Securitisation and wholesale funding are the centres of the shadow banking system in the U.S. As we mentioned in the previous section, loans, mortgages and leases can be securitised and converted into tradable shadow banking instruments, while wholesale funding is an alternative method that banks use to finance operation besides bank deposits. The source of wholesale financing includes federal funds, foreign deposits and brokered deposits (Adrian and Ashcraft, 2016). When banks face difficulty in attracting regular depositors (because of the low-interest payment on deposits), apart from the securitisation, they may turn to this alternative way (wholesale funding) to raise money. Shadow banking system is complex. To understand the mechanism of shadow banking, it is essential to know how securitisation works and the wholesale funding market, in addition to the subsegment of shadow banking, including internal, external and independent, and government-sponsored shadow banking.
2.2.2.1 Securitisation
It is common knowledge that commercial banks collect deposits from depositors and lend out money to borrowers. Deposits are the liability of the bank and loans are the asset on the bank balance sheet. The spread between the deposit rate and the loan rate
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is the net interest of the bank (Matthews and Thompson, 2005). In the 1920s, commercial banks were permitted to invest in the stock market by using money from depositors apart from making bank loans. However, in 1929, the Wall Street crashed alongside share prices plummeting, which rendered banks unable to fulfil their obligation to their depositors. Banks run resulted, and the U.S. economy entered the Great Depression. To remove commercial banks from investment banking businesses, the Glass-Steagall Act was introduced in the early 1930s. It implies that commercial banks can only take depositors money to make loans but not purchase securities.
In contrast, investment banks cannot take money from depositors. Instead, they can assist their customers in accessing debt and equity capital market. After the implementation of the act, the U.S. entered a relatively stable economy (Kroszner and Rajan, 1994). Nevertheless, the profit of the banks had dramatically reduced, and the separation between activity of commercial banks and investment banks became increasingly blurred. Financial communities had never ceased lobbying for the act to be repealed. Investment banks had persistently endeavoured to access the strength of the commercial bank's deposits, while commercial banks had wanted to enter the security market to make a higher profit. In 1999, the Glass-Steagall Act was officially repealed. Large commercial banks merged with large investment banks (Crawford, 2011).
Initially, securitisation was created to culminate the interests of commercial and investment banks. Specifically, investment banks purchase loan books from
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commercial banks and set up a conduit (such as SPV). Subsequently, loan books are passed to SPV, as well as risks being removed from commercial bank balance sheets (Acharya and Richardson, 2009). As mentioned in the previous section, SPV is the institution that issues bonds. This institution bundles the loan books to issue bonds and then sells the bonds to investors (these bonds can be ABS, MBS, etc.). Hence, the funding would transfer from the bondholders to the investment bank via the SPV. The investment bank then returns the money to the commercial banks, which can be used to meet the obligation of repay interests to depositors and further lend out to other mortgage borrowers.
The core operation of commercial banks has been changed due to securitisation. Initially, commercial banks can only have money to lend out contingent upon successfully attracting depositors. However, since loan books can be securitised, commercial banks can attract more money from bondholders if they can issue more loan books that can be bundled and construct to bonds. Loan books are separated into different elements or tranches, and the loan books from the borrowers with lower repay probability is segmented into ‘Inferior’ quality tranches. Similarly, medium-quality borrowers can be classified as ‘Medium’ tranches, and the loan book with very high- quality borrowers is known as ‘Good’.
Banks can charge a higher interest rate on the ‘Inferior’ loans and securitise all the ‘Medium’, and ‘Good’ loan books that can be used to back the bond that is issued by the SPV. Since the process of the securitisation can be very complicated, bondholders
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are unable to understand the nature of each bond. Instead, they use information disclosed by the credit rating agencies, which effectively rate each security that is considered as a correct assessment on the bonds. The safest security is rated as ‘AAA’ rating.
Furthermore, to prevent unexpected events, investment banks purchase insurance against potential risks. In particular, the insurance companies (such as A.I.G) sell credit default swaps (formal insurance contract) to investment banks in case the securitisation goes wrong (although before 2007 nobody believed it could go wrong). Insurance companies receive premiums regularly paid by investment banks (Acharya and Richardson, 2009). Interestingly, insurance companies can also use the money they earn and invest in securities.
The non-technical discussion above explains the function of securitisation. Now, we turn to the demand side of these securitised bonds. In the 1930s, the traditional banking system faced a potential bank run since deposits were not protected. However, this ended in 1934 in the USA (Calomiris and White, 1994) with the introduction of federal deposit insurance (deposit insurance capped at $100,000 per account). It operates satisfactorily for retail investors, but not for institutional investors with large cash holdings. Therefore, it is less safe for institutional investors to deposit their money into a bank account. Instead, institutional investors, such as MMMFs and pension funds, prefer to receive collateral from the bank, which is securitised bonds (created by the mechanism that we introduced above). These collaterals can be asset-backed securities
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with a very high rating that work similarly to deposit insurance - briefly describing, banks corporate with the conduit to issue securities which are essentially bundled by loan books. Banks use these securitised bonds as collateral to borrow money from institutional investors and then lend out the funds to borrowers (Gorton and Metrick, 2010).
We have discussed the general mechanism of the securitisation intuitively. In the following, we will describe shadow credit intermediation in the wholesale funding market in more comprehensive detail.
2.2.2.2 The shadow credit intermediation process
Shadow banks conduct similar business to traditional banks via a more complicated and ‘shadowy’ process. Pozsar et al. (2010) explain the credit intermediation chain that consists of seven steps, including loan origination, loan warehousing, ABS issuance, ABS warehousing, ABS CDO issuance, ABS intermediation and wholesale funding. Other finance companies, besides commercial banks, can perform loan contracts. After loan contracts are originated, single or multiple conduits will conduct loan warehousing, and broker-dealers’ ABS syndicate desk will take over and issue ABS by pooling or structuring all the loan books. Once the ABS issuance is completed, the warehousing will be facilitated through trading books and further convert into CDOs by broker-dealers’ syndicate desk. The next step is ABS intermediation, performed by limited-purpose finance companies, structured investment vehicles
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(SIVs), securities arbitrage conduits and credit hedge funds. The whole process is conducted in the wholesale funding market, and the source of the funding is mainly from institutional investors, such as money market mutual funds and other large cash pools. The authors emphasise that first step (loan origination) and the last step (wholesale funding) are essential in the chain. However, shadow credit intermediation does not have to include all the other five steps, or it can contain more than five by repeating some of the steps; for example, repackage ABS CDOs into the so-called CDO squared, which make the product even more complicated. Intuitively, the whole credit intermediation cannot be implemented without the initial loan contracts (loan origination), and it also cannot be conducted if there is no one to purchase the products (wholesale funding); nevertheless, the procedures that transfer the original loan contracts to tradable shadow banking products (e.g. CDOs) can be adjusted based on different situations.