Deloitte Index Shows Shadow Banking Is Down, For Now

Regulators’ efforts to strengthen the oversight of the shadow U.S. banking system, which plays an important role in mortgage-backed securities financing, appear to be paying off.

According to the Deloitte Shadow Banking Index, the new quarterly index designed by the Deloitte Center for Financial Services, the nation’s volatile shadow banking system is “considerably lower than many estimates.” It dropped to $9.53 trillion at the end of 2011, down over 50% from its peak in 2008.

Market-size estimates so far have ranged from $10 trillion to $60 trillion, said Adam Schneider, the executive director of the Deloitte Center for Financial Services, a research center that focuses on global banks, private equity firms, hedge funds, mutual funds, insurance providers and real estate organizations.

Reasons for the decline may be a combination of factors that include regulatory efforts designed to limit shadow banking activity, and the fact that shadow banking as a concept continues to evolve.

The inaugural quarterly index shows the shadow-banking sector today is not as large as regulators and market participants had feared. However, regulatory changes and new innovations might drive significant market fluctuations in the future, analysts wrote. “With regulatory changes and financial innovation looming, the shadow banking system could creep back very quickly.”

Major regulatory efforts “have either been enacted or are in the works to help reduce the size of this important sector,” stated Don Ogilvie, independent chairman of the Center for Financial Services. Hence, “regulatory headwinds against the shadow banking system will likely be the No. 1 influence” in the market changes.

Findings show shadow banking in the U.S. peaked at $20.73 trillion in the first quarter of 2008 when the traditional banking sector reported assets of about $15 trillion, or 28% lower.

But by the end of 2011 the ratio reversed: assets in the traditional banking sector were $8 trillion higher than shadow banking.

Analysts report similar changes in several areas including money market mutual funds and activities relating to the government-sponsored enterprises. Securities lending emerged as the only activity that is twice the volume today compared to the Index's baseline eight years ago.

The size of the market is closely related to how it is defined. “Shadow banking is a concept continuing to look for a better definition," Schneider said.

The Financial Stability Board broadly defines the shadow banking system as “credit intermediation involving entities and activities outside the regular banking system.” FSB recognizes it as “an integral part of the modern financial system that has an important role in supporting the economy” by providing an alternative source of funding and liquidity.

The Deloitte Shadow Banking Index defines the shadow banking system as a marketplace that exists wholly or partly outside of the traditional banking system, does not have government guarantees in the form of insurance or access to the central bank, and involves securitization and secured-funding mechanisms.

Deloitte's data sources include money market mutual funds, asset-backed commercial paper, asset-backed securities, agency and nonagency mortgage-backed securities, collateralized debt obligations, repurchase agreements and securities lending.

Deloitte said the index is structured based on over six components “that make up a market-funded, credit intermediation system.”

The Deloitte Shadow Banking Index is designed to help define and quantify the sector over time, measure how it is affected by the overall banking system and regulatory actions, as well as assess its potential impact on regulated banking markets.

The sector saw dramatic growth between late 2004—the index's starting point—and early 2008, when it increased in size by nearly two-thirds. Declines in activity during the past couple of years appear to be consistent with an increase in regulatory requirements.

Executives said Deloitte created the index to closely track this important sector because the market needs to have this conversation. In the recent past calls for more transparency and oversight of the shadow banking system from market insiders including FSB were driven by findings showing during the precrisis period many banks used securities’ lending to take on more risk and avoid capital requirements.

The recent decline in transaction volume indicates the shadow banking system “is highly dynamic, and operates amid a backdrop of economic volatility, regulation and significant changes already in the banking system," Schneider said.

Specific recommendations by the Financial Stability Board that are expected to come out later this year are one example. The issue is global as much as it is a concern for the U.S. financial housing markets. (At the Cannes Summit in November 2011, the G20 Leaders agreed to strengthen the oversight and regulation of the shadow banking system and endorsed FSB'a initial recommendations. FSB provided a progress review at the G20 Finance MInisters and Central Bank Governors meeting in April 2012.)

As new laws and regulations are adopted and new financial products are created, Ogilvie explained, “the components in the index will increase or decrease.”