Cutting through concepts

FiF July 2012- In from the shadows

A recurring section which seeks to bring clarity around complex and often misunderstood financial services concepts or issues.

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The term ‘shadow banking’ was born from the financial crisis. It seems to have been coined by Paul McCulley, former Managing Director of Pacific Investment Management Company (PIMCO), and applied to what he termed “the whole alphabet soup of levered-up non-bank investment conduits, vehicles and structures.”1 From its inception, the media image of shadow banking has been tarred with connotations of complexity, deception, even impropriety. There is a risk that politicians are taking the view that something must be done. Experience shows that this is not the basis for effective policy-making. Fortunately, the quality of the discussion on this topic has improved in recent weeks and we are beginning to see some more informed debate.

What is it?

Let’s start with some definitions. According to the Financial Stability Board, the shadow banking system is “the system of credit intermediation involving entities and activities outside the regular banking system.”2 The European Commission, announcing new proposals to regulate this sector,3 recently characterized its scope as including:

  • Money Market Funds (MMFs) and other types of investment funds or products with deposit-like characteristics.
  • Investment funds that provide credit or are leveraged, including Exchange Traded Funds (ETFs) and hedge funds.
  • Finance companies and securities entities providing credit or credit guarantees or performing liquidity and/or maturity transformation without being regulated like a bank.
  • Insurance and reinsurance undertakings which issue or guarantee credit products.
  • Securitization and securities lending and repurchase agreement (repo) transactions.

Assessments of the size of this sector vary widely and are heavily dependent on definition. The FSB estimated it at around US$60 trillion in 2010.4

Why is it a problem?

These companies and institutions carry out certain bank-like activities, such as maturity transformation and liquidity transformation, but they fall outside the full scope of banking regulation. So the potential risks they present may not be fully visible to the authorities. The details vary between jurisdictions, but in most cases, individual investors and counterparties will be adequately protected by existing conduct regulation. However, matters are not so clear-cut in respect to systemic risk.

The financial crisis revealed clearly that these shadow banking entities may have the potential to severely destabilize effects on the financial system, not primarily through their own activities per se, but as a result of their interconnectedness with the mainstream banking system. It is rarely the case that a hedge fund or investment fund, for example, acts as the sole intermediary between an end supplier and an end-purchaser of credit. More likely, there are complex chains of institutions involved, some within the conventional banking sector and some without. It is the exposure of the banking system to credit and liquidity risks originating outside it which drives the need to consider how this sector of the financial industry should best be regulated.

As always, it’s a question of balance. These non-bank institutions bring very clear benefits to the market. The FSB itself recognizes that intermediating credit through non-bank channels has advantages. For example, the shadow banking system may provide market participants and corporates with alternative sources of funding and liquidity.5 What’s more, as Adair Turner, Chairman of the UK Financial Services Authority, pointed out in a recent lecture at the Cass Business School, much of the financial crisis in Europe did not involve shadow banking activities such as securitized lending, but “plain old-fashioned on-balance sheet lending.”6

Equally, though, where prudential regulatory standards and supervisory oversight are different from those imposed on mainstream banks, there is the potential for excess leverage and risk to build up in the system, as well as the danger of regulatory arbitrage. Indeed, one factor behind increased concern about the shadow banking sector is the fear that tougher regulation of banks will drive them to try and circumvent and undermine banking regulations. As the European Commission (EC) put it:

By evading regulation applied to regular banks, shadow banking may also lead to a regulatory ‘race to the bottom’ within the rest of the financial system – other financial bodies may also try to push certain activities outside the scope of regulation.7

Is it still a problem?

On some measures, it may seem that the scale of the shadow banking sector has declined in the aftermath of the financial crisis: The volumes of derivatives, special purpose vehicles and money market funds have all shrunk; Goldman Sachs and Morgan Stanley have voluntarily adopted conventional holding bank status. But this doesn’t mean that the underlying issues have gone away.

It is an argument which was explicitly addressed by Adair Turner.8 In essence, his case is that:

  • The modern financial system, with its reliance on fractional reserve banking, is inherently unstable.
  • Financial systems which combine traditional banking and credit securities markets are potentially very unstable.
  • Even if on some measures the scale of shadow banking has reduced, these factors mean there is always the danger of a repetition of pre-crisis instability, but in changed specific forms.
  • Macro-prudential tools – such as countercyclical capital buffers – are essential to counter this instability across the whole financial system, banks or non-banks.

The recognition that danger may return, but in a different specific form, is shared by the Institute of International Finance (IIF) “New types of financial intermediary potentially undertaking new forms of intermediation may arise at any time, particularly during periods of rapid regulatory change. This means that frameworks need to be sufficiently generic and flexible to allow new and emerging sources of risk to be taken into account.”9

Let’s start with some definitions. According to the Financial Stability Board, the shadow banking system is “the system of credit intermediation involving entities and activities outside the regular banking system.” 

Getting the balance right

The challenge is to provide the necessary protection against excessive risk without prohibiting an appropriate level of dynamism and creativity in financial institutions. This is a subtle and complex undertaking which is not helped when specific parts of the financial services sector are singled out for exemplary treatment. We recognize and accept the systemic risk argument, and few would argue against better macro-prudential oversight. The controversy is about micro-prudential regulation, such as regulation of individual firms for two main reasons: First, many of the activities are regulated in one way or another already and, second, if you accept these are decent businesses (and generally this should seem to be the case), then additional regulation could kill them. We need to work out now, rather than when it is too late, what the economic implications of the potential changes would be given the fragility of national economics.

When Michel Barnier, European Commissioner for Internal Market and Services, launched the EC’s green paper on the topic in March 2012, he spoke in French, saying the French equivalent of ‘shadow banking’ is le système bancaire parallèle. Perhaps we Anglo-Saxons might start by recognizing that we’re dealing with a parallel banking system. The key question, then, is to determine whether the policy response is to address the macro-prudential risks or both micro and macro issues. The results, the costs and wider economic implications will be very different depending on what the regulators choose.


1. Teton Reflections, Paul McCulley, PIMCO, September 2007

2. FSB, Shadow Banking: Scoping the Issues, 12 April 2011

3. EC, Reference: IP/12/253, 9 March 2012

4. FSB, Shadow Banking: Strengthening Oversight and Regulation, 27 October 2011

5. FSB, Ibid

6. Adair Turner, Shadow Banking and Financial Instability, Cass Business School, 14 March 2012

7. EC, Reference: IP/12/253, 9 March 2012

8. Ibid

9. Institute of International Finance, Macroprudential Oversight: an Industry Perspective, July 2011

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