The supplying various debt contracts in order to arrange

The
Financial Stability Board (FSB, 2012) defines shadow banking as
a system of credit intermediation (Credit
intermediation is a lending activity where the saver does not lend directly to
the borrower) that involves entities and activities
outside the regular banking system in other words
shadow banking system refers to unregulated activities by regulated
institutions.

According to European Commission
shadow banking activities consist in:

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 i. Maturity transformation: refers
to using short-term liabilities to fund long-term assets.

 ii. liquidity transformation: refers
to
the fact that a bank’s assets are less liquid than its liabilities. Assets are converted into
cash then they use illiquid assets to create a more liquid one. For example,
mortgage is an illiquid asset that can be used to create an equity which is
easily sold and therefor get more liquid this process is called securitization.

iii. Credit
transformation:
individual loan carries risk specific to a transaction, a bank diffuses its
overall risk exposure by lending to a large number of borrowers.

 iv. using direct or indirect financial
leverage: refers
to capital lent or borrowed in order to boost gains/losses.

There are significant benefits that
shadow banking offers to the financial system by reducing cost of credit and
increasing liquidity of the system through:

1.Securization:is a process of supplying various debt contracts in
order to arrange them according to clients’ needs. Here securitization
transforms illiquid underlying assets into liquid securities and thereby
increases the liquidity of the financial system. For example, loans can be turned
into liquidity.

 2.Money
Market Funds: are investment funds that have the purpose to provide
investor with protection of capital and daily liquidity, and that seek to
achieve that objective by investing in a diversified portfolio of high-quality,
low duration fixed-income instruments.

3.Repurchase Agreements: the borrower borrows money from the lender
for the price difference between the repurchase and initial price and uses
their assets as collateral. highly liquid and low-risk characteristics of
securities led to their acceptance as collateral in repurchase agreements.

4.Decentralization: the shadow banking
system is decentralized, enables specialization and hence further efficiency
gains, it may prevent existence of too-big-to-fail institutions and it supports
competitive environment which has a further beneficial effect on the price of
credit.

If shadow banking is not properly
structured, it can represent a source of systemic risk that can easily affect both
the rest of the financial system and the real economy. Firstly, one of the character
of shadow banking is decentralization which can lead to long and difficult financial
intermediation chains. The process of securitization can be in theory repeated without
ending and thereby creates specialized but augmenting opaque securities. As a result,
pricing of the products becomes very complex as the price should reflect both
the quality of the underlying loans and the risk structure at every single
level.

Secondly, acceptance of securities as
collateral for repurchase agreement builds up leverage. Although leverage is fundamentally related to credit intermediation and it
can turn a non-systemic risk into a systemic one. Moreover, raise of leverage increases
the procyclical nature of shadow banking and extend consequences of financial
crises.

Thirdly, the reliance of shadow
banking on short-term liabilities acquired through repurchase agreements to
fund illiquid long-term assets (loans) is inherently fragile
since it is susceptible to modern
bank-runs. shadow banking institutions do not accept deposits, which is the
reason why they are not currently regulated. Moreover, Shadow
banks buy long term assets and finance them by selling short term securities.
However, if investors become susceptive about a bank’s health, these long-term
assets have to be liquidates with immediate effect. This creates a situation of
distressed sales.

Fourthly: Shadow banks are not defended by the central
bank. They do not have any kind of reserves that would save them from trouble
if the depositors suddenly wanted to withdraw their cash. It is true that
commercial banks indirectly finance these shadow banking institutions. However,
it is difficult for them to deviate cash towards their shadowy arm especially
if a crisis is in progress. This creates a situation where in shadow banks not
only face huge risks themselves but also produce systemic risk. This is because
their business creates the same amount of risk as that of banks. However, they
do not have the preventive regulations or the safety nets that banks have
access to in case things start going wrong. (No access to cash)

Question
two

Too big to fail theory affirm
that certain corporations, particularly financial institutions, are so large
and so intercorrelated that their failure would be catastrophic to the greater
economic system, and that they therefore must be supported by government when
they face potential failure (Fein,2013, p.2). Systemic
risk and moral hazard are a principal immediate cause of the existence of
too-big-to-fail due to growth of bank in size which increases the moral hazard
risk of becoming too-big-to fail institutions.

The failure of a large
bank as HSBC can be an extensive failure of several financial institutions,
first, HSBC have direct implication on the economy, in terms of high labor
force redundancy of a large bank, and interruption in provision of operations
decisively important for smooth market
functioning.
Just to name few aspects of bank operations, the undesirable outcome in this situation would be the interruption
of lending, payment processing, short-term funding, and cash management. Second,
multiple failures have indirect economic effects as well. They cause entire financial market
instability, which spills over real economic activity. Because the financial
institutions are perceived to have very important role in the functioning of real economy, their
failure is perceived to represent a disaster. (Barth,
2012, p.30)

Large banks as HSBC are organized by a form system of
responsibilities along product and regional lines. The product heads of the large divisions into which banks are organized.
As in industrial companies, each division has its own management focusing
exclusively on its own divisional business. However, given the size of HSBC
divisions and his reach into many countries and continents, a problem rises in
the collaboration of the many employees behind offices of the bank with a large
international network. largest banks are
too big and complicated to manage their operation through thousands of
subsidiaries.
In other words, top management cannot detect all widespread internal misconduct.
The size defies the ability of any manager or management team to understand,
manage and control all aspects of operations, or even keep them within legal
boundaries.