FT Alphaville suggested on Wednesday that Dodd-Frank is likely to be a bigger boon to the shadow banking system than — as others have suggested — to European banks.
We’re still getting our heads around the right approach toward shadow banking (and how best to define it) but a couple of insights from recent speeches on the topic caught our attention and may be of interest.
First, from a speech Tuesday by Sandra C. Krieger, head of the Credit and Payments Risk Group at the New York Fed.
The speech is a good introduction to the subject of shadow bank regulation. (To be combined with the FT’s recent survey.) As these charts from the corresponding slide deck remind us, the sector grew rapidly before the crisis and then relied on official sector support when ABCP and other markets collapsed:
Why the rapid rise and continuing popularity?
Starting from first principles, Krieger focuses on a basic function of finance, which banks and some non-banks both perform: “the transformation of long-term risky assets into very short-term liabilities.” This is risky, of course, because sudden requests for full withdrawals cannot be met. See: exhibit 03-2008, Bear Stearns.
She then points out that the nonbank system of financial intermediation is able to thrive because it has some form of liquidity and credit support from the official sector. In other words, in violation of its defining characteristic.
And the more it relies on the banks, the more systemic risk it tends to carry. Thus, to reduce fragility in the sector one can either act indirectly (via Basel III type provisions on the official sector) or directly, via the shadow institutions themselves.
While recognising there are no magic bullets here, Krieger says more needs to be done directly and there are three items left on the regulatory to-do list:
First, we must ensure that short-term liquidity is provided in a risk-sensitive fashion.
Second, we must ensure that maturity transformation and the puts, largely provided by the traditional banking system, are understood and priced properly—so that shadow investors bear the full ex ante economic costs; banks must be required to hold adequate capital and liquidity against these puts and ultimately pass the costs along the intermediary chain.
And third, we must consider private resolution mechanisms for runs on shadow institutions.
Going further than Krieger, and introducing the second insight that caught our eye, Adair Turner in speeches to the IMF on Monday and at Cambridge University in February, cites new research that claims the rise of shadow banking (and the growth of complex credit products) has a deeper origin:
An investor demand for very low-risk debt instruments, which exceeded the quantity of truly low-risk instruments which could objectively exist.
The financial system can divide, repackage, and distribute those risks, but only to a limited extent can it reduce them. But the complexity of a large financial system, combined with ‘local thinking’ of the sort which Shleifer et al have described, can result in assessments of risks which are, in aggregate, impossible given the objective reality of the non-financial real economy.
It means that many credit securities ‘owe their very existence to neglected risk’, and thus that the total amount of credit extended to the real economy could be larger than optimal. It implies that ‘it is not just leverage but the scale of new claims itself, which might require regulatory attention’, and that ‘recent policy proposals, while desirable in terms of their intent to limit leverage and fire sales, do not go far enough’.
To go further, Turner tentatively suggests, regulators need to be more specific in how they address institutions within shadow banking itself:
In particular we may need to regulate the level of collateral haircuts/margins in the repo and other secured finance markets. Which is to say, to regulate leverage at the contract specific level within the market, rather than at the institutional bank level.7 The central question again being how much equity and how much leverage, but now within markets rather than within specific institutions.
And we will need to monitor closely overall developments in credit volumes and credit product innovations whether or not financed directly by banks.
For more on the underlying research by Andrei Schleifer et al — see this post from Felix Salmon looking at an earlier version of the paper cited by Turner. We’re not experts here so please do point out other research that supports or contradicts Turner’s line of reasoning. But if the underlying math supports the intuitively appealing theory, this could have profound impacts on future approaches to regulation.
It’s of course important to remember that the formal banking sector remains more important overall — and according to an article from AV alum Sam Jones on Wednesday, more leveraged, too.
But assuming that post-crisis regulation has increased motivation for shadow banking, a bit more attention is a good thing.
Related link:
Shadow boxes – FT
The where and what of regulatory arbitrage – FT Alphaville