The shady world of shadow banking

The rapid growth of shadow banking has transformed the global financial system, but it could pose a major threat to our economic future

Anastasia-Nesvetailova100x100The phrase ‘shadow banking’ was first coined in 2007 by Paul McCulley, then a senior partner of PIMCO. He was speaking at a Federal Reserve conference about the lessons of the unfolding financial crisis and noted that the meltdown was driven by the growth of ‘shadow banks’ which fund themselves with uninsured commercial papers that are only sometimes backstopped by liquidity lines from ‘real’ banks.

He later declared that the growth of the shadow banking system – which operates legally, albeit entirely outside the regulatory realm – ‘drove one of the biggest lending booms in history, and collapsed into one of the most crushing financial crises we’ve ever seen’.

Yet shadow banking is an unfortunate phrase.  It brings derogatory connotations into a concept that describes a vital part of the global financial system.  It is also rather misleading, since many people associate it with the shadow, or underground, economy (which is not accurate, at least in the context of advanced capitalism).

Despite the controversial definition, the term stuck.  Indeed, McCauley’s focus on the opaque and underreported world of unregulated financial alchemy and credit creation spurred further studies of the phenomenon. This literature has been dominated by US scholarship, led by academics working on socio-legal studies of finance and, uniquely for such a recent problem, pioneered by regulatory institutions, such as the Financial Stability Board (FSB), the Bank of International Settlements and national supervisory bodies.

The efforts of academics and regulators on both sides of the Atlantic yielded unsettling results. In the US, on the eve of the financial crisis in 2007, the size of the unregulated financial system (at some $27 trillion) dwarfed the volume of the official banking system.  Even in the wake of the crisis in 2010, shadow banks in the US still controlled about $12 trillion of assets.

Observers and regulators in Europe are still struggling to quantify the precise volume of shadow banking in their region. They note also that, unlike the US, its growth has continued after the crisis. The FSB estimates that, globally, shadow banking expanded rapidly from an estimated $27 trillion in 2002 to $60 trillion in 2007 and $67 trillion in 2011. This is the equivalent of a third of the financial system world-wide.

The so-called Anglo-Saxon financial system dominates shadow banking, with the US and the UK accounting respectively for 46% and 13% of the global total. Japan and the Netherlands follow closely (at 8% each).   Analysts acknowledge that many of the practices of shadow banking remain obscure and take place under the radar of regulators.  So what is most unsettling about this data is that these figures almost certainly underestimate the scale and global reach of shadow banking activities.

Most analysts of shadow banking also now agree that this opaque and highly complex web of financial intermediation plays a vital role in the economy – not least because restrictions, rules and regulatory requirements imposed on the official banking sector make credit provision slow and costly.

It is not surprising, therefore, that regulatory reform and public debate about shadow banking (and, by extension, banking in general) have become increasingly political. For their part, academics and regulators argue that a parallel system of unregulated financial intermediation raises serious concerns over prudential, regulatory and systemic risks. Against this, private financial companies, such as money-market funds and hedge funds, insist that shadow banking has both existed for a long time and brought efficiency and liquidity benefits to the economy.

It is too soon to anticipate which side will win this battle of positions.

On the one hand, regulators in the US, Europe and the UK are striving to map the various structures and processes of shadow banking as a first, essential step towards a more efficient framework of financial governance.  Many post-crisis reform initiatives (such as Basle II/III, the Dodd-Frank Act and the Volcker and Vickers rules), although not targeting shadow banking specifically, are aimed at enhancing market discipline, transparency and the prudential regulation of activities linked to shadow banking. Indeed, some of these new requirements have already impacted on shadow-banking practices.

On the other hand, especially given its scale, it is naive to assume that the whole universe of financial innovation can simply be regulated away by means of new rules and capital requirements.  The darkest fact about shadow banks is that, without direct and guaranteed access to public liquidity support, they remain the most fragile nodes of the financial system, with the potential to threaten the viability of many, more ‘visible’, financial institutions.

Bankrolling opaque and often secretive structures of financial innovation, which are often embedded in tax havens precisely in order to avoid taxation and regulation, will be a controversial and costly exercise. Data from the Securities and Exchange Commission suggests that money-market mutual funds have been rescued from financial trouble by their parent companies more than 300 times since such funds were created in the 1970s!

Such facts about the destructive power of private financial innovation are slowly assembling into a mosaic that portrays the world of finance as a dubious realm. Questions that were once asked only by left-wing academics are today being raised, and answered, by high-profile regulators.

Can we sum all of this up?  Have our banks become too big to be a healthy foundation for the economy? Yes. Does financial innovation bring benefits to economy and society? Only partly, and in ways that are hard to quantify.  Will a financial crisis happen again in the next 5 to 10 years?  Yes – and, what’s more, it is highly likely to involve shadow banking.