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Bringing light to the shadows

Since the financial crisis hit, there has been a regulatory spotlight shining on the whole of the banking sector.  That light is now trying to bring vision to the shadow banking sector.  Will it succeed? 

The European Commission is trying to close regulatory gaps that may allow risks from shadow banking to amass in the financial system. A fortnight ago, the Commission called for increased capital requirements for non-banks, vis-à-vis Basel III and Solvency II style proposals, and new powers to help regulators identify and deal with any dangerous lending bubbles.

The Commission's green paper on shadow banking sets out new regulatory goals:

  • limiting bank exposure and "flawed risk-transfer" to shadow banking;
  • reducing liquidity disruptions; collateral and conflicts of interest in exchange-traded funds and other securities;
  • limiting the risks of runs on money market funds
  • reducing risks in securities lending and repo collateral management and reinvestment
  • regulating securitisations

These proposals are purely going to extend existing regulations to cover the non-bank sector.

In the U.S. the Financial Stability Oversight Council, which comprises market regulators and the Federal Reserve, will police the capital markets and, in the U.K. the Financial Policy Committee of the Bank of England is now deciding what its role in supervising the sector will be.

Shadow banking has performed so well outside the system for so many years, that it is difficult to regulate, though the proposals are meant to be agreed by 2013.

That’s why the U.K. Financial Services Authority Chairman Lord Turner said in a speech last month that we must not “fool ourselves that any set of reforms we can now design will be sufficient to make the system permanently safe … any system this complex will defy complete understanding.”

This really cuts to the heart as to why regulators struggle, as they are always behind the markets and never in front.  I always remember a key statement in Michael Lewis’s book Liar’s Poker where the General Counsel for Salamon Smith Barney says that his role is “to find the chink in the regulator’s armour”.  That is what the shadow banking system is all about – finding ways to leverage risk for higher reward by avoiding regulation and no matter how much effort the European Commission, FSA and SEC put into the control of shadow banking, there will always be some other issue arising that is unregulated.

This is demonstrated well by Lehman Brothers.

When Lehman Brothers collapsed, regulators and governments were shocked to discover that their $400 billion in debt had been leveraged to the value of $8 trillion through Credit Default Swaps.  It was that leveraged AAA debt which created the spiral of mistrust that caused so much global pain following the September 14th crash.  It also highlighted the growing risks arising from the securitisation of debt through the shadow banking system. 

Regulators concluded that shadow banking had serious implications on commerce, economies and trade and have therefore placed an increasing focus on regulating this sector.

Regulators and bankers have debated the products and markets that should be regulated as shadow banking.

The Financial Stability Board (FSB) defines the sector as “credit intermediation involving entities and activities outside the regular banking system”, and make it clear that although shadow banking sits outside the banking system, it does offer bank-like activities such as:

  • accepting funding with deposit-like characteristics;
  • performing maturity and/or liquidity transformation;
  • undergoing credit risk transfer; and
  • using direct or indirect financial leverage.

Shadow banking is used extensively by hedge funds, money market funds and Structured Investment Vehicles (SIVs) as an important source of funding for securitisation, securities lending and repurchase “repo” transactions.

The FSB estimates that this sector traded around $60 trillion in 2010.  That’s about half the amount of all bank assets and over a quarter of all global trading.

Because regulations have changed the relationship between banks and hedge funds, particularly in the U.S., and have stepped-up supervision of bank trading, debt and liquidity ratios, the shadow banking system's size and significance is expected to grow.

This is why global regulators are now cracking down on the shadow banking sector with the European Commission launching a public consultation into the sector and Lord Turner, Chairman of the Financial Services Authority, calling for radical action.

Turner chairs the group of global regulators working under the FSB to identity the right way to manage this sector’s activities and, quite clearly, recognises that the challenge is to regulate an unregulated sector while realising you cannot plug all the gaps.

So the regulators appear to be trying to take action by cracking down on Exchange Traded Funds (ETFs), alongside stricter rules on the role of repo markets in such funds, but – as noted by Lord Turner – regulators are generally powerless to stop such activity. 

Shadow banking exists to exploit the gaps in the regulatory process and by cracking down on ETFs and repo, something else will appear to take their place. 

Like a large balloon that has been knotted to stop leaks in its periphery, all the regulator achieves is the appearance of another bulge in the financial market balloon somewhere else.

And no matter how much the regulator tries to stop the balloon bulging in different directions, by the very nature of the law of unintended consequences, a bulge will appear somewhere else. 

This is for two reasons:

  1. the markets are always looking to create ways to generate higher risk and returns by leveraging the gaps in regulations; and
  2. the regulator can therefore only address regulatory arbitrage issues after the fact and not before.  

That is the reason why shadow banking will continue to thrive, regardless of a regulatory crackdown.

About Chris M Skinner

Chris M Skinner
Chris Skinner is best known as an independent commentator on the financial markets through his blog, the Finanser.com, as author of the bestselling book Digital Bank, and Chair of the European networking forum the Financial Services Club. He has been voted one of the most influential people in banking by The Financial Brand (as well as one of the best blogs), a FinTech Titan (Next Bank), one of the Fintech Leaders you need to follow (City AM, Deluxe and Jax Finance), as well as one of the Top 40 most influential people in financial technology by the Wall Street Journal’s Financial News. To learn more click here...

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