[Banking] Shadow Banks, Wholesale Banks, Securitization: Functions & Features Nachiket Committee’s recommendationsDevendra Vishwakarma
- What happened in Sub-prime crisis?
- Shadow Banking
- Shadow Banks: Why bad?
- Shadow Banking in India?
- Should India be worried?
- Gold Loan Companies as Shadow Banks?
- RBI’s safeguards on Gold loan NBFC
- Wholesale Bank?
- Wholesale Investment Bank vs Wholesale Consumer Bank?
- Benefits of Wholesale Banks?
- Mock Questions
Under [Banking] Nachiket Committee article-series, so far we’ve seen following
- What is financial inclusion, steps taken by RBI and Government to achieve it.
- Nachi gave six point vision to achieve financial inclusion. Under that, Universal Bank account for everyone. Access to banking within 15 minutes of walking distance.
- Priority sector lending: meaning, benefits, constrains and Nachiket’s recommendation for 50% PSL target and 0% SLR.
If you’ve not read those articles, go to Mrunal.org/economy.
As such very technical topic and not important for exam but basic understanding necessary before dwelling into Shadow Banking, Whole-sale banking. So, first let’s construct a technically-not-so-correct model:
- A retail Bank has given home loans worth total 100 lakhs to 50 families @10% interest rate. (if anyone defaults, bank snatch their house.)
- An investment banker, Hrithik Roshan, buys these loan-files from the normal bank.
- Hrithik makes a new company/entity, backed by those home loan files worth Rs.100 crores.
- Then he breaks down those 100 lakhs into (10 lakh bonds x worth Rs. 10 each) and promise to pay 8% interest rate.
- Aam Aadmi/retail investors/Mutual funds/insurance companies etc. buy these bonds.
Securities =some piece of paper that promises to some money to someone.
- Shares, bonds, IPOs, Debentures these are all examples of “securities.”
- So, What did the investment banker do in above example? He turned those “mortgages” (homes loan files) into “securities“. [and made some profit in between].
- This is called securitization.
So, is it good or is it bad?
- Good for banks because they can gather some new cash, look for new clients. (rather than waiting for EMI payments for 20-30 years.)
- Good for investors, because they can earn interest by buying those bonds.
- Bad? Yes, when the game is played without good faith- as it happened in Sub-prime crisis.
What happened in Sub-prime crisis?
- (normal) Banks gave loan to people who did not have the aukaat to repay the loans (hence they were called “Sub-prime” Borrowers.)
- But banks were smart, they “securitized” those loans, recovered money from investment bankers in wall street.
- Investment bankers in turn, sold securities (bonds) to aam aadmi/retail investors/pension funds/mutual funds/hedge funds etc.
- Then investment bankers used that money to buy even more loan-files from (normal) banks, and created even more mortgage backed securities.
- Everyone is happy. Bubble keeps blowing.
- But soon, one after another, those sub-prime borrowers default on EMIs.
- Wait, we shouldn’t worry right? Because we’ve their loan papers, we can attach their property and auction it to recover money.
- But unfortunately, as many people defaulted on loans, there is over-supply of houses on sale/auction => Real estate prices go down. if the house was originally worth 3 lakh dollars, now it’d sell not even for 30,000 dollars.
- Thus whole system collapsed.=>2007’s subprime crisis.
- World: Since investors all over the world had joined this game, they also suffered losses=>2008 global financial crisis. Ripples were felt even in India.
- Europe: Since European investors also lost money in Subprime crisis + Decline trade, tourism, export+ Their own governments had MNREGAish Maai-baap mindset with huge fiscal deficits and loss making PSUs=> PIGS crisis, sovereign default crisis, Greece crisis. (more on that, explained in old articles under Mrunal.org/Economy)
- Shadow Banks = organizations that function like banks but outside the banking regulation. American examples- hedge funds, securitization companies, Special Investment Vehicles (SIV), Money Market Funds (MMFs) etc.
- This term came after “subprime crisis” in USA, 2007.
- Shadow banks helped creating that asset bubble. But one day, home loan borrowers defaulted and the bubble collapsed =>crisis.
- Shadow banks have significant presence in Netherland, Hong Kong, USA, EU= they continue to remain vulnerable to such crisis even in future.
Shadow Banks: Why good?