Will regulators see the light on shadow banking?

There's no doubt that the health of European banks is concerning, but a bigger financial threat looms in the unwieldy global shadow banking sector.

This time, it is the Reserve Bank of Australia turn to fuss over the stability of the global financial system by putting European banks in the spotlight. The question is when will regulators start to focus on shadow banking — an activity which could cripple the global financial system in days.

There are many events that could harm the stability of global financial markets. European banks have a plethora of problems. The action taken to date by Mario Draghi and the European Central Bank suggests they would prefer to give European banks a lending hand, rather than watch them become part of bankruptcy history.

Balance sheets of European countries and banks dominated financial headlines for much of last year. Headlines about improving economic conditions have been sparse this year.

Draghi has taken action to stabilise the European banking system. The European Stability Mechanism, initiated in 2010, was designed to provide financial instance and has served its purpose, financing the recapitalisation of banks through loans to governments of ESM members.

The measures introduced by Draghi to provide liquidity have helped European banks. The European Central Bank depository facility has been used less recently as European banks decrease their dependency on the ECB for funding. This can only be viewed as a positive.

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The preferred means of rescuing ailing banks is to now bail-in mid-tier debt holders by wiping their debt holdings and giving them equity. This act could be considered deplorable, but it has avoided disrupting the financial system – the key concern of the Reserve Bank.

It was only just this week that Italy’s oldest bank and third largest lender, Monte Paschi, announced it will halt coupon payments on some bondholders to recapitalise the bank. The alternative for Monte Paschi was to default, potentially sending financial markets into an uncontrollable spiral.

In June, Britain’s The Co-Op Group used the bail-in model to continue as a going concern to avoid default or a flat out bailout with taxpayers money.

The history books say in most cases, governments or central banks will do enough to keep banks away from the perils of outright collapse. It was 15 years ago that the Federal Reserve Bank of New York stepped in to save the banks leveraged to imploding hedge fund, Long Term Capital Management.

Since then, the only palpable threat to the global financial system has been the collapse of Lehman Brothers. Central bankers and governments would remember the catastrophic events that followed; we can only imagine they would step in to prevent a similar sequence of events in the future.

Beyond Long Term Capital Management, every other time a financial institution has come under threat, governments across the US, Europe and the UK have come to the party with a lifeline and liquidity to manage the health of the financial system.

We'll never know how different things would have been if Lehman Brothers had not declared bankruptcy. But they are the poster-child for the consequences of a bankrupt bank.

Without doubt, shadow banking provides more of a threat to the financial system. The best way to think of shadow banking is financial institutions acting like banks but not falling under the same regulations.

The IMF estimated the global shadow banking system to be valued at some $US67 trillion at the end of 2011. The difficulty is that it is almost nearly impossible to quantify the risks shadow banking may pose to the financial system. This is far more concerning than any possible threat from European banks.

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