Benjamin Wilhelm
An analysis of the shadow banking system provides at least two insights into the legal underpinnings of the financial system. On the one hand, shadow banking operates on a global or transnational scale, which makes it difficult to relate it to a single national legal framework. On the other hand, shadow banking displays the effects of an ineffective legal framework when ‘adverse’ economic conditions arise. The Financial Stability Board defines shadow banking as “the system of credit intermediation that involves entities and activities outside the regular banking system” (FSB 2011a: 3) and it has recently been “at the heart of the credit crisis” (Pozsar 2008: 17). Indeed, the systemic importance of shadow banking for global finance came to light during the financial crisis of 2007–2008. Paul McCulley (2014), who first coined the term ‘shadow banking’ in 2007, refers to the balance of private and public forces that were distorted before and during this financial crisis. Since then, regulators have endeavored to rebalance the banking system (IOSCO 2009; BCBS 2011; Bakk-Simon et al. 2012; IMF 2014; ESRB 2015; FSB 2015a).
Economically, shadow banking performs banking-like practices; legally, however, it holds a privileged accounting position, which comes with lower or no capital requirements compared to the traditional banking sector (Ordoñez 2013; Plantin 2014; Ferrante 2015). Hence, a pure economic analysis is limited in understanding the role of shadow banking. Instead, exploring the interplay of financial regulation and shadow banking activities will provide a more comprehensive picture of the institutional evolution of the financial practices which stabilize and destabilize the financial system.
After the so-called run on the shadow banking system in 2008, the integration of shadow banking practices into the regulatory frameworks has been discussed (Joint Forum 2008; IOSCO 2008; BCBS 2009; FSB 2011b). The Financial Stability Board (FSB) and others support the development of ‘non-bank financing’ as it “provides a valuable alternative to bank funding and helps support real economic activity” (FSB 2015b: 1). However, the question of what this actually means for the rebalancing of the financial system is still debatable; as highlighted by McCulley, the question is one of ‘if, and how, shadow banking may function in its tamed version.’
This chapter illuminates the practices and regulatory aspects of the workings of the shadow banking system. The first section of the chapter points to the institutional qualities of shadow banking as a fundamental part of the broader financial system. The second section presents a view of the inner workings of shadow banking, which are better understood from a legal perspective than from an economic one. The chapter’s third section lays out the present regulatory adaptations and how they affect the current state of shadow banking. The chapter argues that, in order to understand the shadow banking system, a more finely tuned institutional perspective must be supplemented with a perspective on the social and political contexts which condition (and are also conditioned by) the practices of shadow banking.
The inclusion of shadow banking within regulatory regimes impacts on how intervention in economic systems occurs (Bundesbank 2014; Pozsar 2015). This, in turn, creates a new mode of governing international financial markets that further increases the homogeneity of financial practices and the interconnectivity of risks (Shin 2009). The financial crisis of 2007–2008 further underlines the importance of shadow banking for the functioning of the internationalized capitalist system. Its collapse, starting with the Lehman Brothers’ failure in 2008, indicates the interconnectedness of financial institutions and the systemic vulnerability of the international financial architecture.
Mainstream economics has retained its unquestioned explanations of the present position of shadow banking—greed, moral hazard, asymmetric information, lack of transparency, and false regulation. However, Hodgson (2015) suggests that, in terms of the broader working of capitalism, it is the institutional environment of shadow banking that affects the practice of financial exchange. Furthermore, the influence of shadow banking goes beyond the financial sector. That is, shadow banking enforces not only a ‘homeowner society’ via the repackaging of mortgages into saleable assets but also further integration of financial institutions at the global level. Consequently, shadow banking introduces an additional systemic risk (embedded in new forms of credit and in collateral provision across state borders) that calls for new regulatory measures if such risk is to be contained.
Heterodox economists generally do not limit their analyses to only economic phenomena. Rather, heterodox economic analyses of finance are situated within the social and institutional context, including social norms and sanctions. The legitimacy of these institutions is represented through regulatory regimes as the basis for financial interaction. Since financial transactions are increasingly less contained within national boundaries, they must be governed by complex international regulatory mechanisms. Hence, to understand financial interaction within and beyond state-based legal frameworks, one has to understand international regulatory relations, which have recently been broadened and, consequently, created new forms of ‘financial innovation.’1
Pre- and post-crisis regulatory measures show a tendency to enhance resilience against a crisis, rather than focusing on specific risk characteristics and hedging strategies. Their focus places a greater emphasis on bank equity than on external ratings, and more reliance on trading through third parties (that is, clearing counterparties) than on bilateral interbank markets (that is, over-the-counter transactions). The emphasis on resilience indicates that crisis is increasingly recognized as a common phenomenon. Such recognition is considerably different from the widely accepted view represented by the applied risk models that dominated before the recent global financial crisis. Thus, the rediscovery of the ‘Minsky moment’ (BIS 2008; Nesvetailova 2014; Ordoñez & Gorton 2014) reconfigured the way in which possible future crises can be conjectured in an economic and regulatory sense.
In addition, the ‘Bagehot moment’ (Mehrling 2012) marks the decisive position of the central banks during the collapse of the shadow banking system. The new state of financial affairs created through regulatory reform places pressure on the normal business behavior not only of banks (and the configuration of their financial assets in line with the new regulatory demands), but also of central banks (CGFS 2015). Especially for central banks in the face of a low interest rate environment, financial regulation seems to be a key instrument to adjust the lending behavior of banks and the economy at large.
The new dynamic components of regulatory control provide, among other mechanisms, new tools to govern financial affairs from a regulatory perspective. From this point of view, the new role of the European Central Bank as the main agency of European banking supervision appears to be a logical step towards the adoption of the ‘new normal’ in economic governance from a distance (Mehrling 2012, 2014). The new configuration and transmission of central bank policies have thereby expanded and become more complicated. These new policies might thus more closely resemble adjustable tools vis-à-vis the development of a future shadow banking system.2
In the past few years, some heterodox economic perspectives have developed an analysis of the financial system based on Schumpeterian (Ülgen 2014), Kaleckian/Minskian (Wray 2009; Ryoo 2013; Fisher & Bernardo 2014), or more general Post Keynesian (Guttmann 2012; Lavoie 2013) models. Ülgen (2014), for instance, places emphasis on the self-reflexivity of the financial system (‘finance to finance’ versus ‘finance to production’), which disputes the unquestioned role of banking as a functional step to finance Schumpeterian innovation. A Minskian perspective of unstable capitalism, he argues, enables a better perspective on the destructive capacities of finance.
Wray (2009) draws on Veblen to explicate the transition from commercial to financial capitalism (or Minsky’s money manager capitalism). He argues that in the present system private debt plays the leading role for economic growth, and securitization becomes central to the mode of accumulation. Post Keynesians present a systemic perspective on the present accumulation regime denoted as ‘financialization’ (Lavoie 2013). Since the 1980s, neoliberal economic policies, such as deregulation, privatization, the intensification of competition, and labor market flexibility, have restructured the economic system in favor of money managers.
One point of commonality between these heterodox perspectives is the rejection of the efficient markets theory formalized by Fama (1970, 1991). Moreover, heterodox analyses of the crisis demonstrate that even a broader understanding of economics might be insufficient to understand the setting of shadow banking in the contemporary mode of accumulation with an increasingly homogeneous global regulatory setting becoming evident. Complementing an economic perspective, the question that arises from a socio-political viewpoint revolves around the way certain financial orders flourish and others do not, independently of a posteriori rational explanations, and how political decisions regarding regulation trigger the evolution of the financial system.
Shadow banking is an impediment to better economic governance and regulatory systems. Both aspects suggest the need for interdisciplinary research by heterodox economists, financial lawyers, sociologists, historians, and political scientists. In this way, shadow banking can be understood as the result of a socio-political system, demonstrating how a value system transcends national boundaries and how its institutions provide for financial flows accordingly. In the present low interest rate environment, the ‘search for yield’ does not only challenge the current regulatory space but also resets socio-political ‘normality.’ It provides a new regulatory context for banks as well as for the insurance market or syndicated leveraged loan market (Lysandrou & Nesvetailova 2015; Joint Forum 2015). Financial investors have to adjust their balance sheets and product portfolios. Such an adjustment changes not only the availability of credit for the real sector of the economy but also the financial flows of large institutional investors.
The changes in international regulatory frameworks for banks are well represented by the transition from Basel II to Basel III. Basel II provisions only cover counterparty risk and accentuate the internal governance of financial institutions. Basel III focuses on ‘credit value adjustment’ and encompasses broader market fluctuations such as consumption, industrial production, and foreign exchange. As demonstrated by the recent financial crisis, value adjustments for whole asset categories (for valuations dominantly performed in the shadow banking sector) can cause even more systemic interruption as the actual defaults of specific assets increase. The crisis effects of mark-to-market valuation3 may increase due to the growing need for interest-bearing assets and hence new forms of collateral to securitize remain the dominant form of market-based credit provision (BCBS & IOSCO 2015).
‘Efficiency’ in regulatory terms denotes the need to pursue maturity transformation off-balance sheet in order not to be subject to higher regulatory capital ratios. Banks can outsource an established cash flow and free their balance sheet for further investment (Gorton & Souleles 2005). The interlinking of special purpose vehicles solved this problem. They also allowed for an expansion of seemingly secure assets backed by seemingly reliable hedging strategies based on ‘normal’ probability distributions of future events (Merton 1974; BCBS 2005). The bankruptcy prone off-balance sheet construction of the shadow banking system failed when the banks rescued their sponsored special purpose vehicles (SPVs) more out of fear of losing further credibility within a tumbling financial market than because of contractual obligations. Exposure to special investment vehicles (a type of SPV) shrank from $297 billion in 2007 to $45 billion in 2008 (Joint Forum 2009).
The image of shadow banking as a ‘money market funding of capital market lending’ (Mehrling et al. 2015) suggests an abstract understanding of the cash flow across traditional and shadow banking institutions. Indeed, shadow banking is often presented as the other side of banking, although it is the largest (investment) banks that make broad usage of arbitrage opportunities via the cash flow structure of the shadow banking system (Joint Forum 2009, 2015).
Mehrling’s (2012) inclusive vision of a functioning market-based credit system misses the reality of a global regulatory structure not backed by a sovereign entity like a self-contained nation state during the post-Second World War period of the last century. The next section sheds more light on how shadow banking can be explained and understood in a different way, focusing on the legal structures that enable and restrict certain cash flows or privilege particular financial products.
After the global financial crisis, the G20 (2010) called for tighter regulation of the shadow banking system, as it was marked as a primary source for the global spread of financial turmoil. The Financial Stability Board (FSB 2011b) is the main forum for setting the regulatory agenda for a more stable international financial architecture. Together with the Basle Committee on Banking Supervision (BCBS 2011) and the International Organization of Securities Commissions (IOSCO 2009), the FSB is to provide the means to rebalance and thus to stabilize the architecture of the international financial system.
Even though the FSB took up the new notion of shadow banking as brought forward by the G20, issues such as securitization (Plantin 2011), special purpose vehicles (Gorton & Soule-les 2005), off-balance sheet activities by banks (BCBS 1986) and the associated systemic risk (Hellwig 1995), and macro prudential regulation (Borio 2005) had long been discussed before the crisis. The new notion of shadow banking—non-bank intermediation chains for market-based credit provision—served as a node for a widespread regulatory agenda (FSB 2013). Research on re-intermediation practices (Rajan 2005), mark-to-market accounting (Plantin et al. 2005, 2007), and credit ratings through value-at-risk calculations (Fender & Kiff 2004) has highlighted in detail the systemic challenges posed by what is now called shadow banking.
Shadow banking is commonly defined as non-bank intermediation4 (FSB 2011b). What distinguishes banks from these non-banking entities is that the latter have no direct access to central bank liquidity; nor are they secured through a deposit insurance scheme. Hence, the run on the shadow banking system, which came to a height around the time of the Lehman Brothers’ failure in September 2008, had been fostered by the knowledge about the lack of institutional resources in times of crisis. It is thus commonly acknowledged that the trigger of the financial crisis was very similar to the ones associated with traditional banking crises in the light of which deposit insurance and the lender of last resort function (meaning contemporary central banks) had been put in place (Brunnermeier 2009; Moe 2012).
The shadow banking system relies on mainstream financial economics offering mathematical models to transfer the risk, for instance, of maturity or liquidity transformation (Bouvard et al. 2015). Maturity transformation practiced by banks means providing long-term loans and financing them through short-term debt. The shadow banking system performs a similar function although in reverse order and without the regulatory cushion. In order to reverse the maturity order, debt is transformed into a standardized category backed by risk calculations, credit insurance, collateral pools, and credit ratings. Thereby, long-term credit like mortgages can be transformed into well-tradable assets. Such a market-based credit system transfers (at least in theory) the attached risks directly to the holders of these assets (often banks themselves), without the traditional banking sector as an intermediary.
Legal entities, sometimes called SPVs or Other Financial Entities (OFEs), form a chain of different functions through which investors and creditors can be linked to the traditional banking system and therefore to the traditional back-up systems and regulatory obligations. Investments in the shadow banking system thus do not work in the ‘boring finance’ way—that is, when banks hold low interest-bearing deposits or government bonds through which they leverage investments in higher interest-bearing longer term credit portfolios. Rather, shadow banking can be understood as an off-balance sheet arrangement, which fosters and promotes new practices of securitization.
Thus, the ‘shadowy’ part of banking is created via directing financial flows through non-bank financial institutions, where the whole setting is mainly created by banks that charge for its usage but have no legal responsibility for its sustainability.5 It is the legal structure that enables (or does not forbid) what can be created, sold, and then included in the respective capital structures. Here, Hodgson’s (2015) legal institutionalism therefore points to ‘a disaggregated view.’ In this respect, Lysandrou & Nesvetailova’s (2015) recent study provides a better understanding of the practice of shadow banking than the aggregation of monetary amounts that arguably represent the shadow banking system. As evidenced by Pozsar et al.’ s (2010) mapping exercise, shadow banking is a way to legally enable certain financial products, which in turn interconnect the financial system in critical ways. These cannot be understood by merely looking at the size of monetary aggregates.
As such, the institutional structure allows the shadow banking system to create highly rated short-term products with interest rates above government bonds and significantly above the interbank rates, which are of interest especially to money market mutual funds (Bengtsson 2013; Chernenko & Sunderam 2014). The shadow banking system is able to absorb long-term or lower-rated products, which increase the demand for debt to be securitized; in fact, it establishes a fee-based originate-to-distribute arrangement through which earnings can be realized through transferring, for instance, default risks to investors (Brunnermeier 2009).6 Consequently, the system enables banks to manage their balance sheet in a way that makes it more ‘attractive’ for their shareholders (FSF 2008). This arrangement can also abate the high-risk appetite of other institutional investors through its ability to differentiate risk exposures. The main activity to achieve this is a mixture of risk mitigation strategies, such as liquidity facilities, credit default swaps (CDSs), or cash-flow waterfalls to produce what turns out as ‘pseudo-risk-less’ securities (Stein 2010), safe in good times but very risky in bad ones.
Securities—collateral backed financial instruments—function as a form of money within the shadow banking system, through which one is able to gain income in the form of interest payments correlated to the risk one is willing to take. Standard securities enable the pooling of multiple loans; this strategy has the benefit of not being exposed to total failure if a specific credit cannot be serviced. The second layer of securitization, the securitization of securities or so-called collateralized debt obligations (CDOs), provides risk stratification through trenching—that is, the creation of a so-called waterfall of cash flows from the upper tranches to the lower ones from which a calculated proportion of creditors can service their payment obligations. In the case of losses, this means that cash flows related to securities will first serve the upper tranches (super senior or senior tranches) before the intermediate (the mezzanine tranche) and finally the lowest positioned tranches (junior or equity tranches). In addition, and in order to further reduce risk exposures, financial innovation provides credit insurance for special investment vehicles and security tranches in the form of credit default swaps. In this way, insured upper tranches can receive the highest (triple A) credit ratings, whereas lower tranches can satisfy the hunger for higher returns (mezzanine tranches with B ratings, or unrated junior or equity tranches). Though usually only very secure assets are assigned the lowest default probability, based on such financial engineering, securities based on sub-prime mortgages can receive the highest triple A credit rating by the dominant rating agencies.7
This ‘entanglement’ points to the need for comprehensive regulation that does not rely predominantly on credit ratings. In the context of systemic disruptions, a change in credit ratings has similar effects to those of mark-to-market accounting, creating a high demand for liquidity in non-liquid times. What actually has been created is an enlargement of the capital basis for banks along with other opaque legal entities involved in creating financial products in order to hide their financial relations to banking institutions. The next section turns to the regulatory debate about shadow banking.
As outlined above, shadow banking provides a new way to create debt in a seemingly very profitable and, at the same time, low-risk way, at least as long as most parts of the financial system remain intact. However, as indicated by the Asian Financial Crisis and the failure of Long-Term Capital Management, an emergence of ‘super portfolios’ disrupts the effectiveness of hedging strategies (see MacKenzie 2003), especially if a seemingly highly improbable event challenges the financial order systematically. CDOs, for instance, can be highly efficient if the financial system complies with the projected risk trajectory, assuming that systemic events might happen once in a 1,000 years (implying that a financial system would last that long and that a single event could be imagined in similar distance from present times). The watering down of eligibility criteria for individual creditors and financial products has been long ignored. The systemic success of shadow banking produces new risk configurations through massive supply and demand for private debt—a self-reinforcing, systemic effect that should have been prevented by the pre-global financial crisis regulatory framework.
Considering that activities pertaining to the shadow banking system “often generate benefits for the financial system and real economy, for example by providing alternative financing to the economy and by creating competition in financial markets that may lead to innovation, efficient credit allocation and cost reduction” (FSB 2012: 3), ex post regulatory proposals can also be read as a blueprint to enable such intermediation chains and risk mitigation strategies.
The Basel framework for banking regulation interconnected the international banking system more closely by providing common standards, especially for capital requirements and capital transactions. Consequently, securitization can be pursued within an internationalized market through a common understanding of risk, allowing for the decreased hindrance of financial exchange by national borders. The different jurisdictional provisions concerning banking enable a practice of cherry picking the most suitable legal framework for enhancing and modifying the respective business strategies of financial firms.
As the Joint Forum (2009: 18) highlights: “because the Basel II framework is more risk sensitive, it is likely to have a material effect on bank investors in terms of their interest in various types of securities.” The heightened sensitivity of financial regulation compared to the Basel I framework for financial practices creates incentives for the increased compliance of asset portfolios with the risk hierarchies implemented via Basel II. What looked like a success of the regulatory process, however, turned out to be a trigger in demand for tailored investment products suitable for the respective risk portfolios of banks and provided by shadow banking, which thus became an incremental part of global financial intermediation (Plantin 2014).
One driver of this change was the inclusion of a portfolio invariant risk conception in regulatory standards. This established a singular understanding of risk, meaning that risk could be calculated and compared independently of its spatial, temporal, or institutional origin (Kessler & Wilhelm 2013). Thus, “diversification effects would depend on how well a new loan fits into an existing portfolio” (BCBS 2005: 4). The portfolio in question is made up of risk-weighted assets, which undergo a mark-to-market valuation. In this way, banks are asked to manage their balance sheets according to market variations in a shared governance system to keep up with the regulatory demands concerning their respective capital requirements.
Credit ratings for financial institutions and financial products provide a widespread standard along which the risk structure of a bank’s balance sheet can be calculated. When market developments are retained in the projected range of risk frames, credit ratings provide the ‘facts,’ which “suffice to determine the capital charges of credit instruments” (BCBS 2005: 4). The underlying formulae to calculate the needed regulatory capital contain, however, several assumptions about the functioning of markets (for example, differentiated risk weights for sovereign bonds and car loans). After a crisis, however, these assumptions seem to apply only if ratings had not been built into financial instruments, thus aligning the balance sheets of banks to regulatory requirements and potentially providing for a shared crisis trigger when ratings change for financial product categories.
One assumption built into the capital requirements calculation is that capital charges for long-term obligations should be higher than for short-term exposure. Lower capital charges for short-term investments and similar investment strategies create investment incentives and, thereby, demand for such products by money market funds. An increasing demand for an ‘efficient’ maturity transformation stimulates the need for (seemingly less riskier) short-term debt leading in turn to an increase in the rollover of long-term investments through the issuance of short-term securitized debt. To do so, the shadow banking system makes use of collateralized liabilities which can be produced more ‘efficiently’ off the traditional and regulated banking sector’s balance sheets (Plantin 2014).
Still needed to create such money-like securities is a high degree of standardization, that is, a high degree of information insensitivity paired with broadly accepted standards of transparency. Both aspects are achieved through the regulation of risk weights of securitization categories (especially asset classes like securities backed by prime mortgages), as well as external ratings provided by credit rating agencies. This combination creates an ‘opaque’ and, at the same time, a clear basis for investment decisions in favor of asset-backed securities and securities thereof (Gorton 2015).
There is a sense of there being enough information about abstract categories like a senior tranche of a mortgage portfolio, as well as a sense that the construction of structured investment products is immune to detailed disclosures of the performance of single mortgages. Thus, the rollover risk created through the transformation of single mortgages with long-term maturity into short-term securities can be eliminated, especially via the use of ‘risk neutral’ special investment vehicles. Only through such a legal structure can the exchange of collateralized products function in a money-like fashion.
Although trust in, and the liquidity of, shadow banking practices has vanished, regulators across the globe still try to refine the legal structure to make market-based banking more resilient (ECB & BoE 2014; ESRB 2015; FSB 2015a; BCBS & IOSCO 2015; IMF 2015). These efforts commonly agree about the need to provide more granular data about distinctive investment products, as well as the need to better understand how financial institutions are linked. Therefore, the importance of central clearing counterparties has risen due to further adjustment of the Basel scheme (BCBS 2011). The calculation of risk is now related to how banks interact (‘inter-connectedness’), to their lending along economic cycles (‘pro-cyclicality’), to their indebtedness (‘leverage ratio’), as well as to the size of banking institutions (‘too-big-to-fail’). Each source of risk is now counterbalanced by increased capital buffers (higher risk weights) or lending and borrowing limits (a leverage ratio) to be fully implemented by 2019.
The regulatory net within the European Union (EU), for instance, has been transformed fundamentally since 2008 in response to the global financial crisis. The European Commission proposed new or reformed directives and regulations that change the modes of financial interaction. Institutions like the European Banking Authority, the European Insurance and Occupational Pension Authority, the European Securities and Markets Authority, and the European Systemic Risk Board provide further insights into market operations. Together, these developments impact on a more general conception of financial markets in the EU.
The systemic interconnectedness of the credit system via shadow banking and across jurisdictions has been enabled by common regulatory constructions and complementary cash flows across the Atlantic. Regulatory agencies, private associations, individual, national, and regional actors are all accountable for triggering the build-up of systemic risk and its consequences, although, as separate entities, they are perhaps unaware of creating an unprotected credit system inherently prone to runs. The systemic disruption of the financial system after the Lehman Brothers’ failure created the need for further integration of the international financial order for credit and debt. This paradoxical situation—that is, regulating interconnectedness via a broader common regulatory framework—may not be resolved without understanding the sociopolitical underpinnings of the financial system. Further regulation may defer but not avoid systemic sensitivity.
Shadow banking reflects the increasing homogeneity of the global financial rules that have been pushed into the direction of globally shared categories for financial regulation and practices. This shift is accompanied by not only an unprecedented compatibility of the varieties of international financial capitalism, but also a synchronicity of reactions and consequences in times of crisis. Thereby, financial regulation becomes part of the production of global categories for risk, resilience, or even safety. These aspects, however, are not restricted to the economic domain; nor can they be separated from the socio-political production of purposes or value systems for financial relations. Heterodox economics, in contrast with the mainstream view, provides several pathways to understand the present regime of accumulation. Heterodox economics allows not only an abstract analysis of certain value regimes like currencies, government bonds, or other debt securities, but also an evaluation of the conjunction of financial and societal relations. The orchestration of shadow and traditional banking will not work within a clear-cut regulatory (global) space, but will allow variegation of specificities beyond financial relations. The socio-political aspect of finance and the financial aspect of politics and society have far reaching implications for the reasoning of one value system against another. In this context, finance is one analytical entry point to understand variegation and its associated socio-political hierarchies.
In this regard, the balance of public and private forces points to an ongoing struggle that is not restricted to the field of finance. The preference for private over public debt, debt over taxes, or growth over sustainability structures the financial world; finance, however, enables specific relations over others when conducted in the social world. This points to a rather old concept in institutional economics, that is, how to value the future, expressed in the notion of ‘futurity’ by John R. Commons (1925: 376) at a time when economics was closer to sociology, history, and other social science disciplines.
The notion of futurity allows for the analysis of conceptions of the future rooted in the present and for the structuring of financial flows. In this way, a broader understanding of the sociopolitical production for imaginary thinking is needed, which considers the institutionalizations of future imaginations in the present. Possibly one of the most prominent accounts may be represented by pension schemes; one of the most popular can be seen in science fiction movies as guidance for technological innovation.
The problem of shadow banking shows the ‘plumbing’ of such imaginaries, as it directs monetary resources accordingly. The recent global financial crisis and its widespread consequences raised questions not only about economic theory but also about the political systems governing global relations. After its seemingly local origin, the market interruption challenged long-standing practices of central banks, transnational banking, and international financial regulation. The crisis intervened into economic and political procedures previously perceived as the norm for financial interactions. Systemic interruptions, hence, provide a context within which not only the failure of rules comes to light, but also the assumptions about the normal perception of a time to come.
1 Financial innovation cannot be reduced to individual financial products; rather, it is the way in which financial flows are reconfigured and thereby create new connections between financial products and new organizational nodes (that is, financial institutions organizing exchanges). For a more detailed explanation see Guttmann (2016: Ch. 5).
2 One should not overlook the increasing involvement of central banks in financial exchanges as a counterparty connected to a greater number of financial institutions; and also via their balance sheets and the assets covering a more extensive spectrum of involvement.
3 Mark-to-market accounting is an asset value measurement method based on current market prices that directly link market volatilities to balance sheet exposures, such as securities for trading purposes. This means that capital ratios have to adapt to current market conditions, and that there has to be a market for such financial products in order to generate a market price—both aspects are rather critical for the soundness of financial institutions in the contexts of market turmoil or crisis.
4 Often this practice is also understood as dis-intermediation or a market-based credit system, as the main intermediaries between creditors and debtors (banks) are not directly involved. For the purpose of creating products suitable for a market-based credit system, such as Mortgage Backed Securities, the original mortgage contract has to pass thorough several legal entities, which extend the intermediation chain.
5 Money Market Mutual Funds, for instance, had been main drivers for the repackaging of mortgage loans into differentiated securities as they provide an alternative to government bonds in terms of the probability of default assumptions though promising higher returns.
6 The move from an originate-to-hold to an originate-to-distribute business model also marks the changing incentive structure for risk evaluations. There might be a greater incentive to look at the underlying collateral if banks want to hold a credit they originated to maturity than when they never held the asset but only orchestrate its legal creation. In the latter case, profit does not arise from interest but from fees, which encourage an expansion of the financial manufacturing industry, that is, shadow banking.
7 The role of credit rating agencies in misrepresenting the actual risk of structured financial products should not be understated, though there is a broad discussion on their role in generating the crisis dynamics through their conflicts of interest in the rating of financial products by the institutions that profit from higher rating results. This chapter however discusses more specifically the internal function of shadow banking.
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