With a tip of the hat to Simon Johnson, here’s a Harvard paper with a curious take on two hot topics of the financial future: macro-prudence and shadow banks.
Getting the first wrong might create (more) perverse incentives in the second.
Here’s the problem, according to Samuel Hanson, Anil Kashyap, and Jeremy Stein, the paper’s authors:
…while higher capital and liquidity requirements on banks will no doubt help to insulate the banks themselves from the consequences of large shocks, the danger is that, given the intensity of competition in financial services, they will also drive a larger share of intermediation into the shadow-banking realm.
For example, perhaps an increasing fraction of corporate and consumer loans will be securitized, and in their securitized form will end up being held by a variety of highly-leveraged investors (say hedge funds) who are not subject to the usual bank-oriented capital regulation. If so, the individual regulated banks may be left safer than they were before, but the overall system of credit creation may not.
Interesting argument, given that the regulatory state of play on capital and liquidity requirements is, well, rather liquid in any case, in light of revisions to Basel III.
This paper by contrast starts from a simple question — why we didn’t already have private macro-prudence, such as higher capital and lower leverage, before.
Basically — cheaper funding will always come first, the authors argue:
Unlike in many other industries, the most important (and in some cases, essentially the only) competitive advantage that banks bring to bear for many types of transactions is the ability to fund themselves cheaply. Thus if Bank A is forced to adopt a capital structure that raises its cost of funding relative to other intermediaries by only 20 basis points, it may lose most of its business.
And the authors do reckon, from a study of the expansion of US interstate banking from the 1950s to the 1990s, that banks with previously the highest equity capital would often cut ratios by the most when competition arrived.
Sure — but it’s not really clear how we would have gotten from there to the height of cheap funding in the shadow banking system in the early 2000s. Still, as they note by way of conclusion:
More stringent capital regulation would seem to hold the promise of reducing competition on a dimension that creates negative externalities and systemic risk, while at the same time not raising loan rates by much.
However, the complication is that these same competitive pressures also create powerful incentives to evade either the letter or the spirit of the rules. Thus the most worrisome long-run byproduct of higher capital requirements is likely to be not its impact on the cost of credit to borrowers, but the pressure it creates for activity to migrate outside of the regulated banking sector.
The paper’s answer to this is pretty direct — impose minimum regulatory haircuts on asset-backed securities lending, to contain the potential return of leverage to this bit of the market, and not least stop the margin spirals and fire sales of the crisis.
Well, great — but this only serves to underline the bank-focused nature of the macro-prudential schemes we’ve so far seen chucked around the debate.
And how little has been done to shed light on the shadows.
Related links:
Securitized Banking and the Run on Repo - NBER
Critical Transitions in Markets and Macroeconomic Systems – Macro Resilience