Shadow Banking and Capital Markets RISKS and OPPORTUNITIES

shadow banking and banking shadow capital markets:

shadow banking group of thirty risks and opportunities and risks 1701 K Street, NW, Suite 950 and Washington, D.C. 20006 capital markets ISBN 1-56708-170-3 RISKS AND OPPORTUNITIES

Grou p of Thirty p of Disclaimer This report is the product of the Group of Thirty’s Steering Committee and Working Group on Shadow Banking and reflects broad agreement among its participants. This does not imply agreement with every observation or nuance. Members participated in their personal capacity, and their participation does not imply the support or agreement of their respective public or private institutions. The report does not represent the views of the membership of the Group of Thirty as a whole.

ISBN 1-56708-170-3 Copies of this paper are available for US$49 from: The Group of Thirty 1701 K Street, N.W., Suite 950 Washington, D.C. 20006 Tel.: (202) 331-2472 E-mail: [email protected], www.group30.org shadow banking and capital markets RISKS AND OPPORTUNITIES

Published by Group of Thirty Washington, D.C. November 2016 table of contents

Foreword...... v

Abbreviations ...... vi

Acknowledgments...... vii

Working Group Members...... ix

Executive Summary...... xi

Introduction...... 1

1 Objectives,Objectives, definitions, and focus...... 3

2 Sh Shadowadow banking and other risks to financial stability ...... 5

3 Op Opportunitiesportunities to develop securitization and other forms of nonbank finance...... 33

4 RRecommendationsecommendations...... 45

5 CConclusiononclusion ...... 49

Bibliography...... 50 51.

Group of Thirty Members 2016...... 53 .51

Group of Thirty Publications ...... 56 foreword

he global response to the 2007–08 global finan- of credit extension are creating new risks. In certain cial crisis comprised a series of internationally markets, notably China, shadow banking activities Tcoordinated government and regulatory steps merit extremely close attention. aimed at the world’s largest banks and financial insti- Given the above analysis, we conclude that the risks tutions, designed to reduce financial stability risks, arising from the combination of high leverage and the both macroprudential and microprudential. ways in which credit is intermediated remain concern- Eight years on from the peak of the financial crisis, ing and must be monitored very closely lest they pose the Group of Thirty decided there was a need to address new risks to global financial and economic stability. two related questions: (1) whether growing nonbank * * * credit intermediation is leading to the reemergence of The project was guided by the knowledge and worrisome shadow banking risks; and (2) whether it is insight of Adair Turner, Chair, and Jacques de Larosière possible to develop more stable and sustainable forms and Masaaki Shirakawa, Vice-Chairs. They were sup- of securitization, truly delivering the benefits that the ported by the twelveeleven G30 members who comprised originate-to-distribute model of securitized credit was the Working Group on Shadow Banking, which can supposed to make possible. be found on page ix. This study, Shadow Banking and Capital Markets: This report is the product of the Group of Thirty’s Risks and Opportunities, commenced in 2014, tackles Steering Committee and Working Group on Shadow both questions. The analysis reveals both positive and Banking and reflects broad agreement among its par- negative developments for the global supervisory and ticipants. This does not imply agreement with every financial communities. observation or nuance. Members participated in their We find that the specific forms of nonbank credit personal capacity, and their participation does not intermediation most implicated in the 2007–08 finan- imply the support or agreement of their respective cial crisis have declined significantly and have not public or private institutions. The report does not rep- reemerged or changed shape in response to the global resent the views of the membership of the Group of regulatory steps we have lived through. As a result, Thirty as a whole. the global financial system itself is significantly more We commend this study to the global financial resilient than it was in the run-up to 2008. community. We hope that its findings and recom- But we also find that high real economy leverage mendations are instructive, and that they provide the can create macroeconomic risks, even if the financial basis for further fruitful debate and discussion on the system is itself more resilient. And some new forms possible financial stability risks ahead.

Jacob A. Frenkel Jean-Claude Trichet Jean-Claude Trichet ChairmanChairman of the Board of Trustees ChChairmanairman and CEO Group of Thirty GGrouproup of Thirty

groupgroup of thirty v abbreviations

FSB Financial Stability Board

G30 Group of Thirty

GDP gross domestic product acknowledgments

SMEs small and medium enterprises

n behalf of the Group of Thirty (G30), we Lund, and to Ritesh Jain, both of the McKinsey Global would like to express our appreciation to those Institute, and to the many members of the team at the Owhose time, talent, and energy have driven this McKinsey Global Institute who worked so hard to put project to a successful completion. We would like to this report together. We thank them all for their contri- thank the members of the Steering Committee and butions to the analysis and formulation of the report. Working Group on Shadow Banking, who guided our Finally, the coordination of this project and many work at every stage and added their unique insight. aspects of project management, Working Group logis- The intellect and experience brought to the table by tics, and report production were centered at the G30 the eleven members of the Working Group on the offices in Washington, D.C. This project could not important subject of shadow banking was essential have been completed without the efforts of our editor, to our collective success. Diane Stamm, and the work of Executive Director No project of this magnitude can be accomplished Stuart Mackintosh and his team, including Corinne without the committed effort of a strong team. The G30 Tomasi and Stephanie Tarnovetchi of the G30. We are extends its deep appreciation to Project Director, Susan grateful to them all.

Adair Turner Chair, Working Group on Shadow Banking

Jacques de Larosière Masaaki Shirakawa Vice-Chair Vice-Chair

vi shadow banking and capital markets: risks and opportunities group of thirty vii acknowledgments

n behalf of the Group of Thirty (G30), we Lund, and to Ritesh Jain, both of the McKinsey Global would like to express our appreciation to those Institute, and to the many members of the team at the Owhose time, talent, and energy have driven this McKinsey Global Institute who worked so hard to put project to a successful completion. We would like to this report together. We thank them all for their contri- thank the members of the Steering Committee and butions to the analysis and formulation of the report. Working Group on Shadow Banking, who guided our Finally, the coordination of this project and many work at every stage and added their unique insight. aspects of project management, Working Group logis- The intellect and experience brought to the table by tics, and report production were centered at the G30 the twelveeleven membersmembers ofof thethe WorkingWorking GroupGroup onon thethe offices in Washington, D.C. This project could not important subject of shadow banking was essential have been completed without the efforts of our editor, to our collective success. Diane Stamm, and the work of Executive Director No project of this magnitude can be accomplished Stuart Mackintosh and his team, including Corinne without the committed effort of a strong team. The G30 Tomasi and Stephanie Tarnovetchi of the G30. We are extends its deep appreciation to Project Director, Susan grateful to them all.

Adair Turner Chair, Working Group on Shadow Banking

Jacques de Larosière MasaakiMasaaki Shirakawa Vice-Chair Vice-ChairVice-Chair

groupgroup of thirty vii acknowledgments

Adair Turner Chair, Working Group on Shadow Banking

Jacques de Larosière Masaaki Shirakawa Vice-Chair Vice-Chair

group of thirty vii acknowledgmentsworking group members

Steeringn behalf Committee of the Group of Thirty (G30), we Lund, and to Ritesh Jain, both of the McKinsey Global would like to express our appreciation to those Institute, and to the many members of the team at the OAdair Turner,whose Chairtime, talent, and energy have driven this McKinsey Global Institute who worked so hard to put projectChairman to aof successful the Governing completion. Board, We Institute would for like New to Economicthis report Thinking together. We thank them all for their contri- thankFormer the Chairman, members Financial of the Steering Services Committee Authority and butions to the analysis and formulation of the report. Working Group on Shadow Banking, who guided our Finally, the coordination of this project and many workJacques at everyde Larosière, stage and Vice-Chair added their unique insight. aspects of project management, Working Group logis- President, Eurofi The intellect and experience brought to the table by tics, and report production were centered at the G30 Former Managing Director, International Monetary Fund the eleven members of the Working Group on the offices in Washington, D.C. This project could not importantMasaaki Shirakawa, subject of Vice-Chair shadow banking was essential have been completed without the efforts of our editor, toSpecial our collective Professor success. of International Politics, Economics, &Diane Communication, Stamm, and Aoyama the work Gakuin of Executive University Director FormerNo project Governor, of this Bank magnitude of Japan can be accomplished Stuart Mackintosh and his team, including Corinne without the committed effort of a strong team. The G30 Tomasi and Stephanie Tarnovetchi of the G30. We are extends its deep appreciation to Project Director, Susan grateful to them all. Project Director

Susan Lund Partner, McKinsey Global Institute

Working Group

AdairJean-Claude Turner Trichet Guillermo de la Dehesa Chair,Chairman, Working Group Group of Thirty on Shadow Banking Vice Chairman & Member of the Executive Former President, European Central Bank Committee, Grupo Santander Chairman, Aviva Grupo Corporativo Geoffrey Bell President, Geoffrey Bell and Company, Inc. Richard Debs JacquesFounder, de Group Larosière of Thirty Masaaki ShirakawaAdvisory Director and Former President, Vice-Chair Vice-Chair Morgan Stanley International Jaime Caruana Former COO, Federal Reserve Bank of New York General Manager, Bank for International Settlements Martin Feldstein Former Financial Counsellor, Professor of Economics, Harvard University International Monetary Fund President Emeritus, National Bureau of Economic Research

groupgroup of thirty viiix Arminio Fraga William R. Rhodes Founding Partner, Gávea Investimentos President and CEO, William R. Rhodes Former Governor, Banco Central do Brasil Global Advisors Senior Advisor, Citigroup Philipp Hildebrand Vice Chairman, BlackRock David Walker Former Chairman of the Governing Board, Chairman, Winton Capital Management Swiss National Bank Former Chairman, Barclays PLC

Guillermo Ortiz Treasurer, Group of Thirty executive summary Chairman, BTG Pactual Mexico

Experts rior to the 2007–08 financial crisis, the growth macroeconomic risks even if the financial system is Ritesh Jain of securitized credit, which turned bank loans itself more resilient; some new forms of credit exten- McKinsey Global Institute Pinto marketable securities and distributed them sion are creating new risks, and shadow banking to nonbank investors, was widely believed to offer developments in China mirror precrisis developments Stuart P.M. Mackintosh significant advantages over a purely bank-based credit in the advanced economies. Overall, the risks arising Group of Thirty intermediation system. But the emergence of the from the combination of high leverage and the ways complex combination of activities labelled “shadow in which credit is intermediated may be as great now banking” turned the securitized credit system into as they were before the 2007–08 crisis. an engine of financial instability. Partly as a result of tighter regulation of the formal banking system, new forms of nonbank credit are now growing. This Old risks reduced—and some growth therefore prompts the two questions addressed benign developments in this report: We define shadow banking as activities relating to • Whether growing nonbank credit intermediation credit provision extended outside or partially outside is leading to the reemergence of worrisome “shad- the banking system, but involving the distinctive fea- ow-banking” type risks tures of banking, that is, leverage and liquidity/maturity 1 • Whether it is possible to develop more stable and transformation. In the precrisis years, complex struc- sustainable forms of securitization, truly delivering tured credit securities, distributed via multistep and the benefits that the originate-to-distribute model of opaque distribution chains, allowed leverage and matu- securitized credit was supposed to make possible. rity transformation to flourish, but in forms liquidity difficult for regulators and market participants to understand and manage. These specific precrisis forms Shadow banking diminished, of shadow banking have declined significantly in scale, but overall risks to stability and, at least in the advanced economies, growing nonbank credit intermediation has primarily been in as great as ever forms that do not appear (for now) to raise the same In the advanced economies, the specific forms of financial stability concerns. Specifically, we find that: nonbank credit intermediation most implicated in the • While total bank shares of private credit supply 2007–08 financial crisis have declined significantly have declined slightly in both the United States and have not reemerged in response to tighter bank and Europe, much of the growth of nonbank regulation. But high real economy leverage can create

1 The report uses the Financial Stability Board definition of shadow banking. (See the box on page 4 for key definitions used in this report.)

x shadow banking and capital markets: risks and opportunities group of thirty xi executive summary

rior to the 2007–08 financial crisis, the growth macroeconomic risks even if the financial system is of securitized credit, which turned bank loans itself more resilient; some new forms of credit exten- Pinto marketable securities and distributed them sion are creating new risks, and shadow banking to nonbank investors, was widely believed to offer developments in China mirror precrisis developments significant advantages over a purely bank-based credit in the advanced economies. Overall, the risks arising intermediation system. But the emergence of the from the combination of high leverage and the ways complex combination of activities labelled “shadow in which credit is intermediated may be as great now banking” turned the securitized credit system into as they were before the 2007–08 crisis. an engine of financial instability. Partly as a result of tighter regulation of the formal banking system, new forms of nonbank credit are now growing. This Old risks reduced—and some growth therefore prompts the two questions addressed benign developments in this report: in this report: We define shadow banking as activities relating to • WhWhetherether growing nonbank credit intermediation credit provision extended outside or partially outside is leading to the reemergence of worrisome “shad- the banking system, but involving the distinctive fea- ow-banking” type risks tures of banking, that is, leverage and liquidity/maturity 1 • Whether it is possible to develop more stable and transformation. In the precrisis years, complex struc- sustainable forms of securitization, truly delivering tured credit securities, distributed via multistep and the benefits that the originate-to-distribute model of opaque distribution chains, allowed leverage and matu- securitized credit was supposed to make possible. rity transformation toto flourish,flourish, butbut inin formsforms liquiditydifficult fordifficult regulators for regulatorsand market and participants market participantsto understand to andunderstand manage. and These manage. specific These precrisis specific forms precrisis of shadow forms Shadow banking diminished, bankingof shadow have banking declined have significantly declined significantly in scale, inand, scale, at but overall risks to stability leastand, inat theleast advanced in the advanced economies, economies, growing nonbankgrowing as great as ever creditnonbank intermediation credit intermediation has primarily has beenprimarily in forms been that in as great as ever doforms not that appear do not (for appear now) (forto raise now) the to sameraise thefinancial same In the advanced economies, the specific forms of stabilityfinancial concerns. stability Specifically,concerns. Specifically, we find that: we find that: nonbank credit intermediation most implicated in the • While total bank shares of private credit supply 2007–08 financial crisis have declined significantly have declined slightly in both the United States and have not reemerged in response to tighter bank and Europe, much of the growth of nonbank regulation. But high real economy leverage can create

1 The report uses the Financial Stability Board definition of shadow banking. (See the box on page 4 for key definitions used in this report.)

groupgroup of thirty xi credit has been in the form of straightforward sin- authorities must continually monitor developments, The second is the role of asset managers in illiq- But as China continues with capital account liberal- gle-name nonfinancial corporate bonds, which have and keep a particularly close eye on currently small uid credit markets. In principle, the fact that credit ization, the potential risks of global contagion will increased by US$5.1 trillion from 2007 through the but rapidly growing activities (such as peer-to-peer investments are managed by asset managers (rather increase, and even if a major financial system crisis can second quarter of 2015, becoming a major source lending). But at least for now, and in the advanced than held directly by end investors) need not introduce be avoided, bringing an end to the unsustainable credit of funding for larger companies in advanced econo- economies, the financial system itself seems likely to new risks into the financial system. And the total share boom will inevitably have significant consequences for mies. This development could in principle represent be less vulnerable to the sort of self-reinforcing shocks of all global investments that is “managed” is similar Chinese, and therefore global, growth. a more stable and less risky form of credit exten- experienced during the 2008 crisis. now to what it was in 2007. But some asset manage- sion than bank lending. ment practices can amplify the risks of herd behavior • There has been a dramatic decline in the volume inherent in all liquid traded markets, and if asset man- Sustainable securitization of complex structured credit securities such as Overall risks to stability agers promise immediate liquidity to investors whose and nonbank finance collateralized debt obligations (down 67 percent), as great as ever money is invested in potentially illiquid assets, this The precrisis growth of securitized credit was widely asset-backed commercial paper (down 70 percent), But despite these broadly favorable trends within can introduce a worrying new form of risky maturity lauded as a positive development, not only because it and structured investment vehicles (down the financial system itself, and within the advanced transformation. The evolving role of asset managers would (supposedly) enable more effective risk man- 100 percent), from 2007 through the second economies, overall risks to stability are likely now therefore merits close regulatory attention. agement, but because it increased diversity of credit quarter of 2014. to be as great as ever. This reflects the combination The third is shadow banking risks in China. China’s supply. The larger role for capital markets that secu- total nonfinancial debt to GDP—of households, gov- • The degree of interconnectedness between banks of rising leverage across the global economy together ritization enabled could, it seemed, provide economies ernment, and corporates combined—has risen from and other financial institutions appears to have with some concerning developments in the specific with a “spare tire” of additional credit supply that 116 percent in 2007 to 240 percent in 2015, and is diminished since 2008, a potentially positive ways in which credit is being extended in particular would not dry up in the face of a banking crisis. now similar to that of the United States and other development. markets and countries, and new amplifying mecha- And the fact that the US capital markets provided 68 nisms particularly in illiquid markets. advanced economies and far above typical emerging percent of private credit, compared to only 32 percent • Private debt funds of alternative asset managers, market levels. Total nonfinancial debt is over US$26 in Europe, was seen as an important advantage. such as hedge funds and private equity funds, are Excessive real economy leverage. At the level of the trillion, and has more than quadrupled since 2007. The second question we address in this report is growing rapidly, but are still small in relation to overall world economy, there has been no deleveraging Corporate debt at over 130 percent of GDP in 2015 is therefore whether there are opportunities to grow the total system. since 2008, but rather a gradual increase in global particularly high, and has continued to grow over the nonbank credit intermediation in sustainable ways • Direct lending to corporations by insurance com- debt to GDP. Some deleveraging by, for instance, last year. This massive growth of leverage, funding a that do not create “shadow banking” risks. In particu- panies and pension funds is growing, but does US households, has been offset by large increases in huge property and infrastructure construction boom, lar, we assess the common assertion that securitization not in general pose risks since credit is provided advanced economy public debt and in private sector creates macroeconomic risks and poses major man- could play a greater role (particularly in Europe) in in a simple and transparent fashion, and does not debt in many emerging economies. agement challenges for the Chinese authorities. providing credit to small and medium enterprises involve maturity transformation. This rising real economy leverage in itself creates In addition, some 30 percent of credit is provided via (SMEs), which are often believed to be underserved a multiplicity of unregulated or imperfectly regulated • Hedge fund risks have not increased, with leverage macroeconomic risks, but also makes it more import- by the banking system. shadow banking entities and activities, including trust 2.3 times assets on average, and the average gross ant to identify whether the particular form of debt or Our analysis suggests that some commonly held funds, wealth management products, and “entrusted leverage of fixed-income arbitrage funds (the most the particular ways in which credit flows are inter- beliefs are wrong, and that a more realistic assessment loans.” Some of these structures and activities are eerily highly leveraged class) 4.7 times assets, far below mediated or managed are contributing further to the of the opportunities for securitization is required, par- reminiscent of those that proliferated in the advanced the level seen in banks and broker-dealers before inherent risks. Three developments are of clear or ticularly in relation to the SME sector. Specifically: potential concern. economies before the 2007–08 crisis, with opaque links the crisis. • In all economies, including the United States, secu- The first is the rapid increase in emerging market between some regulated banks and shadow banking • While credit provided through online peer-to-peer ritization plays a trivial role in corporate credit corporate debt, often denominated in foreign cur- entities, and with implicit but unspecified commitments services raises some concerns and regulators must provision. The greater role of capital markets in rency, which grew from US$6 trillion in 2007 to to provide credit or liquidity support. be particularly alert to possible interconnections corporate credit provision in the United States US$20 trillion by the second quarter of 2015. This How far this growth of leverage and of shadow with commercial banks, the sector is, at present, reflects almost entirely a greater role for sin- growth occurred during a period of low global interest bank forms of credit provision poses a threat to global still very small, with total outstanding credit less gle-name corporate bonds. rates, leaving many borrowers vulnerable to interest financial stability can be debated. Most of the debt than US$30 billion globally. rate rises. In addition, many borrowers face significant currently in place links Chinese domestic state-owned • Securitization is almost entirely a household In several ways, therefore, the risks created by currency mismatch risks. But policy makers do not banks to state-owned companies, and to local govern- sector phenomenon, playing a major role in resi- shadow banking entities and activities prior to the have an adequately clear picture of the holders of this ment financing vehicles, with only limited involvement dential mortgage credit in the United States but a crisis have been reduced and have not reemerged on a debt, of their links to the rest of the financial system, (so far) of overseas investors or financial institutions. much more limited role elsewhere. In the United large scale as a result of tighter bank regulation. Given and of the risks to financial stability that such debts And with Chinese central government debt still (in States, moreover, extensive residential mortgage the capacity of the financial system endlessly to evolve, therefore pose. Further analysis of these debts should 2015) only 25 percent of GDP, the government has securitization reflects the pervasive role of the creating new forms of activities and risks, regulatory be a key regulatory priority. the capacity to fund significant bank capitalization.

xii shadow banking and capital markets: risks and opportunities group of thirty xiii The second is the role of asset managers in illiq- But as China continues with capital account liberal- uid credit markets. In principle, the fact that credit ization, the potential risks of global contagion will investments are managed by asset managers (rather increase, and even if a major financial system crisis can than held directly by end investors) need not introduce be avoided, bringing an end to the unsustainable credit new risks into the financial system. And the total share boom will inevitably have significant consequences for of all global investments that is “managed” is similar Chinese, and therefore global, growth. now to what it was in 2007. But some asset management practices can amplify the risks of herd behavior inherent in all liquid traded markets, and if asset man- Sustainable securitization agers promise immediate liquidity to investors whose and nonbank finance money is invested in potentially illiquid assets, this money is invested in potentially illiquid assets, this The precrisis growth of securitized credit was widely can introduce a worrying new form of risky maturity can introduce a worrying new form of risky maturity lauded as a positive development, not only because it transformation. The evolving role of asset managers transformation. The evolving role of asset managers would (supposedly) enable more effective risk man- therefore merits close regulatory attention. therefore merits close regulatory attention. agement, but because it increased diversity of credit The third is shadow banking risks in China. China’s The third is shadow banking risks in China. China’s supply. The larger role for capital markets that secu- total nonfinancial debt to GDP—of households, gov- total nonfinancial debt to GDP—of households, gov- ritization enabled could, it seemed, provide economies ernment, and corporates combined—has risen from ernment, and corporates combined—has risen from with a “spare tire” of additional credit supply that 116 percent in 2007 to 240 percent in 2015, and is 116 percent in 2007 to 240 percent in 2015, and is would not dry up in the face of a banking crisis. now similar to that of the United States and other now similar to that of the United States and other And the fact that the US capital markets provided 68 advanced economies and far above typical emerging advanced economies and far above typical emerging percent of private credit, compared to only 32 percent market levels. Total nonfinancial debt is over US$25 market levels. Total nonfinancial debt is over US$26 in Europe, was seen as an important advantage. trillion, and has more than quadrupled since 2007. trillion, and has more than quadrupled since 2007. The second question we address in this report is Corporate debt at over 130 percent of GDP in 2015 is Corporate debt at over 130 percent of GDP in 2015 is therefore whether there are opportunities to grow particularly high, and has continued to grow over the particularly high, and has continued to grow over the nonbank credit intermediation in sustainable ways last year. This massive growth of leverage, funding a last year. This massive growth of leverage, funding a that do not create “shadow banking” risks. In particu- huge property and infrastructure construction boom, huge property and infrastructure construction boom, lar, we assess the common assertion that securitization creates macroeconomic risks and poses major man- creates macroeconomic risks and poses major man- could play a greater role (particularly in Europe) in agement challenges for the Chinese authorities. agement challenges for the Chinese authorities. providing credit to small and medium enterprises In addition, some 30 percent of credit is provided via In addition, some 30 percent of credit is provided via (SMEs), which are often believed to be underserved a multiplicity of unregulated or imperfectly regulated a multiplicity of unregulated or imperfectly regulated by the banking system. shadow banking entities and activities, including trust shadow banking entities and activities, including trust Our analysis suggests that some commonly held funds, wealth management products, and “entrusted funds, wealth management products, and “entrusted beliefs are wrong, and that a more realistic assessment loans.” Some of these structures and activities are eerily loans.” Some of these structures and activities are eerily of the opportunities for securitization is required, par- reminiscent of those that proliferated in the advanced reminiscent of those that proliferated in the advanced ticularly in relation to the SME sector. Specifically: economies before the 2007–08 crisis, with opaque links between some regulated banks and shadow banking • In all economies, including the United States, secu- entities, and with implicit but unspecified commitments ritization plays a trivial role in corporate credit to provide credit or liquidity support. provision. The greater role of capital markets in How far this growth of leverage and of shadow corporate credit provision in the United States bank forms of credit provision poses a threat to global reflects almost entirely a greater role for sin- financial stability can be debated. Most of the debt gle-name corporate bonds. currently in place links Chinese domestic state-owned • SecuritizationSecuritization is almost entirely a household banks to state-owned companies, and to local govern- sector phenomenon, playing a major role in resi- ment financing vehicles, with only limited involvement dential mortgage credit in the United States but a (so far) of overseas investors or financial institutions. much more limited role elsewhere. In the United And with Chinese central government debt still (in States, moreover, extensive residential mortgage 2015) only 25 percent of GDP, the government has securitization reflects the pervasive role of the the capacity to fund significant bank capitalization.

groupgroup of thirty xiii government-sponsored enterprises; it has not flour- and transparent security structures and distribution ished as a result of a free-market approach. chains, discouraging the overly complex structured • Securitization of SME credit plays a minimal role products and multistep, opaque distribution chains in all financial systems, but if anything plays a pro- that contributed to the 2007–08 crisis. portionately slightly larger role in Europe than in the United States. Recommendations • Single-name corporate bonds also play a minimal This report provides an overview of financial system role in SME finance, and there is no evidence that risks and development opportunities of relevance to corporate bond markets reach further down the investors, financial market participants, and macro- size spectrum of companies in the United States economic policy makers. In addition, we set out several introduction than in Europe or other economies. specific recommendations for regulators focused on • It seems inherent, indeed, that debt capital financial stability risks and for policy makers seeking markets will play only a small role in providing to foster more sustainable forms of capital market credit to SMEs, whether through corporate bonds credit provision. he complex combination of activities labelled Rather than distributing credit risk away from the or through securitized loans. Opportunities to These recommendations fall into four categories: “shadow banking” played a significant role in banking system to more appropriate investors, the improve external finance for SMEs lie instead in Tthe origins of the 2007–08 global financial crisis. shadow banking system that emerged prior to the • The need to monitor risk, creative incentives for equity markets and private debt placements, and Central to those activities was the originate-to-dis- crisis had complex and opaque interconnections with better risk management, improve data availability, policies to improve access to finance should be tribute model of credit intermediation, in which bank the regulated banking system. Troubles that began and increase transparency in a continually evolv- focused on these areas, rather than on creating loans were turned into marketable credit securities with shadow banking entities that had short-term ing financial system markets in securitized business assets. and potentially distributed to nonbank end investors, and potentially unstable funding ultimately spread to • Policy reforms that can help foster the development rather than held to maturity on bank balance sheets. Capital market developments are therefore unlikely of debt capital markets This model, first developed in the 1980s, was believed to play a significant role in directly improving the to deliver important advantages, enabling the more Many of the specific forms of shadow supply of credit to SMEs, which in all economies rely • Policies to support more sustainable forms of secu- efficient “slicing and dicing” of credit risk, and the primarily on banks for credit supply. But there may ritization than proliferated before the 2007–08 distribution of that risk into the hands of the most banking most implicated in the 2007–08 be opportunities to foster the development of secu- crisis appropriate investors. It was asserted that highly ritized mortgage markets in countries other than the financial crisis have declined. • Appropriate approaches to improving SME access developed securitization markets could equip econ- United States, and this may indirectly benefit SMEs to finance, which should focus on equity finance omies with “spare tires” of additional credit supply by freeing up banks to concentrate to a greater extent and private placement, rather than on the develop- that would not dry up in the face of banking crises. the trading books of the major banks and investment on the SME sector. Fostering sustainable securitiza- ment of SME securitization markets. But the system of nonbank credit intermediation banks. Moreover, the scale and risks of these intercon- tion regulators should favor the development of simple Details of these recommendations are presented on that actually emerged failed to achieve those objec- nections were difficult for the market or regulators to pages 45–48. tives, and instead contributed significantly to systemic understand and monitor. Shadow banking thus took risk of the financial system itself. It involved the fol- the originate-to-distribute model of securitized credit lowing components: (a) complex, multistep, and and turned it into an engine of financial instability. opaque chains of credit distribution, which facilitated Two questions arise, both of which this report the origination and distribution of poor-quality loans; explores. They are: (1) Whether the risks involved (b) the creation of complex structured credit securi- in the shadow bank entities and activities prior to ties whose true risk and return characteristics were the crisis have been reduced, or whether they have difficult to assess; (c) the extensive use of derivatives remerged in similar or new ways, in part perhaps as such as credit default swaps that were meant to hedge a result of the more strict regulation of the formal credit risk but instead created counterparty risks; and banking system; and (2) Whether there are opportu- (d) the introduction at multiple points in the system nities to develop more stable and sustainable forms of of leverage and maturity transformation (the defining nonbank credit intermediation, truly delivering the characteristics of banks), but in forms that were diffi- benefits that the originate-to-distribute model of secu- cult for regulators and market analysts to understand. ritized credit was supposed to make possible.

xiv shadow banking and capital markets: risks and opportunities group of thirty 1 1 introduction

he complex combination of activities labelled Rather than distributing credit risk away from the “shadow banking” played a significant role in banking system to more appropriate investors, the Tthe origins of the 2007–08 global financial crisis. shadow banking system that emerged prior to the Central to those activities was the originate-to-dis- crisis had complex and opaque interconnections with tribute model of credit intermediation, in which bank the regulated banking system. Troubles that began loans were turned into marketable credit securities with shadow banking entities that had short-term and potentially distributed to nonbank end investors, and potentially unstable funding ultimately spread to rather than held to maturity on bank balance sheets. This model, first developed in the 1980s, was believed to deliver important advantages, enabling the more Many of the specific forms of shadow efficient “slicing and dicing” of credit risk, and the distribution of that risk into the hands of the most banking most implicated in the 2007–08 appropriate investors. It was asserted that highly financial crisis have declined. developed securitization markets could equip economies with “spare tires” of additional credit supply that would not dry up in the face of banking crises. the trading books of the major banks and investment But the system of nonbank credit intermediation banks. Moreover, the scale and risks of these intercon- that actually emerged failed to achieve those objec- nections were difficult for the market or regulators to tives, and instead contributed significantly to systemic understand and monitor. Shadow banking thus took risk of the financial system itself. It involved the fol- the originate-to-distribute model of securitized credit lowing components: (a) complex, multistep, and and turned it into an engine of financial instability. opaque chains of credit distribution, which facilitated Two questions arise, both of which this report the origination and distribution of poor-quality loans; explores. They are: (1) Whether the risks involved (b) the creation of complex structured credit securi- in the shadow bank entities and activities prior to ties whose true risk and return characteristics were the crisis have been reduced, or whether they have difficult to assess; (c) the extensive use of derivatives remerged in similar or new ways, in part perhaps as such as credit default swaps that were meant to hedge a result of the more strict regulation of the formal credit risk but instead created counterparty risks; and banking system; and (2) Whether there are opportu- (d) the introduction at multiple points in the system nities to develop more stable and sustainable forms of of leverage and maturity transformation (the defining nonbank credit intermediation, truly delivering the characteristics of banks), but in forms that were diffi- benefits that the originate-to-distribute model of secu- cult for regulators and market analysts to understand. ritized credit was supposed to make possible.

groupgroup of thirty 1 Old risks reduced but financial stability risks can be introduced; we high- new ones emerging light the importance of currency mismatch risk in lending to emerging market companies; and we note Regarding the first question, the report finds that many with concern that in China, where overall leverage of the specific forms of shadow banking most impli- has increased most dramatically, a complex shadow cated in the 2007–08 financial crisis have declined banking system has also emerged. significantly in scale, and that, at least in the advanced Overall, the risks arising from the combination economies, the significant growth of nonbank credit of high leverage and the particular ways in which intermediation has primarily been in forms that do credit is intermediated may be as great as before the not appear for now to raise the same financial stability 2007–08 crisis, even if in advanced economies the concerns as precrisis shadow banking. financial system itself is less susceptible to the sort of Nonetheless, the report underscores that national self-reinforcing shocks experienced in that crisis. policy makers and regulators must continue to monitor the shifting, evolving nature of markets, and actors’ responses to those markets. Authorities must Opportunities, but not in all sectors Regarding the second question, the report identifies opportunities to develop more stable and sustainable The risks arising from the combination of forms of nonbank credit intermediation, but stresses high leverage and the particular ways in that the scale of this opportunity varies greatly by sector. In particular, the report finds little support for which credit is intermediated may be as one commonly asserted proposition—that the development of credit securitization could play a major and great as before the 2007–08 crisis. useful role in providing alternative sources of credit for small and medium enterprises. But the report spells out the requirements for a good, stable system of secu- remain alert to identify new financial stability risks, ritization in those areas of credit intermediation—in including those interconnections between the regu- particular residential mortgages—where securitiza- lated commercial banking sector and the unregulated tion can play a useful and major role in an overall shadow banking sector. For example, recent work by credit system. the European Banking Authority suggests that such interconnections continue to be seen in some major * * * markets, notably the UK and Germany.2 This report is structured as follows. Section 1 pres- We also caution that as the overall level of leverage ents the objectives, definitions used, and focus of the in the global economy continues to grow, financial report; section 2 covers shadow banking and other and macroeconomic risks could increase even if the risks to financial stability; section 3 explores oppor- financial intermediation system itself has become tunities to develop securitization and other forms of more resilient. We note that even where financial flows nonbank finance; section 4 offers policy recommenda- are managed rather than intermediated, increased tions; and section 5 presents the conclusion.

2 European Banking Authority, “Report on Institution’s Exposures to ‘Shadow Banking Entities,” London, 2015; https://www.eba.europa.eu/ documents/10180/950548/Report+on+institutions+exposures+to+shadow+banking+entities.pdf.

2 shadow banking and capital markets: risks and opportunities 1 objectives, definitions, and focus

Objectives Assessing opportunity. The second objective is to This report has two principal objectives: to assess risks assess the opportunity for creating stable sources of and to assess opportunity. nonbank credit supply, and in particular safe forms of securitization, to play a positive and (in some econ- We first assess to what degree risks to Assessing risks. omies) larger role in providing finance. This reflects financial stability are reemerging outside the formal the belief that while some forms of securitization banking sector through shadow banking activities. played a role in the origins of the 2007–08 crisis, in The report addesses the concern that shadow-bank- principle nonbank credit supply (including via securi- ing-type risks may be growing as some financing tization) can be a useful alternative to bank lending. activities shift to nonbank sectors in response to In particular, we assess the hypothesis that enhanced tighter regulation of the formal banking sector. development of debt capital markets and securitiza- In assessing these risks, we draw a distinction tion outside the United States (in Europe, for example) between risks that can be generated by the financial might help ensure better credit supply to SMEs or system itself, as a result, for instance, of excessive other types of borrowers. maturity transformation or leverage within financial We conclude by identifying actionable recom- balance sheets, opaque and overly complex intermedi- mendations for the international policy-making and ation chains, or procyclical risk management practices; financial industry communities, in line with the Group and wider macroeconomic risks that could be created of Thirty’s long-standing mission. by high levels of real economy leverage (among companies, households, or governments), or by currency * * * or liquidity mismatches, even if the financial system This report uses definitions consistent with those itself were as resilient as possible, and was not itself used by the Financial Stability Board. The box on the generating additional risks. following page presents definitions of key terms used Our primary focus is on the first of these, that is, on in the report. financial system risks, narrowly defined. Our assessment of overall risk, however, has to take account of the fact that overall global leverage has continued to increase since 2008, with dramatic increases in some specific markets.

group of thirty 3 Key definitions used in this report 2 Nonbank credit is credit provision that does not not equity finance . Second, the credit extension result in a loan permanently and continuously held could be either entirely outside or partially outside on a bank balance sheet *. This could entail simple the banking system . This captures the important credit securities such as single-name corporate reality that what went wrong before the crisis often bonds, securitized credit assets, and loans extended involved loans and credit securities that were first on the balance sheets of nonbank institutions (for originated and held off bank balance sheets, but example, insurance companies, pension funds, or were then repurchased by the trading divisions of shadow banking other financial institutions) . banks, or ended up in vehicles (for example, structured investment vehicles) owned by banks and/ Securitization refers to the creation of tradable or to which banks had extended liquidity guaran- and other risks to credit securities composed of multiple underlying tees . Third, as the name implies, shadow banking loans . It might include structuring of the securities describes activities that are bank-like in character, into multiple tranches of credit risk, and will always and involve leverage and maturity transformation financial stability include pooling of multiple smaller credits into a (the distinctive defining characteristics of banks) . composite credit security . Thus, nonbank credit provided in a simple, nonlev- eraged, and nonmaturity-transforming form—for Shadow banking is the “activities related to credit example, a major corporate issuing a bond that is ebate within the policy-making and financial rising leverage has been accompanied by the prolif- provision extended outside or partially outside the bought by a long-term investor—does not fall within communities has shifted since 2007–08. At first, eration of shadow banking intermediation systems. banking system, but involving the distinctive features “shadow banking ”. Fourth, analyses by the Financial Dpolicy makers and regulators correctly focused Third, overall risks arising from a combination of of banking, that is, leverage and maturity transforma- Stability Board and other regulators illustrates that on reregulating the banking sector; reinforcing capital high leverage and the particular ways credit is inter- tion ”. † There are several key aspects of this definition . shadow banking, as defined here, played a major role and related standards; and coordinating an interna- mediated may, therefore, be as great as before the First, these activities are focused on credit extension, in bringing about the 2007–08 global financial crisis . tional, multitiered, multiyear effort to restore stability. crisis, even if the specific forms of shadow banking Those efforts have strengthened the capital base of seen in the run-up to 2007–08 have declined in impor- * Some loans start on bank balance sheets and then are distributed off the balance sheet . This report sees those loans as part of normal major financial institutions and reduced systemic risks. tance, and even if the financial system itself is less commercial banking activity . But for definitional reasons, we consider those loans as nonbank credit when the loans are distributed vulnerable to self-reinforcing shocks. off the bank balance sheet . But the resulting slower growth in bank lending, offset † Financial Stability Board, Global Shadow Banking Monitoring Report 2015, November 2015; http://www financialstabilit. yboard org. / by growth in various forms of nonbank credit inter- wp-content/uploads/global-shadow-banking-monitoring-report-2015 pdf. . mediation, has raised concerns that risks to financial stability have shifted from the banking system to the A shift to nonbank credit— shadow banking sector. sometimes in less risky forms This section assesses the risks, and there are three Over the last eight years, the slower growth of bank financial instability problems derive from develop- Scope and focus—limits main findings. credit in advanced economies has been matched by ments in credit markets, not in equity markets. of the analysis First, while slower bank credit growth since 2008 the rapid growth of some forms of nonbank credit Second, the report addresses private equity and has undoubtedly been matched by growing nonbank intermediation. But so far this seems to have been pri- Two further points of clarification of this study’s scope hedge funds only if they are involved in the intermedia- credit intermediation, some of the specific forms this marily in forms that do not raise immediate financial are warranted. tion of credit and if their activities introduce significant has taken, particularly in the advanced economies, do stability concerns. First, the report focuses on credit supply, not equity leverage and maturity transformation into the system. not for now appear to raise the same financial stability markets. Equity markets can, of course, be volatile The report proceeds from the observation that many risks that contributed to the 2007–08 crisis. for rational or irrational reasons, and their fluctu- hedge funds and private equity funds were not central Second, our understanding of financial interme- A somewhat reduced banking system role ations can provoke macroeconomic instability. But to the developments leading to the 2007–08 crisis.3 In diation risks remains incomplete, and with overall Since 2008, banks have been subject to much larger movements in equity markets by themselves do not principle, there is a reasonable case that lightly lever- leverage continuing to rise, there is a danger that some capital requirements against both loan and trading necessarily have anything to do with shadow banking, aged equity hedge funds that can impose “gates” on new forms of nonbank credit intermediation (for books, and much tighter liquidity requirements. and the empirical record suggests that the most severe investor withdrawals do not create significant risks instance, through asset managers managing illiquid Partly as a result, there are some signs of a slightly within the financial system itself. assets such as emerging market bond funds) could be reduced role for banks within total credit intermedia- 3 Prior Group of Thirty work has, however, rightly recognized that hedge funds owned by commercial banks were a conduit of transmission amplifying the risks inherently created by high lever- tion. For example, total bank shares of private credit during the formative stages of the 2007–08 global financial crisis. That work, Financial Reform: A Framework for Financial Stability (2009), age. In China, in particular, it is notable that rapidly supply indicate a somewhat reduced banking system led to changes in US law limiting commercial bank ownership of hedge funds.

4 shadow banking and capital markets: risks and opportunities group of thirty 5 12

shadow banking and other risks to financial stability

ebate within the policy-making and financial rising leverage has been accompanied by the prolif- communities has shifted since 2007–08. At first, eration of shadow banking intermediation systems. Dpolicy makers and regulators correctly focused Third, overall risks arising from a combination of on reregulating the banking sector; reinforcing capital high leverage and the particular ways credit is inter- and related standards; and coordinating an interna- mediated may, therefore, be as great as before the tional, multitiered, multiyear effort to restore stability. crisis, even if the specific forms of shadow banking Those efforts have strengthened the capital base of seen in the run-up to 2007–08 have declined in impor- major financial institutions and reduced systemic risks. tance, and even if the financial system itself is less But the resulting slower growth in bank lending, offset vulnerable to self-reinforcing shocks. by growth in various forms of nonbank credit intermediation, has raised concerns that risks to financial stability have shifted from the banking system to the A shift to nonbank credit— shadow banking sector. sometimes in less risky forms This section assesses the risks, and there are three Over the last eight years, the slower growth of bank main findings. credit in advanced economies has been matched by First, while slower bank credit growth since 2008 the rapid growth of some forms of nonbank credit has undoubtedly been matched by growing nonbank intermediation. But so far this seems to have been pri- credit intermediation, some of the specific forms this marily in forms that do not raise immediate financial has taken, particularly in the advanced economies, do stability concerns. not for now appear to raise the same financial stability risks that contributed to the 2007–08 crisis. Second, our understanding of financial interme- A somewhat reduced banking system role diation risks remains incomplete, and with overall Since 2008, banks have been subject to much larger leverage continuing to rise, there is a danger that some capital requirements against both loan and trading new forms of nonbank credit intermediation (for books, and much tighter liquidity requirements. instance, through asset managers managing illiquid Partly as a result, there are some signs of a slightly assets such as emerging market bond funds) could be reduced role for banks within total credit intermedia- amplifying the risks inherently created by high lever- tion. For example, total bank shares of private credit age. In China, in particular, it is notable that rapidly supply indicate a somewhat reduced banking system

groupgroup of thirty 5 role in both the United States and Europe (exhibit as subsidiaries rather than branches, and that they 1). Cross-border bank lending in particular coun- have adequate bank capital.4 Capital flows by type tries (but not all) has declined significantly (exhibit declined US$6.7 trillion from 2007 to 2014. Finally, 2). This may reflect the greater focus within some bank trading assets have significantly declined, with bank regulatory policies on ensuring that the local banks playing a reduced role as holders of securitized operations of banks in different countries operate credit.

EXHIBIT 1 Bank lending accounts for 68% of private sector credit in Western Europe compared to only 32% in the United States Outstanding private sector debt—nonfinancial corporate and households Percent, US$ trillions, constant exchange rates

United States Western Europe*

100% = 13.4 23.8 24.8 100% = 9.7 15.4 16.6

15 15 16 12 14 14 2 9 9 8 7 10 30 32 38

20 20 77 14 70 68

34 33 32

2000 2007 Q2,14 2000 2007 Q2,14

Nonbank loans Securitization Corporate bonds Bank loans

SOURCE: McKinsey Global Institute .

NOTE: * Western Europe includes the United Kingdom, Germany, France, Spain, and the Netherlands .

4 There has been considerable debate over the pros and cons of the regulatory fragmentation of banking activities caused by such policies, whether there has been a resultant loss in economic efficiency, and the degree to which the current balance between stability and efficiency is appropriate.

6 shadow banking and capital markets: risks and opportunities EXHIBIT 2 Cross-border lending has declined by 84% since 2007, re flecting new banking regulation

Global cross-border lending*— Global cross-border lending*— inﬂows inﬂows by region US$ billion US$ billion 5,723 6,000 5,723 China 90 5,000 Other 672 emerging 4,000 Other -84% pp 528 3,000 developed

2,000 United 687 States 925 1,000 925 0 134 Western 127 Europe 3,745 415 -1,000 + UK 141 -2,000 108 1980 1990 2000 2007 2014 2007 2014

Global capital inﬂows by type US$ trillion

11.9 0.9

2.7 Compound annual -6.7 growth rate, 2007–14 2.6 %

5.2 Equity 2 1.0

1.6 Bonds -7 5.7 FDI -6 1.7

0.9 Loans* -23 2007 2014

SOURCE: McKinsey Global Institute .

NOTE: FDI = foreign direct investment; pp = percentage points .

* Includes trade credits, loans, currency, and deposits .

group of thirty 7 More corporate bonds but less in principle represent a more stable and less risky form securitization and shadow banking of credit extension than bank lending. Conversely, however, there has been a dramatic Increasing nonbank credit intermediation has come decline in the volume of complex structured credit primarily in forms that in principle could reduce finan- securities such as collateralized debt obligations and cial system risk. collateralized debt obligations squared,5 a big fall Much of the growth of nonbank credit has been in the role of credit derivatives, and some reduc- in the form of straightforward single-name corporate tion in the role of inherently procyclical short-term bonds (exhibits 3 and 4). Provided these bonds are held funding markets (for example, repo on nonstan- by natural long-term investors—such as pension funds, dard securities) (exhibit 5). And as figures from the insurance companies, or ultimate investors—this could

EXHIBIT 3 Corporate bonds outstanding have increased by US$5.1 trillion since 2007, compared to US$1 trillion between 2000 and 2007 Nonfinancial corporate bonds outstanding per region* US$ trillions, constant exchange rates

C hina China Growth rate Absolute increase 2007–Q2,2015, % 2007–Q2,2015, US$ tn Other developing 11.4 Other developed 0.9 28.3 0.72 Western Europe 1.1 17.4 0.80 United States +79% 2.1 6.2 0.76

+20% 6.3 2.1 5.3 0.3 7.3 0.84 0.1 1.3 1.6 1.2 0.9 5.2 6.2 1.90 3.3 2.7

2000 2007 Q2,2015

SOURCE: McKinsey Global Institute .

NOTE: * Nonfinancial corporate debt securities by residence of issuer .

5 Collateralized debt obligations are financial products that pool assets and repackage them into tranches that can be sold to investors. Collateralized debt obligations squared are similar, but they are backed by these tranches instead of assets.

8 shadow banking and capital markets: risks and opportunities Financial Stability Board’s (FSB’s) Global Shadow In addition, the degree of interconnectedness Banking Monitoring Report 2015 illustrate, secu- between banks and other financial institutions (some ritization-based credit intermediation is a subset of of which may be involved in shadow-banking-type shadow banking that continued to decline between activities) appears to have diminished since 2008 2011 and 2014 (exhibit 6). (exhibit 7).

EXHIBIT 4 Since the financial crisis, corporate bonds have been the main source of funding for companies in advanced economies Change in nonfinancial corporate debt in advanced economies* US$ trillions, constant exchange rates Cumulative change US$ trillion 2004–08 2009–14†

1.4 0.4

0.7 2.3 Nonbank loans 2.0

Securitization 0.3 1.8 1.7 4.0 -0.9 Corporate bonds 0.3 0.5 0.4 0.8 -0.5 1.1 Bank loans 0.3 0

0.3 0.2 0.4 0.2 0.8 0.2 0.2 0.6 0.6 1.2 0.5 0.1 0.4 0.2 0.3 0.9 0.1 0.4 0.9 0.1 0.1 0 0.8 0.6 0.2 0.3 0.4 0.3 0.3 0.4 0.2 0.4 0.3 0 0.1 0 0.1 0 0.2 0.1 0.1 0.1 -0.1 -0.1 -0.1 -0.2 -0.2 -0.1 -0.1 -0.1 -0.1 0 -0.1 -0.1 -0.1 -0.1 -0.4

-0.2 -1.0

-0.7

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014†

SOURCE: McKinsey Global Institute .

NOTE: * Australia, Canada, France, Germany, Japan, the Republic of Korea, the Netherlands, Spain, the United Kingdom, and the United States .

† As of June 30, 2014 .

group of thirty 9 EXHIBIT 5 The riskiest “shadow banking” instruments have declined substantially since the crisis—especially SIVs, ABCP, and CDS US$ trillions, 2007–Q2,14

2007 2014* -67% There has been an upturn of leveraged 58.2 loans in the US, and the creation of CLOs out of them. However, a new regulation (the Volcker Rule) is expected to curb future growth All 29 structured investment vehicles that operated in 2007 have been shut down

-9% -37% -33% -9% 8.7 -70% -100% 19.5 6.4 7.6 5.1 1.0 0.4 7.9 4.3 4.8 4.6 0.3 0

CDS Repos Repos CMO/CDO Money ABCP SIV (Europe) (US) /CLO Market Funds

ABCP has dramatically declined, and risky hybrid and SIV issuances have nearly vanished. The ABCP market has also shifted to less risky “multiname” issuances

SOURCE: McKinsey Global Institute .

NOTE: ABCP = asset-backed commercial paper; AUM = assets under management; CDO = collateralized debt obligations; CDS = credit default swaps; CLO = collateralized loan obligations; CMO = collateralized mortgage obligations; Repos = repurchase agreement; SIV = structured investment vehicle .

* As of June 30, 2014 .

10 shadow banking and capital markets: risks and opportunities EXHIBIT 6 Shadow banking by economic function Annual growth of economic functions from 2011 to 2013* and in 2014 26 jurisdictions

FSB’s “economic functions” view Average 2011–13 2014 % Definition: “nonbank credit intermediation that may pose shadow 15 banking risks (e.g. maturity / liquidity transformation and leverage)” Under this view, nonbank financial 10 entity types are classified intofive economic functions (EF): 5 EF1: Management of collective investment vehicles with features that make them susceptible to runs 0 EF2: Loan provision that is dependent on short-term funding -5 EF3: Intermediation of market activities that is dependent on short- term funding or on secured funding -10 of client assets EF1 EF2 EF3 EF4 EF5 EF4: Facilitation of credit creation EF5: Securitization-based credit intermediation and funding of financial entities

SOURCES: National financial accounts data; other national sources; FSB calculations; Financial Stability Board Global Shadow Banking Monitoring Report 2015 .

NOTE: Shadow banking not classified info EFs = Residual other financial intermediaries with some shadow banking risks but not classified into any of the five economic functions .

* Controlling for exchange rate effects . Average annual growth rates not shown for “not classified” category .

group of thirty 11 EXHIBIT 7 Banks assets and liabilities to other financial intermediaries

Interconnectedness risks for banks Interconnectedness risks for OFIs Percent of bank assets Percent of OFI assets

10 9

6 5

0 0 2002 2004 2006 2008 2010 2012 2014 2002 2004 2006 2008 2010 2012 2014

Banks funding risk Banks credit risk OFI funding risk OFI credit risk

SOURCES: National financial accounts data; other national sources; FSB calculations; Financial Stability Board Global Shadow Banking Monitoring Report 2015 .

NOTE: * Average for 20 jurisdictions and the euro area (China, Japan, the Republic of Korea, and Singapore did not report data on bank assets and liabilities to OFIs; Hong Kong did not report banks liabilities to OFIs) .

New forms of nonbank provided in a simple and transparent fashion by insti- lender—potentially creating tutions whose balance sheets do not involve maturity transformation. European insurers Allianz, AXA, and less financial system risk Aviva are reportedly considering participating in the Three categories of nonbank lenders have rapidly direct lending arena, possibly in partnerships with grown in recent years. banks and other financial institutions.

Private debt funds of alternative asset managers, Credit provided through online peer-to-peer ser- such as hedge funds and private equity funds, are vices is growing rapidly and evolving, although it is growing rapidly, but are still small relative to the total still small, with outstanding credit of less than US$30 system. As long as these managers do not employ high billion globally. Examples include Funding Circle, degrees of leverage or maturity transformation within Lending Club, Prosper, and Zopa. While most of the the funds, these funds could be seen as a positive rather funding for loans on these platforms was originally than a risky development. The assets in credit funds from retail investors, banks and other financial insti- of some of the largest alternative asset managers have tutions have become major sources of funding for doubled since 2009, to over US$400 billion (exhibit 8). some of them, and this could clearly pose risks in the future if a large share of the loans made through these Direct lending to corporations by insurance compa- platforms were to default. At present, loans through nies and pension funds is also growing, but in general these online platforms do not involve maturity trans- this is a positive development. It results in more credit formation or leverage, so while they do risk losses to

12 shadow banking and capital markets: risks and opportunities EXHIBIT 8 Assets in credit funds have more than doubled since the crisis, reaching over US$400 billion in 2014 Credit funds of 8 alternative asset managers US$ billions

Assets under management of credit funds of 8 alternative asset managers Types of credit, 2014*

CVC CAGR ESTIMATE KKR 2009–14,* % Carlyle 406 17 Distressed lending 46 Ares 12 26 Blackstone 15 32 Sakaty 28 64 61 Direct lending Oaktree 13 Apollo 48

37 25 Structured credit 73 6 178 13 10 82 20 34 14 17 5 Mezzanine 16

64 108 44

19 Other† 209 2009 2014*

SOURCE: McKinsey Global Institute .

NOTE: CAGR = compound annual growth rate .

* As of September 30, 2014; Sakaty as of July 1, 2014 .

† Includes US$48 billion of assets of Apollo’s insurance subsidiary Athene .

investors, they do not appear to present systemic risk a central one, however, and the risks posed by the at this point. However, due to the rapid growth of these hedge fund industry to financial stability have not platforms, and the potential for possible future sys- clearly increased. temic risk (if, for example, the credit analyses behind Hedge fund leverage remains only 2.3 times assets, such loans proves substandard, or commercial banks on average, and the average gross leverage of fixed- begin to become interconnected with these platforms), income arbitrage funds (the most highly leveraged regulators must continue to remain vigilant. class) is 4.7 times assets, far below the level seen in banks’ broker-dealers before the crisis. In addition, hedge funds are typically able to impose “gates” Hedge fund risks have not increased on investor withdrawals, significantly reducing the Hedge fund leverage shrank after 2008 as banks danger that self-reinforcing runs will produce panic contracted prime broker activities, but leverage has asset liquidations. Overall, therefore, while the role of since returned to precrisis levels (see exhibit 9). The hedge funds within the financial system needs to be role of hedge funds in the 2007–08 crisis was not kept under tight surveillance, it does not appear that

group of thirty 13 a more robust banking system has been offset by a Areas of rising risk concern major shift of risks to the hedge fund industry. Available data suggest that several of the most risky In summary, recent developments in the balance forms of precrisis shadow banking have diminished of different forms of credit intermediation in the since the 2007–08 crisis, after growing dramatically advanced economies do not suggest that risks equiv- in the years before the crisis. But FSB and International alent to those that flourished in the precrisis shadow Monetary Fund figures still reveal the enormous size of banking system are reemerging as a result of tighter nonbank credit intermediation activities, and we must bank regulation.

EXHIBIT 9 Hedge funds’ leverage ratio has reverted to precrisis level, with total leveraged assets reaching US$6.9 trillion in 2014 Hedge funds’ AUM and leveraged assets* US$ trillions

AUM Leveraged assets 6.9 Gross leverage ratio by fund strategy* Times, 2014

+61% Fixed-income arbitrage 4.7

Global macro 3.9

4.3 Equity market neutral 3.6

3.4 Multistrategy 3.5 3.0 Event driven 2.9

Convertible arbitrage 2.7 1.9 1.9 Dedicated short bias 2.6

Equity long/short 1.9

Emerging markets 1.4

Distressed 1.0 2007 2010 2014

2.3x 1.8x 2.3x Gross leverage ratio*

. Low interest rate environment has encouraged hedge funds to lever up over the past few years. As a result, gross leverage of global hedge funds has increased from 1.8x in 2010 to 2.3x in 2014. . Hedge funds can obtain credit from multiple sources, including prime brokerage, repos, secured credit line, structured financing vehicles, and derivatives.

SOURCE: McKinsey Global Institute .

NOTE: AUM = assets under management .

* Gross leverage ratio (mean) calculated as sum of long market value and absolute short market value, divided by net equity; estimate used for 2007 .

14 shadow banking and capital markets: risks and opportunities be cognizant that available figures can provide only five “economic functions” of shadow-bank-type activ- an imperfect understanding of the multiple different ities, the most rapidly growing segment is collective activities involved in nonbank credit intermediation. investment vehicles, with features that make them FSB figures suggest that narrowly defined shadow susceptible to runs (see exhibit 11). banking activities have expanded as a percentage of International Monetary Fund estimates, in contrast, global GDP since 2011. When viewed as a shadow- based on a somewhat different definition, suggest a banking-to-GDP ratio, the growth rate is still more slight decline in various measures of shadow banking, marked, particularly in several emerging markets and but still indicate its huge potential size (see exhibit 12). most notably in China (see exhibit 10). FSB figures Meanwhile, figures for total real economy lever- show a slight increase in shadow banking as a per- age—whether provided through banks or nonbank centage of GDP since 2010. Further, within the FSB’s intermediation channels—illustrate that there has

EXHIBIT 10 Shadow Banking and GDP 26 jurisdictions

GDP compared to shadow banking growth rates, 2011–14*

Advanced economies† Emerging economies‡

40 Shadow banking growth 45˚ 30

-10 0 10 20 30 GDP growth

SOURCES: National financial accounts data; other national sources; FSB calculations; Financial Stability Board Global Shadow Banking Monitoring Report 2015 .

NOTE: * Average annual growth rate during 2011–14, adjusted for exchange rate effects, except for Singapore where growth rate is from 2012 to 2014 . >45% line indicates shadow banking assets growing faster than nominal GDP in local currency .

† Advanced economies = Australia, Canada, Germany, Euro area, France, Hong Kong, Ireland, Italy, Japan, Republic of Korea, the Netherlands, Singapore, Spain, Switzerland, the United Kingdom, and the United States .

‡ Emerging economies = Argentina, Brazil, Chile, China, India, Indonesia, Mexico, Russia, Saudi Arabia, South Africa, and Turkey .

group of thirty 15 EXHIBIT 11 FSB figures show a slight increase in shadow banking as a percent of GDP since 2010—from 56.7% to 59.1% in 2014

FSB’s measure of shadow banking based on economic functions (or activities)*

Size of shadow banking (left axis)

40 Shadow banking-to-GDP ratio (right axis) 60

35 55 Percent US$ trillion 30 50

25 45

2010 2011 2012 2013 2014

SOURCE: Financial Stability Board Global Shadow Banking Monitoring Report 2015 .

NOTE: FSB = Financial Stability Board; GDP = gross domestic product .

* Based on 26 jurisdictions .

16 shadow banking and capital markets: risks and opportunities EXHIBIT 12 IMF’s shadow banking data based on noncore liabilities also show a decline in shadow banking in the United States and Euro area

IMF’s “activity” view IMF’s measures of shadow banking in the US and Euro area

Definition: “Financing of banks and US$ trillions Noncore liabilities (broad) nonbank financial institutions through Noncore liabilities (narrow) noncore liabilities, regardless of the entity United States Flow of funds that carries it out” 25 Broad measure includes noncore liabilities from both banks and “other financial 20 corporations” Size estimate = US$50–US$55 trillion* 15 Narrow measure excludes noncore liabilities of the financial sector; it is thus 10 a proxy for the intermediation between the ultimate lender (financial sector) and 5 the ultimate borrower (real economy) * 2013 size estimate = US$35–US$40 trillion 0

IMF also provides a flow-of-funds measure 2001 200220032004200520062007200820092010 2011 2012 2013 (entity view), that captures the financial assets of other financial intermediaries Euro area (OFIs) engaged mainly in financial intermediation and entities providing 30 primarily long-term financing. It includes money market funds, leasing corporations, 25 securitization vehicles, broker-dealers, 20 venture capital corporations, and others 2013 size estimate = US$40–US$45 trillion* 15

2001 200220032004200520062007200820092010 2011 2012 2013

SOURCE: International Monetary Fund, Global Financial Stability Report: Navigating Monetary Policy Challenges and Managing Risks, Washington, D C. ., April 2015 .

NOTE: IMF = International Monetary Fund .

* Includes the United States, the United Kingdom, Japan, and the Euro area .

group of thirty 17 been no deleveraging since 2008, but rather a gradual increase in global debt to GDP. Deleveraging by There has been no deleveraging since households in, for instance, the United States, has been offset by large increases in advanced economy 2008, but rather a gradual increase in public debt and by large increases in private sector global debt to GDP. debt in many developing economies6 (see exhibits 13 and 14). The latter, in particular, may in part reflect sustained loose monetary policy that, in addition to flows are intermediated or managed is adding further making existing debt stocks (particularly in developed to that inherent risk. economies) more affordable, also creates incentives for Three areas of particular concern have been identi- new debt growth. fied: the increase in emerging market corporate debt, This rising real economy leverage in itself creates particularly when denominated in foreign currency macroeconomic risks, but also makes it more import- (usually the US dollar) rather than in local currency; ant to identify whether the precise way in which credit the role asset managers might play in amplifying the

EXHIBIT 13 Global stock of debt has increased by US$70 trillion since 2007, outpacing world GDP growth Global stock of debt outstanding by type US$ trillion, constant 2014 exchange rates Compound annual growth rate (%)

2000–07 2007–Q2,2015 208

41 Household 8.5 3.0 +70 trillion 138 59 Corporate 5.7 6.4 33

84 37 19 59 Government 5.9 8.7 25 32

21 Financial 37 49 9.6 3.7 20

Q4,2000 Q4,2007 Q2,2015 Total debt as % of GDP 250 274 299

SOURCE: McKinsey Global Institute .

6 See McKinsey Global Institute, “Debt and (not much) deleveraging,” February 2015.

18 shadow banking and capital markets: risks and opportunities EXHIBIT 14 Growth in global debt has shifted since 2007, with developing economies accounting for half of new debt Change in debt outstanding—by country group and type of debt* %; US$ trillion, constant 2014 exchange rates

2000–07 2007–Q2,2015 100% = US$36 trillion 100% = US$58 trillion

Advanced 21 4 Household 9 9 21 Nonﬁnancial corporate 7 35 Government 26 47 53 24 Developing 35 12 13 Household 5 79 Nonﬁnancial corporate Government

SOURCE: McKinsey Global Institute .

NOTE: Numbers may not sum due to rounding .

* Includes debt of households, nonfinancial corporations, and government .

inherent potential volatility and procyclicality of macroeconomic risks, particularly in the context of capital market credit, particularly in somewhat illiq- likely increases in dollar interest rates at some time, uid markets such as emerging market corporate debt; which may cause currency swings and prompt some and the dramatic growth of leverage in China, which foreign investors to withdraw from the market. Key has been accompanied by the growth of nonbank facts on this risk include the following. credit intermediation channels, some of which have Emerging market corporate debt has increased features reminiscent of precrisis shadow banking in dramatically in dollar terms and as a percentage of the advanced economies. national GDPs over the past seven years, reaching US$20 trillion at the end of the second quarter of 2015, compared to US$6 trillion in 2007 (see exhibit 15). Emerging market debt Growth has occurred in both dollar-denominated Against the backdrop of a continued increase in debt securities and securities denominated in local global debt, the growth of corporate debt in emerg- currency, with the percentage split between dollar- ing markets—and in particular the portion of that denominated and non-dollar-denominated corporate debt that is denominated in US dollars—has raised debt varying significantly by country. The largest con- the concern of a number of observers. The Bank centrations of dollar-denominated corporate bonds for International Settlements and the International (as a share of total corporate debt securities issued) Monetary Fund have both suggested that this are found in Israel, Chile, South Africa, Brazil, and increase poses risks to future financial stability and Mexico (see exhibit 16).

group of thirty 19 EXHIBIT 15 Emerging economy corporate debt has more than tripled since 2007; China accounts for two-thirds of it

Stock of nonﬁnancial corporate debt Nonﬁnancial corporate debt-to-GDP ratio US$ trillion Q2,2015, %

Emerging excluding China China 131 China Chile 93 Corporate 20 debt-to-GDP Vietnam 90 6 Hungary 89 3+ times Malaysia 83

Saudi Arabia 58

14 Thailand 57 6 2 Russia 56 2 1 3 Turkey 55 1 India 49 2000 2007 Q2,2015 South Africa 49 29% 32% 43% Brazil 36 83% 72% 131%

SOURCE: McKinsey Global Institute .

NOTE: GDP = gross domestic product .

20 shadow banking and capital markets: risks and opportunities EXHIBIT 16 Over 65% of corporate debt securities are issued in foreign currencies in emerging economies outside Asia Nonfinancial corporate bonds issuance in select emerging economies, by currency Percent, US$ billions; 2007 to 2014

US$ Other foreign currencies Local currency 100% = Israel 83 17 24

Chile 66 3 31 47

South Africa 63 20 17 20

Brazil 62 8 30 200

Mexico 54 13 32 187

Russia 35 9 56 219

India 25 5 70 106

China 10 89 1,712

Thailand 10 1 90 76

Malaysia 9 4 87 80

SOURCE: McKinsey Global Institute .

group of thirty 21 The Bank for International Settlements reports that Second, some of the borrowers, and in particular total dollar-denominated debt to nonbank corpora- those who have borrowed in dollars, may be exposed tions (including some nonbank financial firms) has to significant currency mismatch risks, making them reached US$3.2 trillion, up from US$1.7 trillion in vulnerable to any further dollar appreciation that 2008 (including bonds and loans). results from dollar interest rate rises. This risk will be Much of the debt is issued by very large corpo- most important where companies have borrowed in rates that are often para-state-owned organizations dollars but do not have revenue streams denominated (see exhibit 17). While some of these companies have in, or naturally linked to, the value of the dollar. dollar-based revenue streams (for instance, mining Third, some of the borrowers are in natural and oil companies), many might not. resource sectors exposed to falling commodity prices This growth in debt clearly creates economic vul- (see exhibit 18). nerability for the borrowers, for four reasons. Fourth, foreign investors have been the source of First, the growth of debt has occurred during a much of the new credit in their “search for yield” as period of low global interest rates, leaving some bor- rates on fixed-income products in advanced economies rowers potentially vulnerable to interest rate rises if and have fallen to historic lows. But already their appetite when their liabilities reprice or need to be refinanced. for continued funding of emerging market debt has

EXHIBIT 17 Corporate bonds market in emerging economies is heavily concentrated, with state-owned enterprises being dominant issuers Share of top 10 corporate bond issuers in select emerging economies Percent, share of total issuances from 2007 to 2014

Share of state-owned enterprises among top 10 issuers Top 3 issuers

Israel 100 Teva, Israel Electric Corp, Gazit Globe

South Africa 86 AngloGold Ashanti, Eskom, Sappi

Mexico 78 Pemex, América Móvil, Cemex

Malaysia 66 Khazanah Nasional, MMC, Usaga tegas sdn bhd

Chile 62 Codelco, Grupo matte, Angelini group Chile

Russia 60 Gazprom, Russian Railways, Rosneft Top 10 issuers Brazil 58 account for 50%+ Petrobras, Odebrecht, Vale of the issuances Thailand 57 in most emerging Ptt, SCG, CP all pci markets India 57 Tata, Power Grid Corporation of India, Reliance Industries

China 20 CNPC, State Grid Corporation of China, CRCC

SOURCE: McKinsey Global Institute .

22 shadow banking and capital markets: risks and opportunities waned in the expectation of rising interest rates in the market reactions, such as runs and fire sales, which United States. would threaten the solvency of financial institutions). The crystallization of these vulnerabilities may in Such risks would exist if a large proportion of the turn have global macroeconomic consequences, with bonds or loans involved are held by highly leveraged the risk that reductions in future investment by over- and maturity-transforming financial institutions, but leveraged emerging market companies—or (at the not if they are held primarily by end investors (whether extreme) bankruptcies or default—might reduce GDP directly or via asset managers) who will face losses if growth and intensify deflationary pressures. the risks crystallize, but who do not themselves have What is less clear, however, is how far the growth of financial liabilities to other financial institutions or to emerging market corporate debt creates major global real economy firms and households. Available evidence financial stability risks (that is, a threat to the solvency does not, however, present an adequately clear picture or liquidity of major financial institutions, or a danger of the holders of emerging market debt. Further anal- that risk crystallization will induce self-reinforcing ysis of significant potential risk is therefore a priority.

EXHIBIT 18 Four sectors account for 65% of the bond issuances in emerging economies— construction and real estate, oil and gas, utilities, and metals and mining Nonfinancial corporate bonds issuance, by industry Percent, US$ billions; 2007 to 2014

Construction & real estate Utility Transportation Others Oil & gas Metals & mining Telecom

100% = 1 20% of total emerging market corporate China 31 9 14 13 10 21 1,712 bonds have been issued by Chinese 2 construction and real estate companies. Thailand 28 23 8 12 4 23 76 1 Malaysia 27 6 24 14 14 15 80 Total issuance in emerging economies 2007–14, percent Brazil 16 31 12 10 3 6 21 200

15 15 23 15 5 9 18 106 India 21% 25% 2 Mexico 14 34 6 3 23 17 187 Total 5% = US$2.7 9% Israel 12 9 21 4 55 24 tn 15%

12% Russia 4 36 8 17 13 9 12 219 13%

South Africa 4 5 14 15 14 15 33 20

Chile 4 6 19 21 5 8 37 47 In Israel, Teva Pharmaceutical accounts for 50% of the issuances.

SOURCE: McKinsey Global Institute .

group of thirty 23 Asset managers and “Assets under management” are that subset of risk amplification all global financial assets that are managed by pro- fessional asset management firms, rather than held The second key area of significant concern relates to directly by investors or by financial intermediaries such the role of asset managers. The International Monetary as banks, insurance companies, or pension funds. Such Fund and the Bank for International Settlements, in asset managers include mutual funds, exchange-traded particular, have expressed concern that managed funds, private equity funds, and hedge funds. Exhibits (rather than intermediated) financial flows may be a 19 and 20 display the evolution of asset management new source of systemic risk, and the FSB is considering in recent years. Total global financial assets (equities whether very large asset managers should be defined and bonds) stood at 209 percent of GDP in 2014, of as “systemically important institutions.” which 51 percent (or US$108 trillion) was managed by

EXHIBIT 19 As a share of GDP, global financial assets and AUM of asset managers are significantly below their precrisis peaks Ratio of global financial assets and assets under management to GDP Percent of GDP

Total ﬁnancial assets excl. loans Government debt securities Assets under management* Nonﬁnancial corporate debt securities Stock market capitalization Financial institutions debt securities Change Percentage points 250 237 2000–07 2007–14

209 36 -30 200 15 -12

150 121 15 -25 108 100 3 10

22 -18 50

-4 2 0

2000 2002 2004 2006 2008 2010 2012 2014

SOURCE: McKinsey Global Institute .

NOTE: AUM = assets under management; GDP = gross domestic product .

* 2014 AUM numbers based on 2013 IMF data and 2014 AUM growth rate from McKinsey & Company’s Asset Management Practice .

24 shadow banking and capital markets: risks and opportunities EXHIBIT 20 Postcrisis, the asset management industry has grown at a much slower rate, and the ratio of its AUM to global financial assets has declined Assets under management of world’s top 500 asset managers US$ trillions

Assets under management by investment vehicles +7 tn 76 Percent, 2013 69 Hedge funds Exchange-traded funds Other alternatives Private equity 2 +34 tn 4 3 Money market 5 funds 35 8 Mutual 42 funds Total = US$76 tn

36 Separate accounts* 2000 2007 2013 52% 51% 48% Ratio of assets under management to global ﬁnancial assets excl. loans

SOURCES: International Monetary Fund, Global Financial Stability Report: Navigating Monetary Policy Challenges and Managing Risks, Washington, D .C ., April 2015; McKinsey Global Institute analysis .

NOTE: AUM = assets under management .

* Providers of separate account services privately manage the money of institutional investors or high-net-worth individuals .

asset managers. This share of total assets held by asset and involved neither balance-sheet intermediation nor managers is the same now as it was in 2007. asset management. Credit assets held by individual An asset manager holds assets on behalf of each investors might grow to levels that create excessive investor. In some cases, the asset manager makes discretionary investment decisions on the investors’ behalf (either in general or within specific asset classes) Potentially irrational volatility and self- or the asset manager invests in passive indexes. The asset management company itself, however, does not reinforcing herd effects could cause normally have a risk-taking balance sheet; investors bear the full upside and downside risk of price move- financial and economic instability. ments and returns in the investment portfolio. Potentially irrational volatility and self-reinforcing herd effects could cause financial and economic leverage and might produce harmful debt overhang instability even if all investment flows passed directly effects. Equity markets might overshoot (on both the from end investors to end borrowers/equity issuers, upside and downside). “Herd effects” could exacerbate

group of thirty 25 initial price movements, with investors rushing to liq- between asset managers and the banking system could uidate positions in falling markets. Some Asian equity arise if many asset managers were to simultaneously markets, such as the Shanghai Stock Exchange, are draw on their credit lines, as would likely be the case dominated by retail investors and “day traders”—and in the event of a major market shock. Regulators must these markets have had wild swings in valuations. be sure to adequately stress test these lines of credit and Unmanaged investment flows can thus create risks. assess their balance sheet risk. But analysis by the International Monetary Fund,7 the Bank for International Settlements,8 the Financial Contagion risks. Finally, in the event that investor Stability Board,9 and others has identified several ways withdrawals exceed cash on hand, asset managers in which asset management practices can exacerbate could introduce contagion effects to other parts of these inherent risks. the financial system, causing sell-offs of assets in unrelated markets or of investments in different asset Herd behavior. There is some evidence that asset man- classes. Moreover, if many asset managers with very agers tend to lean toward or replicate the moves of large credit lines from commercial banks were to their peers and follow benchmark indexes, and this respond to stress and investor withdrawals by calling can create price volatility (both upward and downward on their lines simultaneously, stress could be passed movements) and liquidity issues in times of volatility. onto the banking system. Volatility from herd behavior would be particularly These potential risks in asset management activity acute in less liquid markets and asset classes, such are not wholly new, but their prevalence may have as emerging market bonds and equities (which have grown as the asset management industry has sought grown since the 2007–08 crisis as investors search for to provide end investors with more attractive com- yield), infrastructure funds, or private equity funds. binations of liquidity and return in an environment Bank for International Settlements analysis finds that of low interest rates. And while managed assets as asset managers amplify price movements and volatil- a percent of GDP have not grown since 2008, the ity by selling more financial securities than needed to growth of funds investing in less liquid, thinly traded meet current investor redemptions, with the expecta- markets, such as emerging market debt, is a cause for tion that further redemptions will follow. particular concern. Overall, therefore, while asset management compa- Leverage. Asset management could introduce addi- nies themselves do not create systemic risk, particular tional risk if it facilitated the introduction of additional practices and particular markets give specific cause for leverage, as is the case with most hedge funds and the concern and merit close regulatory attention. To that growing new class of “leveraged beta” funds. end, we make particular recommendations for policy makers (see page 45). Maturity transformation. Asset managers may in effect perform maturity transformation if investors can withdraw their assets at will from a portfolio that is funded While asset management companies with long-term, illiquid assets. Asset management funds hold cash to meet daily investor redemptions themselves do not create systemic and avoid liquidity crunches, and also have lines of risk, particular practices and particular credit with banks. Again, transformation risk is highest in markets with less liquidity, such as emerging market markets give specific cause for concern. equities and bonds. However, worrisome connections

7 International Monetary Fund, Global Financial Stability Report: Navigating Monetary Policy Challenges and Managing Risks, Washington, D.C., April 2015. 8 Jimmy Shek, Ilhyock Shim, and Hyun Song Shin, “Investor redemptions and fund manager sales of emerging market bonds: how are they related?,” BIS Working Papers 50, Bank for International Settlements, Basel, August 2015; http://www.bis.org/publ/work509.htm. 9 Financial Stability Board, “Consultative Document: Proposed Policy Recommendations to Address Structural Vulnerabilities from Asset Management Activities,” Basel, June 22, 2016.

26 shadow banking and capital markets: risks and opportunities Shadow banking in China since 2007, reaching over US$26 trillion by the second quarter of 2015. This partly reflects a govern- This report has focused on shadow banking in the ment stimulus program in 2009 that entailed greatly advanced economies, since it was advanced economy increased bank lending to fund local infrastructure shadow banking that played a major role in the origins projects. As a result, China’s nonfinancial debt to of the 2007–08 global financial crisis, whereas most GDP has reached about 240 percent (and 290 percent of the relevant types of firm and shadow bank activity if financial sector debt is included), similar to levels were virtually absent from emerging markets. But while in the United States, Canada, and Germany, and far some forms of shadow banking have subsequently above typical emerging market levels (see exhibit 21). declined in the advanced economies, shadow banking This high leverage poses major risks.10 has grown rapidly in China, with many features similar First, corporate debt is very high, at 132 percent of to those seen in advanced economies before 2008. GDP. Just under half of total debt to the private sector Even apart from shadow banking, the growth of is related to real estate, including loans to real estate debt in China has recently received particular atten- developers, local government financing vehicles, house- tion. China’s total nonfinancial debt—of households, hold mortgages, and real-estate-related sectors such as government, and corporates—more than quadrupled cement and steel (see exhibit 22). A decline in property

EXHIBIT 21 China’s debt reached 290 percent of GDP in 2015, higher than debt levels in some advanced economies Debt-to-GDP ratio Percent

Government Nonﬁnancial corporate Households Financial institutions

China By country, 2015

290

51 China 51 132 39 68 290

Australia 158 132 35 76 120 59 290

121 42 23 United States 97 70 78 41 286 72 39 83 20 68 8 Canada 75 70 95 45 286 7 24 2000 2007 Q2,15

$2 $7 $32 Germany 78 54 53 69 254

Total debt in US$ trillion

SOURCE: McKinsey Global Institute .

10 For more detail, see Chapter 4 of “Debt and (not much) deleveraging,” McKinsey Global Institute, February 2015.

group of thirty 27 EXHIBIT 22 Nearly half of China’s debt is related to real estate China’s real economy outstanding debt by sector Percent, Q2,2014

Real estate sector

Real-estate- 12 related sectors 100% = US$21.6 trillion Other sectors 56 10 Local government ﬁnancing vehicles (LGFVs) 8

Household mortgages

SOURCE: McKinsey Global Institute . prices could reduce the ability of many borrowers to make loans (often to real estate) and other invest- repay, creating risk of defaults and bankruptcies. ments, and “entrusted loans” from corporations to Second, lending to local governments, including other business and other types of informal loans. local government financing vehicles, are a particular The interconnection of credit risks in these shadow area of worry, and total credit to them has gone from banking activities is unknown, but can grow to be a small amount in 2007 to US$2.6 trillion in 2014 very complex (see exhibits 24 and 25). As a result, (see exhibit 23). These loans have been used to fund they could pose similar risks, as we saw in advanced property development and other infrastructure, but economies prior to 2008. many investments do not have clear revenue streams to repay the loans. A government audit of these funds in 2014 found that up to 20 percent were using new loans to repay old ones. Around 30 percent of credit in China Finally, around 30 percent of credit in China comes from unregulated shadow comes from unregulated shadow banking entities. These include trust funds and “wealth management banking entities. products” that take individual deposits and then

28 shadow banking and capital markets: risks and opportunities EXHIBIT 23 China’s local government debt has grown rapidly since 2007, linked to real estate and infrastructure Outstanding balance of China’s government debt by source US$ trillion, constant exchange rate

6 0.1 Local government bonds 40% 5 of loans are 1.1 Other local government debt repaid with land sales 4

1.7 Local government ﬁnancing 3 vehicle bank loans

2 20% of new loans 2.6 Central government debt 1 are used to repay old loans 0 2001 2003 2007 2010 Q2,14

SOURCE: McKinsey Global Institute .

Despite the risk of future loan losses in China, its barring loan losses, however, growth of debt in China rising debt and leverage currently do not appear to be at some point will collapse under its own weight, and a major threat to global financial stability, because that will be a significant drag on GDP growth. most of the credit is issued by Chinese banks and other As the world saw from 2000 to 2008, a credit boom local investors. Moreover, China’s central government unsustainably raises GDP growth during the boom, currently has outstanding debt of only 25 percent of and the end of credit growth therefore dampens what GDP and thus has ample capacity to bail out the finan- people assumed was “normal” growth. Moreover, cial system, if needed. The larger risk to the global if China pursues capital account liberalization as economy from the rise in Chinese debt and leverage planned, in the future the exposure of foreign cred- would be through macroeconomic forces; a wave of itors to China’s domestic credit market would likely loan defaults and bankruptcies would further reduce increase, creating a direct channel of contagion to GDP growth in the world’s second-largest economy, other countries. directly affecting countries that export to China. Even

group of thirty 29 EXHIBIT 24 Shadow bank loans now account for 30 percent of outstanding Chinese debt

Composition of China’s debt, Q2,2014* Shadow banking entities Credit growth US$ trillion US$ trillion 2007–Q2,2014, %

Total = US$21.6 trillion 6.5

Wealth 86 management 1.7 products

Shadow 30% bank Entrusted loans 1.6 38 loans† Banks 53% 4% Trust loans 0.8 59 Corporate bonds 13%

Government bonds Financing companies 2.4 23 and other loans

SOURCE: McKinsey Global Institute .

NOTE: * Excludes financial sector debt .

† Includes loans from world cooperatives, microcredit institutions, internet peer-to-peer lending, and informal loans .

30 shadow banking and capital markets: risks and opportunities EXHIBIT 25 China’s complex shadow banking system

EVERGROWING BANK

Under-the-table Ownership of an asset guarantees/repurchase management theme agreements CNY 2.5 bn interbank deposit

BANK OF TIANJIN CNY 1.0 bn Holding 3.28% of investment the bank’s share TRCB

CHINA MERCHANT BANK CNY 2.7 bn DONGHAI investment SECURITIES & SINO-AUSTRALIAN TRUST 60% stock beneﬁcial right Ownership of two subsidiaries of CMG CNY 1.0 bn of an asset investment management 60% stock CNY 2.7 bn theme beneﬁcial right of two loan was provided subsidiaries of CMG

GREAT WALL CHENGDU MIND GROUP (CMG) INDUSTRIAL BANK SECURITIES

CNY 1.0 bn CNY 1.0 bn entrust loan entrust loan

SOURCE: Mizuho Research, 2014 .

NOTE: CNY = Chinese Yuan Renminbi .

group of thirty 31 Conclusions regarding risks the 2007–08 financial crisis has declined significantly. There are, moreover, some indications that intercon- While there are reasons to believe that the financial nectedness between the banking system and other system itself may be more resilient than before 2008, financial institutions has declined. the combination of rising global leverage and new Fourth, to a degree, therefore, the financial system forms of financial system risk means that overall vul- itself—and in particular the element of it that relates nerability to financial and macroeconomic instability to intermediation of credit flows via balance sheets— is as great now as it was then. The key points support- is probably more resilient than in 2008, making it ing this conclusion are the following. less likely that we will see self-reinforcing cycles of First, the banking system itself has been made con- financial instability arising within the credit inter- siderably more resilient by the introduction of new mediation system. capital and liquidity requirements. Fifth, as the overall level of leverage in the global Second, more onerous regulation of the banks has economy continues to grow, however, risks to macro- probably encouraged the shift toward the nonbank economic stability could grow even if the financial forms of credit intermediation that has occurred system itself had become more resilient. And even since 2008. where credit flows are managed rather than intermediated, new forms of financial stability risk can be introduced. Risks to macroeconomic stability could Finally, in China, a dramatic increase in leverage has been accompanied by the emergence of a complex grow even if the financial system itself shadow banking system, some of whose features had become more resilient. are reminiscent of precrisis shadow banking in the advanced economies. Therefore, while the specific forms that risk takes have changed, overall risks are as great now as they Third, the significant growth in nonbank credit were before the crisis. Required policy actions (which intermediation has primarily been in forms that do are considered in section 4) need to reflect both the not for now raise the same financial stability concerns severity of the overall risks and the specific forms that as precrisis shadow banking, and the importance of risk now takes. specific forms of shadow banking most implicated in

32 shadow banking and capital markets: risks and opportunities 13 opportunities to develop securitization and other forms of nonbank finance

hile complex and opaque forms of securiti- A common starting point for analysis of these zation clearly played a significant role in the opportunities is to note that the United States has a far Worigins of the 2007–08 crisis, capital-mar- more capital-markets-based system of credit provision kets-based credit provision can in principle play a than the rest of the world, with about 68 percent of US positive role within a financial system. Corporate private sector credit provided by capital markets and bonds, as noted above, are one example. In principle, 32 percent by banks; in Western Europe, the percents simple “plain vanilla” securitization might usefully are reversed (see exhibit 26). This simple observa- free up bank capital for additional lending and extend tion raises the question of whether Europe and other the range of loan types that can be intermediated by economies might benefit by expanding capital market capital markets rather than by banks. credit provision. Some commentators argue that secu- This report, therefore, assesses whether there are ritization, in particular, could play a greater role in positive opportunities for capital markets to play an providing credit to small and medium enterprises increased role in credit provision in some countries (SMEs) which, it is argued, are often underserved by and what is required to seize those opportunities. the banking system.

group of thirty 33 EXHIBIT 26 Bank lending accounts for 68% of private sector credit in Western Europe compared to only 32% in the United States Outstanding private sector debt—nonfinancial corporate and households Percent, US$ trillions, constant exchange rates

Nonbank loans Securitization Corporate bonds Bank loans

United States Western Europe*

100% = 13.4 23.8 24.8 100% = 9.7 15.4 16.6

15 15 16 12 14 14 2 9 9 8 30 38 32 7 10

20 14 20 77 70 68

34 33 32

2000 2007 Q2,14 2000 2007 Q2,14

SOURCE: McKinsey Global Institute .

NOTE: * Western Europe includes France, Germany, the Netherlands, Spain, and the United Kingdom .

To evaluate the idea of increasing the use of capital United States (see exhibit 27). In several countries, market loan origination and securitization, it is vital meanwhile, a significant portion of corporate credit to look separately at the very different roles that comes from nonbank sources—that is, from gov- capital markets, and in particular, securitization, ernment programs, insurance companies, and other play in different economies in both the corporate and nonbank financial institutions. household sectors. Securitization, meanwhile, is almost entirely a In the corporate sector, securitization plays a trivial household sector phenomenon, and is predominantly role in credit provision in all economies, including the used in residential mortgage credit. It plays a major United States, and the differences between the United role in US mortgage provision but a more limited role States and other countries lie almost entirely in the elsewhere (see exhibit 28). greater role of single-name corporate bonds in the

34 shadow banking and capital markets: risks and opportunities EXHIBIT 27 Nonbank credit accounts for a majority of corporate debt outside of continental Europe and Japan Nonfinancial corporate debt by source of financing US$ trillion, percent, Q2,2014

Bank loans Corporate bonds Securitization Nonbank loans 100% = Netherlands 70 17 2 11 0.7 1 Germany 62 10 27 1.8

Spain 58 3 3 36 1.3

Japan 54 17 28 4.0

France 53 31 16 2.4

Australia 50 21 2 27 0.9

United Kingdom 48 33 10 10 1.9 1 Republic of Korea 46 35 18 1.5

United States 35 43 5 16 11.5

Canada 31 46 2 21 1.1

SOURCE: McKinsey Global Institute .

group of thirty 35 EXHIBIT 28 US RMBS accounts for 61% of global securitization outstanding, the vast majority of which is issued by Fannie Mae and Freddie Mac (US GSEs)

Global securitization outstanding by type—household and NFC US RMBS market Percent, Q2,2014 Percent, US$ trillion, Q2,2014 Total = US$ 10.8 trillion 6.6 Non-US corporate* Non-US ABS* 13% Private label 4% 3%

Non-US RMBS* 20%

US RMBS GSE† 6% 87% US corporate 61% 7% US ABS

US RMBS

SOURCE: McKinsey Global Institute .

NOTE: ABS = asset-backed security; GSE = government-sponsored enterprise; NFC = nonfinancial corporate; RMBS = residential mortgage-backed security .

* Non-US includes Australia, Canada, Japan, the Republic of Korea, and Europe including the United Kingdom .

† US Government-sponsored enterprises, including Fannie Mae and Freddie Mac .

Analysis of securitization in these two very differ- credit, and optimal financial systems would likely ent sectors leads us to the following conclusions. entail a balanced mix of bank and securitized house- First, the proposition that capital markets play a hold finance. Policy should focus on ensuring that significant role in providing credit to SMEs, either household credit securitization is based on simple, through corporate bonds or through securitized loans, transparent structures, avoiding the complexity, is not supported. This is true in the United States and opaqueness, and perverse incentives that led to pre- elsewhere. Potentially important differences in the crisis problems. provision of external finance for SMEs lie instead in Based on the above, we find that capital market equity markets and private debt placements, and pol- developments are unlikely to play a significant role in icies to improve access to finance should be focused directly improving the supply of credit to SMEs, which on these areas, rather than on creating markets in securitized business assets. Second, the greater role of securitization in US Capital market developments are unlikely household credit provision reflects almost entirely the to play a significant role in directly role of the government-sponsored enterprises (Fannie Mae and Freddie Mac). There are both advantages and improving the supply of credit to SMEs. disadvantages to a securitized approach to household

36 shadow banking and capital markets: risks and opportunities in all economies rely primarily on banks for credit The relative importance of nonbank credit has supply. But a greater role for capital market credit grown since 2007 (see exhibit 29) and now plays a sig- provision to major corporates (via corporate bond nificant role in credit supply for companies in all major markets) and households (in a securitized form) could economies and in all advanced economies (except indirectly benefit SMEs by freeing up bank capital Japan). Securitization, however, plays a trivial role in to focus on the SME segment, which only they can nonbank credit supply to companies, which instead is effectively serve. provided in the form of single-name corporate bonds or loans from nonbank institutions (see exhibits 27 Capital market credit intermediation and 30). As a result, it is the size of the corporate bond is not the solution to problems market that explains almost all the difference in the of SME credit supply relative importance of banks in the corporate sectors of different economies. It is the growth of corporate Nonbank credit is important for many companies, but bonds that explains the shift away from bank lending securitization of corporate credit plays a minimal role in many advanced economies over the last eight years. in all advanced economies.

EXHIBIT 29 Since 2007, nonbank credit has grown as a source of corporate debt in most advanced economies, except Japan Outstanding nonfinancial corporate debt Percent, US$ trillions, constant exchange rates

Nonbank loans Securitization Corporate bonds Bank loans

United States Western Europe*

100% = 6.5 9.9 11.5 100% = 4.9 7.6 8.2 13 15 16 17 18 5 20 4 9 5 1 3 18 14 21 42 34 43 64 63 56 41 43 35

Japan Republic of Korea

100% = 5.2 4.2 4.0 100% = 0.6 0.9 1.5 21 20 13 1 18 1 30 1 28 1 1 22 31 20 17 34 35

56 49 54 45 54 46

2000 2007 Q2,2014 2000 2007 Q2,2014

SOURCE: McKinsey Global Institute .

NOTE: * Western Europe includes France, Germany, the Netherlands, Spain, and the United Kingdom .

group of thirty 37 Turning specifically to SME lending, contrary to to create collateral to support funding from central the dominant consensus narrative, there is no evi- banks, rather than funding from private capital dence that capital markets play a more extensive role markets (see exhibit 31). Single-name corporate in credit supply to SMEs in the United States than bonds also, for obvious reasons, play a minimal role in other advanced economies. Securitization of SME in SME finance, and there is no evidence that cor- credit plays a minimal role in all financial systems, porate bond markets reach further down the size but if anything plays a proportionately larger role in spectrum of companies in the United States than in Europe than in the United States. The vast majority Europe or other economies. of European SME securitization, however, is used

EXHIBIT 30 Securitization accounts for 5% or less of nonfinancial corporate sector credit in all advanced economies except the UK, which includes WBS Securitization as a share total nonfinancial corporate sector financing Percent, Q2,2014 WBS NFC Securitization outstanding US$ billions

United Kingdom* 4.4 5.2 9.6 181

United States 5.2 602

Spain 2.8 37

Netherlands 2.3 17

Canada 1.6 17

Australia 1.5 14

Republic of Korea 1.4 21

Germany 0.8 15

Japan 0.4 15

France 0.1 3

SOURCE: McKinsey Global Institute .

NOTE: NFC = nonfinancial corporate; WBS = whole business securitization .

* Includes WBS used to turn the future cash flows of a single business into a security; commonly used by pubs .

38 shadow banking and capital markets: risks and opportunities The significant difference between the US and Securitization of household European sources of SME finance is, instead, the more debt: pros, cons, and the extensive role of external equity finance observed in the United States. In addition, private placement optimal way forward markets may play a greater role in the provision of Major differences among advanced economies in finance to some midsize corporates in the United the sources of household debt are almost entirely States. Policy initiatives to improve the supply of explained by the role in the United States of the gov- external finance to SMEs, therefore, seem more likely ernment-sponsored housing agencies. Bank loans to be effective if focused on equity finance and private account for 30 percent of household debt in the United placement debt, rather than attempting to stimulate States compared to 80 percent in Europe, 69 percent securitization markets. in Japan, and 64 percent in the Republic of Korea.

EXHIBIT 31 Nearly all European SME securitization is retained by MFIs as collateral for central banks NFC securitization outstanding in Europe, retained compared to market placed Percent, US$ billions, Q2,2014

Market placed MFI retained

100% = 110 140 101 352

14% The private market for SME securitization in Europe is illiquid and lacks a robust secondary market 63% The ECB has encouraged 92% use of SME securitization 99% as collateral for repurchase 86% agreements, providing short- term ﬁnancing for MFIs

According to Fitch, in 2012, 96% of issued SME 37% securitizations were retained for repo with the ECB

8% 1% CMBS SME WBS TOTAL

SOURCE: McKinsey Global Institute .

NOTE: CMBS = commercial mortgage-backed securities; ECB = European Central Bank; MFI = monetary financial institutions; NFC = nonfinancial corporate; SME = small- and medium-sized enterprises; WBS = wholesale business securitization .

group of thirty 39 In all major countries except Korea, banks have States, and particularly mortgage securitization (see increased their share of household lending since 2008, exhibit 33). Mortgage securitization in the United but the big difference between the United States and States is dominated by government-sponsored enter- other countries in sources of household debt remains prises, a dominance that has dramatically increased (see exhibit 32). since 2008, with the almost complete disappearance This reflects major differences in the role of house- of new issuance of private-label mortgage-backed hold debt securitization in different countries, ranging securities (see exhibits 34 and 35). from 3 percent in France to 55 percent in the United

EXHIBIT 32 Since 2007, bank loans have increased as a share of household debt—except in the Republic of Korea Outstanding household debt Percent, US$ trillions, constant exchange rates

Nonbank loans Securitization Bank loans

United States Western Europe*

100% = 7.0 13.8 13.3 100% = 4.8 7.8 8.4 17 15 15 2 8 10 8 13 12 55 60 55 89 77 80 28 26 30

Japan Republic of Korea

100% = 3.5 3.2 3.0 100% = 0.3 0.7 1.1 32 24 29 23 28 40 7 6 6 10 8 6 71 54 61 69 62 64

2000 2007 Q2,2014 2000 2007 Q2,2014

SOURCE: McKinsey Global Institute .

NOTE: * Western Europe includes France, Germany, the Netherlands, Spain, and the United Kingdom .

40 shadow banking and capital markets: risks and opportunities EXHIBIT 33 The United States has the highest levels of securitization of household debt, followed by the Netherlands and Canada Household sector debt by source of financing Percent, US$ trillions, Q2,2014

Bank loans Securitization Nonbank loans 100% =

France 96 3 1 1.6

Germany 91 3 6 2.1

Spain 81 17 1 1.1

Australia 78 20 2 1.6

United Kingdom 73 15 13 2.5

Japan 69 7 24 3.0

Canada 65 25 10 1.7

Republic of Korea 64 8 28 1.1

Netherlands 50 33 18 1.0

United States 30 55 15 13.3

SOURCE: McKinsey Global Institute .

group of thirty 41 EXHIBIT 34 Since 2007, RMBS has grown as a share of household securitization in advanced economies, while remaining flat in Europe Household securitization outstanding Percent, US$ billions

United States Europe*

ABS Nonagency RMBS Agency RMBS ABS RMBS

US agencies 100% = 3,800 8,239 7,292 100% = 129 1,361 1,420 FNMA, FHLMC, 14 11 10 17% 17% 12 35% 20 33 GNMA, FDIC, NCUA 78 83% 83% 67 56 65% Japan agency Japanese Housing Finance Authority Japan Republic of Korea Purchases long- term ﬁxed rate ABS Nonagency RMBS Agency RMBS ABS RMBS housing loans and issues 206 203 = 100% 100% = 27 41 97 RMBS backed 14 25 30% 30% 20% by assets 35 45 70% 70% 80% 51 N/A 29

2000 2007 Q2,2014 2000 2007 Q2,2014

SOURCE: McKinsey Global Institute .

NOTE: ABS = asset-backed security; FDIC = Federal Deposit Insurance Corporation; FHLMC = Freddie Mac; FNMA = Fannie Mae; GNMA = Ginnie Mae; NCUA = National Credit Union Association; RMBS = residential mortgage-backed security .

* Includes the UK and all European area countries with available data .

42 shadow banking and capital markets: risks and opportunities EXHIBIT 35 Issuance of private-label MBS has dropped to almost nothing since the financial crisis Household securitization issuance US$ billions, 2014

* 2,929 ABS Private-label MBS GSE MBS 225

2,451 573 2,355 281 2,196 262 2,057 2,085 283 1,930 212 215 1,889 1,802 147 195 7 5 183 1,557 399 1,187 1,555 22 1,170 724 1,449 102 202 855 11 1,381 262 119 12 1,220 269 17 2,131 217 1,731 23 806 1,734 1,441 1,597 187 1,447 1,189 1,170 145 1,086 980 1,015 983 923 1,250

474

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

SOURCE: McKinsey Global Institute .

NOTE: ABS = asset-backed security; GSE = government-sponsored enterprise; MBS = mortgage-backed security .

* Includes auto, credit card, equipment, housing related, student loans, and other . Does not include small business ABS .

It is therefore important to understand that mort- developed by the US government-sponsored enter- gage debt securitization plays a dominant and sustained prises—simple, single-tranche securities in which all role only in financial systems where, as in the United investors bore the same credit risks—could enable States, it has been sponsored by government agen- good credit analysis. cies. Large and sustainable private mortgage security In practice, however, before the 2007–08 crisis, the systems should, in principle, be possible, but history tranching of credit risk to create complex structured provides no clearly successful model. credit securities made it more difficult to understand There could be both advantages and disadvantages the underlying risks, for two reasons. to a system of securitized rather than bank-loan-based First, the complexity was magnified by the develop- mortgage provision. In principle, it could help create a ment of the opaque and multistep distribution chains more stable system, enabling the distribution of assets discussed in section 1. to diversified and long-term investors, and freeing up Second, the originate-to-distribute model that bank capital to concentrate on sectors (such as SMEs) emerged undermined incentives for good credit under- where capital markets will inevitably play a small writing, since loan issuers did not retain the credit risk. role. And mortgage securities of the sort originally Mortgage losses, as a result, greatly exceeded those

group of thirty 43 experienced in bank-dominated mortgage markets (see away from their obligations when their house prices exhibit 36). These losses also reflected the political pushed them into negative equity. pressures on Fannie Mae and Freddie Mac to extend The challenge, therefore, is to facilitate the develop their activities to include lower-income borrowers and ment of sound, simple, and transparent mortgage expand homeownership. They also reflected the non- securitization structures and distribution chains, recourse nature of home loans in the United States, while avoiding the specific features that contributed which created incentives for homeowners to walk to the 2007–08 crisis.

EXHIBIT 36 Mortgage losses in the US spiked during the crisis but have now fallen to a lower level than in Western Europe Mortgage losses as a share of total mortgages Risk cost margin,* percent

2.2 United States US is characterized 2.0 by widespread use of Canada 1.8 non-recourse mortgages, Netherlands which may facilitate relatively 1.6 swift resolution of bad debts † via default, but which may also 1.4 Europe undermine borrower caution. 1.2 Europe largely uses ` 1.0 recourse loans, which permit the lender to pursue 0.8 a borrower’s other assets 0.6 and future income for loan payments. As a result, 0.4 borrowers have a strong incentive to limit debt and 0.2 not default. 0

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

SOURCE: McKinsey Global Institute .

NOTE: * Risk cost margin is the loss on mortgages estimated by lenders due to bad debts .

† Europe includes France, Germany, Spain, and the United Kingdom .

44 shadow banking and capital markets: risks and opportunities 14 recommendations

his report finds that financial stability risks nar- (for example, household compared to corporate, rowly defined have been somewhat reduced since and real-estate related compared to lending to other T2008. However, the scale of broadly defined sectors). And a more wide-ranging debate is needed on “shadow banking” activities continues to be large, and the fundamental drivers of rapid debt growth. As part the risks that lie outside the formal banking system of this, policy makers should consider whether rapid continue to be imperfectly understood and are con- debt growth is the product of loose monetary policy.11 tinually evolving. And while the financial system itself is somewhat safer, the macroeconomic risks that can result from sudden changes in price and sentiment in While the systemic risks posed by asset markets are elevated, and the real economy risks arising from high leverage have continued to increase, shadow banking have in some forms stimulated inevitably by sustained low interest rates. declined, this is not the time for complacency. This is not the time for complacency While the systemic risks posed by shadow banking have in some forms declined, this is not the time for Moreover, further consideration needs to be given to complacency. Policy makers must continually monitor the question of whether leverage beyond some level is financial system developments to prevent a resurgence bound to depress growth and produce instability, and of the old types of risk and to offset the development if so, what that level is.12 of new types. The following recommendations are directed at In terms of macroeconomic risk, the most import- governments, policy makers, and market participants ant issue is the continued growth of total real concerned with ensuring that the growth of nonbank economy leverage, in many individual countries and finance takes place in a manner that is consistent with overall for the whole world. Regulators and central the need for financial stability and continued regula- bankers should carefully monitor aggregate levels of tory vigilance. leverage and the mix of leverage by different sectors

11 For a discussion of this question, see Group of Thirty, Fundamentals of Central Banking: Lessons from the Crisis, Washington, D.C., 2015. 12 The issue of how much leverage is “too much” was addressed by Stephen G. Cecchetti and Enisse Kharroubi in “Why Does Financial Sector Growth Crowd Out Real Economic Growth?,” BIS Working Papers 490, Bank for International Settlements, Basel, February 2015. See also Boris Cournède, Oliver Denk, and Peter Hoeller, “Finance and Inclusive Growth,” Economic Policy Paper 14, Organization for Economic Co-operation and Development, Paris, June 2015.

group of thirty 45 RECOMMENDATION 1 • Regulators should continue to gather data on asset managers, hedge funds, and emerging market debt, On monitoring risk and increasing from a financial stability risk perspective. transparency in a continually Overall, while asset management companies them- evolving financial system selves do not create systemic risk, particular practices Care must be taken to ensure the monitoring and and particular markets give specific cause for concern 13 supervisory frameworks for emerging nonbank enti- and merit close regulatory attention. In their ongoing ties match the scale, scope, and potential systemic risk work on asset managers and financial stability risk, these entities may potentially pose. This report recom- we recommend: mends the following: • Financial market supervisors should monitor • International institutions, including the Inter ongoing developments in the asset management national Monetary Fund, the Bank for International industry, including leverage, maturity transforma- Settlements, and the Financial Stability Board, tion of some funds, and use of techniques such should continue monitoring and gathering data as high-speed trading that can exacerbate price on the growth of the shadow banking sector, and volatility. of nonbank credit intermediation more generally, • Funds in less liquid asset classes—such as emerging to be vigilant about detecting the resurgence or market debt, private equity, high-yield corporate reemergence of financial stability risks. bonds, and some hedge funds—warrant partic- • International organizations, including the ular scrutiny. In these cases, “gates” on investor International Monetary Fund and the FSB, should withdrawals may be useful to limit maturity continue efforts to develop data standards on transformation. nonbank intermediaries. As part of this endeavor, • Connections between asset managers and banks, the FSB should continue and expand its work such as through credit lines, should also be mon- related to shadow banking activities. itored. Regulators should ensure banks could • National policy makers and regulators must con- withstand simultaneous drawdowns by asset tinue to monitor the shifting and evolving nature managers. of markets, and of actors’ responses to those • Asset managers (and banks with lines to asset markets. Authorities must remain attentive and managers) should use stress tests to assess their alert, in order to increase the probability that they vulnerability to risks arising from mismatches can identify new financial stability risks, including between highly liquid investor redemption options those interconnections between the regulated and and less liquid underlying assets by asset managers. unregulated sector if and when they develop. In addition, with reference to other new nonbank • National policy makers should expand sectoral platforms: and flow-of-funds accounts to encompass diverse • Regulators should monitor new platforms and nonbank credit entities and related maturity risk, actors such as peer-to-peer and online lending, to liquidity risks, and redemption risks, to better ensure that these developing new markets and the understand bank/nonbank interconnectedness. systemic risks and interconnections they create are • Regulators should monitor leverage ratios in direct properly understood. lending by investment funds, including hedge • Regulators are urged to monitor connections funds and credit funds. between bank and nonbank intermediaries such

13 A recent Financial Stability Board publication sets out further relevant recommendations (Financial Stability Board, “Consultative Document: Proposed Policy Recommendations to Address Structural Vulnerabilities from Asset Management Activities,” Basel, June 22, 2016; http:// www.fsb.org/wp-content/uploads/FSB-Asset-Management-Consultative-Document.pdf).

46 shadow banking and capital markets: risks and opportunities as asset managers or online peer-to-peer lending • Regulatory changes should be considered to enable platforms to ensure that risks outside the banking the participation of insurance and pension funds sector do not create damaging spillovers to the in debt securities markets.15 banking sector. • A rating system for private placement issues should • Authorities should work to ensure that the devel- be established. opment of shadow banking platforms occurs in • The development of a diverse array of debt securi- a transparent manner and that agencies have the ties including social venture bonds, infrastructure ability to enhance oversight, including consumer bonds, and covered bonds should be encouraged. protection, should it prove necessary in the future. • If necessary, the mandates and resources of national authorities should be updated and adjusted to RECOMMENDATION 3 facilitate the proper monitoring and oversight of shadow banking markets and activities that may On encouraging “safe” pose financial stability risks. forms of securitization This report underscores that securitization, if risks are understood and the instruments and markets are trans- RECOMMENDATION 2 parent, can be a useful market finance mechanism. To On mechanisms for developing ensure the growth of safe forms of securitization, this report makes the following recommendations: stable and valuable debt capital • Work should be continued on the standardiza- markets and securitization tion of regulatory documentation (for example, The Group of Thirty has previously underscored14 prospectuses), and on setting standards for report- the importance of deepening debt and equity capital ing of loan-level data, to improve loan quality. markets. This report reiterates that challenging long- • National regulations on underwriting and loan term goal and makes the following recommendations: quality for securitizations should be required, and • Corporate bond markets, particularly in Europe the regulations should be coordinated globally and and emerging economies, need to be further devel- properly enforced nationally. oped to diversify sources of credit and reduce • The detailed securitization attributes and the overreliance on bank lending. credit rating of borrowers should be published • The legal and regulatory infrastructures neces- to help investors more clearly evaluate risks and sary to develop debt market structures need to be payoffs, and programs should be created to remove strengthened. This may include work on post-trade misconceptions about securitization risks. clearing mechanisms, bankruptcy laws, and inde- • Simple, transparent, and comparable securitization pendent credit rating agencies in economies where standards should be applied to whole transactions, they do not exist. The goal is to make it easier for not only to individual tranches.16 companies to issue corporate bonds, while ensuring sufficient enforcement so as to enable capital markets to work efficiently.

14 Group of Thirty, Long-Term Finance and Economic Growth, Washington, D.C., 2013. 15 There is a continuing controversy over the precise regulatory capital standards for holdings of securitized assets, with some regulators and regulated entities holding opposing views. 16 International organizations, including the Basel Committee on Banking Supervision (BCBS), the International Organization of Securities Commissions (IOSCO), and the European Banking Federation (EBF) have moved towards defining simple, transparent, and comparable securitizations. The BCBS and IOSCO have published “Criteria for Identifying Simple, Transparent and Comparable Securitizations,” Basel, July 23, 2015; http://www.bis.org/bcbs/publ/d332.htm. The EBF has responded to the BCBS-IOSCO and European Commission proposals in a series of responses from March 2013 through November 2015. See in particular “EBF Key Points on Regulatory Proposals for Securitization,” Brussels, November 19, 2015; http://www.ebf-fbe.eu/wp-content/uploads/2015/11/EBF_018150-EBF-key-points-on-regulatory-proposals-for- Securitisation-November-2015.pdf.

group of thirty 47 RECOMMENDATION 4 and debt private placement. We recommend, therefore, that: On nurturing SME market financing • Policies to expand the range of financing oppor- Contrary to the conventional wisdom, SME debt is tunities available to SMEs should focus on primarily provided by banks rather than market mech- identifying and removing any barriers to the anisms in all economies, including the United States. effectiveness of these markets, rather than on the Securitization of SME debt always plays a minimal role. probably impossible task of unleashing SME secu- Differences between the US and other markets ritization markets. instead lie primarily in the areas of equity finance

48 shadow banking and capital markets: risks and opportunities 15 conclusion

he analysis presented in this report suggests that As a result, it seems likely that the nonbank credit the financial system itself, at least in the advanced intermediation system, as well as the formal banking Teconomies, is more resilient than in 2008 and less system, now suffer from less excessive leverage, and likely therefore to suffer a sudden and self-reinforcing less dangerous maturity transformation, than they did crisis. But the combination of rising global leverage before the crisis. and new forms of financial system risk means that But this cautiously favorable assessment of the overall vulnerability to financial and macroeconomic advanced economy credit intermediation system is no instability is as great now as it was before the crisis. cause for complacency. The financial system continu- In response to the 2007–08 crisis, global regulators ally mutates, and there are many aspects of nonbank have greatly strengthened bank capital and liquidity credit intermediation that are still imperfectly under- requirements, making the banking system significantly stood. And even where credit flows are managed more resilient. And these stronger requirements have rather than intermediated, new forms of financial probably encouraged the slight shift to nonbank credit stability risk can be introduced. intermediation that has occurred since 2008. Moreover, growing leverage across the global In the advanced economies, however, most of this economy can create important risks to macro- growth in nonbank credit intermediation has been in economic stability even if the financial system itself forms such as single-name corporate bonds, which is more resilient. And two developments are partic- do not raise the same financial stability concerns ularly concerning: the growth of emerging market as precrisis shadow banking. The specific forms of foreign currency debt and the rapid growth of Chinese shadow banking most implicated in the 2008 financial leverage accompanied by a proliferation of shadow crisis have declined significantly in importance, and it banking activities are ominously reminiscent of pre- appears that interconnectedness between the banking crisis developments in the advanced economies. system and other parts of the financial system may The specific forms that risk takes have thus have declined. changed, but overall risks are as great now as they were before the crisis. Policy makers must remain vigilant to ensure that they spot new risks emerging and respond to them before a new crisis erupts.

group of thirty 49 bibliogr aphy

Basel Committee on Banking Supervision and the International Organization of Securities Commissions. 2015. “Criteria for Identifying Simple, Transparent and Comparable Securitizations.” Bank for International Settlements, Basel, July 23. http://www.bis.org/bcbs/publ/d332.htm.

Cecchetti, Stephen G., and Enisse Kharroubi. 2015. “Why Does Financial Sector Growth Crowd Out Real Economic Growth?” BIS Working Papers 490, Bank for International Settlements, Basel, February.

Cournède, Boris, Oliver Denk, and Peter Hoeller. 2015. “Finance and Inclusive Growth.” Economic Policy Paper 14, Organization for Economic Co-operation and Development, Paris, June.

European Banking Authority. 2015. “Report on Institutions’ Exposures to ‘Shadow Banking Entities.’” European Banking Authority, London, December. https://www.eba.europa.eu/documents/10180/950548/Report+on+institutions+exposures+to+shadow+banking+entities.pdf.

European Banking Federation. 2015. “EBF Key Points on Regulatory Proposals for Securitization.” European Banking Federation, Brussels, November 19. http://www.ebf-fbe.eu/wp-content/uploads/2015/11/EBF_018150-EBF-key-points-on-regulatory- proposals-for-Securitisation-November-2015.pdf.

Financial Stability Board. 2015. Global Shadow Banking Monitoring Report 2015. Financial Stability Board, Basel, November.

———. 2016. “Consultative Document: Proposed Policy Recommendations to Address Structural Vulnerabilities from Asset Management Activities.” Financial Stability Board, Basel, June 22. http://www.fsb.org/wp-content/uploads/ FSB-Asset-Management-Consultative-Document.pdf.

Group of Thirty. 2009. Financial Reform: A Framework for Financial Stability. Washington, D.C.: Group of Thirty.

———. 2013. Long-Term Finance and Economic Growth. Washington, D.C.: Group of Thirty.

———. 2015. Fundamentals of Central Banking: Lessons from the Crisis. Washington, D.C.: Group of Thirty.

International Monetary Fund. 2015. Global Financial Stability Report: Navigating Monetary Policy Challenges and Managing Risks. Washington, D.C.: International Monetary Fund, April.

McKinsey Global Institute. 2015. “Debt and (not much) deleveraging.” McKinsey Global Institute, February.

Shek, Jimmy, Ilhyock Shim, and Hyun Song Shin. 2015. “Investor redemptions and fund manager sales of emerging market bonds: how are they related?” BIS Working Papers 509, Bank for International Settlements, Basel, August.

groupgroup of thirty 51 group of thirty members 2016 *

LEADERSHIP Mark Carney Governor, Bank of England Paul A. Volcker Chairman, Financial Stability Board Chairman Emeritus, Group of Thirty Member, Board of Directors, Bank for Former Chairman, President Barack Obama’s International Settlements Economic Recovery Advisory Board Former Governor, Bank of Canada Former Chairman, Board of Governors of the Federal Reserve System Jaime Caruana General Manager, Bank for International Settlements Jacob A. Frenkel Former Financial Counsellor, Chairman of the Board of Trustees, Group of Thirty International Monetary Fund Chairman, JPMorgan Chase International Former Governor, Banco de España Former Governor, Bank of Israel Former Chairman, Basel Committee Former Professor of Economics, University of Chicago on Banking Supervision Former Counselor, Director of Research, International Monetary Fund Domingo Cavallo Chairman and CEO, DFC Associates, LLC Jean-Claude Trichet Former Minister of Economy, Argentina Chairman, Group of Thirty Former President, European Central Bank Mario Draghi Former Governor, Banque de France President, European Central Bank Member, Board of Directors, Bank for Guillermo Ortiz International Settlements Treasurer, Group of Thirty Former Governor, Banca d’Italia Chairman, BTG Pactual Mexico Former Chairman, Financial Stability Board Former Governor, Banco de México Former Vice Chairman and Managing Director, Former Chairman of the Board, Bank Goldman Sachs International for International Settlements Former Secretary of Finance and Public Credit, Mexico William Dudley President, Federal Reserve Bank of New York * * * Member, Board of Directors, Bank for International Settlements Leszek Balcerowicz Former Partner and Managing Director, Professor, Warsaw School of Economics Goldman Sachs and Company Former President, National Bank of Poland Former Deputy Prime Minister and Roger W. Ferguson, Jr. Minister of Finance, Poland President and CEO, TIAA Former Chairman, Swiss Re America Ben S. Bernanke Holding Corporation Distinguished Fellow in Residence, Economic Former Vice Chairman, Board of Governors Studies, Brookings Institution of the Federal Reserve System Former Chairman, Board of Governors of the Federal Reserve System Arminio Fraga Founding Partner, Gávea Investimentos Former Chairman of the Board, BM&F-Bovespa Former Governor, Banco Central do Brasil

* As of NovemberOctober 1, 1,2016. 2016.

groupgroup of thirty 53 Timothy Geithner Kenneth Rogoff Ernesto Zedillo Richard A. Debs President, Warburg Pincus Thomas D. Cabot Professor of Public Policy Director, Yale Center for the Study of Advisory Director, Morgan Stanley Former Secretary of the United States Treasury and Economics, Harvard University Globalization, Yale University Former President, Morgan Stanley International Former President, Federal Reserve Bank of New York Former Chief Economist and Director of Research, IMF Former President of Mexico Former COO, Federal Reserve Bank of New York

Gerd Häusler Tharman Shanmugaratnam Zhou Xiaochuan Martin Feldstein Chairman of the Supervisory Board, Deputy Prime Minister, Singapore Governor, People’s Bank of China Professor of Economics, Harvard University Bayerische Landesbank Chairman, Monetary Authority of Singapore Member, Board of Directors, Bank for President Emeritus, National Bureau Chairman of the Board of Directors, Former Chairman of International Monetary International Settlements of Economic Research BHF Kleinwort Benson Group & Financial Committee, IMF Former President, China Construction Bank Former Chairman, Council of Economic Advisers Former Chief Executive Officer, Bayerische Landesbank Former Assistant Minister of Foreign Trade, China Former Director and Financial Counselor, Masaaki Shirakawa Gerhard Fels International Monetary Fund Special Professor of International Politics, Economics Former Director, Institut der deutschen Wirtschaft and Communications, Aoyama-Gakuin University SENIOR MEMBERS Philipp Hildebrand Former Governor, Bank of Japan Toyoo Gyohten Vice Chairman, BlackRock Former Vice-Chairman, Board of Directors, E. Gerald Corrigan President, Institute for International Monetary Affairs Former Chairman of the Governing Bank for International Settlements Former Managing Director, Goldman Sachs Group, Inc. Former Chairman, Bank of Tokyo Board, Swiss National Bank Former Professor, Kyoto University Former President, Federal Reserve Bank of New York John G. Heimann Former Partner, Moore Capital Management School of Government Guillermo de la Dehesa Founding Chairman, Financial Stability Institute Gail Kelly Lawrence H. Summers Vice Chairman & Member of the Executive Former U.S. Comptroller of the Currency Global Board of Advisors, US Council Charles W. Eliot University Professor, Harvard University Committee, Grupo Santander Former Superintendent of Banks, New York State on Foreign Relations Former Director, National Economics Chairman, Aviva Grupo Corporativo William McDonough Senior Global Advisor, UBS Group AG Council for President Barack Obama Chairman, Centre for Economic Policy Research Former President, Federal Reserve Bank of New York Member, McKinsey Advisory Council Former President, Harvard University Former Deputy Managing Director, Banco de España Former Secretary of State, Ministry of Board Director, Woolworths Holdings, South Africa Former Secretary of the United States Treasury Sylvia Ostry Economy and Finance, Spain Distinguished Research Fellow, Munk Centre Mervyn King Tidjane Thiam for International Studies, Toronto Member of the House of Lords, United Kingdom CEO, Credit Suisse Yutaka Yamaguchi Former Ambassador for Trade Negotiations, Canada Former Governor, Bank of England Former CEO, Prudential plc Former Deputy Governor, Bank of Japan Former Head, OECD Economics Former Professor of Economics, Former Chairman, Euro Currency Standing Commission and Statistics Department London School of Economics Adair Turner Chairman of the Governing Board, Institute William R. Rhodes Paul Krugman for New Economic Thinking EMERITUS MEMBERS President and CEO, William R. Rhodes Global Advisors Distinguished Professor, Graduate Center, CUNY Former Chairman, Financial Services Authority Abdlatif Al-Hamad Senior Advisor, Citigroup Former Member, Council of Economic Advisors Member of the House of Lords, United Kingdom Director General and Chairman of the Board of Former Senior Vice Chairman, Citigroup Haruhiko Kuroda Kevin M. Warsh Directors, Ernest Stern Governor, Bank of Japan Distinguished Visiting Fellow, Hoover Arab Fund for Economic and Social Development Partner and Senior Advisor, The Rohatyn Group Former President, Asian Development Bank Institution, Stanford University Former Minister of Finance and Former Managing Director, JPMorgan Chase Lecturer, Stanford University Graduate Minister of Planning, Kuwait Former Managing Director, World Bank Christian Noyer School of Business Honorary Governor, Banque de France Geoffrey L. Bell Former Governor, Board of Governors David Walker Former Chairman, Bank for International Settlements Founder, Group of Thirty of the Federal Reserve System Chairman, Winton Capital Management President, Geoffrey Bell & Company, Inc. Former Chairman, Barclays PLC Raghuram G. Rajan Axel A. Weber Jacques de Larosière Former Chairman, Morgan Stanley International, Inc. Professor of Economics, Chicago Chairman, UBS President, Eurofi Former Chairman, Securities and Booth School of Business Former Visiting Professor of Economics, Conseiller, BNP Paribas Investments Board, U.K. Former Governor, Reserve Bank of India Chicago Booth School of Business Former Chief Economic Advisor, Former President, European Bank for Former President, Deutsche Bundesbank Marina v N. Whitman Ministry of Finance, India Reconstruction and Development Professor of Business Administration & Former Managing Director, Public Policy, University of Michigan International Monetary Fund Former Member, Council of Economic Advisors Former Governor, Banque de France

54 shadowshadow banking and capital markets: risks and opportunities group of thirty 55 Timothy Geithner Kenneth Rogoff Ernesto Zedillo Richard A. Debs President, Warburg Pincus Thomas D. Cabot Professor of Public Policy Director, Yale Center for the Study of Advisory Director, Morgan Stanley Former Secretary of the United States Treasury and Economics, Harvard University Globalization, Yale University Former President, Morgan Stanley International Former President, Federal Reserve Bank of New York Former Chief Economist and Director of Research, IMF Former President of Mexico Former COO, Federal Reserve Bank of New York

Gerd Häusler Tharman Shanmugaratnam Zhou Xiaochuan Martin Feldstein Chairman of the Supervisory Board, Deputy Prime Minister, Singapore Governor, People’s Bank of China Professor of Economics, Harvard University Bayerische Landesbank Chairman, Monetary Authority of Singapore Member, Board of Directors, Bank for President Emeritus, National Bureau Chairman of the Board of Directors, Former Chairman of International Monetary International Settlements of Economic Research BHF Kleinwort Benson Group & Financial Committee, IMF Former President, China Construction Bank Former Chairman, Council of Economic Advisers Former Chief Executive Officer, Bayerische Landesbank Former Assistant Minister of Foreign Trade, China Former Director and Financial Counselor, Masaaki Shirakawa Gerhard Fels International Monetary Fund Special Professor of International Politics, Economics Former Director, Institut der deutschen Wirtschaft and Communications, Aoyama-Gakuin University SENIOR MEMBERS Philipp Hildebrand Former Governor, Bank of Japan Toyoo Gyohten Vice Chairman, BlackRock Former Vice-Chairman, Board of Directors, E. Gerald Corrigan President,Honorary Advisor,Institute Institutefor International for Monetary Affairs Former Chairman of the Governing Bank for International Settlements Former Managing Director, Goldman Sachs Group, Inc. FormerInternational Chairman, Monetary Bank of AffairsTokyo Board, Swiss National Bank Former Professor, Kyoto University Former President, Federal Reserve Bank of New York Former Chairman, Bank of Tokyo John G. Heimann Former Partner, Moore Capital Management School of Government Guillermo de la Dehesa FoundingJohn G. Heimann Chairman, Financial Stability Institute Founding Chairman, Financial Stability Institute Gail Kelly Lawrence H. Summers Vice Chairman & Member of the Executive Former U.S. Comptroller of the Currency Global Board of Advisors, US Council Charles W. Eliot University Professor, Harvard University Committee, Grupo Santander Former SuperintendentU.S. Comptroller of ofBanks, the Currency New York State on Foreign Relations Former Director, National Economics Chairman, Aviva Grupo Corporativo Former Superintendent of Banks, New York State William McDonough Senior Global Advisor, UBS Group AG Council for President Barack Obama Chairman, Centre for Economic Policy Research FormerWilliam President,McDonough Federal Reserve Bank of New York Member, McKinsey Advisory Council Former President, Harvard University Former Deputy Managing Director, Banco de España Former President, Federal Reserve Bank of New York Former Secretary of State, Ministry of Board Director, Woolworths Holdings, South Africa Former Secretary of the United States Treasury Sylvia Ostry Economy and Finance, Spain DistinguishedSylvia Ostry Research Fellow, Munk Centre Mervyn King Tidjane Thiam Distinguishedfor International Research Studies, Fellow, Toronto Munk Centre Member of the House of Lords, United Kingdom CEO, Credit Suisse Yutaka Yamaguchi Formerfor International Ambassador Studies, for Trade Toronto Negotiations, Canada Former Governor, Bank of England Former CEO, Prudential plc Former Deputy Governor, Bank of Japan Former Head,Ambassador OECD for Economics Trade Negotiations, Canada Former Professor of Economics, Former Chairman, Euro Currency Standing Commission Formerand Statistics Head, OECD Department Economics London School of Economics Adair Turner Chairman of the Governing Board, Institute and Statistics Department William R. Rhodes Paul Krugman for New Economic Thinking EMERITUS MEMBERS PresidentWilliam R. and Rhodes CEO, William R. Rhodes Global Advisors Distinguished Professor, Graduate Center, CUNY Former Chairman, Financial Services Authority Abdlatif Al-Hamad SeniorPresident Advisor, and CEO, Citigroup William R. Rhodes Global Advisors Former Member, Council of Economic Advisors Member of the House of Lords, United Kingdom Director General and Chairman of the Board of FormerSenior Advisor, Senior Vice Citigroup Chairman, Citigroup Former Senior Vice Chairman, Citigroup Haruhiko Kuroda Kevin M. Warsh Directors, Ernest Stern Governor, Bank of Japan Distinguished Visiting Fellow, Hoover Arab Fund for Economic and Social Development PartnerErnest Stern and Senior Advisor, The Rohatyn Group Former President, Asian Development Bank Institution, Stanford University Former Minister of Finance and FormerPartner Managingand Senior Director, Advisor, JPMorganThe Rohatyn Chase Group Lecturer, Stanford University Graduate Minister of Planning, Kuwait Former Managing Director, WorldJPMorgan Bank Chase Christian Noyer School of Business Honorary Governor, Banque de France Geoffrey L. Bell Former Managing Director, World Bank Former Governor, Board of Governors David Walker Former Chairman, Bank for International Settlements Founder, Group of Thirty of the Federal Reserve System Chairman,David Walker Winton Capital Management President, Geoffrey Bell & Company, Inc. FormerChairman, Chairman, Winton BarclaysCapital Management PLC Raghuram G. Rajan Axel A. Weber Jacques de Larosière Former Chairman, MorganBarclays StanleyPLC International, Inc. Professor of Economics, Chicago Chairman, UBS President, Eurofi Former Chairman, SecuritiesMorgan Stanley and International, Inc. Booth School of Business Former Visiting Professor of Economics, Conseiller, BNP Paribas FormerInvestments Chairman, Board, Securities U.K. and Former Governor, Reserve Bank of India Chicago Booth School of Business Former Chief Economic Advisor, Former President, European Bank for Investments Board, U.K. Former President, Deutsche Bundesbank Marina v N. Whitman Ministry of Finance, India Reconstruction and Development ProfessorMarina v N. of Whitman Business Administration & Former Managing Director, ProfessorPublic ofPolicy, Business University Administration of Michigan & International Monetary Fund FormerPublic Member, Policy, UniversityCouncil of ofEconomic Michigan Advisors Former Governor, Banque de France Former Member, Council of Economic Advisors

54 shadow banking and capital markets: risks and opportunities groupgroup of thirty 55 International Insolvencies in the Financial Sector Post Crisis Asia: The Way Forward group of thirty Study Group Report. 1998 Lee Hsien Loong. 2001 Global Institutions, National Supervision Licensing Banks: Still Necessary? and Systemic Risk Tommaso Padoa-Schioppa. 2000 publications Study Group on Supervision and Regulation. 1997 Banking Supervision and Financial Stability Latin American Capital Flows: Living with Volatility Andrew Crockett. 1998 Latin American Capital Flows Study Group. 1994 SPECIAL REPORTS SINCE 1990 Derivatives: Practices and Principles, Global Risk Management Appendix III: Survey of Industry Practice Defining the Roles of Accountants, Bankers Ulrich Cartellieri and Alan Greenspan. 1996 Fundamentals of Central Banking: Global Derivatives Study Group. 1994 and Regulators in the United States Lessons from the Crisis Study Group on Accountants, Bankers The Financial Disruptions of the 1980s: Derivatives: Practices and Principles, Appendix II: Central Banking Working Group. 2015 and Regulators. 1994 A Central Banker Looks Back Legal Enforceability: Survey of Nine Jurisdictions E. Gerald Corrigan. 1993 Banking Conduct and Culture: A Call for Global Derivatives Study Group. 1993 EMU after Maastricht Sustained and Comprehensive Reform Peter B. Kenen. 1992 Culture and Conduct Working Group. 2015 Derivatives: Practices and Principles, OCCASIONAL PAPERS SINCE 2000 Appendix I: Working Papers Sea Changes in Latin America A New Paradigm: Financial Institution Global Derivatives Study Group. 1993 Pedro Aspe, Andres Bianchi, and Domingo Cavallo, 94. Oil and the Global Economy Boards and Supervisors with discussion by S.T. Beza and William Rhodes. 1992 Abdlatif Al-Hamad and Philip Verleger, Jr. 2016 Banking Supervision Working Group. 2013 Derivatives: Practices and Principles Global Derivatives Study Group. 1993 The Summit Process and Collective Security: 93. Thoughts on Monetary Policy: A Long-term Finance and Economic Growth Future Responsibility Sharing European Perspective Clearance and Settlement Systems: Long-term Finance Working Group. 2013 The Summit Reform Study Group. 1991 Jacques de Larosière. 2016 Status Reports, Autumn 1992 Toward Effective Governance of Financial Institutions Various Authors. 1992 Financing Eastern Europe 92. Financial Stability Governance Corporate Governance Working Group. 2012 Richard A. Debs, Harvey Shapiro, Today: A Job Half Done Clearance and Settlement Systems: and Charles Taylor. 1991 Andrew Large. 2015 Enhancing Financial Stability and Status Reports, Year-End 1990 Resilience: Macroprudential Policy, Various Authors. 1991 The Risks Facing the World Economy 91. Growth, Stability, and Prosperity in Latin America Tools, and Systems for the Future The Risks Facing the World Economy Alexandre Tombini, Rodrigo Vergara, Conference on Clearance and Settlement Macroprudential Policy Working Group. 2010 Study Group. 1991 and Julio Velarde. 2015 Systems. London, March 1990: Speeches The Reform of the International Monetary Fund Various Authors. 1990 90. Central Banks: Confronting the Hard Truths IMF Reform Working Group. 2009 THE WILLIAM TAYLOR MEMORIAL LECTURES Discovered and the Tough Choices Ahead Clearance and Settlement Systems: Philipp Hildebrand. 2015 Financial Reform: A Framework for Financial Stability Status Reports, Spring 1990 Three Years Later: Unfinished Financial Reform Working Group. 2009 Various Authors. 1990 Business in Financial Reform 89. The Digital Revolution in Banking Gail Kelly. 2014 The Structure of Financial Supervision: Approaches Paul A. Volcker. 2011 and Challenges in a Global Marketplace REPORTS SINCE 1990 It’s Not Over ’Til It’s Over: Leadership 88. How Poland’s EU Membership Helped Financial Regulatory Systems Working Group. 2008 and Financial Regulation Transform its Economy Sharing the Gains from Trade: Reviving the Doha Marek Belka. 2013 Global Clearing and Settlement: Final Monitoring Report Thomas M. Hoenig. 2010 Study Group Report. 2004 Global Monitoring Committee. 2006 The Credit Crisis: The Quest for Stability and Reform 87. Debt, Money, and Mephistopheles: How Key Issues in Sovereign Debt Restructuring Do We Get Out of This Mess? Reinsurance and International Financial Markets E. Gerald Corrigan. 2008 Study Group Report. 2002 Adair Turner. 2013 Reinsurance Study Group. 2006 Lessons Learned from the 2008 Financial Crisis Reducing the Risks of International Insolvency 86. A Self-Inflicted Crisis?: Design and Management Enhancing Public Confidence in Financial Reporting Eugene A. Ludwig. 2008 A Compendium of Work in Progress. 2000 Failures Leading to the Eurozone Crisis Steering & Working Committees on Accounting. 2004 Two Cheers for Financial Stability Guillermo de la Dehesa. 2012 Collapse: The Venezuelan Banking Crisis of ‘94 Global Clearing and Settlement: A Plan of Action Howard Davies. 2006 Ruth de Krivoy. 2000 85. Policies for Stabilization and Growth Steering & Working Committees of Global Implications of Basel II for Emerging Market Countries in Small Very Open Economies Clearing & Settlements Study. 2003 The Evolving Corporation: Global Stanley Fischer. 2003 DeLisle Worrell. 2012 Imperatives and National Responses Derivatives: Practices and Principles: Study Group Report. 1999 Issues in Corporate Governance Follow-up Surveys of Industry Practice William J. McDonough. 2003 Global Derivatives Study Group. 1994

56 shshadowadow banking and capital markets: risks and opportunities group of thirty 57 International Insolvencies in the Financial Sector Post Crisis Asia: The Way Forward group of thirty Study Group Report. 1998 Lee Hsien Loong. 2001 Global Institutions, National Supervision Licensing Banks: Still Necessary? and Systemic Risk Tommaso Padoa-Schioppa. 2000 publications Study Group on Supervision and Regulation. 1997 Banking Supervision and Financial Stability Latin American Capital Flows: Living with Volatility Andrew Crockett. 1998 Latin American Capital Flows Study Group. 1994 SPECIAL REPORTS SINCE 1990 Derivatives: Practices and Principles, Global Risk Management Appendix III: Survey of Industry Practice Defining the Roles of Accountants, Bankers Ulrich Cartellieri and Alan Greenspan. 1996 Fundamentals of Central Banking: Global Derivatives Study Group. 1994 and Regulators in the United States Lessons from the Crisis Study Group on Accountants, Bankers The Financial Disruptions of the 1980s: Derivatives: Practices and Principles, Appendix II: Central Banking Working Group. 2015 and Regulators. 1994 A Central Banker Looks Back Legal Enforceability: Survey of Nine Jurisdictions E. Gerald Corrigan. 1993 Banking Conduct and Culture: A Call for Global Derivatives Study Group. 1993 EMU after Maastricht Sustained and Comprehensive Reform Peter B. Kenen. 1992 Culture and Conduct Working Group. 2015 Derivatives: Practices and Principles, OCCASIONAL PAPERS SINCE 2000 Appendix I: Working Papers Sea Changes in Latin America A New Paradigm: Financial Institution Global Derivatives Study Group. 1993 Pedro Aspe, Andres Bianchi, and Domingo Cavallo, 94. Oil and the Global Economy Boards and Supervisors with discussion by S.T. Beza and William Rhodes. 1992 Abdlatif Al-Hamad and Philip Verleger, Jr. 2016 Banking Supervision Working Group. 2013 Derivatives: Practices and Principles Global Derivatives Study Group. 1993 The Summit Process and Collective Security: 93. Thoughts on Monetary Policy: A Long-term Finance and Economic Growth Future Responsibility Sharing European Perspective Clearance and Settlement Systems: Long-term Finance Working Group. 2013 The Summit Reform Study Group. 1991 Jacques de Larosière. 2016 Status Reports, Autumn 1992 Toward Effective Governance of Financial Institutions Various Authors. 1992 Financing Eastern Europe 92. Financial Stability Governance Corporate Governance Working Group. 2012 Richard A. Debs, Harvey Shapiro, Today: A Job Half Done Clearance and Settlement Systems: and Charles Taylor. 1991 Andrew Large. 2015 Enhancing Financial Stability and Status Reports, Year-End 1990 Resilience: Macroprudential Policy, Various Authors. 1991 The Risks Facing the World Economy 91. Growth, Stability, and Prosperity in Latin America Tools, and Systems for the Future The Risks Facing the World Economy Alexandre Tombini, Rodrigo Vergara, Conference on Clearance and Settlement Macroprudential Policy Working Group. 2010 Study Group. 1991 and Julio Velarde. 2015 Systems. London, March 1990: Speeches The Reform of the International Monetary Fund Various Authors. 1990 90. Central Banks: Confronting the Hard Truths IMF Reform Working Group. 2009 THE WILLIAM TAYLOR MEMORIAL LECTURES Discovered and the Tough Choices Ahead Clearance and Settlement Systems: Philipp Hildebrand. 2015 Financial Reform: A Framework for Financial Stability Status Reports, Spring 1990 Three Years Later: Unfinished Financial Reform Working Group. 2009 Various Authors. 1990 Business in Financial Reform 89. The Digital Revolution in Banking Gail Kelly. 2014 The Structure of Financial Supervision: Approaches Paul A. Volcker. 2011 and Challenges in a Global Marketplace REPORTS SINCE 1990 It’s Not Over ’Til It’s Over: Leadership 88. How Poland’s EU Membership Helped Financial Regulatory Systems Working Group. 2008 and Financial Regulation Transform its Economy Sharing the Gains from Trade: Reviving the Doha Marek Belka. 2013 Global Clearing and Settlement: Final Monitoring Report Thomas M. Hoenig. 2010 Study Group Report. 2004 Global Monitoring Committee. 2006 The Credit Crisis: The Quest for Stability and Reform 87. Debt, Money, and Mephistopheles: How Key Issues in Sovereign Debt Restructuring Do We Get Out of This Mess? Reinsurance and International Financial Markets E. Gerald Corrigan. 2008 Study Group Report. 2002 Adair Turner. 2013 Reinsurance Study Group. 2006 Lessons Learned from the 2008 Financial Crisis Reducing the Risks of International Insolvency 86. A Self-Inflicted Crisis?: Design and Management Enhancing Public Confidence in Financial Reporting Eugene A. Ludwig. 2008 A Compendium of Work in Progress. 2000 Failures Leading to the Eurozone Crisis Steering & Working Committees on Accounting. 2004 Two Cheers for Financial Stability Guillermo de la Dehesa. 2012 Collapse: The Venezuelan Banking Crisis of ‘94 Global Clearing and Settlement: A Plan of Action Howard Davies. 2006 Ruth de Krivoy. 2000 85. Policies for Stabilization and Growth Steering & Working Committees of Global Implications of Basel II for Emerging Market Countries in Small Very Open Economies Clearing & Settlements Study. 2003 The Evolving Corporation: Global Stanley Fischer. 2003 DeLisle Worrell. 2012 Imperatives and National Responses Derivatives: Practices and Principles: Study Group Report. 1999 Issues in Corporate Governance Follow-up Surveys of Industry Practice William J. McDonough. 2003 Global Derivatives Study Group. 1994

56 shadow banking and capital markets: risks and opportunities groupgroup of thirty 57 84. The Long-term Outlook for the European 73. Nine Common Misconceptions about Project and the Single Currency Competitiveness and Globalization Jacques de Larosière. 2012 Guillermo de la Dehesa. 2007

83. Macroprudential Policy: Addressing 72. International Currencies and the Things We Don’t Know National Monetary Policies Alastair Clark and Andrew Large. 2011 Barry Eichengreen. 2006

82. The 2008 Financial Crisis and Its Aftermath: 71. The International Role of the Dollar Addressing the Next Debt Challenge and Trade Balance Adjustment Thomas A. Russo and Aaron J. Katzel. 2011 Linda Goldberg and Cédric Tille. 2006

81. Regulatory Reforms and Remaining Challenges 70. The Critical Mission of the European Mark Carney, Paul Tucker, Philipp Hildebrand, Stability and Growth Pact Jacques de Larosière,William Dudley, Adair Jacques de Larosière. 2005 Turner, and Roger W. Ferguson, Jr. 2011 69. Is it Possible to Preserve the European Social Model? 80. 12 Market and Government Failures Leading Guillermo de la Dehesa. 2005 to the 2008–09 Financial Crisis 68. External Transparency in Trade Policy Guillermo de la Dehesa. 2010 68. External Transparency in Trade Policy Sylvia Ostry. 2004 79. Lessons Learned from Previous Banking 67. American Capitalism and Global Convergence Crises: Sweden, Japan, Spain, and Mexico 67. American Capitalism and Global Convergence Marina V.N. Whitman. 2003 Stefan Ingves, Goran Lind, Masaaki Shirakawa, Jaime Marina V.N. Whitman. 2003 Caruana, and Guillermo Ortiz Martinez. 2009 Caruana, and Guillermo Ortiz Martinez. 2009 66. Enron et al.: Market Forces in Disarray Jaime Caruana, Andrew Crockett, Douglas 78. The G30 at Thirty Jaime Caruana, Andrew Crockett, Douglas Flint, Trevor Harris, and Tom Jones. 2002 Peter Kenen. 2008 Flint, Trevor Harris, and Tom Jones. 2002 65. Venture Capital in the United States and Europe 77. Distorting the Micro to Embellish the 65. Venture Capital in the United States and Europe Guillermo de la Dehesa. 2002 Macro: The Case of Argentina Guillermo de la Dehesa. 2002 Domingo Cavallo and Joaquin Cottani. 2008 Domingo Cavallo and Joaquin Cottani. 2008 64. Explaining the Euro to a Washington Audience Tommaso Padoa-Schioppa. 2001 76. Credit Crunch: Where Do We Stand? Tommaso Padoa-Schioppa. 2001 Thomas A. Russo. 2008 Thomas A. Russo. 2008 63. Exchange Rate Regimes: Some Lessons from Postwar Europe 75. Banking, Financial, and Regulatory Reform Lessons from Postwar Europe Charles Wyplosz. 2000 Liu Mingkang, Roger Ferguson, and Charles Wyplosz. 2000 Guillermo Ortiz Martinez. 2007 Guillermo Ortiz Martinez. 2007 62. Decisionmaking for European Economic and Monetary Union 74. The Achievements and Challenges of Economic and Monetary Union Erik Hoffmeyer. 2000 European Union Financial Integration and Erik Hoffmeyer. 2000 its Implications for the United States Jacques de Larosière. 2007

58 shshadowadow banking and capital markets: risks and opportunities shadow banking and banking shadow capital markets:

shadow banking group of thirty risks and opportunities and risks 1701 K Street, NW, Suite 950 and Washington, D.C. 20006 capital markets ISBN 1-56708-170-3 RISKS AND OPPORTUNITIES

Grou p of Thirty p of