It’s Time to Bring Shadow Banking into the Light

by John Kiernan on July 11, 2012

shadow bankingThey exist in the shadows, operating outside the law and making monumental moves with the fate of society resting in their hands. They are thrust into the headlines only during times of trouble, yet are unquestionably a major part of history. Their importance must not be overlooked by politicians and regulators any longer. No, I’m not referring to the Illuminati, Batman, or even the CIA, but rather the entities that comprise the so-called shadow banking system, which played a significant role in causing the Great Recession and are finally on Washington’s radar.

For those of you who don’t know, the shadow banking system is the collection of financial institutions and investment vehicles that are not subject to the same laws and regulations as traditional banks and bank accounts given that they do not allow you to make deposits. It includes hedge funds, money market funds, and many securities. It’s also common for investment banks to engage in shadow banking practices in order to keep certain transactions off their balance sheets and therefore hidden from regulators and investors alike.

Perhaps more alarmingly, shadow banks serve as intermediaries between large institutional investors and borrowers, and their lack of regulation enables them to take risks not permitted in the mainstream banking system as well as thwart laws designed to prevent economic collapse. In other words, the shadow banking system tends to represent far more debt than it can immediately cover, and when investors all come a-callin’, there isn’t enough to go around, shadow banks are therefore forced to sell assets at cents on the dollar, and the economy is put in jeopardy.

This is exactly what happened prior to the Great Recession, and many economists in fact point to the run on shadow banks as being the driving force behind the downturn.

The obvious questions are therefore why didn’t regulators see this coming and what are they doing about it now?

Let’s take things one step at a time, starting with why regulators didn’t foresee problems arising from the shadow banking system. Much of this can be ascribed to the system’s rapid growth. According to the Deloitte Center for Financial Services’ Shadow Banking Index, the value of the shadow banking system in the US grew by two-thirds from late 2004 to early 2008, when it reached a peak of $20.73 trillion, or 28% more than the value of the traditional banking system. In other words, regulators simply moved too slowly to keep up with the changing face of finance.

Many have also made the point that it’s clear in retrospect that regulators and other industry insiders simply did not understand the inner-workings of the economy as well as they thought. Unfortunately, it took the Great Recession to make that obvious.

Ok, but now we know that there’s a problem, we’re tackling it head on, right?

Not exactly. While the Dodd-Frank Wall Street Reform and Consumer Protection Act included intermediary provisions that gave regulators jurisdiction over entities that significantly impact the economy, require that hedge funds of a certain size be registered, and necessitate that derivative trading be scrutinized, the other significant changes that must still be made are all talk at this point.

More specifically, the Financial Stability Board (FBS), an international economic oversight group, is in the process of making recommendations for how the world’s 20 largest economies should handle their shadowy problem. Daniel K. Tarullo, one of the Financial Reserve Board’s governors, has also been particularly outspoken on the matter.

“Without policy changes, existing channels for shadow banking will grow, and new forms creating new vulnerabilities will arise,” he said in a speech at a Federal Reserve Bank of San Francisco conference in mid-June. “That is why I suggest what is, in essence, a two-pronged agenda: first, near-term action to address current channels where mispricing, run risk, and potential moral hazard are evident; and, second, continuation of the academic and policy debate on more fundamental measures to address these issues more broadly and proactively.”

In terms that you and I can more easily understand, Tarullo wants to correct the system’s obvious ills now, while exploring solutions to additional issues moving forward. As far as immediate measures are concerned, he recommends that regulators at home and abroad take the following four steps:

  1. Increase transparency in the shadow banking industry in order to give consumers a better sense of what it’s comprised of
  2. Add safeguards against unsustainable runs on shadow banking entities, including requirements for liquid reserves and restrictions on redemption of investments
  3. Overhaul the settlement process for credit transactions
  4. Establish rules related to the risky reliance on debt in order to facilitate shadow banking investments

These changes have been a long time coming, and at the end of the day, they must work if we are to avoid a double-dip recession. What’s more, we better hope that regulators have learned their lesson from the last recession and are informing Congress of the best course of action to avoid future economic problems. Shadow banking might not seem like as big of a problem as obvious concerns such as national security, but the risk of doing too little too late is perhaps just as great.

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