Shadow Banking : A Form Of Regulatory Arbitrage

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Shadow banking can be seen as a form of regulatory arbitrage that provides important financial intermediation functions distinct from those preformed by banks and capital banks [Claessens et al (2012)]. Some of these functions include securitization and collateral intermediation both of which we have partially discussed. One thing that should be pointed out is that, contrary to its name; shadow banking is not completely unrelated to conventional banking. For instance, shadow-banking complements traditional banking by expanding access to credit or by supporting market liquidity, maturity transformation and risk sharing [Nico Valckx et al]. The only major difference between the two banking systems is that shadow banking is not regulated.…show more content…
The shadow banks responded to this by trying to issue new securities and force selling the underlying collateral. However due to the aforementioned slump in mortgages and real estate prices, this response failed and the value of these repurchase agreements continued to decline whilst the haircuts continued to increase. Due to this, lenders refused to offer short-term loans whilst haircuts grew to new highs. This meant that repo lending drastically decreased and lead to the collapse of the shadow banking system. To highlight the extremity of the above scenario, Figure 2 shows the drop in the US repo market before and after the 2008 recession [Financial Times (2013)] [Figure 2]. In retrospect, due to the above events, regulators became concerned by the use of repo agreements and the simultaneous use of haircuts in these agreements. These regulators were concerned that haircuts would amplify negative market trends and in situations where asset prices were falling, the increases in haircuts in response to the loss of confidence in an asset could reduce the liquidity of market users who may then sell assets, and so reducing the price of the asset and causing the haircuts to further increase [ICMA]. They believe that this scenario contributed greatly to the current financial recession. However, there are some arguments against this

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