Monday, June 18, 2012

The Ins and Outs of Deloitte's "Shadow Banking Index"

Deloitte LLP has come up with clever new way to describe and track the size and changes in the shadow banking industry. Recognizing that market participants and regulators lacked clarity and consistency when it came to defining, measuring, and framing the debate about this complex and dynamic subject, Deloitte has devised a "Shadow Banking Index." Starting with a baseline definition and using data gathered from 2004 onward, Deloitte's index represents an ongoing effort to more closely measure the size, importance, and effect of market and regulatory actions on the activities defined as "shadow banking." The index is also intended as a way to assess the potential effect of shadow banking on regulated markets.

Deloitte started off with a baseline definition of "shadow banking;" one which mirrors the definition the Financial Stability Board and others have devised as a baseline for discussion.

Shadow banking is a market-funded, credit intermediation system involving maturity and/or liquidity transformation through securitization and secured-funding mechanisms. It exists at least partly outside of the traditional banking system and does not have government guarantees in the form of insurance or access to the central bank.

The accountants then used the definition to determine which shadow banking activities belong in the Index:
  1. money market mutual funds (MMMF), 
  2. asset backed commercial paper (ABCP) conduits, 
  3. asset-backed securities (ABS), 
  4. non-agency mortgage-backed securities, 
  5. collateralized debt obligations (CDOs), 
  6. repurchase agreements (repos), 
  7. securities lending, and 
  8. agency mortgage backed securities.
Notably, Deloitte left out hedge funds, non-money market mutual funds, financial companies, insurance firms, and activities such as swaps/derivatives and clearing.  These do not neatly fit Deloitte's definition and presumably gives them a cleaner data set.  Omitting them als recognizes that many of those industries and activities are, or since the financial crisis, have been regulated and are no longer living entirely in "the shadows."  

Deloitte chose 2004 as the baseline year for the index due to the availability of data, and anticipates updating the Index every quarter.  The Index does have some limitations, however, due to data availability.  At present it only includes activities in US market, and Deloitte had to leave out auction rate securities, despite conforming to its "shadow banking" definition because of insufficient data. 

After components of the Index were identified, the steps taken to create the Deloitte Shadow Banking Index included:

  1. Historical time series data (as measured by the dollar value of outstanding assets) were gathered as of Q4 2004 for each of the Index’s individual components. Exhibit 9 presents more detail on the data sets. To a large extent, this choice of Q4 2004 was born from practicality – data prior to 2004 were not readily available. In fact, this is a fundamental problem in measuring shadow banking, as pointed out by the FSB.
  2. The dollar value of outstanding assets of components was used to arrive at the aggregate gross size of the U.S. shadow banking sector in each time period from Q4 2004 to Q4 2011.
  3. The Index was computed by setting its value for the base period (Q4 2004) at 100, which represents the total dollar value ($12.8 trillion) of the shadow banking sector in Q4 2004. For subsequent periods, the dollar value of assets was converted to an Index value. For instance, in Q4 2006, the Index value was 136 ($13.3 trillion), rising from 100 in Q4 2004. Currently, the Deloitte Shadow Banking Index is unweighted. In the future, a weighting approach using one or a combination of variables such as risk, volatility, momentum, liquidity characteristics, or concentration may be adopted.
  4. The components of the Index are not constant. Some have been removed at various periods due to regulatory or government action. New components will likely be added if and when new activities fitting the characteristics of shadow banking emerge. 

Despite Deloitte's scope and data limitations, their Index analysis thus far has revealed some interesting ups and downs over the time period from 2004 to the present.

What the Index has found – unsurprisingly – is that there was a dramatic growth of the sector between late 2004 and late 2008, which even eclipsed the size of the traditional banking sector. Since then, there has been an abrupt decline – both in absolute terms and relative to the size of the traditional banking sector – amid a backdrop of economic crisis and volatility, increased regulation, and significant changes in the regular banking system. By our measure, the sector was some 25 percent smaller at the end of 2011 than at the end of 2004, totaling $9.53 trillion.

The shadow banking sector in the U.S. will likely remain suppressed in the near-term, though it is unlikely that it will cease to exist; repurchase agreements (repos) and securities lending, to name two components, are vital to the functioning of the modern financial system and will likely bounce back eventually.

The firm has used the index and supporting data to present some fairly striking data on the growth and changes not only of the shadow banking industry as they have defined it, but also drilled down into some of the components like money market funds, the activities of government sponsored entities, and securities lending.  The exercise of creating the Index has also given Deloitte a chance to examine and analyze the regulatory drivers affecting shadow banking.  

Using the Index, Deloitte hopes to add some focus and hard data to the shadow banking discussion.  Going forward, they hope the Index will help them measure the effects the tide of regulatory change is having on shadow banking activities, as well as the effect shadow banking has on regulated markets.