Journal of Financial Economics

REF 109 The Unregulated Finance

The financing of the economy has undergone dramatic changes over the last two decades. In fact, a growing source of credit to the private sector has been generated outside the traditional banking system. Meanwhile, banks have offloaded credit risk from their balance sheet and changed their funding structures. These evolutions have been considered by many observers as one of the main roots of the current financial crisis. In particular, these evolutions have highlighted the key role played by the so-called shadow banking system. While shadow banking is still mainly a US phenomenon, it has also developed in Europe, in particular in the UK but also in the Euro area. Despite sustained efforts by the European Commission to foster maximum harmonization, delays in harmonizing both financial regulation and supervision in Europe raise specific concerns regarding the monitoring and the surveillance of the shadow banking system.

Working on the online statistical data warehouse of the ECB, we estimate the size of the shadow banking sector (SBS) in the Euro area, referring to several estimates – credit provided, total assets – based on our definition. We find that the credit provided by the SBS amounts to one fifth of the total credit supplied in the Euro area. We describe the balance sheet of the main actors and also provide an assessment for the risk of bank run in the European SBS and the risk of contagion between the SBS and the traditional banking sector (TBS).

The shadow banking system played a critical role in the financial crisis of 2007-2009, but why it grew so rapidly in the pre-crisis period remains an open question. This paper discusses explanations for the growth of the shadow banking system, as well as recent empirical work seeking to evaluate these explanations. Increases in both the demand for and supply of shadow banking claims likely played a role, but relative magnitudes of each remain unclear.

The rise of the shadow banking system (SBS), providing liquidity and credit as a classic bank, raises theoretical questions regarding the rationale behind its apparition. Is it a mere response to banking regulation that would have eroded bank profitability or does it have a distinct economic function? There is empirical evidence that banking regulation has led to some regulatory trade-off and has impacted the size of the SBS, but this system does have a specific economic role of its own. It allows for a better risk diversification due to the theoretical advantages linked to securitization. But the reality of this diversification has empirically been challenged after the 2007-2008 crisis. The economic function of the SBS also relies on the very nature of its liabilities, which offer institutional investors, in search of short-term safe deposits, and who are not entitled to deposit insurance which is reserved to households, a form of deposit insurance through collateralized debt issued by these structures, protection which nevertheless remains subject to variation of the collateral value on financial markets.

Exchange Traded Funds (ETF) are designed to track a benchmark. ETF facilitate asset management and contribute to reduce management fees and transaction costs, they are traded like stocks at current price on continuous markets and meet an increasing success. Initially, an ETF was a stock index-tracking fund and with a full replication approach, the fund included all index constituents in the weightings defined by the index. Currently, underlying extend to all the asset classes, of which commodities or volatility but also strategies: inverse ETF try to achieve the opposite performance or leveraged ETF that seek to magnify the performance of the indexes they track. Baskets of commodities or a single commodity as gold or wheat are benchmark’s candidates. The physical replication (quasi-replication indeed) always has its partisans with security lending generating a complementary income, but synthetic replication (swap-based ETF) is spreading in Europe.

While offering similar exposures, these products may vary significantly in their structures and risk profiles. The differences between structures can bring additional risks to those of the underlying: counterparty risk, conflict of interest. The replication of particular benchmarks (metals, agricultural commodities) raises some questions about price manipulations: can the ETF’s trading destabilize the underlying markets? An improvement of the European transparency regulation would facilitate, from the investors’ point of view, risk-adjusted performance measures of these products.

For numbers of politicians, commentators and regulators, it is politically correct to be ready to reinforce the bank and finance regulations and to discover non-regulated activities liable of having systemic implications. The large commodities trading houses could be the next “too big to fail” threat. The economic importance of international commodities traders (oil, energy, metal, agricultural products) has been increasing for the last 30 years. In 2012, Vitol had a 297 billion dollars revenue, negotiating a daily average production of 5,5 million barrels of oil. In 2011, the Glencore turn over reached 186 billion dollars and its profit went beyond 5 billion dollars. In 2012, this trading house bought Xstrata, the third most important mining company in the world. Since 2007, this growth was partly done at the expense of the trading operations of the big investment banks.

At all times, the international commercial banks (mostly European) were the main financing sources of the trading commodities houses, but since 2008-2009, the traders have sought for new financial resources they have found in the capital markets (IPO and bonds) and among sovereign wealth funds. The Dodd Frank Act and the Basle 3 regulations account for this weakening of the investment and commercial banks to the benefit of large commodities trading houses and the capital markets. The commodities trading houses are becoming so important that some regulators have foretold a systemic risk. This fear seems exaggerated. Indeed, the trading houses are not in the middle of so complex and interconnected financial relations as those maintained by CME Group, Intercontinental Exchange and the 28 international banks pointed out by the Financial Stability Board.

How can Central Counterparty (CCP) clearing help to make the over-the-counter (OTC) derivatives market safer? To answer this question, we lay out two views of risk management. The “contract view” considers how to control the loss given default, while the “counterparty view” looks at the likelihood of a default first and, hence, at the incentives to take on risks. Applying the latter view to the market for OTC derivatives, we argue that the risk transfer that characterizes CCP clearing leads to incentives for individual risk-taking, as well as a collective failure of participants to take into account that the OTC derivatives market concentrates aggregate, system-wide risk. With central clearing this systemic risk externality worsens, as CCPs concentrate this risk further and become too-big-to-fail. To correct this problem, we propose the establishment of systemic risk insurance as a necessary component of CCP clearing in OTC derivatives markets.

The collateral constraint of a bank is usually viewed as a “physical” limit to what it can pledge in order to fund its activity, either through the Central bank or private agents. The view here is different. By pledging its best assets for securing its funding, the bank creates an externality: it deprives unsecured lenders and customers’ deposits from the implicit pledge these assets offer. The limit of what can be pledged without weakening the security of these claims is the “hidden collateral constraint”. We build a model of a bank that incorporates this new constraint and show that it may be more powerful than the usual solvency and liquidity constraints. Applied to the euro-zone, it seems already binding. We derive some macroeconomic consequences of our model on credit supply by banks and conclude that it definitely favors a credit crunch, by increasing the spread required by the lender.

Faced with the challenges raised by shadow banking for financial stability, this article deals with two major issues. On the one hand, it presents the risks created by the shadow banking system and shows that it raises specific risks, as well as complex interactions with the banking system. On the other hand, the article aims at determining the best regulatory framework to address them. It describes the major improvements that have been brought to banking regulation contributing to a form of “indirect” regulation of shadow banking: by setting rigorous standards for banking groups, one may influence operations within the unregulated sector. The financial crisis demonstrated, however, that this approach was necessary but not sufficient. Today, there is a certain consensus for a dual approach to go forward: to elaborate “horizontal” regulations for some specific activities and to limit or even ban some activities for banks, without however jeopardizing banking business models.

For the last past years following the financial crisis, the EU has displayed a huge legislative activity to regulate the banking sector but had left aside the shadow banking system, except for the AIMF5 regulating the alternative investment industry. Things recently changed with the publication of a Green Paper dedicated to this non regulated finance. This paper estimates its shape, its potential risks and provides insights regarding the way to handle it from a regulatory perspective. It will be used by the Commission as a starting point to act from the second semester of 2013.

Protecting retail savings has taken on crucial importance today. The place of banks and financial markets has evolved considerably in just a few years, driven by several factors: the rise of new players and insufficiently-regulated financing circuits; new risks with ever-more-complex financial products; and technological innovations upsetting the existing regulations. These apparently-technical debates have a very immediate impact on the perception the general public have of the workings of financial markets, a perception often tinged with wariness. Several examples drawn from European texts currently being debated or implemented highlight the fundamental role – even more so since the crisis – of financial regulation today.

These days, even countries sometimes have difficulties repaying just the interests generated by the debt. But, strangely, the medieval doctrine banned the charging of a profit on the lending of money. This theory advocated only the benefit generated from the capital invested should be shared between the lender and the borrower ex post according to an agreement drawn up ex ante. This article analyses the contribution of this theory and its underlying concepts. Part I presents the theories of rate regulation in the Ancient world. Part II analyses their developments in the Middle Ages under the influence of the canonists until the end of prohibition of usury in the 18^th century. The medieval approach is making a come back in France under a new form: the Islamic finance which outlaws interest and advocates the sharing of benefits. Part III examines the underlying doctrine of this form of financial intermediation to better understand its principles, differences with the scholastic theory and development paths.

The payment industry is undergoing profound changes due to technological breakthroughs with contactless payments (cards and mobile), internet payments… This paper compares and exploits original datasets on the payment behavior of two representative samples of the French population in 2005 and 2011. The analyses clearly show that the use of the payment card has increased between 2005 and 2011 at the expense of cash and checks on small and large amounts, respectively. This can be explained by a change of the legal framework on credit consumption and co-branding, an evolution of the card acceptance, electronic commerce and a generation effect. If rates of progress between 2005 and 2011 continue, we expect the payment card will dominate purchases of very small amounts, i.e. lower than 5 €, at the horizon of the 2030s.