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Table of Contents

Financial stability: Shadow banking and securitization – Part 3

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1.3 Shadow Banking and Securitization

1.3.1 Shadow banking system

A range of financial institutions act like-banks, they benefit from specialization and comparative advantages over banks. The last authors affirm this system is parallel to the conventional banking system. Yet, it is due to the mediators which are akin to banks exist outside the regular banks, their actions are not overseen and the revelation of their deeds lay on their own conditions and benchmarks. And as regulation fails to reach them, a few risks exist, for the regular or conventional banking sector in particular. Their activities are off-radar; in the “shadow”; therefore this range of financial institutions outside of the regular banking system and its activities is called the “shadow banking system”, or even “market finance”.

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Indeed, many argue that securitization grew quickly prior to the recent financial crisis essentially because it was a novelty that empowered intermediaries to fund more money-like claims. “In this narrative, the so-called “shadow banking system” used highly-rated, long-term securitized bonds as collateral to back safe, liquid, money-like, short-term debt. In response to growing demand for money-like claims from institutional investors and firms, the shadow banking system manufactured more of this short-term debt.”

Shadow banking is an underground banking environment where financial intermediaries create credit across global financial system. However, this system of credit creation is unregulated and also some unregulated activities of regulated institution. It is because of this reason that since shadow banking system has always escaped from the regulations many of the institutions in the financial market employed market, credit and liquidity risk without commensuration risk with capital cushions. Such banking system is said to be the one of the prime cause of 2008 financial meltdown and since then shadow banking is under increasing scrutiny and regulations.

Lastly, as a result of securitization, finance professionals had a reduced incentive to be prudent and primarily for huge investor demand for subprime lending, banks and other financial institutions issued the loans and securitized them as AAA Bonds. These mortgaged backed securities were widely distributed to investors which later caused repercussions, globally, when subprime lending went into a financial disaster in 2007. This argument is maintained by Bengtsson, E. (2011) and Chang, W. (2011), who also argue that investors relied heavily on rating agencies’ assessments “due to the sheer magnitude of the pools and the complexity of the credit intermediation process.” (p.4)

We focus on the shadow banking system and securitisation more broadly for two reasons. Principally, they played a crucial role in the financial crisis. Endeavours to comprehend the origins of the crisis, as well as systems to evade such crises in future, necessitate a better grasp of what drove the growth of the system of shadow banking. Second, the growth of variety of financial instruments is an indication of a wider shift in the financial intermediation from traditional commercial banks to securities markets. It is crucial for both the financial and monetary economics to understand the degree to which these markets can carry out the same functions like the banks.

Likewise, regulating the market integrity essentially seeks to reduce market delinquency in the form of manipulation of the market and also consumer exploitation. The objective of market integrity regulation is the promotion of confidence pertaining to the efficiency and impartiality in the financial markets by making sure that the financial markets are strong, methodical and crystal clear. In view of these, regulators globally enact and enforce disclosure requirements like prospectus and rules for conduct of the financial institutions.

In a regulated market the laws or rules are made by the government or regulatory body, such as the security and exchange commission. These rules provide orderly procedures and complete procedures to protect the consumer and investor. Regulated markets have attractions due to their rules and regulations and such attractiveness of exchange market’s is maintained and increased by providing an efficient and well regulated market place, stock exchange notices and disseminates amendments to market rules and regulations. The primary aim of the exchange is to provide the investor, intermediaries and issuers with efficient attractive and well-regulated market in which to raise capital and fulfil investment and trading requirement.

Rapid technological revolution, globalization of various marketplaces, and the growing intricacy of financial innovations are only a couple of factors that have radically changed the financial environment globally. Considering the magnitude of changes in the financial backdrop, both at a national scale as well as the global scale, many nations have started a kind of retrospection of whether their existing regulatory structures are still apt, and a few nations have already employed drastic reforms to their regulatory regime.


Arguing in the favour of free market it is said that when a free market does not exist, there will be no competition in the market and such market will completely ignore many businesses. The wealth will not be equally distributed as due to the lack of competition in the market. There will be less intention to decrease the prices and the poor individuals will not be attracted towards the market. There will be not economic stability in the absence of free market. There are a lot of examples of the success of free market such as AT & T and US airline. There are also many examples of the failure of non-regulated free market.

There are a lot of examples that prove markets which follow the government regulations as the successful market. Some of the examples are DDT & PCBs etc. they use the government regulations and by following the regulated market they made a successful business and prove the regulatory market as successful market. on the other hand there are also such examples that shows the failure of regulated markets just because of the government regulations which they follows. The discussion does not show the single side of regulated market. If it discusses in the favour of regulated bodies and proves it as the successful market, it also shows the disadvantages and the failure of the markets which follows the government regulations as well. No one market from the non-regulated free market and the regulated market shows itself as perfect and successful in any case. So both of the markets require the balance and shows that there is a delight balance between an unregulated free market and a market will follow the regulations made by the government.

The good example of such a market is the market of United States (U.S). United State (U.S) has struck balance between the unregulated free market and the market which follow the government regulations. There are many cases in which the economy has become out of balance as a result of deregulation of a market or following the government regulations as well.

There is a main question that which market is better to follow as there were many confusions for the people about both type of markets. There was a lot of confusion that prevails concerning the fact as to which type of market such as Non-regulated free market (or the market which follow less rules) and the market which uses the government regulations is better at all.

As discussed above both markets have positive and negative aspects as well. The economy of non-regulated free market is not ever perfect and never the economy of regulated market. Both non-regulated free market and regulated markets show the advantages and disadvantages as well.

The key point to solve this problem is that to strike a good balance between the non-regulated free market and the amount of government regulations needed to protect the people and the environment as well. This is the best technique for a successful market or it can be said that it is important to make a market successful. This type of market also called the balanced market as it takes the balance between the non-regulated free market (Pure free market) and the regulated market which follows the government regulations. The market where there is good balance between the non-regulated free market and regulated market, the public interest is protected in such a market and the private business will flourish.

Banking regulation is another angle that is to be explored. As the excessively trade liberalization and the flaws in the regulation and supervision of the financial sector have been attributed as reasons for the global financial crisis which was again a result of the sub-prime mortgage crisis of the United States in the year 2007-2008, financial practitioners as well as academicians have been incessantly stressing upon the imminent need for reforming the financial regulatory framework.

As a result, the ‘Basel III: A global regulatory framework for more resilient banks and banking systems’ was unveiled by the Basel Committee on Banking Supervision in December 2010. This Basel III framework for regulation predominantly includes two different parts namely, a micro-prudential regulatory structure and a macro-prudential structure. The micro-prudential regulatory structure of Basel III encompasses these measures - levitation of both the quality as well as the degree of the regulatory capital base and augmenting the risk coverage of the same along with introducing global liquidity standards as well as a regulation on leverage ratio. This micro-prudential framework also is intended to strengthening regulation, risk management and disclosure.

On the contrary, the macro-prudential regulatory structure encompasses introduction of the countercyclical barriers and a regulation on leverage ratio along with strengthening the regulation on systemically significant banks.

The primary objective behind designing the Basel III is to enhance the global banking system’s stability in the medium to long-term by way of offering incentives to the banks for their effort towards boosting the liquidity base as well as the capital base. Moreover, the Basel III would also curtail the practices of banks in taking excessive risks in a plethora of ways that is currently prevalent.

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If the regulations on the banks are strengthened this might result in an increase of private sector funding costs and also lead to the reduction of credit availability and in the due course would affect the real economy. Strengthening regulation would lead to the reduction in the profitability of the banks. This is a counter effect of the increased funding costs and the investment expansion pertaining to the assets having a low-yield. Essentially, all these costs would be passed on to the private sector by the banks by way of increasing the lending interest rates and worsening the funding conditions in the private sector. A variety of studies in regard to the impact of tightened regulation over the banking sector have predominantly focused on the microeconomic aspects which includes the operational behaviours of the banks as well as the changes in the lending spreads.

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