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Table of Contents

Financial stability: Shadow banking and securitization - Part 9



This study, contrary to the general perception that, the American banks have been overtaken by other financial systems in shadow banking, have proved that banks have considerably retained their own relative to mono-line insurance organizations, in provision of credit enhancements. This shows that banks still continue to play a key role in providing enhancements.

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Evidences from cross-sectional regressions are in favor of the buffer hypothesis of the enhancements. It is here, that a positive relationship is established between delinquency rates on banks that securitized assets and credit enhancements. There is a new model of shadow banking that creates a securitization model, without any kind of risk transfer out of the regular core banks. Securitization permits banks to diversify risks, while concentrating and minimizing their exposure to systematic risk only. This allows them to expand their balance sheets by only funding carry trades with minimal risk debts. When all the risks have been recognized, the market allots them to risk neutral intermediaries, while expanding insurance and inter-temporal trade opportunities. Thus, securitization on logical expectations is the root for many empirical phenomena like driving the role of demand in safe debt and securitization, increasing interdependence of banks because of securitization. This highlight, how fragile the shadow banking system can be, when tail risks are neglected. Securitization increases exposure to unknown risks through the contracts among intermediaries that could possibly improve welfare.

Securitization empowers intermediaries in accessing large pools of quick capital which is without risks, without even providing government deposit guarantees. Investors often misperceive risks, as recency plays an important role and this is where financial intermediaries through the element of securitization, can actually finance a lot more risk. This, however, exposes them to residual risks. It is exactly through the process of risk control, diversification, and securitization, which exposes intermediaries to common risks and thus compiles instability over and above what each bank could speculate on individually. The risks avoided by market participants are usually subtle, and evolves constantly. Hence, it is being optimistic to actually look up to the market regulators, in identifying these risks when others fail in it. Few policy interventions may actually make the system far more stable than what it is currently. It is therefore in better interest to manage overall bank leverage to the maximum extent, than relying on risk weighted capital requirements, as the ratings suffer from vulnerability due to the neglect of risks.


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Table 1 Recession Episodes

Table 2 US mortgage debt outstanding, by type of property and holder

Figure 2 Excess Liquidity

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