Shadow banking grows thanks to distracted regulators

Akin to the effects of Prohibition in the 1930s, stricter controls on the banking industry have resulted in institutions moving into the troubling world of shadow banking

The one that got away: while regulators work to control retail and investment banks, shadow banking has quietly grown

In November 2014, the Financial Stability Board (FSB) published Transforming Shadow Banking into Resilient Market-Based Financing. The FSB was concerned that a largely unregulated sector had grown globally to $75trn in 2013 – an increase of $5trn on the preceding year. The paper also included an updated “roadmap” from the G20 for the ‘Strengthened Oversight and Regulation of Shadow Banking in 2015’.

Banking reform has long been focused on clipping the wings of retail and investment banks, but it appears the strength of shadow banking has not been on the supervisor’s radar. It has recently become a subject of much debate and the statistics alone suggest it could pose a significant risk of systemic failure to the global economy.

In China, the shadow-banking sector has risen to an estimated $6trn – or 69 percent of
the economy

The FSB defines shadow banking as “credit intermediation involving entities and activities (fully or partly) outside the regular banking system”. This covers derivatives, money-market funds, securities lending and repurchase agreements, as well as the riskier investment products and loan-shark activities. The FSB is now proposing to combine ‘bank and market-based finance’ (its new name for shadow banking) into a more diverse financial system, hoping it will prove more resilient and, through greater competition, more effective. In the meantime, hedge funds and private equity firms in particular will be well aware they face increased regulatory scrutiny and the threat of market intervention.

A surprisingly big problem
We should be mindful that net credit growth since the economic crisis has essentially been in bond rather than bank finance, and the importance of shadow banking to the economic success of China and India cannot be overemphasised. In practice, many shadow banks are based in tax havens and rely on short-term funding – causing great alarm to those monitoring its stellar rise. Action by our regulators appears long overdue as problems have arisen across the globe.

Although the collapse of Shanxi Platinum Assemblage Investment in December 2014 was relatively small fry, it serves to highlight the financial risks lurking in China’s shadow banking system – especially where high-yielding wealth management products blur into grey-market lending. In China, at least 90 percent of small businesses fail to get bank loans and the shadow-banking sector has accordingly risen to an estimated $6trn – or 69 percent of the economy. There is, of course, no prospect of a public bailout if failure occurs as this is unregulated territory. The Financial Times stressed: “A series of similar incidents…. suggests China’s slowing economy has created fertile ground for hucksters as companies become increasingly desperate for funds amid a pullback in lending from banks as well as more mainstream non-bank lenders, such as trust companies.”

Shadow banking also makes it far harder for countries to control their economies by fiscal policy. Argentina, for example, whose economy could implode at any time, saw a 50 percent increase in the shadow-banking sector in 2013. Worldwide, nearly half of the $70trn in managed assets is in funds offering investors redemption at short notice, but, conversely, funds are investing increasingly in higher yielding, less liquid assets. The writing is on the wall.

Global fault lines
With the benefit of hindsight, Mark Carney (the FSB chairman) has declared the global economic crisis exposed significant “fault lines” in shadow banking activities. It is clear regulators did not understand the interconnectivity between banks and shadow banks. Heavy reliance by the latter on short-term wholesale funding and a lack of transparency hid the leverage and maturity mismatch and camouflaged the inherent risks. Credit intermediation through the shadow banking system came to an abrupt halt, threatening the viability of the entire financial system when the funding markets simply dried up. The FSB has accordingly adopted a two-pronged, high-level strategy to deal with these fault lines, although there is no obvious panacea.

First, it has created a ‘global’ monitoring framework to track developments in the shadow-banking sector – specifically, to identify systemic risks and apply corrective actions if necessary. This monitoring started in 2011 and now covers 25 jurisdictions, representing 80 percent of global GDP.

Second, to prevent the re-emergence of systemic risks from shadow banking, the FSB is looking to significantly increase the regulation of the sector. It will coordinate the development of policy measures in five core areas. These are: mitigating the risks in banks’ interactions with shadow banking entities; reducing the susceptibility of money market funds to ‘runs’; improving transparency and aligning incentives in securitisation; dampening pro-cyclicality and other financial stability risks in securities financing transactions; and assessing and mitigating financial stability risks posed by other shadow banking entities and activities.

FSB policies will focus on the economic functions involved in shadow banking activities in order to cater for innovations and adaptations on or outside the regulatory perimeter. The G20 roadmap of planned activities for 2015 covers actions by the FSB, the International Organisation of Securities Commissions and the Basel Committee on Banking Supervision. It includes an analysis of the global hedge fund sector, a review of the progress of money market fund reforms and a study of global securities financing data. Clearly, a massive change programme is in the pipeline.

The FSB strategy is to implement a series of integrated policies worldwide to mitigate the financial stability risks and, for sustainable economic growth, to transform shadow banking into “resilient market-based financing”. To many observers, this is wildly optimistic. Experience tells us regulators are often poorly coordinated. They will also face intensive lobbying from the banking industry and distrust from third world countries. In the emerging world, shadow banking fills a vacuum and the FSB has come up with no viable alternatives. Although the FSB says avoiding a repeat of past failures is not a recipe for success, in many ways it is a fear of the past that is guiding G20 policy – not the specific needs of today. Banking can never be risk-free.

Mark Carney has said the world has turned a corner in reducing the probability of another financial crisis, but globally there is a voracious appetite for market-based finance that will not succumb easily to regulatory restraint. We have not heard the end of shadow banking.