Chapter 11: The Shadow Banking System
Does shadow-banking system pose a threat to the stability of the U.S. financial system?
- It played a key role in the financial crisis of 2007–2009. Many shadow banks were highly
leveraged. Therefore, as housing prices fell, these firms suffered heavy losses, and some
failed. Shadow banks can continue to operate as much as they did because they are more
efficient in filling a role in the financial system than commercial banks.
1. Financial Engineering, includes risk management
- Involves developing new financial securities or investment strategies using sophisticated
mathematical models and investment banks help to raise funds by selling stocks and bonds,
and construct risk management strategies for firms
2. Providing advice on issuing new securities
- Firms ask investment banks for advice on how to raise funds by issuing stock or bonds or by
taking out loans
3. Providing advice and financing for merger and acquisitions
- Find an acquiring firm willing to pay more than the market value of the firm.
- Advise firms on their capital structure (mix of stocks and bonds) used to raise funds
4. Proprietary Trading
- Buying and selling securities for bank’s own account rather than for clients
- Provides research for advising investors on M&As
- Research analysts’advice investors to buy, sell, or hold particular stocks.
- Overweight used for a recommended stock and underweight for not recommended stock
6. Underwriting new securities – investment banks earn income by underwriting firms’sales of
new stocks or bonds to the public
Did Moral Hazard Derail Investment Banks?
- Aseparation of ownership from control in corporations results in a principal–agent problem.
- Underwriting complex financial securities is an activity that shareholders and boards of
directors do not understand and therefore cannot effectively monitor.
- Since top managers also suffered significant losses during the crisis, the moral hazard
problem could not have been so severe.
1. Mutual Funds
- Closed-End Mutual Funds – a fixed number of nonredeemable shares is issued, with the
share price fluctuating with the market value of the assets
- Open-End Mutual Fund – investors can redeem shares after the markets close for a price tied
to the value of the assets in the fund
- Exchange-Traded Funds (ETFs) – market prices track the prices of the assets
- Load Funds – funds charge buyers a “load” to both buy and sell shares - No-Load Funds – funds do not charge a commission, or “load.”
- Index Fund – consists of fixed-market basket of securities, such as the stocks in the S&P 500
2. Hedge Funds
- Organized as partnerships of 99 investors or fewer
- Largely un-regulated and f