UNIVERSITY OF AMSTERDAM AMSTERDAM BUSINESS SCHOOL
MASTER IN INTERNATIONAL FINANCE MASTER THESIS
COLLATERAL INTERMEDIATION
AND
SHADOW BANKING
Submitted by: ALPER KAY Supervised by: RAZVAN VLAHU AUGUST, 2013ABSTRACT
The aim of this paper is to provide an extensive overview of the growing role and importance of collateral intermediation in modern finance, mainly in the context of shadow banking. Use of collateral is a common practice for reducing counterparty risk in financial transactions. In modern finance, financial assets like treasury bonds, commercial papers and mortgage backed securities are used as collateral in complex lending and trading activities. Especially in the run-up to the latest financial crisis in 2008, there has been an increasing demand for high quality assets which can be used as collateral, and this demand is likely to increase further due to greater risk aversion of financial institutions. Because of the increasing demand, use of collateral has become a very important function of the global financial system. This growing importance comes with costs since such transactions are more complex than traditional financing activities and they are vulnerable to different type of risks. Therefore this new phase of global finance needs special attention on both institutional and regulatory level. In the first part of this paper, we first identify the shadow banking system in which most of the collateral transactions take place. Then, we investigate securitization which is one of the primary functions of shadow banking and an important source of collateral. Third part presents an overview of the collateral intermediation function, types of collateral transactions and market practices. Last part will provide a review of the current issues in the market.
TABLE OF CONTENTS
PART 1. INTRODUCTION 1
PART 2. SHADOW BANKING 2
2.1. What is Shadow Banking? 3
2.2. Why Does Shadow Banking System Exist? 4 2.2.1. Bank Runs and Introduction of Deposit Insurance 5
2.2.2. Regulation Q and Interest Rate Ceilings on Deposits 6
2.2.3. Emergence of Money Market Mutual Funds 7
2.2.4. Repo Market and Demand for Safe Assets 9 2.2.5. Pressure on Banks’ Fire Power –Regulatory Capital Requirements- 10
2.3. Shadow Financial Intermediation 11
PART 3. SECURITIZATION 14
3.1. How Does Securitization Work? 15
3.2. Primary Roles in Securitization 17
3.3. Why Do Banks Securitize Their Loans? 18
3.4. Securitization’s Role in Shadow Banking 20
PART 4. COLLATERAL INTERMEDIATION 21
4.1. Primary Drivers of Collateral Use in Capital Markets 22
4.2. Main Players in the Collateral Market 24
4.3. Collateral Based Transactions 25
4.3.1. Repurchase Agreements 25
4.3.2. Securities Lending 27
4.3.3. Re-hypothecation 29
4.4. Historical Evolution of Securities Lending and Repo Markets 30
4.5. Benefits on Macro and Micro Levels 32
PART 5. TOPICS OF DISCUSSION 33
5.1. Role of Shadow Banking in the 2007-2009 Crisis 33
5.2. Importance of Repo Markets and the Run on Repo 35
5.3. Haircuts 36
5.4. The Role of Rehypothecation and Velocity of Collateral 36
5.5. Collateral Scarcity 37
5.6. Other Issues 38
5.6.1. ABCP Conduits and Securitization Without Risk Transfer 38
5.6.2. Asset Encumbrance 39
5.6.3. Key Frictions in the Securitization Market 40
5.7. Concluding Remarks 41 REFERENCES
LIST OF FIGURES
Figure 1. US Shadow Bank Liabilities vs. Traditional Bank Liabilities Figure 2. A Simple Illustration of Traditional Banking
Figure 3. The Size of Cash Pools and Deposits
Figure 4. Distribution of U.S. Financial Assets by the Main Types of Financial Intermediaries
Figure 5. Total Net Assets and Number of Shareholders of Money Market Mutual Funds
Figure 6. A Simple Illustration of a Repo Transaction Figure 7. Channels of Financial Intermediation
Figure 8. Issuance of Corporate Debt and Asset-Backed Securities, 1990-2009 Figure 9. The Securitization Process
Figure 10. Tranching of Securities in a Waterfall Structure Figure 11. Illustration of a Repo Transaction
Figure 12. Illustration of a Securities Lending Transaction
Figure 13. An Example of Repeated Use of Collateral in a Dynamic Chain Figure 14. U.S. Private Label Securitization Market, 2001-11
Figure 15. Total Assets at 2007Q2
Figure 16. Repo Haircuts on Different Categories of Structured Products Figure 17. Shadow Banking System in the U.S.
Figure 18. The Safe-Asset Share
PART 1. INTRODUCTION
Use of collateral is a centuries-old contractual way for reducing counterparty risk in transactions. Traditionally, this method has been widely used in different types of traditional banking activities such as utilization of project finance deals and providing mortgage loans. A simple example of collateralization is pledging a house against the mortgage loan which is provided to buy that house. By pledging the property, the bank holds the right to liquidate the asset in case of a default, thus mitigating the repayment risk of the borrower.
Like physical goods, securities are also used as collateral for financial transactions, especially in capital markets. Unlike traditional banking, this is a more complex system in which non-bank financial institutions like dealer banks, hedge funds, custodians, broker-dealers and money market funds are also involved. Some of the securities that are used as collateral in this system are treasury bonds, corporate bonds, equities, collateralized debt obligations and mortgage backed securities. As mentioned above, this is a more complex system and there are various types of transactions and different scenarios in which securities are used as collateral. Main types of transactions are securities lending, repurchase agreements (repo) and over-the-counter derivatives. For example, a hedge fund (the pledgor) who holds some US Treasury Bills as an investment, can post these assets as collateral and source funding from a broker to use it for new investments. While the broker reduces the counterparty risk by receiving collateral against the loan it provides, the hedge fund enjoys efficient (or extra) use of its assets which otherwise sit idle in its books. A potential use for the broker is that it can borrow against the same collateral it received. For instance, the posted collateral can be re-used in a repo transaction in which broker gets funding from another hedge fund who needs those securities for covering its short position in the market. This practice of re-using collateral is called rehypothecation. Rehypothecation process can go on and on in a chain where a single security can be used as collateral by different parties for more than one transaction. The use of collateral has risen in the aftermath of the latest global financial crisis. As financial institutions have become more risk averse and regulatory focus has increased after Lehman Brothers’ collapse, financial activities have shifted towards secured transactions and use of collateral has increased sharply. These changes highlighted the growing importance of collateral for the functioning of the global financial system. During the same period, it has become apparent that use of collateral in complex financial transactions is one part of a broader system which is called shadow banking. In order to understand collateral’s role in modern finance, it is crucial to identify what shadow banking is and how it functions.
PART 2. SHADOW BANKING
Collateral intermediation is one of the main functions of the shadow banking system. To understand collateral’s ever-growing importance in modern finance, we first need to understand what the broader “shadow” system is. Shadow banking, which is the younger brother of traditional banking, has become a very important part of the financial system in the last 20 years. So important that the markets are heavily dependent on it for functioning properly, also very fragile to the problems it causes. Luttrell et al. (2012) point out that at its peak in 2008, US shadow banking liabilities was about $20 trillion, almost double the total size of commercial banks’ balance sheets, which was $11 trillion. This makes it apparent that shadow segment needs special attention from every part of the financial system. Figure 1 illustrates shadow vs commercial banks’ growth in the last 40 years. Shadow banking exceeded commercial bank liabilities after 1996 and it continued to grow until the financial crisis of 2008. Perotti (2012) further noted that while much reduced since 2008, in the USA, shadow banking’s size still exceeded bank assets in 2011.
Figure 1. U.S. Shadow Bank Liabilities vs. Traditional Bank Liabilities ($ trillion)
Source: Luttrell et al, 2012. Understanding the Risks Inherent in Shadow Banking: A Primer and Practical Lessons Learned
If you ask different members of the finance family, some of them will say that it’s difficult to survive without shadow banking, whereas some think it is a problem-child who has to be disciplined. Of course there are many different motivations behind these contrary thoughts. Banks advocate that shadow system allows risk sharing and efficient use of capital. Another supporting argument comes from institutional investors who say that shadow banking creates a new source of liquid and safe collateral for their transactions. In contrast, regulators think that it’s a manifestation of regulatory arbitrage which is prone to systemic shocks and therefore needs to be carefully controlled. Although above figure already gives some clue about these
different approaches, we ‘ll further investigate the motivations behind shadow intermediation in the following sections.
2.1. WHAT IS SHADOW BANKING?
But what is this shadow banking really? Shadow banking is a complex form of financial intermediation where a chain of activities is performed by regular banks and non-bank financial intermediaries in order to channel funding from savers to investors through a range of securitization and secured funding techniques. Simply, it is the process of pooling, tranching and transforming illiquid financial assets (e.g. residential mortgages, auto loans, student loans) into liquid securities which are then used for trading and pledging outside the regulated financial system. In its broadest definition, shadow banking includes such familiar institutions as investment banks, money-market mutual funds (MMMFs), and mortgage brokers; some rather old contractual forms, such as sale-and-repurchase agreements (repos); and more esoteric instruments such as asset-backed securities (ABSs), collateralized debt obligations (CDOs), and asset-backed commercial paper (ABCP) (Gorton and Metrick, 2010a). Financial Stability Board (2011) describes shadow banking as “the system of credit intermediation that involves entities and activities outside the regular banking system”. Pozsar et al (2010) define shadow banks as “financial intermediaries that conduct maturity, credit, and liquidity transformation without access to central bank liquidity or public sector guarantees”.
The term “shadow” banking was first coined by Paul A. McCulley in August 2007 at the Fed’s annual symposium in Jackson Hole. According to McCulley (2009), unlike conventional regulated banks, unregulated shadow banks fund themselves with uninsured short-term funding, which may or may not be backstopped by liquidity lines from real banks. Since they fly below the radar of traditional bank regulation, these levered-up intermediaries operate in the shadows without backstopping from the Federal Reserve’s discount lending window or access to FDIC deposit insurance. ICMA (2012) defines shadow banking as an alternative (and pejorative) term for market finance. Shadow banking is market-based because it decomposes the process of credit intermediation into an articulated sequence or chain of discrete operations typically performed by separate specialist non-bank entities which interact across the wholesale financial market.
All these different definitions suggest that this type of financial intermediation is performed outside the regulated financial system. But why were there a need for such a complex parallel system?
2.2. WHY DOES SHADOW BANKING SYSTEM EXIST?
According to Acharya and Oncu (2010), the emergence of a shadow banking system in the United States may be traced as far back as the early 1970s. Gorton and Metrick (2010a) supports this argument and adds that shadow banking is the outcome of fundamental changes in the financial system in the last 30 to 40 years, as a result of private innovation and regulatory changes that together led to the decline of the traditional banking model. According to Pozsar (2008), the traditional model of banking –borrow short, lend long, and hold on to loans as an investment—has been
fundamentally reshaped by competition, regulation and innovation. One force came from the supply side, where a series of innovations and regulatory changes eroded the competitive advantage of banks and bank deposits. A second force came from the demand side, where demand for collateral for financial transactions gave impetus to the development of securitization and the use of repos as a money-like instrument. Both of these forces were aided by court decisions and regulatory rules that allowed securitization and repos special treatment under the bankruptcy code (Gorton and Metrick, 2010a). As a source of funds for financial intermediaries, deposits have steadily diminished in importance. In addition, the profitability of traditional banking activities such as business lending has diminished in recent years. As a result, banks have increasingly turned to new, nontraditional financial activities as a way of maintaining their position as financial intermediaries (Edwards and Mishkin, 1995). As most of the academics agree, a chain of historical events and changes that occured in financial markets have triggered the emergence of shadow banking system. Bank runs and Great Depression introduced deposit insurance for retail investors but this was not able to meet the demand of institutional investors since deposit insurance was and has always been limited to a certain amount for each account. Also, with the Federal Deposit Insurance System, banks were prohibited to pay interest on demand deposits and interest rates on savings accounts were capped. In response to these challenges (mainly) for institutional investors, money market mutual funds were created. These instruments act as an insured investment for institutional investors since they invest only in high quality and liquid assets. But as these funds have grown so much, availability of sufficient amount of high quality assets came into question. During the same period, regulations on banking –like minimum capital requirement ratios- have forced banks to find new instruments which require less (or no) capital than traditional banking activities and contribute to the expansion of banks’ business. Also, emergence of repo markets has driven the increasing demand for high quality safe assets. Due to these developments, financial world has shifted towards an alternative system where transactions are more complex than traditional banking and
2.2.1. Bank Runs and Introduction of Deposit Insurance
In traditional banking, there are 3 main actors: savers, borrowers and banks. Savers are primarily households with savings and firms with excess cash, whereas borrowers are households and firms who need loans for investments such as buying a house or building a new factory. As illustrated in the below figure, banks act as intermediaries who obtain funds from savers in the form of deposits and provide these funds to borrowers as loans.
Figure 2. A Simple Illustration of Traditional Banking
While savers prefer deposits to be of a shorter maturity (to be able to use their savings whenever it’s needed), borrowers usually require loans of longer periods. Banks manage this maturity mismatch by exploiting the general belief that only a small portion of savers have sudden liquidity needs at a given time. Therefore, banks hold a small portion of deposits in the form of liquid assets –which are easy to convert into cash- and lend the rest as illiquid loans. This function of traditional banking is known as maturity transformation. However, by doing this, banks become fragile to bank runs1. A bank run occurs when a large number of customers withdraw their deposits from a bank at the same time. This kind of events happen when there is a sign of trouble about bank’s financial situation and such bank runs can easily lead to a banking panic which effects the whole system. In history, governments made numerous attempts to stabilize deposits through different schemes such as clearinghouses, but these attempts didn’t stop bank runs and banking panics happening until after the Great Depression. These runs were ended in the United States in 1934 through the introduction of Federal Deposit Insurance. With their deposits insured by the government, savers have little incentive to withdraw their funds when the financial situation of the bank comes into question. This insurance scheme works well for retail (household) investors, as most of the retail deposits are below the limit of deposit insurance, which is 250.000 $ as of 2013. But this cap on deposit insurance leaves a challenge for institutional investors like pension funds, municipalities and some other nonfinancial companies with (millions of dollars of) large cash holdings as they lack access to safe (insured) , interest earning , short-term (liquid) investments. Below figure illustrates the increasing size of institutional cash pools. Pozsar (2011) calculated that the volume of institutional cash pools rose from $100 billion in 1990 to over $3.8 trillion (conservative estimate=$2.2 trillion) at their 1 For more information on bank runs, please check Xavier Freixas and Jean-Charles Rochet’s book
peak in 2007 (3700% growth). He also estimated that in 2010, institutional cash pools stood at $3.4 trillion (conservative estimate=$1.9 trillion).
Figure 3. The Size of Cash Pools and Deposits
Source: Claessens et al, 2012. Shadow Banking Economics and Policy
Cap on deposit insurance was an important factor for institutional cash pools’ shift towards alternative investments. According to Pozsar (2011), insured deposit alternatives dominate institutional cash pools’ investment portfolios relative to deposits and the principal reason for this is not search for yield, but search for principal safety and liquidity. As documented in his study, between 2003 and 2008, institutional cash pools’ cumulative demand for short-term government guaranteed instruments (as alternatives to insured deposits) exceeded the supply of such instruments by at least $1.5 trillion. The “shadow” banking system rose to fill this vacuum, through the creation of safe, short-term and liquid instruments.
2.2.2. Regulation Q and Interest Rate Ceilings on Deposits
Another challende for large depositors is the Regulation Q which was introduced with the Federal Deposit Insurance System. Regulation Q prohibited the payment of interest on demand deposits and authorized the Federal Reserve to set interest rate ceilings on time and savings deposits paid by commercial banks. The motivation behind the introduction of Reguation Q was the perception that the bank failures during 1930s had been the result of excessive bank competition for deposits which encouraged speculative investment behavior on banks. Because of interest rate ceilings and limits on deposit insurance, there was a great demand for bank substitutes that were safe yet could deliver a higher yield than banks were legally permitted. The imposed interest rate and insurance cap on deposits encouraged the creation of alternatives to banks, including money market funds. According to Gorton and Metrick (2010a), money market mutual funds were a response to interest rate ceilings on demand deposts.
2.2.3. Emergence of Money Market Mutual Funds
A money market fund is a type of mutual fund that is required by law to invest in low-risk instruments such as US Treasury bills , commercial papers or other highly liquid and low-risk securities. Money market funds seek to maintain a net asset value of 1 $ per share, which means that their aim is to never lose money. These funds are closely regulated by the SEC under the Investment Company Act of 1940 and the rules adopted under that Act, particularly Rule 2a-7 under the Act. This rule restricts the quality, maturity, liquidity and diversity of investments made by MMMFs. Money market funds are required to hold a diversified portfolio composed of high-quality securities that pose minimal credit risks. The fund must maintain sufficient portfolio liquidity to meet reasonably foreseeable redemption requests. They must also invest in securities that are considered short-term.
According to Olson (2012), many investors came to believe that MMMFs were so thoroughly restricted by regulation that they had an implicit government guarantee, a viewpoint somewhat validated when the funds were essentially bailed out in 2008. Like other mutual funds, money market fund shares can be bought or sold at any time. Besides, these vehicles were not subject to deposit rate ceilings. So, theoretically they have the potential to offer higher yields than bank deposits. These features of MMMFs let them become one of the primary investment tools for big cash pools and fill the gap for institutional investors’ need for safe and liquid instruments. Below figure illustrates that starting from 1950s, banks -depository institutions- have been losing ground to other intermediaries. And significant portion of these other intermediaries consists of mutual funds.
Figure 4. Distribution of US Financial Assets by the Main Types of Financial Intermediaries
Cook and Duffield (1979) argues that the rapid growth of MMFs in 1978 and 1979 has been both a reaction to government regulations and a result of fundamental changes in the way some institutional and individual investors manage their short-term financial assets. MMMFs really took off in the mid-1980s, their assets growing from $76.4 billion in 1980 to $1.8 trillion by 2000, an increase of over 2,000 percent. Assets of MMMFs reached a peak of $3.8 trillion in 2008, making them one of the most significant financial product innovations of the last 50 years. (Gorton and Metrick, 2010a).
Below figure, which is extracted from Investment Company Institute’s 2013 Annual Investment Company Fact Book, illustrates money market mutual funds’ growth in the last 25 years. According to the data provided in the Fact Book, total assets of money market funds grew from $292 billion in 1986 to $3.8 trillion at its peak in 2008, which is equal to 1/4 of commercial banks’ total assets in the same year. After its peak in 2008, total assets of money market funds declined due to the crisis and stood at $2.7 trillion level in 2012. Considering its short history, money market funds have seen a very rapid increase in assets. Primary reason for this is the ability to act as a substitution of bank deposits for large cash pools.
Figure 5. Total Net Assets and Number of Shareholders of Money Market Mutual Funds
0" 10,000" 20,000" 30,000" 40,000" 50,000" 60,000" 0" 500,000" 1,000,000" 1,500,000" 2,000,000" 2,500,000" 3,000,000" 3,500,000" 4,000,000" 4,500,000" 1986" 1987" 1988" 1989" 1990" 1991" 1992" 1993" 1994" 1995" 1996" 1997" 1998" 1999" 2000" 2001" 2002" 2003" 2004" 2005" 2006" 2007" 2008" 2009" 2010" 2011" 2012" Total"Net"Assets"(mn"$)" Total"#"of"Shareholder"Accounts"('000)"
2.2.4. Repo Market and Demand for Safe Assets
Development of repo markets has also played an important role in the creation of shadow banking because it added to the increasing demand for safe assets. A repurchase agreement (repo) is a financial contract used by market participants as a financing method to meet short-term liquidity needs. It is the sale of securities together with an agreement to buy back the securities at a higher price on a later date. Securities used in this type of transactions include treasury bills, corporate bonds, commercial papers and asset backed securities. Below figure demonstrates a simple view of a repo transaction. In this example, a repo seller (for instance a broker-dealer) agrees with a repo buyer (for instance a money market fund) to sell U.S. Treasury securities at T0 and buys back the same securities at T1 at a higher price. So, basically securities act like a collateral in repo transactions. From money market fund’s point of view, repo allows them to invest their cash in a secured transaction in which they hold securities as collateral. From broker-dealer’s point of view, repo transaction allows them to expand their funding sources.
Figure 6. A Simple Illustration of a Repo Transaction
Source: SIFMA, 2012. Repo Market Fact Sheet
Because of institutional investors’ strong preferences on safety, they are not fit to be intermediated through the traditional, deposit funded banking system. Therefore, for
large depositors like pension funds, mutual funds and other institutional investors, repos can be a good substitute for insured demand deposits because repo agreements are excluded from Chapter 11, which means they are not subject to the automatic stay in bankruptcy. Repos also don’t bear any limits on interet rates. So, they can earn higer interest rates than commercial bank deposits.
The repo contract allows either party to enforce termination of the agreement as a result of a bankruptcy filing by the other party. This feature allows a lender to terminate its repo with a bank and sell the collateral if the bank becomes insolvent. As money under management by institutional investors grew, use of repurchase agreements has increased as well. Especially during the period of high inflation in the 1970s , rising short-term interest rates made repos highly attractive short-term investments for institutional investors. Because unlike commercial bank deposits, repo transactions don’t have any interest rate ceilings and they are safer for large cash pools as they are backed by a collateral. So large cash pools prefer repo over bank deposits mainly for two reasons: 1- to earn higher yields , 2- to get insurance.
According to Gorton and Metrick (2010a), one key driver of the increased use of repos is the rapid growth of money under management by institutional investors, pension funds, mutual funds, states and municipalities, and nonfinancial firms. These entities hold cash for various reasons but would like to have a safe investment that earns interest, while retaining flexibility to use the cash when needed—in short, a demand deposit-like product. In the last 30 years these entities have grown in size and become an important feature of the financial landscape. For example, according to the Bank for International Settlements (BIS 2007, p. 1, note 1), “In 2003, total world assets of commercial banks amounted to USD 49 trillion, compared to USD 47 trillion of assets under management by institutional investors”. Pozsar (2011) argues that relative to the aggregate volume of institutional cash pools, however, there was an insufficient supply of short-term government-guaranteed instruments to serve as insured deposit alternatives. This shortage amounted to $1.1, $1.6 and $1.6 trillion in 2005, 2006 and 2007, respectively, and has been exacerbated by increasing foreign official holdings of short-term government guaranteed instruments since 2000. With a shortage of short-term government-guaranteed instruments, institutional cash pools next gravitated—almost by default—toward the other alternative of privately guaranteed instruments, fueling the secular rise of the non-bank-to-bank subset of wholesale funding markets and the “shadow” banking system in general. Institutional cash pools’ increasing demand for safe, short-term and liquid instruments was one of the primary reasons that gave birth to “securitization” which will further be discussed in the following sections.
2.2.5. Pressure on Banks’ Fire Power -Regulatory Capital
Requirements-Up to this point, we discussed developments mainly on inverstors’ side. Another very important factor in the run up to the creation of shadow banking was capital requirements in the banking sector2. The introduction of capital requirements in 1981, and the various revisions of those requirements in the decades since then (under the Basel capital rules), has had the significant unanticipated consequence of motivating banks to move assets off their balance sheets in order to avoid the regulatory capital cost (Olson, 2012). The last major overhaul of bank capital requirements, commonly referred to as the Basel Accord, was agreed to in 1988 and implemented in the United States from 1990. The 1988 agreement implemented what have become known as risk-based capital requirements, which mandated, for the first time, different capital requirements for different assets. In particular, banks were required to hold a higher percentage of equity capital per loan than per government security, to reflect the presumption that loans are more risky than securities. Because these requirements made lending relatively more expensive than purchasing securities, banks were given an incentive to shift their portfolios away from loans into securities. Shortly following the introduction of the 1988 accord, banks reduced their investments in commercial lending and simultaneously began to hoard government securities. The share of total bank credit invested in commercial and industrial loans fell from around 22.5% in 1989 to less than 16% in 1994. The share of total bank credit invested in U.S. Government securities increased from just over 15% to nearly 25% over the same time period (Furfine, 2001). Since government securities are limited in supply and also not as profitable as commercial loans in general, banks had to find another way to expand their businesses. According to Pennacchi (1988), banks faced with significant competition for deposit financing, as well as regulatory constraints in the form of required capital and/or reserves, cannot profit by simply holding money-market assets but must provide other services. Loan sales can reduce the cost of funding these loans. Gorton and Metrick (2010a) argues that if bank regulators impose capital requirements that are binding (that is, that require banks to hold more capital than they would voluntarily in equilibrium), then, when charter value is low, bank capital will exit the regulated bank industry. One way to do is through off-balance-sheet securitization, which has no requirements for regulatory capital.
2.3. SHADOW FINANCIAL INTERMEDIATION
There are 3 main types of financial intermediation. One is direct lending. Direct lending means that there is no any intermediary involved. So, lender and borrower
2 An extensive review of the subject can be found on the paper “Jackson et al (1999), Capital
interacts with each other directly. The Second one is traditional banking, where banks intermediate the transformation of savings to credits. The third type of credit intermediation is shadow banking, where multiple entities intermediate the transformation of savings to credits. Below figures is a simple demonstration of these 3 types.
Figure 7. Channels of Financial Intermediation
Nonintermediated Direct Lending (no intermediary)
Traditional Banking (Intermediated)
Shadow Banking (Multiple Intermediaries)
Households Business borrowing Bank originates loans but instead of holding them,
distributes the loans to capital markets through multiple steps and intermediaries.
Households Business Borrowing Individual
Bank originates and holds loans Households Business Borrowing Corporations Institutions Securities Lenders Pension Funds SOURCE OF
FUNDS CREDIT INTERMEDIATION USE OF FUNDS
Households / Corporations
Households
Source: Interpreted from Luttrell et al, 2012. Understanding the Risks Inherent in Shadow Banking: A Primer and Practical Lessons Learned.
In the traditional model of financial intermediation, banks take deposits from savers and lend out these deposits to borrowers. This is done by performing three important activities: maturity, liquidity and credit transformation. Maturity transformation refers to using short-term deposits to fund longer-term loans. Deposits are banks’ liabilities which are collected from households and firms. Since traditionally, deposits have shorter maturity than loans, banks assume the risk of rollovers and duration. They have pools of deposits with different maturities, which allow them to conduct financing without being exposed to maturity mismatch. Liquidity transformation refers to the difference between bank’s assets and liabilities in terms of liquidity. Liabilities, which are mostly composed of deposits, are available on demand at any time. Basically, they are very liquid. In contrast, assets of a bank –loans- usually have longer and fixed maturities, which means that they are not as liquid as deposits. So, if all deposit customers withdraw their money at the same time, the bank may not be able to finance all of its loans. To avoid such an illiquidity problem, banks are required to hold a portion of the deposits as cash. Also central banks provide deposit insurance to deposit holders to avoid simultaneous cash withdrawals. These features give banks the ability to use liquid liabilities (deposits) to fund illiquid assets (loans). Credit transformation refers to the ability to fund lower quality loans by issuing higher quality debt mainly due to the presence of bank’s equity. Performing these
inherent in financial intermediation, governments support banking sector with public sector guarantees such as deposit insurance and liquidity backstops in the form of discount window. While deposit insurance shields banks from maturity mismatch risk, discount window provides liquidity backstop to banks during times of stress.
Shadow banking, which is a market-based system, decomposes credit, maturity and liquidity transformation functions of a traditional bank into several different roles. These roles, organized around securitization and wholesale funding, are performed by different bank and non-bank specialist institutions who don’t have access to public sector guarantees. Like traditional banks, shadow intermediaries’ ultimate role is to create a flow of credit from savers to borrowers. Although shadow banks resemble the traditional credit intermediation role of banking, they do it in several steps in multiple balance sheets rather than a single balance sheet. These steps include loan origination, securitization (including loan warehousing, ABS issuance, ABS warehousing) and wholesale funding. Traditional banks or other regulated finance companies originate loans (majority being long-term loans such as auto loans and motgages) and transfer them to special purpose vehicles. With the support of credit agencies and broker-dealers, these vehicles warehouse the loans and pool them into tranches with different risk categories. Then, broker-dealers intermediate the issuance and marketing of securities which are backed by these asset pools. Finally, investors like money market funds purchase these asset backed securities in wholesale funding markets. As it can be seen, several different specialist institutions are involved in the wholesale funded securitization based credit intermediation process. Through securitization, loans are converted into tradable instruments. These instruments are then funded in capital markets via transactions such as commercial papers and repos. This intermediation chain transforms long-term, risky and illiquid assets to seemingly short-term, safe and liquid claims which are then used in capital markets as an investment. Unlike traditional banking, in which all risks are gathered in banks’ balance sheets, shadow credit intermediation disperse financial risks across the whole economy. This improves credit availability, lowers cost of funding and diversifies both credit risks and funding sources.
Shadow banking doesn’t have access to deposit insurance and liquidity backstops. Absence of public sector guarantee leaves shadow banking susceptible to runs. To avoid such circumstances, shadow intermediaries use various risk mitigation tools like credit ratings, liquidity support from broker-dealers and collateral backing as a (explicit) private sector guarantee.
PART 3. SECURITIZATION
Securitization, which is one of the most important financial innovations of the latest century, is an outcome of increasing regulatory pressure on banking and capital markets’ demand for safe assets. It is the process through which a variety of financial assets (usually commercial bank loans like mortgages) are packaged into securities and then sold to investors. By converting their loan portfolios to securities, banks can free-up regulatory capital and also serve these securities to capital markets where there is an increasing demand for safe and liquid assets.
Securitization’s origins date back to the Great Depression, when there were historically high levels of unemployment rates and an unprecedented wave of loan defaults in USA. These issues in the economy had disastrous effects on the housing market. In order to overcome these problems, Federal Housing Administration (FHA) was created to help reviving the housing market and protecting the lenders from loan defaults. The role of the FHA was to provide insurance against loan defaults in the housing sector. In 1938, Fannie Mae was chartered to create a secondary mortgage market by purchasing FHA-insured loans from lenders and thus provide liquidity to support the flow of credit. In 1968, Fannie Mae was split into 2 separate corporations; Fannie Mae to purchase non-government backed mortgages, and Ginnie Mae to provide timely payment guarantee for the mortgage backed securities which are backed by loans that are insured by FHA (or the government). In 1985, securitization techniques that had been developed in the mortgage market were applied for the first time to a class of nonmortgage assets — automobile loans. A pool of assets second only to mortgages, auto loans were a good match for structured finance; their maturities, considerably shorter than those of mortgages, made the timing of cash flows more predictable, and their long statistical histories of performance gave investors confidence. Since then, securitization technology has been applied to a number of different sectors such as credit cards, student loans, commercial mortgages and auto loans. Federal Reserve Flow of Funds data show that the ratio of off-balance-sheet to on-off-balance-sheet loan funding grew from zero in 1980 to over 60% in 2007 (Gorton and Metrick, 2010a). Below figure shows the annual issuance of all securitized products versus corporate bonds as a comparison. As shown in the figure, both corporate bonds and asset backed securities go almost parallel to each other until 2000s, when securitization really took off. In 2006, annual ABS issuance reached record high levels of $1.6 trillion and then dropped significantly in 2008 due to the crisis.
Figure 8. Issuance of Corporate Debt and Asset-Backed Securities, 1990-2009 (trillions of dollars)
Source: Gorton and Metrick, 2010a. Regulating the Shadow Banking System
According to Adrian and Ashcraft (2012), securitization is at the heart of shadow banking, as it allows credit originators to sell pool of credit to other institutions, thereby transferring the credit risk. The shadow banking system decomposes the credit intermediation into a chain of wholesale-funded, securitization-based lending. Through shadow intermediation process, the shadow banking system transforms risky, long-term loans (subprime mortgages, for example) into seemingly credit-risk-free, short-term, money-like instruments. Claessens et al (2012) claims that securitization is the first key shadow banking function, and it is a process that, through tranching, repackages cash flows from underlying loans and creates assets that are perceived by market participants as fully safe. This function caters to institutional cash pools that seek deposit-like safe investments and to banks that use securitized debt for repo funding and to boost leverage. Noeth and Sengupta (2011) put out that in modern banking, origination of loans is done mostly with a view to convert the loan into securities—a practice called securitization, whereby the transaction, processing and servicing fees are the intermediaries’ principal source of revenue. Due to increasing competition and regulations, banks shifted their activities from originate-to-hold model to originate-to-distribute by transforming their long-term loan portfolios to short-term tradable investment instruments.
3.1. HOW DOES SECURITIZATION WORK?
But how does this originate-to-distribute model work? Instead of holding long term and illiquid assets like mortgage loans on their balance sheet, banks pool all these loans together and sell them to other entities, often called as a special purpose vehicle. Then, SPVs (asset-backed commercial conduits) issue rated securities which are backed by these assets (loan pools) and sell their shares to investors through intermediaries. This structure allows banks to transfer risk to the investors who are
willing to hold it and eases banks’ balance sheet with regards to the minimum capital requirements. Also, with the new funds raised through securitization, banks can increase their lending and revenues.
According to Cetorelli and Peristiani (2012), under the securitization model, lending (loan origination) constitutes not the end point in the allocation of funds, but the beginning of a complex process in which loans are sold into legally separate entities, only to be aggregated and packaged into multiple securities with different characteristics of risk and return that will appeal to broad investor classes. And those same securities can then become the inputs of further securitization activities. Below figure demonstrates a simplified view of securitization process. As it can be observed in the figure, securitization divides banks’ traditional role of credit intermediation into several steps which can be summarized as pooling of assets (loans), transferring the pools to SPVs, tranching of pools into several risk categories and distributing these tranches to investors.
Figure 9. The Securitization Process
Source: Gorton and Metrick (2010a): Regulating the Shadow Banking System
Securitization process redistributes a bank’s traditional role of intermediation into several specialized functions. These functions are performed by different entities in several steps. In the first step, the bank –or the originator of loans- identifies the loans (usually mortgage loans, auto loans, credit card receivables, student loans, consumer loans etc.) that it wants to remove from its balance sheet and pools them together into a portfolio. It then sells this asset pool –portfolio- to an external legal entity, often called a special purpose vehicle –or the issuer-. At this point, since it’s a true sale, pooled loans leave bank’s balance sheet and move to SPV’s balance sheet. The SPV finances the purchase of the pooled loans by issuing tradable, interest-bearing securities that are backed by those assets. In general, these securities are called asset backed securities. If the underlying loan is a mortgage, then they are referred to as
different risk level and rating. Then, the issuer sells these security shares to capital market investors. The investors receive fixed or floating rate payments from a trustee account funded by the cash flows generated by the loan portfolio. In most cases, the originator services the loans in the portfolio, collects payments from the original borrowers, and passes them on—less a servicing fee—directly to the SPV or the trustee.
3.2. PRIMARY ROLES IN SECURITIZATION
There are several different parties involved in the process of asset securitization. Originator, as the name suggests, is the bank who originates the underlying loan portfolio. It is sometimes referred to as the sponsor. Originator is the initial owner of the underlying assets. It pools together a selected portfolio of loans and transfers these assets to a special purpose vehicle. Issuer is the special purpose vehicle who issues security shares which are backed by the loan pool. Underwriter represents the issuer, analyses investor demand and splits securities into tranches accordingly. It is also responsible for marketing and selling the securities. Another role of the underwriter is to provide liquidity support to the securitization in the secondary market. Rating agencies publish ratings for different tranches of the issued securities. Servicer, is the party who handles the payments and interaction with ultimate borrowers of the loans. Servicer’s primary responsibilities are to collect and divert cash flows of loan repayments, to monitor borrowers’ performance, and if needed, to liquidate the collateral in the event of default. Originator bank can often be the servicer. Trustee, is an independent firm responsible for the management of SPV, distributing payments to investors and protecting the rights of the investors.
SPVs play a key role in the process of securitization. They are specifically designed to move the assets from the balance sheet of the originator and convert them into tradable securities. Gorton and Metrick (2010a) argue that in order to understand the potential economic efficiencies of securitization, it is important to understand how the SPV structure works. An SPV has no purpose other than the transaction or transactions for which it was created; it can make no substantive decisions. SPVs are set up specifically to purchase the assets and realize their off-balance-sheet treatment for legal and accounting purposes. First important feature of SPVs is that they are bankruptcy remote, meaning that if the originator bank goes into bankruptcy, the assets of the issuer will not be distributed to the creditors of the originator. It also means that the SPV itself can never become legally bankrupt. Bankruptcy remoteness comes into effect by a –true sale- of the underlying assets. In a true sale, originator bank surrenders the control of receivables and loans are transferred to the balance sheet of the SPV. According to Cetorelli and Peristiani (2012), the transfer of the assets to the SPV has the legal implication of obtaining a true sale opinion that
removes originator ownership and insulates asset-backed investors in the event of a bankruptcy.
Another important feature of SPVs is slicing and transformation of loan pools into different tranches of tradable securities such as asset backed commercial papers (ABCP), residential mortgage backed securities (RMBS), and collateralized debt obligations (CDO). As illustrated in the below figure, several classes (tranches) of securities are issued each with different risk-return profiles.
Figure 10. Tranching of Securities in a Waterfall Structure
Source: Noeth and Sengupta (2011), Is Shadow Banking Really Banking? -
Brunnermeier (2008) explains that these tranches are then sold to investor groups with different appetites for risk. The safest tranche -known as the “super senior tranche”- offers investors a (relatively) low interest rate, but it is the first to be paid out of the cash flows of the portfolio. In contrast, the most junior tranche -referred to as the “equity tranche” or “toxic waste”- will be paid only after all other tranches have been paid. The mezzanine tranches are between these extremes. The exact cutoffs between the tranches are typically chosen to ensure a specific rating for each tranche. For example, the top tranches are constructed to receive an AAA rating. The more senior tranches are then sold to various investors, while the toxic waste is usually (but not always) held by the issuing bank, to ensure that it adequately monitors the loans. There is also the practice that banks keep some part of senior tranches on their balance sheets to attract repo funding and through this to boost leverage.
3.3. WHY DO BANKS SECURITIZE THEIR LOANS?
Banks securitize their loan portfolios for various reasons. Primary motive of securitization is regulatory capital arbitrage. Suppose that a bank’s existing regulatory capital can’t afford any additional loan issuance. In this case, in order to
securitizing a portion of existing loan portfolio, the bank can release some regulatory capital and use it for new loans. According to Altunbas et al (2009), by removing loans from their balance sheet, banks can obtain regulatory capital relief on account of the transfer of credit risk, which allows for a positive net effect on the loan supply. Jackson et al (1999) argues that banks in a number of countries are using securitisation to alter the profile of their book. This may make a bank’s capital ratio look artificially high, relative to the riskiness of the remaining exposures, and in some cases may be motivated by a desire to achieve exactly this. According to Affinito and Tagliaferri (2010), in order to meet both economic capital requirements linked to market discipline, and mandatory capital requirements linked to regulation, banks traditionally had two ways to choose from: Either they altered the numerator, for instance by retaining earnings and issuing equity, or the denominator, by cutting back assets and reducing lending or shifting into low risk-weighted assets. Securitization allows a third way: banks can adjust their capital ratios by engaging in securitization. Loan securitizations avoid the disadvantages of warehousing loans and then they automatically decrease regulatory and market capital requirements.
Another important motive behind securitization is risk transfer or risk-sharing. According to Stein (2010), when banks sell their loans into the securitization market, the risks associated with these loans can be distributed across a wider range of end investors, including pension funds, endowments, insurance companies, and hedge funds, rather than being concentrated entirely on the banks themselves. This improved risk-sharing represents a real economic efficiency, and lowers the ultimate cost of making the loans. Moreover, as put out by Schwarcz (1994), a securitization transaction can provide obvious cost savings by permitting an originator whose debt securities are rated less than investment grade or whose securities are unrated to obtain funding through an SPV whose debt securities have an investment grade rating. Even an originator with an investment grade rating may derive benefit from securitization if the SPV can issue debt securities with a higher investment grade rating and, as a result, significantly decrease the originator's interest costs. Securitization provides diversification of funding sources. According to Adrian and Shin (2009), securitization opens up potentially new sources of funding for the banking system by tapping new creditors. Claessens et al (2012) suggests that banks accumulate, on their balance sheets or in affiliated investment vehicles, a significant share of the long-term AAA claims produced by securitization. Banks used these claims in part as collateral for repo funding. By pledging high-quality securitized debt, banks could raise wholesale funds (and increase leverage) more cheaply and in larger volumes than if they relied on traditional liabilities, such as deposits and unsecured funding.
3.4. SECURITIZATION’S ROLE IN SHADOW BANKING
Securitization of assets has been in use for a long time but only in the last 20 years has it grown dramatically. As discussed in previous parts of this paper, growth of securitization was a response to changing market dynamics, which are mainly the increasing demand of cash pools for safe and liquid assets as well as increasing competition and regulatory pressure in the banking sector. Securitization contributed to the rise of shadow banking by moving assets of traditional banks off their balance sheets and transforming these assets to tradable securities. This role of securitization filled the gap between traditional banking and modern finance by building a bridge where bank loans can be transformed into securities and transferred to the capital markets. This allowed more efficient use of bank capital and supply of a new source of assets to the investors. According to Claessens et al (2012), securitization caters to two sources of demand. The first is the demand from corporations and the asset management complex for what are perceived as safe, short-term, and liquid “money-like” claims to invest their large cash balances. The second is the demand from banks (especially European banks) that use securitized safe and long-term “AAA” assets to attract repo funding (from institutional cash pools directly or money market funds) and boost leverage. Gorton and Metrick (2010b) put out that with each level of securitization, the SPV often combines many lower-rated (BBB, BBB-) tranches into a new vehicle that has mostly AAA and AA rated tranches, a process that relies on well-behaved default models. This slicing and recombining is driven by a strong demand for highly rated securities for use as investments and collateral: essentially, there is not enough AAA debt in the world to satisfy demand, so the banking system set out to manufacture the supply. According to Brunnermeier (2008), securitization allows certain institutional investors to hold assets (indirectly) that they were previously prevented from holding by regulatory requirements. For example, certain money market and pension funds that were allowed to invest only in AAA rated fixed-income securities could now also invest in a AAA-rated senior tranche of a portfolio constructed from BBB-rated securities. These features of securitization make it an important source of collateral within the asset management complex.
PART 4. COLLATERAL INTERMEDIATION
Collateral is the lifeblood of today’s capital markets. Hedge funds, money market funds, pension funds, asset managers, broker-dealers, investment banks, insurance companies all rely on collateral for continuation of their investments and fundings. Especially after the financial crisis in 2008, cash lenders’ growing risk-aversion boosted the ever increasing need for collateral and policy makers supported this increase and led the market to greater use of collateral based transactions. As put out by Claessens et al (2012), collateral intermediation function is likely to become more important over time.
Collateral, in its most basic form, is a protection against the counterparty risk. It is a physical or financial asset that a lender holds in order to be secured against a credit exposure taken. In finance, commercial banks usually take collateral from borrowers in order to be covered in the event of a default. Defaulting means that the borrower is unable to meet its contractual obligations, for example when the loan is not repaid in maturity. In such an event, the bank can close the loan by selling/liquidating the collateral that it holds. There are different types of collateral that is used in finance. While cash is the most preferable one for lenders, many other types of collateral such as treasury bills, corporate bonds, commodities, commercial papers, equities, securities and credit claims also exist. Essentially, any liquid asset that allows transferability of legal ownership and has a market price can in practice be used as a collateral. For example, banks, who provide trade finance loans, hold physical commodities such as steel, coal or grain as collateral. If a customer can’t repay the loan, bank sells the commodity and closes the corresponding exposure. In collateral based commercial loans like this, haircut is also a very common risk management practice. It is a tool that lenders use to cover themselves against possible price/value changes of the collateral. Back to the trade finance loan example, the bank is aware that the commodity it holds as collateral has a market price that changes almost on a daily basis. In order to prevent the collateral from not being sufficient to repay the loan (a sudden price decrease in markets), bank either lends less than the value of collateral it takes, or gets margin i.e. more collateral than the loan that customer asks for. For instance, if a customer has 1 mn $ worth of nickel and asks for a loan, the bank can apply a 10% haircut and either provides a loan of 900K $ or requires 1,1 mn $ worth of nickel to be pledged against a 1 mn $ loan. This haircut also helps to cover the interest and additional costs of the corresponding loan.
Collateral is not only used in commercial banking loans. Actually, commercial banks do also borrow from each other or from non-bank financial institutions against collateral. As mentioned in the very beginning of this paper, collateral use in capital
markets has become a very common practice in recent years. It’s emerged as one of the key elements for functioning of the modern finance along with securitization. Not only commercial banks use collateral for attracting additional funding, but also non-bank financial intermediaries like asset managers, hedge funds, money market funds, insurance companies and broker-dealers heavily engage in secured financing transactions (such as repo, secured loans and securities lending) for their investments and fundings. A wide range of different assets such as cash, treasury bills, commodities, bonds, securities and equities are used as collateral in capital markets. After cash, government debt (such as US Treasury Bills) appears as the ideal type of collateral since it is perceived as the safest and most liquid type of debt/claim available. However, the problem is, there is not enough supply of government debt as collateral in the financial world. Therefore, investors who are involved in collateral transactions, need other liquid and safe sources of collateral3. As discussed in the previous part, securitization of bank loans is also one of the (imperfect) substitutes of government debt as a collateral in secured transactions. Gorton et al (2012) suggests that the demand for safe or information-insensitive debt exceeds the supply of U.S. Treasuries outstanding. The private sector can produce substitutes for government debt in the form of short-term instruments or long-term debt securities that can be used as collateral or as safe stores of value. Consistent with the rise of the shadow banking system, the main producers of safe debt are not commercial banks, whose share of private safe debt has been shrinking. Of course, the government could attempt to completely satiate the demand for safe debt by issuing more Treasuries. In such a world, there would be no need for “safe” private financial-sector debt outside of banking deposits. However, recent developments in sovereign debt markets suggest that even governments cannot issue too much debt without such debt becoming information-sensitive. Thus, if the demand for safe assets cannot be met in whole by the government, near-riskless debt issued by the financial sector plays an important role in facilitating trade.
4.1. PRIMARY DRIVERS OF COLLATERAL USE IN CAPITAL MARKETS Different parties have different motivations for engaging in collateral based transactions. While some use it as a secured investment instrument which allows return enhancement for the excess cash they hold, others use it to obtain cash funding or to get temporary access to specific securities.
Large institutional investors like pension funds and mutual funds are important users of collateral based transactions. The main reason for their increasing use of repos and
securities lending transactions is the rapid growth of money under management and the need of using this cash as a secured investment. These firms hold large amounts of cash for various reasons and they would like to invest this cash in short-term, liquid and safe –money-like- instruments. Even though asset managers invest households’ long-term savings into long-term instruments, their day-to-day management and return mandates—absolute or benchmark— effectively requires them to transform a portion of these long-term savings into short-term savings. This in turn drives the money demand of asset managers (Pozsar and Singh, 2011). As discussed in previous parts, institutional investors with large cash holdings can’t benefit from government insured deposits as their cash pools exceed the maximum insurance amount. For large cash holders like these, secured and collateral based transactions act as a substitute for insured demand deposits. Therefore they invest their excess cash in instruments like repos. They also use securities lending transactions to boost their profits without being exposed to too much risk by lending out their securities against collateral and generating additional income from their securities portfolio.
Another motivation is hedge funds’ need to cover their short positions. This type of firms commonly engage in short sale transactions. Basically, they sell securities which they don’t own, in the expectation that they can buy back same securities at a lower price in the future. To cover these short positions, hedge funds need to obtain those same securities that are sold short. They can do so by going into securities lending markets and borrow the securities from another firm against posting either cash or other securities as collateral. In such a market, it’s not easy to locate a specific security which is available for borrowing. Therefore, hedge funds rely on prime brokers who acts as an intermediary between security lenders and those who need specific securities. Prime brokers are in continuous search for available securities in the market. They locate available securities and service these securities to those who need them for specific purposes like in the case for hedge funds. Another incentive of hedge funds for involving in collateral transactions is to obtain leverage. Some hedge funds are not creditworthy enough to attract unsecured funding. Therefore, they rely on secured transactions to boost their leverage. They lend securities that they hold through prime brokers and obtain funding from capital markets by using collateralised transactions.
Investment banks and broker-dealers borrow securities for various reasons. Their primary motives are to support their own proprietary trading, customers’ transactions and finally their own market-making activities. Dealers trade with each other as well as with their customers. To support these trading activities, they use collateral transactions (mainly repos) to obtain funding. They use econonomies of scale by pooling customers’ securities and source funding at the lowest cost available. They
also re-hypothecate their clients’ assets to originate additional secured financing which in turn supports their own and clients’ funding needs.
4.2. MAIN PLAYERS IN THE COLLATERAL MARKET
The ultimate sources of collateral in the shadow banking system are asset managers. Asset managers can be subdivided into two main groups: levered accounts and unlevered (or real money) accounts. Broadly speaking, levered accounts refer to hedge funds, and real money or unlevered accounts refer to exchange traded funds, sovereign wealth funds, central banks, pension funds, insurance companies and mutual funds (Pozsar and Singh, 2011). Mutual funds usually lend cash against various type of assets as collateral. But they also do lend their securities with a motivation to get additional revenue while minimizing the credit risk by taking various types of eligible collateral. Hedge funds may also take role in both sides of the transaction. They can either lend their securities to borrow cash, or lend cash to borrow securities. They borrow cash to boost their leverage and expand their investments. And they borrow securities to cover their short positions in the market. Other important players in the market are intermediaries. The sophistication of transactions and required infrastructure (administrative, operational, accounting, risk management) to accommodate them are highly costly and necessitate third party specialist institutions to be involved. These institutions are: agent intermediaries (custodian banks), broker-dealers, prime brokers and central clearing counterparties (CCPs). These intermediaries are sub-divided into 2 broad category: agent intermediaries and principal intermediaries.
Agent intermediaries including custodian banks are employed by benefical owners to lend their securities on behalf of them. These institutions are responsible for services such as collateral management, trade settlement, risk management and operational activities. They don’t assume counterparty risk. Therefore, deciding to whom the securities will be lent (counterparty risk) is however still beneficial owners’ responsibility. Custodian banks are a type of agent intermediary with capability to mobilise large pools of collateral. They usually have large numbers of institutional clients and they act as a meeting point for the securities lending market. These features of custodians allow their clients to benefit from economies of scale as well as custodians’ advanced market and technological expertise.
Unlike agents, principal intermediaries assume principal risk, provide credit, liquidity and take positions on behalf of themselves (proporietary trading). They perform credit
counterparty they don’t know. Instead of assuming the risk of an unknown third party, benefical owners assume principal intermediary’s risk who is usually a well-known investment bank. Also this provides borrowers access to new resources. For instance, some hedge funds may not be eligible or don’t have a proper credit rating to transact with large cash pools like pension funds. But pension funds can engage in transactions with principal intermediaries such as broker-dealers who are commonly high rated and well-known investment banks. By intermediating such transactions, broker-dealers act like a bridge between these institutions who don’t/can’t be directly exposed to each other. Hedge funds heavily use prime brokers to source funding and borrow securities. Brokers earn income from these services as well as their own proprietary trading activities. To support their own activities, they also engage in repo transactions among themselves as well as with third parties such as mutual funds. 4.3. COLLATERAL BASED TRANSACTIONS
There are two main types of collateral based instuments: securities lending and repurchase agreements4. While these two transaction types have many similarities, different motivations of market participants and specific characteristics of the transactions divide them into two categories. A key difference between securities lending and repo is that the first one is motivated by the need of temporary access to specific securities (securities-driven), whereas the latter is mostly motivated by the need to obtain cash financing (cash-driven). Repo is a key instrument for market participants who are in search of liquidity. In a repo, the borrower borrows cash against a collateral posted to the lender. In contrast, securities lending transactions are motivated by the need to borrow specific securities and might not necessarily include a cash exchange. It provides lenders of securities with low risk return enhancement, while enabling borrowers to cover their short positions which requires specific securities. Both markets are composed of lenders and borrowers of cash and securities as well as intermediaries who organize and manage these transactions.
4.3.1 Repurchase Agreements
A repurchase agreement (repo) is the sale of an asset in exchange with cash, together with an agreement to buy back the same asset at a higher price on a predetermined future date. In such transctions, financial assets serve as a collateral for what is effectively a cash loan. Following is a simple demonstration of a repo transaction. In this example, a dealer gets into a repo transaction with a money market fund. Money
4 For a detailed overview of repo and securities lending markets, please check “Adrian et al (2013),
Repo and Securities Lending” and “Financial Stability Board (2012), Securities Lending and Repos: Market Overview and Financial Stability Issues”.
