The loophole, shadow banking

The 'too big to fail' problem evolves to 'too interconnected to fail' through shadow banking.

For countries, where securities dominate financial products, shadow banking obstructs the implementation of macroprudential tools, such as the liquidity and capital ratio.

Securities surge systemic risk disabling macroprudential tools. Because financial funds are not concentrated in the banking sector, it becomes harder to regulate and monitor financial activities of thousands of security issuers.

Capital requirements do not bound the leverages in the financial sector since securities are off the balance sheet.

Consequences of securitization from the financial reporting perspective

Through securitization, financial agencies become an intermediary matching lenders with borrowers. While doing so, they do not concentrate credit risk. Instead of collecting deposits and providing credits, they match borrowers and lenders via securitization in return of a commission. The credit risk is hence distributed to thousands of firms that issue and guarantee securities.

Capital requirements only constrain the growth of assets that belong to financial agencies. Financial agencies can produce unlimited securities without owning them. Capital requirements have thereby been incapable of controlling leverages in security markets.

Pros

Financial reporting of securities generate serious consequences. First, banks do not undertake the credit or deposit risk, nor do they take the maturity risk. Credit risk belongs to the borrower and the guarantors. Banks also do not have to manage the maturity mismatch. In fact, the maturity transformation is fulfilled by the security itself (Armour et al. 1999). While the borrower is funded long-term, the security can be sold in the market any time needed.

Second, banks do not need to reserve extra capital or liquidity, because the risk arising from the liquidity and maturity transformation does not belong to banks. Thus, as a transaction facilitator, banks can match as many borrowers and lenders as possible.

Third, the credit risk is distributed to thousands of firms (Pozsar 2011). Hence collapse of a major bank is becoming less a concern. As the share of the banks in the financial sector decreases, the “too big to fail” risk becomes less of a concern. When the collateral of a certain asset type come out to be weak, the financials of the asset issuer, who is just one of the thousands of the issuers in the market, would be affected negatively; whereas, in traditional banking, a steep rise in the non-performing loan ratio of a large-scale bank can lead to undesired consequences for the whole banking sector.

Cons

In fact, the mentioned advantages can become disadvantages as well. Traditional banking was easier to control for the policy makers since the funds were centralized. Securitization enables funding of nonfinancial institutions outside the banking system.

Securitization decentralizes finance by transferring funds from banks to too many firms. The decentralization trend rarifies to analyze and manage the systemic risk. First, setting standards for non-financial institutions is not as easy as for banks since they vary in their sectors, size, needs etc. For an SME with no financial expertise, abiding the financial regulations would be too complicated. Second, supervision of the banking sector would be more efficiently handled compared to the supervision of thousand of firms.

Securitization as a source of systemic risk

Off balance sheet mechanism transfers the risk from banks to nonfinancial businesses and guarantors. Even though banks match parties of securitization, the credit risk belongs to a variety of borrowers and guarantors. Since securities do not belong to banks, traditional risk management tools such as capital and liquidity requirements fizzle out.

If the borrower does not pay the credit back, the asset backing security would be liquidized. In good times, high demand of securities inflates the price of collaterals causing price bubbles (Pozsar 2011). However in the crisis time, large-scale collateral liquidation causes steep price declines of the assets backing securities. Hence, governments need to ensure that there is no price bubbles in the collateral of the securities in the peacetime.

Besides decentralization, securitization fostered the interdependence among financial and nonfinancial firms. Each security transaction forms a credit relationship between parties irrespective of financial or nonfinancial classification. Hence, in the crisis time, the failure of a considerably small entity, which is 'too interconnected to fail', triggers the domino contagion effect. Therefore, governments should regulate and monitor securitization activities to ensure that they will not cause a contagion in the crisis time. As explained here, a macroprudential approach is essential to measure the interconnection risk.

Conclusion

Through securitization, banks match borrowers and lenders without taking risk and growing balance sheet. This approach exempts banks from liquidity and capital requirements. On the macro level, credit, liquidity and maturity risks are distributed from a couple of banks to thousands of nonbanks.

The securitization trend can be harmful in times of panic due to the rising interdependence among the banks and nonbanks. For the regulatory bodies, controlling the systemic risk became more complex since too many entities have been involving in providing financial services today.

References

Gary B. Gorton and Andrew Metrick, Securitization, 2013, Handbook of the Economics of Finance, Volume 2A, George Constantinides, Milton Harris, and Rene Stulz eds., 1 - 70, Elsevier. (Just read the first three sections).

John Armour, Dan Awrey, Paul Davies, Luca En riques, Jeffrey Gordon, Colin Mayer and Jennifer Payne, 1999, Principles of Financial Regulation (Oxford: Oxford Universit. Press), pp. 275-289.

Zoltan Pozsar. 2011, Institutional Cash Pools and the Triffin Dilemma of the U.S. Banking System, International Monetary Fund Working Paper 11/19.