Shadow Banking Marc Eskinazi Nedbank Retail Risk Retail

Shadow Banking Marc Eskinazi Nedbank Retail Risk: Retail Legal marce@nedbank. co. za

Objectives of the lecture • • • 4 main questions (1) What time will the lecture end? (2) Can we watch a video? (3) Will this be in the exam? (4) How comprehensive and useful will the slides be?

Regulatory Tsunami • Interesting time in banking law. • Exceptionally important to all business in financial sector. • Silver lining to uncertain economic climate. • This lecture aims to give a broad global perspective on shadow banking in the light of the global financial crisis.

Video • https: //www. youtube. com/watch? v=i 0 ucl_Df YGo

What is Shadow Banking? Size: $80 trillion worldwide. 2 different definitions of shadow banking. 1 narrow definition and 1 broad definition. The narrow definition was coined by Paul Mc. Culley and was used to describe risky off-balance-sheet vehicles hatched by banks to sell loans repackaged as bonds. • This came to represent one of the many deficiencies of the financial system ahead of the financial crisis. • However, is this definition still relevant? • •

What is Shadow Banking • Shadow banking has now evolved beyond this definition. • Now defined as: a non-bank entity that provides lending services similar to a traditional bank but does so outside of the traditional regulatory environment in which a commercial bank must operate. • These include, but are not limited to, (1) Mobile payment systems (2) Pawn shops (3) Peer-to-peer lending (4) Hedge funds (5) Bond-trading platforms (6) Microfinance (e. g. loan sharks) (7) Money Market Funds.

Relevance of Shadow Banking • A massive issue in the American election. Hillary Clinton outspoken on shadow banking. • Did it cause the Global Financial Crisis (Directly or Indirectly? ) In China, two-thirds of shadow bank lending are bank loans in disguise. • Merely a bad naming convention? It sounds negative, murky, underhanded. But is it? What could it potentially be called? Alternative banking sector? • May be the first step in changing perceptions?

Benefits of Shadow Banking • The shadow banking system at the moment is flourishing. • Primarily, because traditional banks, as a result of the GFC are under severe pressure. • Subjected to penalties e. g. (AML fines) Governments need to be seen to be doing something! • Tighter capital and liquidity requirements (Basel III) • Too late?

Benefits of Shadow Banking • Banks still low offering low interest rates on deposits. Thus, opportunity for higher returns in the shadow banking sector.

Benefits of Shadow Banking • Can solve certain problems in society such as making affordable credit available to people who would generally not qualify at commercial banks. • Increases competition to banks. Forces them to improve offerings to stay relevant. • Shadow banking being driven by innovation, or those who see an opportunity to “disrupt traditional banking by offering a cheaper and more efficient service. ”

Benefits of Shadow Banking • Shadow banks can be growth initiators. • Provide lending where traditional banks will not (risk) or cannot (regulation) • That is badly needed at the moment. Austerity and tightening of the purse strings are necessary but not sufficient to solve the low growth problems the global economy is facing.

Benefits of Shadow Banking • Stokvels in the South African context? • Historical concept that benefits everyone involved. • Traditional banks attempting to get involved in these type of transactions. • No overheads, relationship of trust, personal accountability, recourse (double-edged sword).

Risks of Shadow Banking • Inherently riskier with smaller safety margins. • Lack of clarity, wider scope for corruption. • • (1) Unregulated. (2) Minimal Recourse. (3) No lender of last resort. (4) No deposit insurance.

Risks of Shadow Banking • (1) Unregulated • - Subject to different, and usually lesser, levels of regulatory oversight. • - Reduces financial stability. • - Fewer controls in place.

Risks of Shadow Banking • • • (2) Minimal Recourse - “Capital Guaranteed” - No Banking Ombudsman or Credit Regulator - Can potentially result in massive losses. - Skittish investors exacerbate the problem.

Risks of Shadow Banking • (3) No lender of last resort • -SARB can provide emergency loans to a traditional bank, if required. • -This is an additional safety mechanism on top of the onerous liquidity and capital requirements.

Risks of Shadow Banking • • • (4) No deposit insurance - Not offered in the shadow banking industry. - Too expensive. - Would not allow such high returns. - This is all a trade-off. Depends on risk appetite.

The Global Financial Crisis • Prior to the GFC the shadow banking sector was not considered to be systemically important. • Authorities were unable to monitor build up of risk and leverage within the system. • Growth of shadow banking meant that this actually posed a systemic risk.

The Global Financial Crisis • The shadow banking sector has been blamed for causing the global financial crisis. Securitisation, derivatives, etc. • Traditional banks played a massive role in this and were using the shadow banking system for their own benefit. • Very quick to divorce themselves from this reality and shift blame.

The Global Financial Crisis • In the aftermath of the GFC, traditional banks have cut back significantly on using SPV’s for debt financing purposes. • It has illustrated how interconnected the shadow banking and traditional banking sectors are.

The Global Financial Crisis • Impact of panic withdrawals was massive in the shadow banking sector. • No safety net. • US money market funds which were important lenders in Europe faced massive redemptions. • Caused collapse of insurance companies like AIG.

The Global Financial Crisis • Shadow banking, in the aftermath of the crisis, has now become more influential. • When are shadow banks traditionally most relevant and highly utilised? • - When strict banking regulations are in place which leads to circumvention of regulations. • Corporates and general public are now desperate for growth.

Shadow Banking in South Africa • Size: R 2. 5 trillion. • Very conservative estimate. • Grown tenfold in a decade.

Shadow Banking in South Africa • The justification provided is that the shadow banking sector in South Africa predominantly “appears to be limited to direct lending”. • This is a function of being a developing economy with high poverty, high unemployment and a large unbanked sector. • In SA, estimated that 67% of the population is not in the traditional banking sector. Bank fees, FICA requirements, large rural population and no internet access are the reasons for this.

Shadow Banking in South Africa • Shadow banking therefore necessary and not a massive risk. • However, South Africa is a member of the G 20 and therefore expected to “fit in with global developments on the regulatory front” • National discretion?

Shadow Banking in South Africa • Massive issue in the South African traditional banking sector is the pressure to reduce fees. • BUT massively increasing regulatory burden which increases compliance costs. • Therefore, this is exceptionally difficult to achieve. Accountable to shareholders. • Shadow banking will thus become more prominent.

Shadow Banking in South Africa • In SA context, not a massive threat to financial stability. Only 6% of credit is extended by the shadow banking sector. • Shadow banks are now obliged to register with the National Credit Regulator (NCR) but whether or not they do so is almost impossible to enforce. • Bad debts are purportedly decreasing in SA? Reason for this? Affordability assessments?

Should Shadow Banking be Regulated? • Current position. Minimal growth, risk averse, no disposable income, high unemployment, increased cost of living. • Overregulation of shadow banking could have unintended and disastrous consequences. • Effective? “Can’t regulate for ethical behaviour. ” • Overregulation can make it more onerous and costly for compliant market participants but fail to stop those who operate unlawfully.

Should Shadow Banking be Regulated? • Regulation of shadow banking must be balanced against the need for greater financial inclusion and improved competition without stifling innovation. • It has been suggested that South Africa has two options. • (1) Nanny state; • (2) Acknowledge cause of problem. Alternatives. Less focus on symptoms. • In the US, proposed new rules that all non-banks have a minimum net worth of $2. 5 million.

What is the Best Method of Dealing with Shadow Banking? • (1) Supervision v Regulation • (2) Transparency • (3) Situation in South Africa as opposed to the developed world • South Africa in a similar position to China (much smaller scale) In this regard see: Elliot, Kroeber and Qiao (Shadow Banking in China: A primer)

What is the Best Method of Dealing with Shadow Banking? • (1) Supervision v Regulation • - Supervision requires bravery from government institutions. Trust in their ability to determine potential problems. Acknowledgement of the current situation. • - Is this likely? Given the current trend of the regulatory tsunami? • (2) Transparency. “Market participants get a fair price for taking the risk. ” • - G 20 Financial Stability Board Recommendations relating to securitisation. Full disclosure.

What is the Best Method of Dealing with Shadow Banking? • (3) Situation in South Africa • - Appears to be understanding that shadow banking is here to stay. • - Not yet overly regulated, even with the amendments to the NCA. • Vital part of financial system as supports economic activities. Imperative to monitor risks and respond appropriately and timeously.

Conclusion (Impact of Shadow Banking) • Shadow banking has a large impact on the economy and continues to grow. • Poses a risk to stability but also a potential method to create positive economic change. • Very dynamic sector and risks need to be regularly monitored. • Effectively, shadow banking in the modern economy needs to be understood and utilised correctly to maximise benefit but minimise risk.

Conclusion (Do Benefits Outweigh Risks? ) • This is ultimately the question that needs to be answered? • Your opinion?

Conclusion (Is Shadow Banking the Way of the Future? ) • Increased regulation in the US and Europe has made the narrow definition of shadow banking almost obsolete. Response to the GFC. But the broad definition is now expanding. Backed by technological innovation. • Potential reach of mobile banking? • Will traditional banking institutions become obsolete? Lack of trust? • Investment funds. Project Finance.

Benefit of Studying this Course in Banking and Finance Law • Employment prospects. Risk, Legal, Compliance. • Indispensable. • Indicator to potential employers. • Investment in yourself.

Thank You • Any questions? • I can be contacted at marce@nedbank. co. za.