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Table of Contents

Financial stability: Shadow banking and securitization - Part 6


Chapter 2. Theoretical Framework

Shadow banks do credit and maturity transformations akin to traditional bank systems. However, they do without explicit public sources of funds. Therefore, shadow banks are implicitly delicate and are very similar to regular banks, before creation of safety net. The funding techniques that are adopted by shadow banks are seen as key innovations in transferring credit risk and are definitely linked to the stability of the real economy. What happened in 2007 – 09, brought to fore the basic defects in the very design of the shadow banking environment. Short-term funding marketing, operated through asset backed commercial paper (ABCP) and repurchase agreements (repos) were totally demolished during the financial crisis, and therefore the credit innovations of shadow banking, which is fundamentally volatile, evaporated without leaving a trace. This collapse exposed the hitherto unknown liquidity build-up, credit tail risks, which precipitated a crisis. What the underpricing of liquidity and credit tail risks promoted in form of the credit boom, the shadow bank crisis created deep trauma in the financial system, which penetrated into the real economy also.

All the relevant transaction taking place would hence be on account of international trade in goods or services, or due to acquirement or liquidation of the financial assets, or due to creation or repayment of the international credit. One of the numerous methods of investments that shadow banking invest in is hedge funds and in the recent financial crisis that hit the US economy very hard, failure of the hedge fund systems also contributed intensely on the misery that occurred in the real US economy.

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2.1 Hedge Funds

Hedge funds are actually a part of the futures market. Futures market area fairly recent development. These markets were originally developed to meet the needs of the farmers and merchants. The prime objective of using future markets is to manage price risk. It is possible to acquire insurance against adverse price changes, by establishing a price now, for items to be delivered later. The principle underlying hedging in the futures market is that one can establish a known price level even weeks or months before the actual outflow or inflow. A Futures position protects against the unfavorable price changes before the due date. The activity of trading in futures to control or reduce risk is called as ‘Hedging’.

Trading in futures market acts as a substitute for cash market transactions, as the former allows one to know about the actual outflow or inflow in advance. On the other hand, in the latter, price fluctuations are possible. Futures contracts normally are traded in the auctions markets, as in such markets, the prices are driven by the order. In such markets, every individual broker and trade can purchase at the lowest price that is offered and contrarily sell the same at the highest bid price. Here, the liquidity is preserved by the participation of these buyers and sellers. Some of these buyers and sellers are hedgers, seeking to protect their investments, some are speculators who are risk-takers seeking to trade in pursuit of profit incidentally keep bid and ask prices close together and to provide efficient trading in the system.

The futures market was the development following the forwards market. While the forwards markets took centuries to evolve, they provided good assurance against price uncertainties and later on, started becoming more standardized and regulated. Futures markets are a fairly recent development, but understanding their origins help to appreciate the role the markets play in today and like future changes in that role.

Usually, futures contracts are traded in auctions markets, where the prices are order driven. In these markets, each broker and trader can but at the lowest offered price and sell at the highest bid price and the liquidity is maintained by the participation of these buyers and sellers. Some of these buyers and sellers are hedgers, seeking to protect their investments, some are speculators who are risk-takers seeking to trade in pursuit of profit incidentally keep bid and ask prices close together and to provide efficient trading in the system. Future contracts are designed in such a way so that their prices should always reflect the prices of underlying cash market. The activities of speculators and arbitragers also bring price alignment In ‘calendar spreading’ traders ell the current delivery-month contract and buy a later delivery-month contract, or vice versa. This reduces price variance between the futures contracts.

There are two types of hedging, namely short hedging and long hedging. Short hedging is alternatively named selling hedge and it takes place when the futures are sold with an objective of hedging the cash commodity against falling prices. Long hedging, also called as buying hedge occurs when the futures are bought for hedging against the growing commodity prices. Short hedges and long hedges come with risk or without risk and this are purely dependent on the degree of minimization of the basic risk.

Almost 60% of the assets side of a bank’s balance sheet is credit. The banks or the management of the various financial corporations globally should therefore, make sure that lending decisions are in conformity with the bank’s overall objectives of growth and stability (ICFAI Center for Management Research (ICMR), 2005). For example, Hedge funds at the Wall Street of the United States are nothing more than the gambling games that happened at Las Vegas. This is because market prices have been manipulated like anything in the recent times. Hedge funds usually invest in ventures which are highly risky in nature. Additionally, such ventures are less transparent as no details regarding their asset holdings, their liabilities or trading activities are disclosed to the public. Another important aspect with regard to such ventures is that they carry a huge amount of leverage.

Securities markets have turned out to be playing a very pivotal role in offering funding to businesses and the role of banks is the issuance of securities related to different corporations. Investment banks have the required proficiency and know-how for managing issues efficaciously, to draw the interest of potential investors, to sustain the securities market, and to hedge or underwrite potential risks. “With relevance to the trade in shares, bonds, and derivatives, banks increasingly focus their activities on executing customers’ orders, speculate on market developments, and engage in proprietary trading.” These kinds of activities fetch additional income in the form of commission to the banks.

2.2 Hedge Funds and the Retail Investors

In the olden days, individual positions were evaluated separately on their own merits and risk was defined as negative return. Significant advances in academic theory have had a major impact on practical risk measurement. Applications such as risk diversification, portfolio construction and hedging are no longer the esoteric domain of the academic ivory tower but are now widely applied by every bank, market – maker, investment management organization and pension fund.

In the recent times, most of the worlds’ financial institutions have pushed the concept of risk management a few steps ahead the corporate agenda and also they regard the same to be the greatest threat to their market value. Yet, it is the quantifiable risks, such as credit and market risk, which still absorb the most attention amongst financial institutions. Risk and return go hand in hand in investments and finance. One cannot talk about returns without talking about risk, because, investment decisions always involve a trade-off between risk and return. In a survey of more than 130 senior executives in financial institutions worldwide, 82 per cent agreed that awareness of risk is now more pervasive in their organisations than it was two years ago and 73 per cent agreed that their organisations define their appetite for risk more clearly. However, there are yet certain significant concerns that are covered by these encouraging results.

Substitute investment choices are as wide and unclear an area than any other within the industry of financial services. An alternative or substitute investment choice can be defined as anything other than a long position in a particular stock or bond related holdings of an individual. Few people may consider commodities and real estate do not come under the category of alternative investments. The reason for this being the ownership of gold and land has been a more conventional manner of investment right through the evolution of human history (Seeking Alpha, 2006).

The semantics of the aforementioned asset classes is not the issue of important now. What is believed to be important in the current context of discussion is how these asset classes, in concurrence with the conventional “stock and bond” portfolio, will have an effect on the portfolio’s general return and performance. During the recent past, many investors have made a shift of their choice of investments to newer alternatives like hedge funds and private equity investments.

Hedge funds are undoubtedly a better option for retail investors because of a plethora of reasons that are discussed as under. Most of the hedge funds and private equity funds do concentrate on absolute returns on contrary to relative returns. Most retail investors usually look at relative performance. On the contrary, most hedge fund managers are just interested in taking care of their money every year. Because of this focus shift on absolute returns, hedge funds may pursue equity indexes during the bull market years. However, it is during the bear markets, that hedge fund indexes have revealed their most potential results. Hedge funds also have an intrinsic supremacy at their disposal; hedge funds are very popular for their capability to use leverage, purchase derivative securities, and also the advantage of extensively high turnover, all in the search of alpha - the positive returns which is actually impossible to be explained by overall stock market gains. However, all securities are exposed to market risk but equity shares are the ones that are affected more. This risk includes wide range of factors exogenous to securities themselves like depressions, wars, and politics etc. Apart from this, there is also another risk named the interest rate risk which is the inconsistency in the return offered by a security, as a result of the changes in the interest rates. The reason for this is related to the valuation of securities. This risk affects bondholders more directly than equity investors.

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Many of the subprime lenders were mortgage companies rather than banks. Moreover, the financial system in the United States was geared in increasing the revenues in a very short period. Rising debts and the decline of the union movement were also some reasons for the crises. Many financial institutions of the United States offered easy loans without even considering the credentials of the borrower. This is due to the lack of proper regulation.

In the recent times, many investors in the U.S. financial market were taking high risks. This is because hedge funds do not have any capital requirement and the initial crunch of the financial market when the high-risk ventures of the subprime lending clubbed with high leverage investors. The amount of regulation in the U.S. financial market is very less. Most of the financial institutions of the U.S. market were not regulated and were also undercapitalized. Such institutions were the liquidity providers to the subprime markets. This being the scenario, whenever there is a solvency issue with respect to certain institutions of the subprime markets, the so called non-regulated companies faced liquidity crunch and hence the trading used to stumble. Lack of transparency in the market is another reason behind the crisis.

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