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Keeping Shadow Banking from Going Shady: Financial Regulation Beyond Traditional Banks

Keeping Shadow Banking from Going Shady: Financial Regulation Beyond Traditional Banks

Moments of disruption provide clarity on structural issues that previously went unnoticed. If vulnerabilities permeating the financial system prior to the global financial crisis (GFC) had been obscured by investor optimism, fervent ideological support from academic circles embodied in the efficient market hypothesis, and normative attachment to laissez-faire capitalism, the system’s near-collapse in 2008 brought to the surface the shortcomings of financial practices of the time. Opaque financial products (including the so-called “exotic derivatives” – complex credit instruments whose risk is hard to calculate) had been proliferating at economically unsustainable and unjustifiable rates for decades. Their growth reduced transparency of the financial sector while helping it expand in size relative to the real economy. Compensation and bonus payment schemes in top financial firms were rewarding excessive risk-taking and creating an environment of perverse incentives with a focus on short-term profits. Some experts might have correctly recognized these simultaneously existing conditions as alarming even before financial markets worldwide hit their lowest points. Yet, it was not enough to contain a boom destined to burst. Leverage continued rising, liquidity kept shrinking, and regulatory agencies remained idle until the fateful collapse of Lehman Brothers, the fourth-largest investment bank in the U.S., in September 2008. 

This propensity to allow markets to self-regulate under lax government supervision until a crisis hits is known in political economy literature as “procyclical regulation.” In good times, like the 2006 housing market peak, investors and policymakers tend to be overly optimistic about the soundness of the financial system; in bad times, like the September 2008 turmoil, fears about a complete meltdown of the global economy lead to haphazard political and regulatory backlash. In a revised version of his testimony to the U.S. Congress, Dr. Andrew W. Lo of the Massachusetts Institute of Technology put it bluntly: market panics birth unreasoned emotional responses, which lead to more, but not always better, regulation.

Now that the smoke of the GFC has mostly cleared and the global financial system is in a benign cycle, it is a fitting moment to revisit the post-2007 regime while our collective consciousness is not clouded with the “unreasoned emotional responses” that Dr. Lo refers to. The truth is, regulatory powers that are often portrayed as omnipresent do not reach all corners of financial markets – or even all systemically important ones. One of the riskiest domains of financial activity, which the catastrophe of 2007 originated from, shadow banking, remains weakly regulated or altogether unsupervised. As the present prevailing sentiment is that the global financial market is doing well, no one is willing to expend their political capital on pushing for stricter oversight of shadow banking. Meanwhile, the very nature of activities this industry entities engage in puts the entire financial system at risk – yet again. 

Shadow banking, also referred to as nonbank financial intermediation to underscore its separateness from the traditional banking industry, is hard to define due to the diversity of activities it encompasses. Various definitions of nonbank financing formulated by scholars and practitioners of finance seem to agree on the following: at its essence, shadow banking is the provision of financial services and products by institutions other than banks, not subject to regulatory oversight. It is a web of financial markets and payment mechanisms alternative to conventional depository institutions, banks. Think money market mutual funds, private equity funds, broker-dealers, financial holding companies, Special Investment Vehicles (SIVs) created by banks, and asset-backed commercial paper conduits. Think all the imaginable obscure corners of the financial world, whose purpose and activities are incomprehensible for a member of the general audience. Most importantly, think mortgage-backed securities packed with subprime loans – one of the inventions of the shadow banking industry that led to a near-collapse of the global economy when the U.S. housing market went south in 2007-8. Shadow banks are innovative, diverse in structure and function, and systemically important: in 2018, nonbank financial institutions represented 30 percent of total global financial assets, according to the Financial Stability Board’s (FSB).

The prominence of the so-called nonbanks demands more thorough and complete comprehension of what the growing industry is and does. Shadow banks perform functions similar to that of traditional banks, yet do so without the direct and explicit access to insurance from the central bank that traditional banks enjoy. They tend to attract cash-rich, short-term investors – a factor that doubtfully makes the system any more stable. At the same time, shadow banks are not subject to normal banking regulation. An undeniably important source of financial innovation and additional supply of financing during economic booms, when more lucrative investment projects arise than banks can satisfy, entities operating in the shadow banking sector are still more fragile by the virtue of being backed by funding from the private sector. When the private sector fails to account for adverse market shocks and does not provide enough support to shadow banks by neglecting or understating risks – as it did in the U.S. in 2007 – nonbank financial entities are at risk of failure. If enough systemically important shadow banks fail, the stability of the entire financial system is threatened, due to the interconnectedness of shadow banking and traditional banking. Moreover, shadow banking tends to encourage decentralization and opacity of financial systems, which makes panic more likely by reducing transparency and exacerbating information asymmetry among market participants. 

None of these facts are not universally known or acknowledged by financial sector supervisors. Yet, despite its pernicious potential, the shadow banking industry remains outside of the macroprudential regulatory perimeter. If the turmoil of the GFC provided plenty of inspiration for the current traditional banking regulatory framework, nonbank financial institutions continue to operate under little oversight. Immunity from supervision has become one of the prime characteristics of shadow banking and is frequently included in its very definition.

A scenario in which shadow banking creates turbulence in the traditional banking system and, eventually, in the real economy would not play out within the confines of one country’s borders. Nowadays, financial and economic crises are almost inescapably international. Acknowledged contagion risks in the global financial market emanating from shadow banking call for an internationally coordinated approach to supervising nonbank entities. This would allow to more easily identify and measure cross-border interconnectedness of nonbank financial institutions, both with each other and with banks. Further underscoring the importance of some form of global nonbank supervision standards is the possibility of cross-country regulatory arbitrage. Inter-country differences in the various ways shadow banking is regulated have the potential to trigger a “race to the bottom” in oversight and supervision in which countries would try to relax respective regulatory regimes to attract more investors than other jurisdictions. The International Monetary Fund (IMF) claims the forms of shadow banking most detrimental to the resilience of financial markets have been eliminated since the post-2008 regulatory reform. However, this conclusion does not rule out, or even simply address, the possibility that new, unanticipated threats to financial stability can originate in nonbanks and spill over the entire system again. 

One of the primary challenges to an international effort to devise global standards of effective supervisory tools for nonbanks is limited data availability. The IMF identifies closing data gaps as the main objective of shadow banking regulation at its current stage. The complexity of some of shadow banking activities makes information disclosure difficult – according to some authors, nearly impossible. Improved data collection methodologies would facilitate transparency of the shadow banking industry and advance our understanding of the size and scope of nonbank financial intermediation. 

The economic efficiencies and innovation nonbank financial intermediation generates are hard to overlook, and even a possibility of suffocating the industry in regulation similar to bank supervision is enough for some to argue against any oversight of nonbanks. Yet, shadow banks are also capable of triggering and transmitting systemic risk, increasing interconnectedness and decentralization of the global financial system, and creating spaces in which overly complicated and obscure credit instruments, like mortgage-backed securities, are created and used unconstrained. As the importance of shadow banks grows, so should the body of our knowledge about them. This knowledge can be applied to strengthen the productive, socially optimal capabilities of nonbanks and minimize the risks they create for the global financial system. Understanding the pitfalls of the past appears to be the focus of much research on financial regulation, but it is not enough to deter future crises. Regulators worldwide must keep pace with the developments in the financial industry, accelerating at an astonishing rate. This, among other things, means directing utmost attention to the USD 52 trillion shadow banking industry and its even more impressive, hidden potential – benevolent, or else.

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