Recently in Shadow Banking Category

Reshaping the banks has only just begun

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The US media has been buzzing with reviews and comments about William D Cohan's new 670-page blockbuster Money and Power, How Goldman Sachs Came to Rule the World, his third Wall Street "history" in just three years.

by Roy C. Smith

Charles D Ellis spent 10 years writing The Partnership, his much praised 2008 effort to capture the "culture" of Goldman Sachs, and so Cohan's latest effort seems a rush job to catch the last of the lingering public rage against the big banks that played so rough during the financial crisis.

Cohan interviewed former senior partners, who turned out to be much more loquacious than expected for a firm known for its secretive ways.

The glitzy New York version in Vanity Fair included a lengthy, pre-publication excerpt covering 1989-1999 when the firm had five chief executives. This was truly a messy period in the firm's history, full of juicy bits for gossips to savour.

But the piece never mentioned that these were very difficult times in both Wall Street and the City of London, when firms changed their business models drastically to survive and a great many distinguished names either failed or disappeared into mistaken or unwanted mergers.

Goldman is one firm that sailed through this period, despite its management changes and other tumultuous events, without slowing down much at all. Indeed, it emerged after its initial public offering in 1999 as the unquestioned leader of the global capital markets industry.

read the full opinion-editorial on

No need to fear the shadows

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by Roy C. Smith

With the big banks under the boot of the regulators, tucked up with tougher capital ratios, trading restrictions and deferred incentives to rein in recklessness, some bank chief executives and academics have called for similar restrictions on the "non-bank monsters" of the shadow banking system where dangerous, unregulated risks are said still to reside.

A shadow banker is anyone who participates in the lending of money or its near equivalent. These would include financial intermediaries, off-balance-sheet investment vehicles and hedge funds, as well as institutional asset managers.

Altogether, global institutional investors managed about $150 trillion of securities and derivatives in 2009, compared with about $95 trillion for all banks.

But the idea that the next meltdown will occur in the widely distributed shadow banking sector is nonsense, now that its riskier aspects have been addressed.

The five systemically important US non-bank intermediaries - investment banks - were dissolved by the crisis: Lehman Brothers failed, large banks acquired Bear Stearns and Merrill Lynch, and Morgan Stanley and Goldman Sachs turned themselves into banks. The Federal Reserve now regulates them all.

Read the full opinion editorial on

Coming Out of the Shadows?

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by Viral Acharya

Regulators face difficult choices about how to regulate shadow banking.  There is much they might learn from the choices made by Depression-era governments.

Shadow banking is a system of financial institutions that mostly look like banks.  These highly leveraged institutions borrow in short-term debt markets and invest in longer-term illiquid assets.  This part of the financial system includes asset-backed commercial paper (ABCP), money market funds, securities lending and collaterialised repos (at broker-dealers).

The size of this market is roughly $800bn in the US alone (and even larger by some estimates) and matches the size of deposits, both insured and uninsured, held at depository institutions.  The growth of shadow banking over the past 25 years has been extraordinary relative to the growth of deposits.

Read the full piece from The Banker

Hedge Funds after Dodd-Frank

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By Stephen Brown, Anthony Lynch, and Antti Petajisto

Now that the Dodd-Frank Act has been passed by both houses of Congress, we finally know its broad implications for hedge funds. As expected, it requires all large hedge fund advisers to register with the SEC. Also the new rules on derivatives trading have an additional impact on many hedge funds. However, since the Act leaves many specifics up to the regulators, considerable uncertainty remains about the exact form of the new rules. The main tradeoff is between the government's desire to learn more about hedge funds, both to assess systemic risk and to protect investors, and the compliance costs this imposes on funds and investors. Overall, how economically sensible is hedge fund regulation in the Act, and how well does the Act resolve this tradeoff?

by Philipp Schnabl and Marcin Kacperczyk

Money market funds are the stepchild of finance. Even though they manage more than $4 trillion in assets, you won't find them in the Senate's financial reform bill from last Thursday . Is this justified?

If you analyze the track record of money market funds up to 2007, you would think that the Senate bill got it right. Apart from a small hiccup in the early 1990s, not a single fund ever got into trouble. However, in August 2008, a large money market fund, the Reserve Primary Fund, went bankrupt. As a result of the Reserve Primary Fund's troubles, investors started pulling their money from the entire industry.

Faced with a panic, the government decided to act promptly. Three days after the start of the run, it announced that all money market funds would be guaranteed. This announcement successfully stopped the run, but it also meant that going forward investors expect to get bailed out again.

We therefore believe that the government has to explicitly acknowledge that money market funds will receive government support during times of crisis. Even though this may be unpopular in policy circles, this is an honest thing to do. How should the government do this? This blog post has the answer.

Money Funds Too Big to Be Ignored

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by Marcin Kacperczyk and Philipp Schnabl

Money market funds are the stepchildren of finance. Though they manage more than $4 trillion in assets, they have not gotten much attention recently. Sen. Chris Dodd's regulatory reform proposal does not even mention money market funds. Is the omission justified?

If you analyzed the track record of money market funds up to 2007, you would think that Sen. Dodd is right. Money market funds are simple structures; some may even call them boring. They collect deposits and invest them in (almost) riskless money market instruments. In doing so, they earn a small yield while making sure the fund does not lose any money or, in Wall Street parlance, "never breaks the buck." For this reason, many investors think of money market deposits as the big brother to bank deposits. The only difference between the two is that money market deposits have no Federal Deposit Insurance Corp. guarantee.

However, if you analyze the performance of money market funds during the financial crisis, you would find that their omission from the Senate legislation is a glaring mistake.

Read our full opinion editorial at American Banker (subscription required)

by Viral Acharya and Marti Subrahmanyam

A key aspect of the bill on Restoring American Financial Stability proposed by the Senate Banking Committee under Senator Christopher Dodd is the sweeping reform of the derivatives markets targeted at improving their transparency and accountability. The bill aims to "eliminate loopholes that allow risky and abusive practices to go on unnoticed and unregulated - including loopholes for over-the-counter (OTC) derivatives." 

The Paradox of "Too Safe to Fail" Assets

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by Viral V Acharya and Arvind Krishnamurthy

While the House and the Senate Bills empower the regulators to impose greater capital requirements on banks and systemically important institutions, they provide little guidance on how we might have to improve design of capital requirements going forward. In particular, how should we deal with fail-safe assets such as AAA-rated tranches of mortgage-backed securities and liabilities such as overnight secured borrowing ("repos") which were not capitalized, were held in large quantities, and ended up bringing down the entire financial sector through losses and runs? The Financial Times oped at the link below (joint with Arvind Krishnamurthy) argues that the entire risk of these "too safe to fail" transactions is systemic in nature, and hence financial sector has incentives to essentially ignore the risk, unless we reform capital requirements to be higher for these transactions. This is in fact the opposite of how (Basel) capital requirements are currently designed, which is to in fact give higher incentives for such transactions.

Financial Times Market Insight column

Why bankers must bear the risk of "too safe to fail" assets.

March 18, 2010



The Dodd-Frank Act, signed into law in July 2010, represented the most significant and controversial overhaul of the U.S. financial regulatory system since the Great Depression. Forty NYU Stern faculty, including editors Viral V. Acharya, Thomas F. Cooley, Matthew P. Richardson, and Ingo Walter, provide a definitive analysis of the Act, expose key flaws and propose solutions to inform the rules’ adoption by regulators, in a new book, Regulating Wall Street: The Dodd-Frank Act and the New Architecture of Global Finance (Wiley, November 2010).

About Restoring Financial Stability

Previously, many of these faculty developed 18 independent policy papers offering market-focused solutions to the financial crisis, which were published in a book, Restoring Financial Stability: How to Repair a Failed System (Wiley, March 2009).

About the Authors