So-called “shadow banks” were at nexus of the financial market meltdown that induced the Great Recession. But what’s a “shadow bank or investment company” and why does it cause problems? Daniel Sanches offers an summary in “Shadow Banking and the Crisis of 2007-08,” in the Business Review of the Federal Reserve Bank or investment company of Philadelphia (2014, Q2, pp. As a starting point, think about how a plain vanilla ordinary bank or investment company functions in the economy, acting as a financial intermediary between borrowers and savers. Here is a schematic extracted from Chapter 29 of my Principles of Economics textbook (and undoubtedly, Year to check on it out I encourage those teaching intro econ next.) Savers deposit profit banks. Banks give those money to borrowers.
Borrowers repay the loans with interest, and the initial savers are paid some of that interest, along with to be able to withdraw their money as desired. But here’s the problem. Once the money is loaned out, the borrowers are on a schedule to repay over time gradually. However, the initial savers want the capability to withdraw their money any right time they please.
The resources of the bank (the loans it has made) are long-term, as the liabilities of the bank (the amount of money it owes to savers) are possibly very short-term. The combination of deposit insurance and bank regulation worked to keep the U.S. 70 years from the past due 1930s up to the start of the Great Recession.
But over the last few decades, a new type of financial structure arose. As he writes, step one 1 is perfect for the bank to make loans. However, in cases like this the bank or investment company will not desire to continue keeping or servicing the loans, and so it creates an SPV, or special purpose vehicle, which buys the loans from the bank. Next, the special purpose vehicle issues asset-backed securities (ABS), which are just financial securities where in fact the return is determined by the loans that the SPV purchased from the bank.
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Outside investors can purchase these asset-backed securities. There is certainly nothing at all always wrong with some of this. By selling from the loans to a special purpose vehicle, the lender insulates itself from the chance that loans may go bad. As a total result, the lender regulators are pleased. But several issues can arise in the new financial framework, as well. Area of the credit crunch during the Great Recession was because investors became aware that at least a few of the SPVs that included home mortgage loans were quite risky–but they didn’t know which ones. Because of this, they became unwilling to purchase any SPVs based on home mortgage loans for a time.
Another issue arises if those investing in the SPV aren’t an entity just like a pension fund, with long-term time horizons and an capability to trip out the bumps in the market, but have very short-term time horizons instead. Imagine that a corporation is being run by you or a big financial organization like a pension fund, and you need to keep some your money in cash, so that you can utilize it to pay payroll and bills. As a spot to invest their liquid assets and earn some return still, these institutions considered what’s called the “repo” market, where repo is short for “repurchase.” The marketplace works this way.