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Will Shadow Banking remain in the shadows?

As banks reduce their lending in response to new banking regulations, ‘shadow banks’ are taking on a growing share of their business. Will this make finance safer?

What is Shadow Banking?

The term ‘shadow bank’ was first used by PIMCO economist Paul McCulley in 2007 to describe off balance sheet vehicles created by banks to sell repackaged bonds as loans. The Financial Stability Board (FSB) broadly describes shadow banking as “credit intermediation involving entities and activities outside the regular banking system”. ‘Shadow banking’ is used more liberally today to describe financial intermediaries that perform banking functions but are not regulated as a bank. P2P (peer-to-peer) lending websites, asset management firms and the corner pawnshop may be included under this umbrella term. The FSB noted in its Global Shadow Banking Monitoring Report that this sector is estimated to be worth up to $80 trillion.

Shadow banks rose in prominence during the great recession as loans from ‘traditional’ banks dried up in the face of tighter capital requirements and a credit crunch. Regulators and economists are wary of shadow banking as these entities usually lack safety nets such as deposit insurance, a lender of last resort and sufficient regulatory oversight.

Why is shadow banking viewed with suspicion?

Shadow banking has several pros and cons. Shadow banks are able to encourage economic activity by making loans cheaper (lower operating costs) and more accessible (by offering services to customers that banks cannot or will not serve). However, this flexibility and price competitiveness often comes at the expense of an adequate safety net: banks are required to maintain certain levels of capital and liquidity which makes them safer but shadow banks are not required by law to do so. Shadow banks may also choose to assume more risk by lending to riskier customers which makes them susceptible to risky behaviour.

Shadow banking got a bad reputation during the financial crisis as they were listed on banks’ balance sheets as off balance sheet entities that were independent and separate from the banks. In reality however, these entities were dependent on the banks which owned them as their primary assets were risky securitized loans. Existential justification for these entities was to expand credit while removing them from banks’ liabilities, allowing banks to maintain a lower capital ratio. During the great recession, the intricate relationships between banks and these entities started to unravel as credit dried up. Because these special entities depend on money markets to meet their short-term funding, the flight of capital from money markets left them and eventually parent banks unable to repay depositors and creditors, leading to costly taxpayer bailouts. Since 2008, new accounting regulations forced banks to be safer by prohibiting them from owning these off balance sheet entities.

The Tide Turns

The shadow banking business boomed during the Great Recession. The retreat of traditional banks in debt markets during the height of the Recession allowed shadow banks to step in and fill the void. It can be argued that by lending to firms and individuals rejected by traditional banks, shadow banks brought liquidity and credit back into financial markets. P2P lenders such as the Lending Club, a P2P website, saw loan issuance grow from $43 million in 2009 to more than $15 billion in 2015.

An interesting point to note is the growth of shadow banking relative to GDP growth rates in emerging market economies and the benefits it brings to the countries. In India for example, microfinance companies are mandated to fulfil targets for socially-oriented lending and business is thriving: loan portfolios reached a record high rate in 2015.

This doesn’t necessarily mean that banks are becoming increasingly irrelevant. Rather, only their market share will be reduced as shadow banking firms continue to expand. Regulators will be hiding a smile as it has been their intention all along to see banks shrink and risks to be spread out across other areas of the economy.

Where do we go now?

Regulators face a delicate balancing act between encouraging shadow banks to supply credit to areas where traditional banks are reluctant to venture into while maintaining financial stability and protecting investors.

Bank of England Chairman Mark Carney said that “non-bank financing is a welcome additional source of credit to the real economy. The effort to transform shadow banking into resilient market-based finance, through enhanced vigilance and mitigating financial stability risks of the Financial Stability Board, a forum that sets the agenda for regulation at an international level, will help facilitate sustainable economic growth”.

To this end we saw different countries discussing different measures to curb the shadow banks in question. Former Vice-President of the Executive Board, Christian Noyer said that duplicating bank rules for non-banks could cause all investors to take the same positions at the same time, leading to a “one way” market of violent moves in one direction. “This herd behaviour can lead to detrimental consequences in terms of financial stability by amplifying an irrational market decision based upon no fundamentals, which could rapidly spread to the whole financial sphere,” Noyer told a conference on non-bank regulation at the Bank of France.

Former Bank of England deputy governor Jon Cunliffe said that regulators’ approach to shadow banking should focus on short-term stress testing and making sure funds can handle client redemptions. “You can’t wheel up the machine that we’ve built for banks and say that the same laws apply” to shadow banks, Cunliffe said.

U.S. Fed Governor Daniel Tarullo, the central bank’s top financial regulation official, said that the amount of capital an institution holds should focus firstly on the liabilities they bear rather than whether they are a bank, an insurer or asset manager.

Bundesbank board member Andreas Dombret said although shadow banks need to be scrutinised, demanding extra capital would be difficult for all non-banks other than insurers, which are already heavily regulated.

But we have come a long way since then. Speaking at the White House last Monday, March 4, President Barack Obama met Treasury Secretary Jack Lew and Federal Reserve Chairwoman Janet Yellen, who both are members of a Financial Stability Oversight Council created by Obama’s 2010 banking reform law to discover threats that may arise outside the banking system.

The council is working on determining whether rules are needed for the asset management sector, which includes companies such as BlackRock and Vanguard. Separately, the Federal Reserve and other regulators are looking for ways to reduce risks in shadow banking using their existing authorities. Obama also called for the Securities and Exchange Commission to finalize regulations on compensation for executives as well as for improving cybersecurity. In his brief remarks, Obama said the 2010 Dodd-Frank financial reform law has “worked.” The law has come under fire from Republicans arguing that the new regulations have crimped growth as well as from Democrats, especially presidential candidate Bernie Sanders, who have warned that it did not go far enough to curb risk-taking by banks.

In essence, shadow banking is an extremely liquid market which might foster the presence of liquidity in the economy and provide for huge stimulus if adequately regulated and if all the concerns mentioned by key regulators addressed above. However, shadow banking attracts consumers which are in a huge need of liquidity, such as households putting their money in money market funds. If suddenly, the securities issued by shadow banks become illiquid, everyone might easily run away because they are extremely averse to it

Summing up, if appropriately managed, shadow banking may have a positive effect. Yet, due to its volatile nature, it might lead to frightful consequences if even a small thing goes wrong.




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