May 2012

May 2012: What You Need To Know About - Shadow Banking

Author: Robert Star | Photographer: Photography by Anne

There are entities operating in the financial system as though they are banks without being regulated as banks. These entities are large institutions comprised of private capital and are engaged in what is called “shadow banking.” They may be hedge funds, private equity firms or other institutions that provide a service for institutional clients that traditional banks are not participating in. This type of activity, while potentially profitable and encouraging of economic innovation and development, poses a significant threat to the world’s financial system.

As the immediate causes of the Global Financial Crisis abated, great concern was expressed that the governments of the world had not done enough to regulate their own financial systems, and consequently the world’s financial system had fallen into disarray.

The obvious starting point for politicians seeking to avert popular outrage was banks and their appetite for risk and profit. Governments responded by introducing new institutions and new regulations, only to find that a vast amount of banking business was being conducted in the shadows.

As the name suggests, shadow banking is defined in terms of banking. Banking is generally defined as the business of both taking money on deposit and making advances of money, including paying and collecting checks drawn by or paid in by customers.

The economic functions of banks are integral to modern finance. Banks ensure the formation of significant capital in an efficient and stable manner. Banks also provide credit intermediation (back-to-back borrowing and lending of money), which includes credit quality improvement and maturity transformation.

In performing credit intermediation, banks may be high quality borrowers of money who in turn lend to lower quality borrowers. The buffers provided by the banks allow them to absorb losses without defaulting on obligations, resulting in an overall credit quality improvement. This has important implications for the stability of the financial system. In addition, banks are able to borrow on shorter terms and lend on longer terms. This has important implications for improving the liquidity of the financial system.

These functions and their systemic importance are generally well recognized by the laws of most countries, which creates special obligations for banks. Generally banks are highly regulated in the form of prudential supervision, designed to ensure there is a reserve of cash or cash-like assets. This provides the banks with the buffers to absorb losses without defaulting on their obligations.

The most commonly used supervisory standards are set under the Basel Accords (currently Basel III). The laws usually create special rights for banks, which are generally expressed in terms of the banks’ access to central bank funding. This is integral to monetary policy and related fiscal matters. Banks act as a credit guarantor of final recourse.

The key distinguishing elements of a bank is that it may take money on deposit and it has special access to central bank funding. Shadow banking is, accordingly, the performance of some or many of the economic functions of banks by various entities in the financial system that are not able to take deposits and do not have direct access to central bank funding. Examples include finance companies, asset-backed commercial paper issuers and distributors, structured investment vehicles, credit hedge funds, money market funds, securities lenders, and margin providers.

Shadow banks do not have the special obligations and rights applicable to banks. They are not highly regulated in the form of prudential supervision, and they do not have the rights of recourse to public money. The implications of this are tremendous: Shadow banks are financial intermediaries that conduct capital formation, maturity, credit, and liquidity transformation without access to central bank liquidity or state credit guarantees. At the same time, Shadow banks are inextricably tied to the banking system.

Some studies indicate that Shadow banking rivals the size of the traditional banking system in the intermediation of credit to households and businesses. The size and scale of Shadow banking combined with its interconnectedness with the banking system presents a substantial risk to the financial system in that it may be a source of financial contagion.

With visions of another Lehman Brothers, the G-20 directed the Financial Stability Board (FSB), to examine Shadow banking and to make recommendations as to how to regulate the Shadow banks. The FSB, is a non-government organization comprised of representatives of all G-20 economies, several emerging economies, the European Commission and European Central Bank, the International Monetary Fund, the World Bank, the Bank of International Settlement and a raft of other international monetary and financial system related organizations. The FSB was established to monitor and make recommendations about the global financial system in order to address vulnerabilities and to develop and implement strong regulatory, supervisory and other policies in the interest of global financial stability.

When considering regulatory measures, the FSB suggests that there are four broad areas for regulatory responses:

-Direct regulation: regulating shadow banking entities themselves.

-Indirect regulation: regulating banks’ interactions with shadow banking entities.

-Product and Market regulation: regulating particular products, markets or activities affecting shadow banking entities.

-Regulation enabling effective macro-prudential measures: policies and regulations directed at strengthening market infrastructure to mitigate contagion.

Generally, the regulatory systems assume that bank regulations make individual banks safer, which makes the financial system as a whole safer. This assumption may be flawed, because in times of crisis, the efforts that individual banks take to make themselves safer can undermine the system’s stability. These regulatory assumptions automatically exclude Shadow banking.

The FSB would like to introduce a standardized approach: regulating substance over form with regard to function. In other words, by applying disclosure principles to the institutions engaged in shadow banking, the distinctions between banking and its shadow may better be overcome, thereby providing greater stability and mitigating system-wide risk by bringing the unsupervised aspect of the financial system within the regulatory net.

This seems to be a sensible though unoriginal approach that ignores the reality and not always sensible idea of independence. There are fundamental differences in both the laws and the policies of individual countries when dealing with their own financial systems.

For example, some countries believe that people are little better than irresponsible children who are not capable of making informed decisions and must be protected from themselves. Those countries adopt policies designed to control and restrict financial products or investment opportunities, even at the cost of innovation and development.

Other countries believe that people are not only entitled to make decisions for themselves, but that the costs of individual financial loss are more than compensated by the benefits of overall financial innovation and development. Those countries make policies aimed at fair play while encouraging what they regard as important benefits for the welfare of their societies, namely individuals exercising their autonomy and taking responsibility for their own decisions.

One way to reduce this risk would be to get rid of the shadows by casting a regulatory light on all aspects of banking-like activity. This would require implementation of a globally uniform method for such regulation. There are, however, several approaches and philosophies used by countries to regulate their respective financial systems. These differences mean that even while the governments of the world are trying to cast more light on their banks, the shadows grow ever larger. It seems that while the FSB has made a good start, there is still a very long way to go before concrete and functional suggestions are made with regard to managing and regulating shadow banks.

Robert Star is managing director of EDI Financial Group in Bluffton. For more information, call (843) 815-6636.

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