Shadow Banks and the Financial Crisis of 2007-­2008

Shadow Banks and the Financial Crisis  of 2007­2008 

    Jason Hsu, Research Affiliates LLC    Max Moroz, Research Affiliates LLC 

19 March 2010

Abstract: This paper argues that bank runs on the shadow banking system was a significant factor in the spread of subprime losses to the overall financial system. Highly leveraged shadow banks with illiquid assets suffered from the loss spiral effect whereby they were forced to deleverage due to higher margin requirements and falling asset prices. This deleveraging increased margin requirements and reduced asset valuations, thus fueling the next round of the loss spiral. We also show that informational problems, agency issues, the reliance on historical data to estimate future risks, and the lack of a multilateral settlement mechanism contributed to the spread of the financial crisis.

Shadow Banks and the Financial Crisis of 2007-2008

©Research Affiliates

Page 1

Electronic copy available at: http://ssrn.com/abstract=1574970

Introduction 

2005 was the first year without bank failures in the US since reliable records began to be kept in 1892 (Figure 1; source: FDIC Table BF02 and Goldenweiser et al., 1932).

Figure 1

The prospects looked good too, with the major indicators above historical averages, and well in excess of the requirements for well-capitalized banks (Table 1; source: FDIC).

Table 1

2006 Core capital (leverage) ratio 8.23%

2005 8.25%

2004 8.11%

2003 7.88%

2002 7.86%

2001 7.79% 9.90%

2000 7.71% 9.42%

WellCapitalized 5% 6% 10% N/A

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Tier 1 risk-based capital ratio 10.52% 10.66% 10.76% 10.47% 10.43% Total risk-based capital ratio Net charge-offs to loans

12.99% 12.98% 13.19% 13.00% 13.00% 12.72% 12.13% 0.38% 0.50% 0.56% 0.78% 0.97% 0.83% 0.59%

Shadow Banks and the Financial Crisis of 2007-2008

©Research Affiliates

Electronic copy available at: http://ssrn.com/abstract=1574970

As late as the fall of 2006, the regulators in their...