The inevitability of shadowy banking (and how to regulate for it) | FT Alphaville

The inevitability of shadowy banking (and how to regulate for it)

FT Alphaville decided earlier this week that we are sick of the term “shadow banking”. We’ve failed to come up with an alternative, however, and in the meantime Edward Kane, a professor at Boston College, has presented a paper entitled “The inevitability of shadowy banking” at the Atlanta Fed-hosted financial markets conference.

Kane’s paper says shadowy banking is basically safety-net arbitrage. He defines it thus:

It covers any financial organization, product, or transaction strategy that –now or in the future– can opaquely (i.e., nontransparently) extract subsidized guarantees from national and cross-country safety net by means of “regulation-induced innovation.”  This way of thinking about the safety net clarifies that taxpayers serve as its buttresses.  It also implies that the shadowy sector is a moving target. It consists of whatever entities can issue a worrisomely large volume of financial instruments that, given the boundaries of current laws or control procedures, are either actually or potentially outside the firm grip of the several agencies currently charged with monitoring and managing the financial safety net.

Kane’s paper is quite a good (and provocative) read, even for the non-financial-type, partly because it’s free of formulae and instead makes wide use of humanities: sociology, philosophy, politics and, er, parenting (don’t worry, Kane apparently is an economist). He also provides a short history of recent notorious examples of regulatory failure, and regulatory arbitrage gone catastrophically wrong.

Starting with the sociology, however. Kane takes the Hegelian dialectic approach of thesis-antithesis-synthesis. Which Kane also describes as:

Conflict generation -> Conflict resolution -> Conflict renewal.

Or, Regulation -> Regulatory avoidance -> Regulatory Change.

And then, when the new regulatory regime is in place: start all over again…

The paper then moves to a comparison of financial regulation and early childhood — because this is when our first experience with “regulation” usually occurs. Don’t worry, it’s not getting psychoanalytical, yet.

The long-run goal is to develop a well-behaved child who takes pride in living up to the set of parental rules, which is to say a child who has developed a keen sense of shame.  When conformance with parental rules becomes a child’s own preferred course of behavior (and ideally a source of self-esteem), enforcement problems melt away.  But most parents show a rescue reflex of their own, so that conditioning efforts at least partially backfire.  Children who recognize this reflex and refuse to be bound by parental rules may pursue either of two paths: defiant disobedience or creative avoidance.

It’s the tactic of avoidance, rather than outright disobedience, that Kane prosecutes in this early-childhood/shadowy banking analogy. And this is the part where childhood behaviour sounds very much like accounting regulation:

Avoidance differs from outright evasion by respecting the words of a command, even as the intent of the command is at least partially frustrated.  The avoider has a lawyerlike or playful perspective on rules that differs from the criminal mindset of the nonupright, undisciplinable child.  An evader is unruly.  An avoider is a resourceful escape artist who welcomes the challenge of shaking free from externally imposed restraints.

No one really wants to block every loophole, mainly because it is incredibly time-consuming (and we’d argue, close to impossible). The difference is that parents can punish ‘avoidance’ ex-post, whereas policymakers… can be voted out of office.

Kane points out that regulatory personnel are also part of this conflict: he maintains that both the industry and those trying to introduce the numerous rules enforcing the Dodd-Frank Act are well aware that regulatory personnel don’t want to to impose very burdensome rules.

In the presence of a safety net, bank managers face a threefold incentive: to lobby for lenient standards, to hide and understate risk exposures, and to overstate accounting net worth. This set of incentives makes risk and stockholder-contributed net worth hard to measure accurately and reliable standards by which to judge improvements in incentive alignment difficult to set and enforce.   Undone by the Regulatory Dialectic.  Because regulators have relatively short terms in office, they are attracted to temporary, rather than lasting fixes.  The costs and benefits of capital requirements extend far into the future and are by no means fixed or exogenous.  Regulatees search tirelessly for ways to reduce the burdens of regulation.  Value maximization leads bankers to devise progressively lower-cost ways to exercise political clout, to adjust and misreport their asset and funding structures, and to choose the jurisdictions in which they book particular pieces of business. This kind of financial engineering resembles what happens on a “makeover” television show.  Top managers deploy the equivalents of fashionistas, cosmeticians, and hairdressers to revamp their firm’s external appearance without changing the underlying character of the risk exposures that they expect taxpayers to support.

Keep reading. The part where he gets to “Why does shadowy banking endure?”

Part of the reason is that it serves a useful purpose. Only it’s not quite as useful as its proponents would have us think:

The longer I live the better I understand Friedrich Nietzsche’s assertion that “There are no facts, only interpretations.”  Almost all forms of shadowy banking offer some benefits to society.  This is because at the same time that financiers use emerging technologies to extract safety-net subsidies, they create new, better, or cheaper services for their customers.  This favorable dimension of innovation is routinely overstressed in the narratives that sponsors of shadowy instruments offer the public to justify their existence. See, for example, the pleas to spare money-market funds (MMFs) from further restrictions that former Comptroller Hawke (e.g., 2012a and b) has published on the American Banker’s Bank Think website this year.  Hawke takes issue with the idea that MMFs deserve to be called shadow banks because they are in fact supervised by the SEC.  He denies that MMFs face an “appreciable threat of future runs” (assuming away the danger of concentration risk) and frames his presentation to suggest that the temporary liquidity facilities put in place in September 2008 did not cost a “single penny of public money.”

(Here’s that John Hawke defense of MMFs, by the way.)

From there on we have a good look at moral hazard and the shortcomings of the various Basels — I and II were overly restrictive in their prescriptions for bank capital, while at the same time allowing numerous loopholes on both country-level implementation and on accounting treatment of risk weightings.

The current wave of Reregulation is much weaker than it looks.  Incentive conflict remains the central problem.  To reduce incentive conflict, society must explore ways to identify shadowy arrangements promptly and to regulate their access to the safety net more effectively (cf. Schwarcz, 2012). To my mind, this requires society to find ways to impose and enforce stronger and clearer moral duties on unwilling financiers, politicians, regulators, and creditrating firms (Kane, 2010a and b).

Kane’s argument is that the size of the taxpayer put can be measured. Furthermore, a regulator that is empowered to measure and communicate the size of the put to taxpayers themselves might be able to overcome these obstacles:

I believe society would be better off if it were the newly formed Office of Financial Research (OFR) rather than the Federal Reserve that enjoyed statutory independence. To be free to measure and report on systemic risk, the OFR desperately needs the freedom to resist shortterm political interference.  To begin to reclaim an effective role in the political system, taxpayers need to receive regular and unbiased estimates of their side of the taxpayer put. Precisely because the benefits of shadowy arrangements are overpraised by their proponents, unconventional substitute instruments ought to be routinely screened for tail risk and safety-net consequences by the OFR.  The OFR ought to be notified to undertake this analysis by any market maker as soon as its own volume of trading in any over-the-counter derivative contract surpasses a specified size threshold.  With the help of trade associations for traditional types of financial institutions, the OFR ought also to be on the lookout for fast-growing financial firms, especially those that adopt unconventional funding structures.

There’s a bit on the method developed by Kane, along with Santiago Carbo-Valverde and Francisco Rodriguez-Fernandez, here in a paper they authored about EU taxpayer exposure to losses from partner countries. The trio have two papers forthcoming that expand on this idea.

Related link:
Shadow banking out of the shadows – FT