disclosure about losses recorded on securitized loans thus contributing to increase the opacity of securitization transactions undertaken. Overall we interpret these results as evidence that CEOs have foreseen in securitizations under US GAAP an opportunity to bypass regulatory requirements, hiding risks while bearing them and generating profits and cash flows because of the risks. In additional analyses we document that before the collapse of the subprime mortgage market in 2007, financial institutions involved in the securitization of subprime loans have largely over performed other banks. On the contrary, starting from 2007 subprime securitizers have recorded worse market performances than other financial institutions that were not involved in subprime securitization. This indicates that by securitizing risky loans CEOs have been successful in boosting stock price but the risks undertaken have turned out to be extremely costly.

Two Perspectives on Risk in Financial Reform

Full Title

Two Perspectives on Risk in Financial Reform

Author

John Glenn

Abstract

This paper examines the financial reforms that have been undertaken through two perspectives on risk: that of Beck’s world risk society and an alternative Foucauldian approach. The former argues that, catastrophes such as the recent financial crisis will induce a political shift towards a cosmopolitan form of statehood. Yet, the lack of radical reform since the financial crisis would suggest otherwise. The paper therefore argues that what we are witnessing is best understood in terms of reflexive governance in which the various rationalities of risk are reassessed and strengthened in order to avoid a similar occurrence in the future. Moreover, in response to the uncertainty that surrounds such rare events, more intense forms of surveillance have been adopted with the objective of pre-empting any future crisis. Yet, for various reasons, the reforms remain rather limited and the new rationality of pre-emption is unlikely to prevent further crises from occurring in the future.

Panel 3A. Varieties of Shadow Banking

The Historical Role of the European Shadow Banking System

Full Title

The Historical Role of the European Shadow Banking System in the Development and Evolution of Our Monetary Institutions

Author

Israel Cedillo Lazcano

Abstract

When we hear about the 2008 Lehman Brothers crisis, immediately we relate it to the concept of “shadow banking system”; however, the credit intermediation involving lightly regulated entities and activities outside the traditional banking system are not new for the European Financial Systems, after all, many innovations developed in the past, were adopted by European nations and exported to the rest of the world (i.e. coinage and central banking), and European innovators unleashed several financial crises related to “shadowy” financial intermediaries (i.e. the Gebroeders de Neufville crisis of 1763). However, despite not many academics, legislators and regulators even agree on what “shadow banking” is, this latter does not refer exclusively to the functions of credit intermediation and maturity transformation. This concept also refers to the creation of assets such as digital media of exchange which are designed under the influence of Friedrich Hayek and the Austrian School of Economics. This lack of a uniform definition of “shadow banking” has limited our regulatory efforts on key issues like the private money creation, a source of vulnerability in the financial system that, paradoxically, at the same time could result in an opportunity to renovate European institutions, heirs of the tradition of the Riksbank, the Wisselbank and the Bank of England which, during the seventeenth century, faced monetary innovations and led the European monetary revolution that originated the current monetary and regulatory practices implemented around the world.

Shadow Banking and Systemic Risk in Europe and China

Full Title

Shadow Banking and Systemic Risk in Europe and China

Authors

Sara Hsu, Jianjun Li & Qin Yanzhi

Abstract

We compare the European and Chinese shadow banking systems. While the European shadow banking system is better developed than the Chinese shadow banking system, herd behavior in European markets creates systemic risk, which contributed in part to the financial crisis. Dispersion of risk across the “underdeveloped” shadow banking system in China has led to some cases of localized, concentrated risk, but not to systemic risk. We discuss proposed European shadow banking regulation and its implications for systemic risk, and discuss what lessons China might glean from such policies. We also discuss what lessons China’s diverse and systemically uncoordinated shadow banking sector might provide for Europe.

Two Instances of Regulatory Re-Framing Post Crisis

Full Title

Don’t Mind the “Funding Gap”: Two Instances of Regulatory Re-Framing Post Crisis

Author

Ewald R. Engelen

Abstract

This paper focuses on attempts by banks, industry organisations, regulators to re-invigorate the international market for mortgage securities after the crisis. While securitization is an old technique for the transformation of illiquid financial products into liquid ones, it really came of age from the early 1990s onward. This required a gradual transformation of existing lending practices in a growing number of jurisdictions to make financial markets safe for securitization. These transformations were both of a legal-material nature and a discursive-ideational ones. That is: they required both humdrum legislative work and more imaginative narratological work. While the legislative part resulted in strong reliance of banks for the upkeep of their business model on working markets for securitized assets, the crisis has severely delegitimated the discursive underpinnings of these markets, resulting in a more or less complete breakdown of any transactions in securitized assets in Europe. Taking the differential dependence of banks on the sale of securitized assets for their funding as its starting point, the paper empirically tries to explain differences in lobbying activities to again kick-start the market as well as ensuring the continuing acceptability of securitized assets as collateral on the basis of a Varieties of Financialized Capitalism approach.

Panel 3B. Mapping Shadow Banking Structures

Sizing the European Shadow Banking System: A New Methodology

Full Title

Sizing the European Shadow Banking System: A New Methodology

Authors

Judith Tyson & Mimoza Shabani

Abstract

One of the critical unanswered questions relating to the shadow-banking system has been to quantify its scale in an industry where entities, by design, are opaque and often outside of regulated and publically shared frameworks. However almost all shadow banking entities, including hedge funds, private equity funds and special purpose vehicles (“SPVs”), interact with the financial markets via regulated investment banks. For example, many SPVs are in fact originated as part of investment banking business and hedge funds typically transact in financial markets exclusively via the “prime brokerage” division of investment banks. This interface with the regulated banking environment combines with the typical practise by investment banks of equalizing compensation (Including bonus) ratios to revenues globally which then allows identification of the implied difference in revenues and hence assets that represents the shadow banking system. The paper will present for critique the results of this methodology to estimate the UK shadow banking system. The estimate will imply a larger scale of shadow banking than previous estimates and it will be proposed that this is because this methodology includes more comprehensively, and in addition to widely included hedge funds, the highly secretive and rarely disclosed activities of private equity funds, sovereign wealth funds and on- and off-shore SPVs.

Shadow Banking and the Crisis: An Amplifying or Causal Role?

Full Title

Shadow Banking and the Crisis: An Amplifying or Causal Role?

Author

Photis Lysandrou

Abstract

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The Time of Shadow Banking

Full Title

The Time of Shadow Banking: Liquidity and Maturity Transformations and the Politics of Financial Regulation in the EU

Author

Benjamin Wilhelm

Abstract

Global financial practices change or become visible through crisis dynamics. This is not just a chain of historical events but they are a constitutive part of the economic history themselves. One dimension of this reconfiguration are the interactions within ‘non-bank credit activities’ or the so-called shadow banking system (SBS). Recent reports and research dominantly locate it in the US and associate its brake down with the financial collapse of Lehman Brothers in September 2008. However, a minor discussion is what kind of analogue or complementary system exists in Europe? Therefore, this contribution seeks to highlight financial practices and their regulation in Europe. The first part offers an analytic perspective which concentrates on temporal orders (re)presented by the activities within the SBS. As mentioned before, the SBS is not only part of the recent economic history but dynamically constitutive. In the same way it implies distinctive temporal orders via the construction of financial products. A main difference between the SBS and the Traditional Banking System is the way in which credits become possible (market or capital based). Here, through a changing concept of risk, it refers to different constructions of temporal orders. In order to exemplify this, the second part focuses on one specific aspect of the SBS, i.e. the processes of liquidity and maturity transformations which show how short term financial products were increasingly possible by non-bank financial intermediaries. This points not only to financial practices but also to the evolving regulatory framework (MiFID, Solvency II, CRD III/IV, and AIFMD) in the EU. Changing temporal structures of financial practices as well as of financial regulation, both, transform the time of Shadow Banking.

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