Shining light on a banking shadowland

Mark Carney has made it clear the FSB's goal is not to kill off shadow banking but drag it into the sunlight, while harnessing its risk appetite and ability to provide alternate liquidity sources.

Nearly three-and-a-half years ago, when the last of the Wall Street heavyweights, Goldman Sachs and Morgan Stanley, sought refuge in the official banking system after Lehman Bros collapsed, it appeared the shadow banking system had been dealt a major blow. After a minor hiatus, however, it appears to have bounced back to the point where the shadow system is now as big as it was before Lehman fell.

Last October the Financial Stability Board released a paper containing its recommendations for dealing with the shadow system. In the report, it said the shadow system, having grown from about $US27 trillion in 2002 to $US60 trillion pre-crisis, was still estimated to be around that size – or about 25 to 30 per cent of the global financial system and almost 40 per cent of the US financial system. (The non-bank share of the Australian system is less than 20 per cent.)

The shadow system may have been, and may still be, somewhat larger than that – there were some credible estimates before the crisis that the shadow system, inhabited by hedge funds, private equity firms, money market funds and other non-bank entities, was at least as big as the official system in the US.

The FSB recommendations were centred on setting up working groups to essentially do some fact finding on the nature and extent of shadow banking and its interactions with the official system, as well as creating the capacity to monitor and perhaps regulate some shadow activity.

The danger the shadow system poses to financial stability has been recognised since the onset of the crisis, which demonstrated that there were conduits for contagion between the shadow system and the regulated core of the system, but international regulators have found it difficult to decide how to deal with it.

The quest for a global approach has become more urgent because regulators are well aware that even as they increase the capital and liquidity requirements for banks and other regulated institutions they are driving activity into the shadow and increasing the incentives for regulatory arbitrage by the regulated institutions.

The Financial Times carried an interview with the new chairman of the FSB, Bank of Canada’s Mark Carney, yesterday, in which he talked about the need to drag shadow banking into the sunlight and reshape it so that it shifted from representing a threat to the financial system to providing diversification and resilience within the system.

It is the lack of transparency that hampers the ability of regulators to regulate the non-banks. One of the insights into the sector provided by the crisis was that US hedge funds and private equity funds and other shadow banking sector participants didn’t even have to register with anyone, let alone provide any meaningful information to regulators.

The post-crisis approach is to regulate all potentially systemic important institutions – not just banks – more rigorously and bring some markets, like the over-the-counter options market, into the sunlight of exchange trading platforms.

The regulators can, to some extent, quarantine their systems from the shadow system by the way they regulate banks and other key financial institutions.

Provided they can ring-fence, and shore up with stringent capital and liquidity requirements, the core banking operations of institutions deemed too big to fail – as the Vickers Commission has recommended in the UK – the risks being taken "outside the fence" by banks and others would be of concern to shareholders and creditors, rather than regulators.

That does pre-suppose, of course, that the institutions don’t devise mechanisms for regulatory arbitrage and gaming that might appear to transfer risk to unregulated institutions but don’t. The big universal banks and investment banks at the heart of the 2008 crisis were very "creative" in structuring products that appeared to transform and transfer risk, but didn’t.

Even if the core of the system is protected by stronger and better-quality regulation, however, there is a risk if that regulation and the higher costs it imposes helps shrink the official system – and banks are likely to shed trillions of dollars of assets to achieve the new minimum capital requirements that will be phased in over the rest of this decade – that will simply fuel the growth in the shadow system.

If banks aren’t allowed to conduct proprietary trading activities, for instance – and the US banks are being forced to withdraw from prop trading – hedge funds and others will take their place. They’ll also be creative in helping the banks to appear to meet the tougher regulatory regime.

There is, as an illustration, considerable concern among regulators, for instance, that exchange traded funds could be used to make it appear that illiquid or poor quality exposures have been removed from a bank balance sheet while the bank still retained an exposure to the risks.

The regulators are aware that the ingenuity and financial engineering skills of financial market participants – and the inherent amorality of financial markets (as opposed to the immorality of some individuals and institutions demonstrated in the lead-up to the crisis) – can’t be underestimated.

The FSB’s Carney did make it clear, however, that the goal of the regulators is not to kill off the shadow system, which in any event would be impossible, but to reduce the level of risk it poses to financial stability while harnessing its appetite for risk and its ability to provide different sources of liquidity for the system.

The first step, as the FSB has stated, is to gain access to better data on all non-bank credit intermediation so that the regulators have an understanding of the risks shadow banking activities might pose to the financial system.

The second is to focus on the linkages and potential conduits for risk between the shadow and official systems to prevent contagion by regulating interactions.

The third is to actually regulate some shadow banking system activities, like money market and exchange-traded funds, big hedge funds, special purpose vehicles, securitisation and securities lending.

The reality that the shadow system does live in the shadows, its participants are often based outside the major jurisdictions, and that the system is fluid and creative is going to make that task challenging at best.

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