Regulators home in on a growing bank shadow

The Financial Stability Board's second report on shadow banking notes that the sector is now larger than it was pre-GFC. Despite this revelation, progress on regulation remains painfully slow.

Even before the crisis it was evident that there had been dramatic growth in the volumes of credit being originated and intermediated by non-banks or, as it has been dubbed, the ‘’shadow’’ banking system. It was also appreciated that the shadow system was linked into the official banking system, although those links and their implications weren’t well understood.

After the crisis, which was sparked by the implosion of various asset-backed paper markets and the implosion of the ‘’originate to distribute’’ model there is a far more acute awareness of the need for regulators to understand the shadow system and its working better, to monitor developments within it and to regulate some aspects of it, particularly where they have the potential to ‘’infect’’ the core banking system.

That need has become even more pressing as the imposition of tougher capital and liquidity standards on banks has created incentives for activity to be shifted outside of the banking system in a form of regulatory arbitrage.

About a year ago the Financial Stability Board, an international organisation that coordinates national financial regulators and policymakers to develop policies aimed at improving global financial stability issued its first report on the shadow sector and some broad guidelines on how it proposed to improve regulation of systemically important non-banks.

Over the weekend the FSB issued its second monitoring report and a more developed framework for strengthening oversight and regulation of shadow banking entities.

Perhaps the most striking aspect of the monitoring exercise the FSB undertook is that it indicates that the shadow system today is larger than it was pre-crisis. In the lead-up to the crisis the sector experienced explosive growth, from $US26 trillion in 2002 to $US62 trillion in 2007.

Post-crisis that growth rate has flattened, but the FSB still estimates that it is now a $US67 trillion sector – it contains financial assets equivalent to 111 per cent of the aggregated
GDP of the jurisdictions the FSB monitoring covers (which cover 86 per cent of global GDP and 90 per cent of the assets within the global financial system).

While the shadow system’s share of total financial intermediation has edged down from 27 per cent in 2007 to about 25 per cent according to the FSB it is still roughly half the size of the official banking system.

It is clear from the experience of the financial crisis that while the shadow banking institutions may not be regarded or regulated as banks they do create regulatory and systemic risk. Fannie Mae and Freddie Mac, or AIG, for instance weren’t banks. Neither were the big Wall Street investment banks that were forcibly yanked into the official fold during the crisis. The crisis demonstrated, painfully, that there is moral hazard for taxpayers within the shadow system.

That’s not to say that all shadow institutions pose systemic risks or perform roles that don’t contribute to the efficiency and effectiveness of the system. It does, however, suggest that any institution of significance to a financial system that conducts activity that looks like a banking activity – if their core function is credit, maturity or liquidity transformation – needs to be identified and regulated in broadly the same fashion as a bank to reduce risk and the incentives for regulatory arbitrage that can create contagion.

History also suggests that if activities are regulated out of the banking system, or priced out of it, those activities will subsequently be effectively re-acquired by the banks to create exposure to activity that undermines their own profitability. We saw that in collateralised debt exposures and securitisation more generally. That’s why regulators are now focusing on the functions of shadow institutions rather than their form.

They are also trying to cast some light on some of the less transparent markets that shadow institutions have large exposures to, like over-the-counter derivatives, trying to bring those markets into the sunlight and onto platforms that facilitate regulation.

None of this is easy, which explains why the FSB’s progress has been incremental and the initial effort has been directed towards gathering more information and understanding of the shadow banking system and its inter-connectedness with the official system.

Quite rationally, many of the measures it is advocating focus on better regulation of banks’ exposures to shadow banks, using the existing capital adequacy framework to provide some disincentives and insulation against risk.

It also advocates stronger regulation of some particular types of shadow institutions, like money market funds and other entities and markets with activities that are similar to some banking activities, like the securitisation and securities lending and repo markets.

The next phase of the FSB’s involves developing more granular recommendations to promote greater transparency, the regulation of banks’ interactions with shadow entities, the regulation of systemically important non-banks and the regulation of other non-bank activity and markets by the middle of next year.

It may be taking quite a while to bring the shadow system out of the darkness and developing and implementing actual regulation will take even longer, but at least some progress, however glacial, is being made.