28 March 2014

Bank of England: Shadow banks and macroeconomic instability

Authors develop a macroeconomic model in which commercial banks can offload risky loans to a ‘shadow’ banking sector, and financial intermediaries trade in securitised assets. They analyse the responses of aggregate activity, credit supply and credit spreads to business cycle and financial shocks.

Between the early 1990s and the onset of the 2007-09 sub-prime crisis, the financial system in the United States and elsewhere underwent a remarkable period of growth and evolution. Banking underwent a shift away from the traditional ‘commercial’ activities of loan origination and deposit issuing towards a ‘securitised banking’ business model, in which loans were distributed to entities that came to be known as ‘shadow’ banks. As shadow banks came to replicate core functions of the traditional banking system, in particular those of credit and maturity transformation, they took on many of the same risks but with far less capital. An overreliance on securitisation, and the increased leverage of the financial system as a whole, ultimately contributed to financial instability, recession, and a substantial contraction in shadow banking activity.

The aggravating role play by flaws in the securitised banking model have been rightly emphasised in many accounts of the subprime crisis and ensuing ‘Great Recession’. But there is also a need to understand the increasingly central role played by securitisation in credit provision over the decades prior to the crisis. To illustrate why, authors show that in the US data from 1984 to 2011 periods when traditional bank credit underwent cyclical contraction were often periods when shadow bank credit expanded. Similarly, other authors have documented that over the post-1984 period, consumer credit and mortgage assets held by commercial banks were positively correlated with GDP, while holdings outside the banking system were negatively correlated with GDP.

These observations suggest that a macroeconomic model which seeks to account for the behaviour of intermediated credit should be able to account for the differences in credit supply across institutions, as well as the collapse in shadow banking during the crisis. To that end we develop a dynamic general equilibrium model featuring securitisation and shadow banking, which aside from its treatment of the financial sector, closely resembles a standard macroeconomic model.

In author’smodel they show that the ability of commercial banks to securitise can stabilise the overall supply of credit in the face of aggregate disturbances, but that risk-taking by the shadow banking system leads to an increase in macroeconomic volatility. They then give conditions under which the negative correlation between traditional and shadow bank credit observed in the US data come about, and quantify the credit dynamics resulting from the interaction between banks and shadow banks. Finally, they argue that in a securitisation crisis government policies targeted at the shadow banking system, such as purchases of asset-backed securities, can have spillover effects on the rest of the financial system which weaken the effectiveness of interventions.

Taken together, these points constitute a first step towards addressing what are widely thought to be some important shortcomings of the generation of dynamic general equilibrium models used for research and policy analysis prior to the recent crisis.

Their model does not attempt to capture the full complexity of shadow banking activities, however, and leaves room for future research. First, authors do not attempt to model the process of financial innovation and regulatory change which lay behind the rapid expansion of shadow banking. Second, the crisis highlighted shortcomings in the workings of key asset markets, which we ignore.

Last, authors do not deal with issues of prudential regulation, or with policies relating to financial system structure. An important contributory factor behind the creation of some shadow banking entities, in particular structured investment vehicles, was a desire by banks to reduce the amount of regulatory capital they held against credit exposures. In our model there is no explicit regulatory motive behind the existence of shadow banks or the market for securitised assets, although we proxy the advantage that shadow banks enjoy from being unregulated by allowing them to carry higher leverage than commercial banks. Relaxing some of these strong assumptions is a topic ripe for future work.

Full working paper

© Bank of England