Finance

Shedding Light on Shadow Banking


Carney chairs the FSB, which has a five-point plan to reform shadow banking

Photo illustration by 731; Photographs by Tomohiro Ohsumi/Bloomberg (Carney); Grove Pashley/Stockbyte/Getty Images (brick wall)

Carney chairs the FSB, which has a five-point plan to reform shadow banking

(An earlier version of this story ran online.)

The last time people paid attention to shadow banking was when it was ripping the world apart. The 2008-09 global financial crisis, the worst since the Great Depression, was precipitated by a “bank run” that hit nonbank financial firms such as the Reserve Primary Fund money-market fund and American International Group (AIG), then the world’s largest insurer. Creditors accumulated chits that were unpayable by debtors, and the lack of government deposit insurance meant there was nothing to stop the creditors from panicking when the chits hit the fan.

What’s surprising is that four years after the crisis, shadow banking remains a huge force. According to a Nov. 18 report (PDF) by an international body of regulators, the Financial Stability Board, worldwide assets in shadow banking, ranging from money-market mutual funds to banks’ off-balance-sheet vehicles to credit derivatives, totaled $67 trillion last year. That’s higher than $62 trillion in 2007, the year before the crash. The U.S. accounts for 35 percent of that. The field has shrunk a bit as a share of the surveyed countries’ economies, to 111 percent from a peak of 128 percent, while remaining about half the size of the conventional banking sector, the board says.

Shadow banking covers any kind of lending that’s not done by banks that take insured deposits. Shadow banking, which remains lightly regulated, matches savers with borrowers in ways that conventional banks can’t. For example, money-market funds allow people and companies to stash excess cash that’s put to work financing auto loans, credit-card borrowings, and so on. Similarly, repurchase agreements (repos)—a form of secured lending—are a cheap way for pension funds and the like to raise money. “Where nonbank financial entities have specialized expertise in assessing risks, they may provide these functions in a cost-efficient manner and provide competition, innovation, and lower borrowing costs,” the Financial Stability Board wrote. Like banks, they fail when they can’t pay off their creditors in a crisis because their funds are tied up in long-term assets.

In the U.S., the mutual fund industry managed to stave off a Securities and Exchange Commission plan to change how money-market funds value their shares. “We’re already seeing a contest of wills” over attempts to tighten regulation, says Erik Gerding, a law professor at the University of Colorado at Boulder.

The Financial Stability Board comes down in favor of more transparency and tighter regulation to get the good parts of shadow banking without the bad. Chaired by Bank of Canada Governor Mark Carney, the board consists of regulators from more than 20 countries and organizations such as the International Monetary Fund. While it can only recommend rules for countries to follow, by staking out positions that challenge the financial sector “it provides some political and legal cover for regulators within the United States and other countries,” Gerding says.

In a five-point plan released on Nov. 18, the board sided with critics of the money-market funds who say that locking in their price at $1 a share makes them vulnerable to runs if there’s a decline in the value of the underlying assets. It softens that stand, though, by saying the funds should allow their price per share to float only “where workable,” a phrase that leaves room for funds to keep things as they are. The board also pulled its punches on repo lending. One reason for the explosive growth of repo and securities lending is that such loans get preferential treatment in bankruptcy court. Changes in that treatment “may be viable theoretical options,” but “they will not be pursued for now due to practical difficulties,” the board said. It’s seeking comment on the proposed rules and hopes to finalize them by September 2013.

Lena Komileva, chief economist at London-based G+ Economics, an investment advisory firm, describes the balancing act that regulators face. “Bringing shadow banking out of the shadows recognizes the systemic importance of nonbank finance for the health of the global economy,” Komileva wrote in an e-mail. “But regulators need to apply a surgical scalpel, not an ax.”

Yale University economist Gary Gorton, who’s known for spotting the nonbank bank run of 2008, says regulators need a better understanding of the industry so they can prevent a recurrence. Asks Gorton in an e-mail, “Where and what are the conceptual and measurement improvements that can prevent that from happening again?”

The bottom line: Regulators are seeking ways to control the $67 trillion shadow banking industry without limiting its usefulness.

Coy_190
Coy is Bloomberg Businessweek's economics editor. His Twitter handle is @petercoy.

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