In the aftermath of the 2007–08 financial crisis, regulators had agreed to reform banking regulations and significantly increased banks’ cash reserves to prevent another financial debacle. However, with the recent suggestions of a banking crisis, it seems that regulatory efforts might not have been as effective as we had hoped.
The question on everyone’s mind right now is why have the worldwide banking reforms put in place after 2008 seemingly fallen so short? The answer may lie in the so-called shadow banking system.
Shadow banks are institutions that operate like banks, but are not officially recognised as such. And so shadow banks are not subject to most of the banking regulations in place – particularly the reforms implemented after 2008.
The shadow banking system of special purpose vehicles (SPVs), which innovatively transformed banks’ mortgage and other long-term loans into bond-like securities (the securitisation process), was at the root of the 2007-08 financial crisis.
Following the banking reforms targeting securitisation, SPVs almost disappeared. However, other shadow banks remained untouched by the banking reforms, particularly those in the funds and insurance industries, which often hold more cash and financial assets than the banks themselves.
In 2021, non-banking financial institutions (NBFIs), with $239.9tn, held a 49.2% share of total global financial assets, growing 8.9% over the latest 12-month period after an average annual growth of 6.6% between 2016 and 2020.
Liquidity constraints
Liquidity is key to any bank’s survival. When a major bank – such as Silicon Valley Bank (SVB) or Credit Suisse – suffers from significant liquidity constraints, it shatters market confidence in other banks, effectively causing a market-wide banking crisis.
Last month, both US and Swiss financial authorities were swift to react in order to preserve confidence in the financial markets after the failures of SVB and Credit Suisse.
Within 48 hours of SVB’s collapse, the US authorities stepped in to guarantee all deposits at SVB and gave all banks access to emergency funds. Swiss authorities forced UBS to take over Credit Suisse over the weekend as the latter was expected to go bankrupt on Monday.
Shadow banks can significantly affect traditional banks’ liquidity. One of the main sources of liquidity for banks has been repurchase agreements (repos) with shadow banks. Other financial institutions’ net repo position significantly increased in 2021.
By contrast, banks’ net repo position significantly decreased in 2021. As indicated by the graph below, banks significantly increased their reliance on other financial institutions for repo borrowings to cover their liquidity shortages after 2020.
Repos are effectively short-term borrowings. Traditional banks that need more liquidity sell their securities, such as government bonds and shares, to shadow banks with ample liquidities in exchange for cash, and then buy back these securities from the shadow banks when their liquidity constraints are alleviated. These repo transactions are mostly off balance sheets and hence invisible to the public.
When interest rates rise rapidly, as we have seen recently, shadow banks may decide to raise borrowing rates charged on the repos or even stop lending to traditional banks by diverting funds to products with higher interest yields.
With vital liquidity supplies drying up, traditional banks with higher liquidity constraints can quickly start to experience financial difficulties.
For example, SVB held billions of dollars of US Treasury bonds and AAA-rated mortgage-backed securities, which are guaranteed by the US Treasury. If SVB had been able to repo these securities instead of selling them, which resulted in huge losses due to rising interest rates, it might not have collapsed.
Credit Suisse had a similar experience. Even though the bank held large amounts of liquid assets and the value of its assets was substantially higher than its liabilities, it was not able to repo them to acquire more liquidity, leading to a rapid deterioration of its solvency.
The failure of a systemically important bank then causes market-wide panic. Since these repo transactions are often undisclosed, the banking crisis caught investors and regulators off guard.
Can special audits help?
With the latest banking crisis involving liquidity problems and shadow banks, regulators may now want to put shadow banks into the orbit of banking regulation. This would, however, be a great regulatory challenge, as shadow banks are complex institutions and often elude government controls.
Another way to improve the current situation may be to implement special audits on banks’ liquidity constraints that are linked with off-balance sheet transactions. The traditional audit model only covers banks’ on-balance sheet items, and liquidity is only treated as a routine part of the normal audit process.
After the Enron and WorldCom corporate scandals in the early 2000s, regulators implemented the special audit model on corporate internal controls, which has generally been viewed as a success.
So, would it be possible to design and implement a special audit on banks’ liquidity constraints, especially regarding off-balance sheet transactions linked to shadow banks?
My research has shown that auditors are aware of these off-balance sheet transactions and are able to adjust their responses according to banks’ liquidity constraints.
Whether a special audit focusing on banks’ liquidity constraints can increase transparency and help prevent a future banking crisis is a question that warrants further discussion and conversation among practitioners and policy-makers.
John Zhang is a professor of accounting at Audencia Business School.
