How Shadow Banking Led to the Collapse of the Banking Sector

Shadow banking commonly refers to financial activities taking place outside of the regulated banking sector. Its prominence was highlighted during the 2007-2008 financial crisis, when the demise of shadow banking led to the collapse of the banking sector as a whole. To better understand these events, Nicola Gennaioli (Department of Finance), Andrei Shleifer (Harvard University) and Robert W. Vishny (University of Chicago), propose a model of shadow banking in a recent paper entitled A Model of Shadow Banking (doi: 10.1111/jofi.12031) forthcoming in the Journal of Finance.

In this model, financial intermediaries issue large amounts of safe debt to shadow banks by collateralizing such debt with large pools of securitized loans. The authors show that this process, which causes a simultaneous growth of the debt of intermediaries and their pooling of risks, creates financial fragility. As traditional banks get rid – through pooling – of all sorts of loan-specific risks, their portfolios seem safer to market participants. But in fact, banks are swapping small, idiosyncratic risks for the unobserved, exceptional risk in which a sizeable number of loans default together. As this low-probability neglected risk materializes, all banks fail together. Failure occurs precisely because the impression of safety allowed banks to issue so much debt ex ante and the pooling of risks transmits large losses to all banks ex post.

Critically, financial fragility is precipitated by the very size of the shadow banking sector, namely of financial institutions demanding safe debt, such as money market funds. When the shadow banking sector is small, the demand for riskless debt is low, and the internal funds of traditional banks are enough to guarantee the moderate amount of debt they issue. In this case, the equity cushion of banks is sufficient to render the banking sector resilient to the occurrence of tail risks. Asthe shadow banking sector grows large, however, the internal funds of intermediaries are no longer enough to back the total amount of riskless debt demanded. To meet such large demand for safe debt, intermediaries create safe collateral by pooling risky loans. In this process, intermediaries become inter-linked, increasing their exposure to neglected tail events, which therefore renders the entire system fragile.

These findings can shed important light on the recent crisis. The neglect of tail risk indeed appears to be a trademark of recent events, for even sophisticated investors appear to have overlooked the possibility of a sharp decline in housing prices prior to the crisis. Accordingly, the use of securitization and risk pooling techniques facilitated an overexpansion of banks' leverage.This analysis has also relevant implications for the way regulators should view the process of financial innovation. The standard argument in favor of financial innovation is that the creation of new financial assets allows market participants to exploit gains from trade.That model however crumbles once one recognizes that people may not fully understand the risks of the new financial products. In this case, the unregulated issuance of new securities will be excessive, which causes a destabilizing flight to quality when previously neglected risks are revealed to be even merely possible. The final outcome may thus be worse than what would have obtained if innovation had not taken place.