Question

1. After Li Hui’s husband died in a car accident a decade ago, she received an insurance payout of 800,000 Yuan. The money could not begin to make up for his loss, but Ms. Li, a soft-spoken pensioner, thought it would at least help tide her over for the rest of her life and provide a nice inheritance for her daughter. Yet relying on savings alone is difficult in China. The cost of housing, food and travel has risen steeply, whereas interest rates on bank deposits have barely kept pace with inflation. For a risk-averse woman who likes yoga and oil painting, decent investment options are limited. Playing the stockmarket, she knew, was foolhardy.

Then one day Ms Li came across the Fanya Metals Exchange. On its platform she could lend money, at an annualized interest rate of 13%, to buyers of rare industrial metals. Fanya seemed exotic but safe. It advertised partnerships with China’s biggest banks and flaunted its connections with the government, including endorsements from officials who pledged to support it. She poured in her savings.Bottom of Form

Last year disaster struck. Fanya suspended all withdrawals. The value of its stocks of metal had collapsed. Up to 43 billion Yuan vanished from the exchange under suspicious circumstances. Investors hoping for a comfortable retirement became protesters overnight, picketing outside banks and government offices. Regulators distanced themselves from the wreckage. They declared Fanya an illegal venture and intimated that people should have done their homework before investing in it.

Just beyond the conservative confines of China’s banking system, there is a much rowdier parallel universe: shadow banking. This is where borrowers and industries shunned by banks look for funding. In some corners, promised investment returns run to double digits. Regulators look the other way   

1. Analyze how a repressed financial system may sprout high-risk alternatives to banks.
2. Evaluate the role shadow banking played in 2007-2010 financial crisis.

Answer 1

a) A repressed financial system seems conservative in its dealing in order to immune itself from the outside shocks which could be fatal to their existence. But such behavior might lead to more dangerous consequences. There is a fund requirement of the public and it needs to be quenched, if banks would not do so, some other alternatives come out to serve such needs of the customers. Sometimes banks become stringent in their policies and leave out customers with low credit ratings. It has led to a parallel market for deposits and credit lending where most of the people and companies with low worth and most often shunned by banks go to satisfy their funds' requirements. The perils of this parallel market of shadow banking become a threat to the economy as these financial institutions are not regulated by the regulators which intervene and supervise the working of the banks in order to make them a safe dealer of public money. Shadow banking is a blanket term to describe financial intermediaries which are non-bank financial institutions outside the scope of fed regulators. Examples of financial intermediaries not subject to govt regulation are hedge funds, investment banks, mortgage lenders, money market funds, insurance companies, private equity funds and payday lenders, unlisted derivatives, But these financial institutions deal with public money and are not answerable to the regulators and do not follow their rules, policies, and procedures. This arrangement has been called shadow banking as these do not come under the banking system completely. They cannot accept deposits as banks so they cannot be called banks. The institutions facilitate credit creation but do not come under the oversight of the regulatory authorities. Over time, shadow banking has increased its footprints in the market which has become a great threat to the viability and health of the economy. Banks are regulated but these institutions' failure becomes a huge blow to the economy. One failure has great contagious effects and even one failure could lead to the failure of many sectors and turn the economy upside down.

b) Many shadow banking institutions were heavily involved in lending during the boom period for the real estate sector, this boom led to high subprime mortgage lending and further, these were sold as loan securitization making them more complex and making it very hard for the govt. to resolve the crisis. There was a boom in the real estate during the 2000s which prompted NBFCs to extend subprime lending to the borrowers and when those borrowers could not pay back the interests and principal, one after another NBFC started collapsing which further triggered a recession worldwide. Subsequent to the subprime crisis in 2008, the financial activities of the shadow banking intermediaries came under scrutiny due to their high role in the extension of credit and systemic risk in the economy and the resulting financial crisis of 2008. The blow caused by the bursting of the housing bubble and sub-prime mortgage crisis triggered a run on the shadow banking system. Shadow banks were not covered by the traditional deposit insurance or the central bank's lender of last resort measures to protect them from the run. Bear Stearns (NBFC) was the first major investment bank that was affected by the run. Short-term lenders and repo markets started to withdraw funding from Bear Stearns leading to the risk of its liquidation. The government was not in a position to directly stop this panic so people would not be afraid and things could be sorted out in a more orderly manner. But the govt. was able to take emergency action through JP Morgan, by providing finance to the JP Morgan’s acquisition of Bear Stearns and providing JP Morgan with certain guarantees against the loss-making assets of Bear Stearns.

However, another blow came six months later at Lehman Brothers. The government did not rescue Lehman this time as it did earlier with Bear Stearns, which led to its collapse. This collapse triggered a crisis in money market mutual funds. The Reserve Primary Fund was a money market mutual fund that financed short-term funding of Lehman Brothers. The institutions and funds went into crisis due to their exposure to Lehman Brothers which subsequently caused investors to rapidly withdraw money from such funds. This panic caused the contagion effect throughout the money market mutual fund industry.

This crisis and fearful investors pulling back their funds in various parts of the shadow banking system helped fuel a credit crunch in the US economy, causing many businesses to scale back through layoffs which lead to a recession in the whole economy and contagion effects were limited to the US only, these had spilled over effects all over the world.

Even today, despite the increasing scrutiny of shadow banking institutions after witnessing the financial crisis, the sector has grown significantly.