Shining a light on shadow banking

Conventional banking is safer than a decade ago but risk from the non-banking sector could spread to the rest of the global financial system

By Richard Portes 17 January 2019

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More than 10 years since the financial crisis, how safe is the world’s financial system?

On one hand, we can agree that conventional banks are more regulated, better capitalised and less leveraged than they were a decade ago. Are they regulated enough? That’s debatable. But at least there are constraints, and the banks’ activities are closely monitored. We have a pretty good idea of what they are up to.

On the other hand, the same can’t be said of what’s come to be known as ‘shadow banking’. The very term sounds mildly sinister, suggesting something hidden from plain sight. It hints at a threat. Some people may object that this is an exaggeration. I disagree. If it sounds dangerous, that’s no bad thing: in some cases, I believe it genuinely is.

For here we have a whole range of institutions – from hedge funds, asset managers and pension funds to insurers, money market funds, real estate funds and many others – doing exactly what conventional banks routinely do: take money from one party and lend it to another. To use the formal, if inelegant, term, they are in the business of financial intermediation, doing what banks have done for centuries.

Yet many of these activities remain in the shadows, not subject to the scrutiny and prudential regulation imposed on banks. At the same time, they raise all the issues associated with any relatively lightly regulated financial intermediation. 

In most jurisdictions, there are few, if any, limits on leverage, allowing shadow institutions to borrow as heavily as they like without regulatory constraint. 

There is also the issue of ‘maturity transformation’ – taking money that is invested short term to put into assets whose value will mature only in the long term. This issue has a close cousin, ‘liquidity transformation’, whereby money from short-term depositors is turned into illiquid assets, preventing them from cashing out when they need to.

These issues have posed real problems in the past. For example, in the wake of the UK Brexit vote, investors feared that commercial real estate prices would tumble, causing open-ended real estate funds (where investors can ask for their money back from the fund at any time) to place a temporary ban on repayments. 

It takes time to sell an office block. Shadow banks undertaking maturity and liquidity transformation run the same risk that brought Northern Rock to its knees: fatally, Northern Rock relied on short-term deposits from savers and borrowings on the wholesale money markets to lend to house-buyers who wouldn’t repay their mortgages for years.

"Increased banking regulation has prompted activity to migrate to the less regulated non-banking sector"

Normal commercial risk, you might say – except that it is hard to see from available data exactly what shadow banking entities (money market funds, hedge funds, private equity, exchange- traded funds, special purpose vehicles and so forth) are up to, what sort of sums they are playing with, and what their interconnections with the rest of the financial system, including the conventional banks, are.

Should we worry? Yes, we should. In the US, the shadow banking sector is roughly the same size as the formal banking sector, although it has contracted over the past decade. The picture is different in the European Union, where the banking sector is larger relative to the economy as a whole than in the US. Here, the shadow sector now accounts for perhaps 30–40% of total financial intermediation.

But it is growing. Between 2012 and 2016, shadow banking as broadly measured expanded by almost 40% in the eurozone. The reasons are quite easy to divine. Banks have been forced to reduce their leverage and new lending has been low. And with the banks contracting, in what looks like a classic case of regulatory arbitrage, the increased intensity of banking regulation has prompted activity to migrate to the more lightly regulated non-banking sector.

How much does any of this matter? Institutions involved in shadow banking do not operate in isolation. They have a myriad of linkages to the rest of the global financial system. And some of the organisations are colossal: asset management group Blackrock, for example, handles investments worth US$4 trillion (£3.06 trillion) – not a trivial sum. If it faced a run by investors, it would have to liquidate some very large positions, with substantial knock-on effects for markets and a high risk of contagion.

Look, too, at pension funds, some of which are now in the business of making direct loans. In other words, they are acting as banks – but lacking both the regulatory oversight to which banks are subject and their experience in loan and risk evaluation.

Banks themselves are vulnerable.

About 60% of European banks’ exposure to shadow banking is to institutions outside the EU and therefore completely outside the EU’s regulatory framework. That’s risky – or, to be more accurate, it’s doubly risky, since we can’t be sure just how risky it is.

In short, much of shadow banking justifies its name. It would benefit from greater illumination – as would we all.

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