Financial Risk Manager Part 1
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The correct answer is C.
The shadow banking system is a network of non-depository financial institutions – investment banks, structured investment vehicles, conduits, hedge funds, and other non-bank financial entities that serve as intermediaries to channel savings into investments. Due to the fact that they do not take deposits, they escape a myriad of limits and laws imposed on traditional banks. Before the crisis, shadow institutions used to borrow via short-term, liquid markets and then used the funds to invest in longer-term illiquid assets. When the housing bubble burst, lenders and investors started to avoid taking on the credit risk, and short-term borrowing dried up almost overnight, making these institutions unable to raise money for their own operations. Compounding their woes was the inability to get funds from their collapsing investments in securitized assets, which were now considered "toxic" in investment terms.
A is incorrect because the shadow banking system, while operating outside of traditional banking regulations, is not exclusively made up of institutions engaged in illegal activities or money laundering. While the lack of regulation can make these institutions more susceptible to such practices, it is incorrect and oversimplified to categorize the entire shadow banking system in this way.
B is incorrect because while some institutions in the shadow banking system, like money market funds, may invest in short-term financial assets such as Treasury bills (T-bills), it is not a defining characteristic. The shadow banking system is broad and diverse, with different entities focused on various types of assets and investments.
D is incorrect because, unlike traditional banks, the institutions in the shadow banking system typically do not operate under the oversight of central banks. Although these institutions may have certain operational flexibilities, they are not directly regulated by central banks, which is one of the reasons they fall under the umbrella of 'shadow banking'.
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Explanation:
Explanation
The shadow banking system refers to a network of non-depository financial institutions that operate outside traditional banking regulations. Key characteristics include:
Key Features:
- Non-depository institutions: Unlike traditional banks, they don't accept deposits from the public
- Diverse entities: Includes investment banks, structured investment vehicles (SIVs), conduits, hedge funds, and other non-bank financial intermediaries
- Regulatory arbitrage: They escape many banking regulations and limits imposed on traditional banks
- Funding model: Typically borrow via short-term, liquid markets and invest in longer-term, illiquid assets
Why Other Options Are Incorrect:
- Option A: Incorrectly characterizes shadow banking as primarily involving illegal activities or money laundering. While lack of regulation can create vulnerabilities, this is not the defining feature.
- Option B: While some shadow banking entities may invest in short-term assets, this is not a defining characteristic. The system is diverse with various investment strategies.
- Option D: Shadow banking institutions typically operate outside central bank oversight, which is actually one of their defining features, not a characteristic that distinguishes them.
Risk Implications:
The shadow banking system played a significant role in the 2008 financial crisis due to:
- Maturity transformation risks (short-term borrowing vs long-term investments)
- Lack of regulatory oversight
- Vulnerability to liquidity crises when short-term funding dried up
- Exposure to "toxic" securitized assets during the housing market collapse
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