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The vulnerabilities of debt in the shadow banking sector

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The shadow banking sector has managed to successfully replicate the functions of the traditional banking sector by creating a variant of demandable debt. However, debt in the shadow banking sector is not riskless. The paper says that it is vulnerable to not being rolled-over when market participants begin to suspect problems with the underpinning assets used for collateral and margining purposes. Thus, the produced debt is ‘runnable’. According to the author, for debt to be ‘safe’, the assets used for collateral and margin must be ‘information insensitive’. His key idea is that the asset has a credible underpinning, and he makes recommandations on how to put this into practice.

FSC Research Workshop 2019
29 October 2019
Policy paper contribution
Source: Financial Risk and Stability Network

Author:
Ross Spence, PhD Candidate, Leiden University

PDF   >  The vulnerabilities of debt in the shadow banking sector

The policy paper has been prepared as an accompanying contribution to the Financial Stability Conference 2019 in Berlin and presented at the FSC Research Workshop the following day. Researchers from various institutions were invited to draft policy papers on aspects of the conference topics and financial stability issues to be presented and discussed at the workshop.
Introduction

An essential pillar of the shadow banking sector (“SBS”) is the creation of ‘safe’ debt – transforming long term risky assets (for example bonds) into short term, safe ones (for example cash). Traditionally, only credit institutions could create safe debt by way of demand deposits but demand has now grown. The SBS has therefore managed to successfully replicate the functions of the traditional banking sector (“TBS”) by creating a variant of demandable debt, which is short-term, not subject to deposit insurance and credibly backed by a direct claim on liquidity.

However, the SBS cannot produce ‘riskless’ debt. Because debt in the SBS is not riskless, it is vulnerable to not being rolled-over when market participants begin to suspect problems with the underpinning assets used for financial collateral (“FC”) and margining purposes. This makes SBS produced debt ‘runnable’. In the SBS, a run is systemic event and generally a precursor to crises. When runs happen, asset prices crash, margin levels increase and fire sales ensue resulting in a cumulative downward spiral. The situation becomes particularly precarious when highly leveraged financial institutions are forced to de-leverage precisely at a time when market volatility is high and asset prices are low.

Conclusion

Debt is an essential function of the SBS – it is the ‘technology for conducting trade’ and is a necessity for an economy to function effectively. The origins of debt lie in the TBS but given the growing demand, the SBS has created a functionally equivalent debt contract to that found in the TBS. The SBS does this through the use of CFTs where long term securities, such as government bonds, are used as FC to secure short-term funding. The tenor of the CFT is generally short-term, albeit routinely rolled-over, so there is confidence in immediacy. Margin is applied to the transaction to provide a time horizon financial buffer thereby adding a further layer of security.

In order for SBS produced debt to be ‘safe’, the assets used for FC and margin must be ‘information insensitive’. The key idea is that the asset has a credible underpinning. This mitigates the costly production of information given there is nothing (or minimal) information worth knowing. However, such assets are not completely riskless and the transition from information insensitivity to information sensitivity can be extremely damaging. Of course the transition of an information insensitive government bond becoming information sensitive is very rare, but not inconceivable. Moreover, the fact that safe assets are now ‘scarce’, other forms of riskier assets are often relied upon to secure the debt contract. One way to mitigate the information sensitivities of debt is to apply higher margins at the point of trade.

Synonymous with information insensitivity is liquidity. The assets used for FC and margin have to be liquid if they are to be information insensitive. An asset that is liquid has money like equivalence in that it can be easily bought and sold in the marketplace without loss. When it is easy to raise funds in the market, funding liquidity is ‘high’, which means that markets are liquid. Indeed, more intermediation by the SBS results in more credit to the economy, which is important for production and consumption. In good times, when credit levels are high and market and funding liquidity are at an optimal, leverage levels are also high. The flipside is that more credit increases vulnerability. The fact that firms are highly leveraged directly translates into potential solvency problems if/when there is a shock to the system. If asset prices crash, the result is that market and funding liquidity simultaneously shrink. This means that market participants may find difficulty in raising funds to fulfil their obligations. The fact that margin levels will also rise to mitigate CTs’ losses, means that CGs will have to fund a higher proportion of the transaction with its own capital, which it may, or may not, be able to do. In this sense, margin is destabilising.

The author thereafter introduces three plausible policy recommendations that he founds useful to mitigate the vulnerabilities of debt within the SBS.

 

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