Mohammad.fheili shadow banking

Mohammad Fheili ⌂⌂⌂ fheilim@jtbbank.com
The Economics of [The Unregulated]
Shadow Banking, & its Inherent
Risks.
Mohammad Fheili / AGM ‐ Jammal Trust Bank
In
collaboration
with
The Anti‐Money Laundering Forum Legal
Requirements & Audit Procedures
May 4, 5 of 2015 / BIEL – Pavillon Royal

Mohammad Fheili
“Over 30 years of Experience in Banking. Contact Details: mifheili@gmail.com (961) 3 337175
Mohammad has successfully delivered over 1,500 hours of training to
professional bankers.
He served as an Economist at ABL, and Senior Manager at BankMed
and Fransabank: and he currently serves in the capacity of an
Executive at JTB Bank in Lebanon.
In addition, He worked as an Advisor to the Union of Arab Banks.
Mohammad also served as Basel II Project Implementation Advisor to
CAB and HBTF Banks in Jordan.
Mohammad received his college education (undergraduate & graduate)
at Louisiana State University (LSU), and has been teaching Economics
and Finance for over 25 continuous years at reputable universities in
the USA (LSU) and Lebanon (LAU).
Finally, Mohammad published over 25 articles, of those many are in
refereed Journals (e.g., Journal of Money Laundering & Control;
Journal of Operational Risk; Journal of Law & Economics; etc.) and
Bulletins.”

Financial Markets
are prone to panics
and runs;
Banking crisis have
become all‐too‐regular
occurrences in market
economies.
Complexity(=Shadow Banking) has been responsible for
Financial markets Panics and Banking Crisis!
17171414

How Big Is The Shadow Banking System?
The Economics Of Channeling & Intermediation
The Collateralized Debt Obligations ‐ CDOs
The Rating Agencies’ Pitfalls
The Regulator & Regulations: Blessing or Curse?
Closing Remarks
1
2
3
4
5
6
End
Outline

The Interconnectivity and Complexity which Characterizes Shadow Banking Makes It Near Impossible to effectively
size the problem. … but here is what’s available.
How Big is the
Shadow Banking
System?
1

World Reserve Currency is no longer
pegged to Gold
• Unregulated, Offshore, Off‐Balance Sheet, OTC
Securitization and Swaps Explodes.
• Shadow Banking fully emerges with protracted,
historically low interest rates.
• Interest Rate and Currency Swaps grow by
Trillions monthly.
Volatile Changes in Industrial Production!Steady Growth in Money

Mohammad Fheili ⌂⌂⌂ fheilim@jtbbank.comRisk
The Economics
of Channeling
&
Intermediation
2

Lenders
Surplus Spending
Units ‐SSUs
• Individuals (Current
Income is GREATER than
Current Expenditures)
• Firms (Earnings in excess of
what the firm needs currently)
• Government (Current
Revenues are in excess of
planned Expenditures)
• Financial
Intermediaries (Funding
is currently GREATER than
investment)
Where to Warehouse
the Surplus of Fund?
Where to Warehouse
the Surplus of Fund?
Borrowers
Deficit Spending
Units ‐DSUs
Income is LESS than Current
Expenditures)
• Firms (Earnings falls short of
Revenues fall short of planned
Expenditures)
• Financial
is currently LESS than
investment)
Where to Go
to Fund My
Ideas?
Where to Go
to Fund My
Ideas?
Tapping into International Market for Loanable
Funds
Local Pool of
Loanable
Funds
Decision is a
function of:
• Motive
• Risk Aversion
Firms,
Governments,
Fin. Institutions,
Households
Channeling …

Lenders
Surplus Spending
Units ‐SSUs
• Financial
investment)
Borrowers
Deficit Spending
Units ‐DSUs
Expenditures)
Expenditures)
• Financial
investment)
The Channeling of Funds Feeds and Fuels:
 Household Consumption
 Gross Private Domestic Investments
 Government Expenditures
 Exports and Imports.
it Benefits the REAL ECONOMY (Real GDP).
Debt, Equity,
etc. Instruments
Deposit &
Loans
MMMF, CP, ABCP,
Repos, etc.
The Economics …

Lenders
Surplus Spending
Units ‐SSUs
• Financial
investment)
Borrowers
Deficit Spending
Units ‐DSUs
Expenditures)
Expenditures)
• Financial
investment)
Regulated
but not like
Banks
Heavily
Regulated
Not
Regulated
Regulation in this context indicate to: Presence of Lender of Last Resort; Legal Reserve; Deposit
Insurance; Capital Adequacy; etc.
Debt, Equity,
etc. Instruments
Deposit &
Loans
MMMF, CP, ABCP,
Repos, etc.
Regulated or Not …
Very Inter‐Connected

Lenders
Surplus Spending
Units ‐SSUs
• Financial
investment)
Borrowers
Deficit Spending
Units ‐DSUs
Expenditures)
Expenditures)
• Financial
investment)
With intermediation in Both
Without
Intermediation
Intermediation or Not?
Shadow Banking
Replicates
“Intermediation” in
the Banking Model
But . . .

• Maturity Transformation.
The use of short‐term
sources of funds (e.g.,
Deposits) to fund long‐term
loans. Traditional deposits
are a bank’s liabilities,
collected in the form of
savings and checking
accounts (pooled or
decomposed) and
redistributed as loans to
consumers and businesses
(i.e., part of assets). . . .
The risk associated with
this Maturity
Transformation is totally
assumed by the Bank.
Three Critical Intermediations Activities Are Undertaken.
• Liquidity Transformation. A
Bank’s assets are less liquid
than its liabilities – The
liabilities (i.e., Depositors’
Money) that fund the long‐
term assets are available on
demand at any time.
However, Banks extends
loans in the amount in
excess of what is required
under the Legal Reserve
System – i.e., Creating
Money. … In the case of
massive withdrawals by
depositors, the Bank runs
the risk of insolvency.
• Credit Transformation. While any individual
loan carries risk specific to that transaction,
a bank diffuses its overall risk exposure by
lending to a large number of borrowers.
Despite this diversification, the riskiness of
a Bank’s assets usually exceeds that of its
liabilities. Taking on this Credit Risk is
typically how banks earn a return above
the cost of their liabilities, a concept know
as Net Interest Margin.
In the Regulated Banking Landscape, …..
“Deposit Insurance” mitigated Credit Risk of
bank depositors, and the “Lender of Last
Resort” addressed liquidity needs that can
arise from bank loans that have longer
maturity and less liquidity relative to
liabilities.

Channels of Financial Intermediations
Credit Intermediation
Credit Intermediation has become more market‐based, and No Longer Institution‐Based
Sources of
Funds
Uses of
Funds
Individuals
(With Money to
warehouse)
Households/
Business
Borrowings
Financial Markets
Financial Markets: No Intermediation
Households /
Corporations
(With Money to safe
keep)
Households/
Business
Borrowings
Traditional Banking: “Originate and Hold Loans” Till Maturity.
Institution‐Based Intermediation.
Traditional Banking
Households /
Corporations /
Institutions /
Securities
Lenders / Pension
Funds
(With Money to Invest)
Household /
Business
Borrowings
Shadow Banking
Shadow Banking: “Originate‐To‐Sell”
Multiple, Market‐Based, and Layered Intermediation

Channels of Financial Intermediations
Credit Intermediation
Credit Intermediation has become more market‐based, and No Longer Institution‐Based
Sources of
Funds
Uses of
Funds
Individuals
(With Money to
warehouse)
Households/
Business
Borrowings
Non‐Intermediated
Direct Funding (No Intermediaries)
Households /
Corporations
(With Money to safe
keep)
Households/
Business
Borrowings
Banks “Originate and Hold Loans” Till Maturity.
Traditional Banking (Institution‐Based Intermediation)
Households /
Corporations /
Institutions /
Securities
Lenders / Pension
Funds
(With Money to Invest)
MMMF
Purchases
CP
ABCP
Repos, Etc.
ABS
Intermediation
ABS
Issuance
Loan
Warehousing
Loan
Origination
Household /
Business
Borrowings
Shadow Banking (Multiple and Market‐Based, and Layered Intermediations)
Note: MMF is Money Market Mutual Fund, CP is Commercial Papers, ABCP is Asset‐Backed CP, Repos is Repurchase Agreements, and ABS is Asset‐Backed Securities.
rapid balance sheet growth,
a market rise in leverage, and
a proliferation of complex and difficult‐to‐value financial products.

The Potential For Excess Leverage through Securities
Financing Transactions (SFT):
• The temporary transfer of securities by a lender to
a borrower on a collateralized basis……
• Then these securities can be used to raise more
fund…..
• Then funds can, in turn, be used to buy more
securities……
• Where these securities can be used as a collateral
to raise more funds … The higher the value of the
collateral gets, the more fund can be raised (i.e.,
Pro Cyclicality)
• Etc…..
The Stock of Collateral and its velocity (the intensity
with which it is re‐used) are both fundamental to
understanding the financial plumbing in the Shadow
Banking World.
Just Like Money Creation… Collateral Intermediation Function.
The Velocity of Collateral
The better is the economic outlook, the more fund can
be raised, the higher the velocity of collateral, …

Intermediation is expanding into Un‐Regulated Territories!
• The Shadow Banking System De‐Constructs the familiar Credit Intermediation process of
Deposit‐Funded, Hold‐To‐Maturity lending by traditional banks into a more Complex,
Wholesale‐Funded, Securitization‐Based Intermediation Chain.
• Shadow Banking functionally is similar to traditional banking maturity, liquidity, and credit
transformation – BUT the financial flows occur in an Un‐Regulated Landscape, and in Multiple
steps rather than within one institution’s balance sheet.
At each step in the process of “Shadow Intermediation,”
• The true quality of the underlying collateral is further obscured.
• As more links are added to the chain, more loans are included (i.e., layered intermediation).
• The end buyer holds a very “small slice” of a very large number of loans. In theory, this
diversifies risk because any single loan going bad will have little effect on the total pool’s
value.
• However, this also complicates the evaluation of the quality of individual pieces, leaving
investors to rely on aggregate data to assess the riskiness of assets.
• This Complexity leads to a decline in underwriting standards because the loan originator has
little stake in the long‐term performance of a loan that is quickly sold to be wholesaled,
warehoused, and Repackaged in a Pool (e.g., Originate‐To‐Sell)

Shows the Flow of Funds from LENDERS to BORROWERS; not the reverse
Simple & Clear Traditional
Banking
Lenders
Surplus Spending
Units ‐SSUs
• Financial
investment)
Borrowers
Deficit Spending
Units ‐DSUs
Expenditures)
Expenditures)
• Financial
investment)
Banks
A Flavor of Complexity

Lenders
Surplus Spending
Units ‐SSUs
• Financial
investment)
Borrowers
Deficit Spending
Units ‐DSUs
Expenditures)
Expenditures)
• Financial
investment)
Banks
Dealers
Securitization
Money Market Mutual
Funds
Hedge Funds
Finance Companies and Other Non‐Bank Lenders
Money Money
Money
Money
Securities
Loans
Money
Money
Loans
Money
Loans
Money
Securities
Money
Securities
SecuritiesSecurities
Money
Securities
Money
Securities
Shows the Flow of Funds from LENDERS to BORROWERS; not the reverse
Shadow Banking: Decompose & RedistributeA Flavor of Complexity

A Long Term Corporate Bond could actually be sold to three separate ‘Market
Participants’, of varying degrees of Risk Aversion, and using three distinct financial
instruments:
• One would supply the money for the bond
• One would bear the interest rate risk
• One would bear the risk of default
These two would not have to put up any capital for
the bond, though they might have to post some sort
of collateral
Interest Rate
Swaps which is sold
separately
Credit Default
Swaps which is sold
separately
By doing so, they’re
lowering the price of
Corporate Credit
Decompose & Redistribute: The Structure of a Simple Transaction has been Decomposed and the
Risks has been Redistributed in a Complex, hard to assess manner.
Another Flavor of Complexity

Collateralized Debt
Obligations ‐ CDOs
3

1. The Collateralized Debt Obligations ‐ CDOs
• CDOs are a special type of derivatives. Like its name implies, a derivative are any
kind of financial product that derives its value from another underlying asset
(Housing Loan, Car Loan, Credit Card, …)
• CDOs turn individual loans into a portfolio in which a default by any single
borrower is unlikely to have an enormous impact on the portfolio as a whole.
• By aggregating many different mortgages together into a CDO, investors can own a
small percentage of many different mortgages, and therefore the CDOs losses as a
result of borrowers defaulting on their obligations usually represent the statistical
averages in the market as a whole.
• Typically, a pool of debt is divided into three tranches, each of which is a separate
CDO. Each Tranche will have different maturity, interest rates and default risk. This
allows the CDO creator to sell to multiple investors with different degrees of risk
preference.
• This time of growth in CDOs is the era of “Quant Jocks”: Statistical experts whose
job is to write computer programs that would model the value of the bundle of
loans that made up a CDO.

Banks sold CDOs to investors
for three distinct reasons:
• The funds banks received
gave them more cash to
make new loans.
• It moved the loan’s risk of
defaulting from the Bank to
the Investor.
• CDOs gave banks new and
more profitable product to
sell, which boosted share
prices and Managers’
Bonuses.
2. The Collateralized Debt Obligations ‐ CDOs
More Liquidity to fund
more loans
Freed Up Capital
Economic Booster
+
‐
+
‐

Collateralized Debt Obligations (CDOs) Pooling, Decomposing, and Distributing Risks!
AAA
Super
Senior
Tranche
AA
A
BBB
BB
B
Equity
Pool Of
Mortgage
Loans
Investment
Grade
Lower Risk
Lower Yield
Higher Risk
Higher Yield
Last Loss
First
Loss
Non‐Investment
Junk Grade
Mortgage‐Backed Securities
MBS
Loan1
Loan2
Loan3
Loan3
Unrated

AAA
Super
Senior
Tranche
AA
A
BBB
BB
Unrated
AAA
Super
Senior
Tranche
AA
A
BBB
BB
Unrated
B B
AAA
Super
Senior
Tranche
AA
A
BBB
BB
Unrated
AAA
Super
Senior
Tranche
AA
A
BBB
BB
Unrated
B B
AAA
Super
Senior
Tranche
AA
A
BBB
BB
Unrated
B
MBS MBS MBS MBS
Re‐Distribute Risk!
Collateralized Mortgage Obligations
CMO
This process can be repeated to create more structured
credit products.
This depicts the process by
which MBS pieces with
lower credit quality
(including some non‐
investment‐grade tranches)
are “Recycled” to create a
CMO, . . .
a significant
portion of
which
garners an
investment‐
grade
rating.
Investment
Grade
Debt
Or CDOs

AAA
Super
Senior
Tranche
AA
A
BBB
BB
Unrated
AAA
Super
Senior
Tranche
AA
A
BBB
BB
Unrated
B B
AAA
Super
Senior
Tranche
AA
A
BBB
BB
Unrated
AAA
Super
Senior
Tranche
AA
A
BBB
BB
Unrated
B B
AAA
Super
Senior
Tranche
AA
A
BBB
BB
Unrated
B
CMO1 CMO2 CMO…
CMO
CMOn
Re‐Re‐Distribute Risk!
2
……..
This depicts the process
by which CMO pieces
with lower credit quality
(including some non‐
investment‐grade
tranches) are “Recycled”
to create a . . .
Significant
portion of
which
garners an
investment
‐grade
rating.
Investment
Grade
Yet another layer whereby the “True
Risk” is being camouflaged …
This process can be repeated to create more structured credit
products.
Or CDOs

CDOs Camouflaged Risk
About the Underlying Asset.
• Housing prices became unrelated to their actual value.
• People bought homes simply to sell them.
• The easy availability of debt meant people charged too much for the asset.
About the Banks.
• CDOs allowed banks to avoid having to collect on them when they become due, since the
loans are now owned by other investors.
• Less discipline in adhering to strict lending standards, so that many loans were made to
borrowers who weren’t credit worthy (ensuring disaster)
About the CDOs.
• CDOs became so complex that the buyers didn’t really know the value of what they were
buying.
• The sophisticated computer models based the CDOs value on the assumption that housing
prices would continue to go up. When prices went down, the computers couldn’t price the
CDOs.
• The Opaqueness and the complexity of CDOs created a market panic: Overnight the market
for CDOs disappeared!

The Rating
Agencies’
Pitfalls!
4

1. Induced Risk & Complexity … but in the Shadow: Camouflaged By
The Rating Agencies and Overlooked by The Regulators.
• Despite the good intentions, ratings agencies and regulators were significant contributors to the
imbalances that culminated in financial crisis.
• The big three Rating Agencies’ (S & P, Moody’s, and Fitch) oligopoly prevailed –
 Without their ratings, companies could not sell debt instruments.
 An inherent conflict of interest arose; issuers paid the companies for ratings.
 Many investors depended on those evaluations when purchasing debt in lieu of a more thorough due‐
diligence review.
 Investors ran into further difficulties because the evaluations frequently lagged material market
development.
• The Ratings Agencies were complicit in the growing complacency of investors leading up to the
credit crisis.
 Large structured‐product deals involving complex securities were very profitable for ratings agencies.
 Issuers had the ability to choose among potential raters, leading to “ratings shopping.”
 The rating agencies shift from an Investor‐Pay to an Issuer‐Pay business model degraded the value of the
evaluations provided because the agencies faced little risk from inaccurate ratings.

• Regulatory Arbitrage
• Reserve Requirements imposed a disadvantage
on banks
• Compliance
• Technological Innovations
• Erosion of Banks’ informational and transactions
cost advantages
• Encouragement from the Regulator
• Financial Sector Productivity
• Appetite of Market Players for speculation
• Finance Know‐How
• De‐Banking became a plausible alternative.
• Etc ….
The Journey from
Traditional Banking to
Shadow Banking was
made possible By:

• Because the Rating Agencies did not examine the underlying mortgages, they failed to see a shift
in borrower behavior and mortgage terms.
 The emergence of speculative home purchases with 100% financing,
 The emergence of low‐ and no‐documentation loans
Meant that the environment was very different from the past, when homebuyers made significant down payments and
lived in the houses they purchased.
• The Rating Agencies’ failings affected the Shadow Banking industry:
 Because many of these securitized products were rated AAA, assuming risk mitigation through diversification, they
were perceived as the safest of the safe.
 These investment‐grade products garnered significantly more demand than would have otherwise been the case.
 This sent broker‐dealers into overdrive, producing more of these securities and fueling a flood of credit.
 Robust credit supply, in turn, led to declining underwriting standards to meet broker‐dealer demand.
 The AAA ratings also allowed Shadow Banks to “lever up” because Repos counterparties required smaller discounts
for higher‐quality, investment‐grade collateral.
 Lax Regulatory oversight compounded the issue as securitized instruments spread globally. Banks and Shadow Banks
became increasingly intertwined.
 Regulations incentivized purchases of highly rated ABS by requiring banks to retain a smaller amount of capital in
support of these assets.
2. Induced Risk & Complexity … but in the Shadow: Camouflaged By
The Rating Agencies and Overlooked by The Regulators.

5

The Basel Accord: An Evolution or a Revolution!
Basel I Basel I½ Basel II
Credit Risk
Credit Risk
Market Risk
Credit Risk
Market Risk
Operational Risk
1986
proposed
1993
proposed
1999
proposed
1988 effective 1996 effective 2007 effective
Consultative Paper (CP1)
in Nov 18, 1999, and CP3
in July 2003
Debt Crisis
Financial
Crisis Financial
Innovations
Response Quality:
Reactive
Response Quality:
Reactive
Response Quality: Pro-Active
Basel III
Credit Risk
Market Risk
Operational Risk
Capital Quality
Capital Buffers
Liquidity: LCR, NSFR
2009
proposed
In response to Financial Crisis
which dawned on us in 2007:
Sub-Prime Real Estate Lending
Back To
Financial Crisis
Kick Off in 2011
Basel IV
Credit Risk
Market Risk
Operational Risk
Shadow Banking
Additional Buffers
(Primary response: increase
capital requirements)
2015
Anticipated
In response to the growth
of Shadow Banking and its
implications on Financial
Stability
To Prevent Yet
Another Financial
Crisis
Kick Off in 20__
?

ON The Banking Model: Regulators Induced a Very Demanding Model
 MAXIMIZE PROFIT subject to:
RISK Constraints
REGULATORY Constraints
RISK .  . .
 Default
 Liquidity
 Maturity
 Other Types of Risks
REGULATORY . . .
 Basel I
 Basel II
 Basel III
 Other Types of
Regulations
 Sanctions Rules
 FATCA Requirements
 AML, Etc.
Uses of
Funds
Sources of
Funds
 Reserves
 Loans
 Securities
 Other
Investments
 Fixed Assets
 .  .  .
 All Types of
Deposits
 Borrowings
 Other
Sources
 Equity
Capital
 .  .  .
. . . and Off-Balance Sheet . . .
Management …. For
both regulated and
unregulated financial
institutions
Compliance . … only for
regulated with an
additional cost of
Compliance

Return
Risk
Return
Risk
Intentional Risks
Managing Revenue
Unintentional Risks
Managing Costs
CreditRisk
MarketRisk
Reputation&
OtherRisks
Operational
Risk
TOTAL Risks = Intentional (Speculative) + (Unintentional (Hazards)
ON Risks: Multi‐dimensional and much more … !
The higher the realized
risks; the lower the realized
return…
The higher the anticipated
risks; the higher the
expected return…
The Risk reality in both regulated and unregulated Financial Institutions

Legal Obligation:
• The Public at Large has the
Right to Know! Where its
impact on the Financial
Institution’s Reputation and
Performance is often severe.
Profitability suffers, and it
triggers immediate additional
expenses for Damage Control.
Regulator Obligation:
Issues of non‐compliance
are handled inside closed
doors at the Central Bank.
ON Compliance: Shifted from a Regulatory Obligation to a Legal Obligation
De-Risking
De‐Risking would have the effect of driving the development of
alternative financial markets and payment mechanism – i.e.,
Shadow Banking.

RiskRisk Management is a Decision & a Choice.
Complianceis a Task
You are suited to follow a
well defined track!
You are geared up
and equipped to
travel through
unchartered
territories and be
creative in
avoiding danger
(not Risk)

The Challenge for the Regulator is to be flexible and to allow innovation to occur, and to adopt
standards and regulations to deal with threats and dangers but not at the expense of killing
innovation.
Should We
Be Scared Of
Shadows! . . .
Yes
6

1. The Potential Future of Shadow Banking
The Long‐run equilibrium share of Shadow banking is
• Negatively related to information costs, and
• Positively related to
the absolute burden of bank reserve requirements
the relative burden of capital requirements on commercial versus shadow bank
credit.
The steps taken towards de‐regulations
The extent of Financial Innovations
Recent Financial crisis proved that Shadow Banking is Procyclical and vulnerable to
Liquidity shocks.

• Shadow Banking is likely to remain suppressed due to current
regulatory climate (e.g., DFA); however, future financial innovations
might create “New Shadows”.
• Regulatory arbitrage may occur on a Country‐to‐Country basis.
• Traditional Banks may consider funding alternatives as new regulations
place constraints on Shadow Banking.
• Under New Regulatory Regimes, Banks will likely need to consider how
exposed their counterparties are to the Shadow Banking System.
• More attention must be put in understanding of the linkages between
the Shadow Banking and Traditional Banking Systems.
• The Complexity of financial innovations must push us to pay close more
attention to financial activities regardless of institution… Focus on Bank
Deposit Substitutes (Alternatives to traditional funding).

• Regulatory Arbitrage can never be eliminated fully because of the Diversity of
Regulators & Regulations, and the Creativity & Resourcefulness of Banks.
• The increasing Complexity of the Financial Landscape makes it impossible to
effectively regulate the Shadow Banking System.
• If Banks can bypass Capital Regulation in an opaque shadow banking sector, it may
be optimal to relax capital requirements so that liquidity dries up in the shadow
banking system.
• Tightened capital requirements may spur a surge in shadow banking activity that
leads to an overall larger risk on the Money‐Like Liabilities of the formal and
shadow banking institutions.
• If the liquidity in the Shadow Banking System is needed for stability in the overall
financial system, an institutionalized guarantees for buyers of securitized assets to
sit alongside guarantees for retail depositors – An FDIC type regime for the
Securitization Market.

Mohammad.fheili shadow banking

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