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IIF: "Regulate risk, not shadow banking"

The IIF offers a robust defence of shadow banking while demanding a more nuanced approach to systemic risks.

There’s a lot to take away from the IIF’s recent report on regulation of shadow banking. This is partisan stuff indeed, but there are plenty of interesting observations. At its core, the IIF posits that any attempt to try and regulate shadow banking by focusing on defined shadow banking institutions is misguided and unlikely to succeed – indeed even setting out a list of actions that form a definitive list of shadow banking activities would be difficult. Rather than trying to create such pigeonholes and ring-fencing of activities, the IIF thinks that regulators should take a more nuanced approach to risk rather than tainting non-bank intermediaries with the same brush.

“In particular, while the terms “shadow banking” or “non-bank credit intermediation” can be broadly described, this description is likely to be of limited value, and using it to develop practical policy is extremely challenging. Indeed, starting with the term and then attempting to come up with a definitive list of “shadow banking” activities or entities conducting these activities, or to come up with a single figure for the size of “shadow banking” is unworkable, unnecessary, and risks being a diversion from the real focus of policy, which should be the mitigation of systemic risk.”

Put simply:

“The policy should focus primarily on activities rather than the entities that conduct them,”

In short, not everything a shadow banking institution does is systemically risky while instituting regulations specifically for “shadow banks” runs the risk of incentivizing these institutions to alter their structure, while continuing with systemically risky activities.

The IIF is also keen to emphasize that shadow banking can serve a variety of useful functions, including:

Efficiency, innovation, and specialization. An extensive study by the New York Federal Reserve argued that “there were also many examples of shadow banks that existed due to gains from specialization and comparative advantage over traditional banks...This can have additional benefits such as aiding financial inclusion.

Diversification and mitigation of risk. These activities can enable investors to diversify and mitigate their risks, as their deposits are not concentrated on a single bank balance sheet but are spread over a number of investments.

Greater flexibility and investment opportunities. These activities can give investors greater flexibility over the duration and risk profile of their investments and also broaden their investment opportunities, making available assets such as corporate treasury financing and mortgage loans, which might otherwise not be available.

Increased liquidity and funding. For borrowers and market participants, such activities can lead to a greater diversity and supply of funding and liquidity in the market. This option allows firms to reduce reliance on traditional sources of funding, sometimes at lower cost.

The three most obvious examples are money market funds, securitization and securities lending. Since these practices have received serious knocks to their respective reputations, the IIF offers a robust defence: If systemic risk can be mitigated then money market funds offer a relatively safe non-bank financing outlet for investment on a short-term and relatively liquid basis. Securitization can allow banks to offer low cost funding to the real economy, and securities lending can support trading and investment strategies. Too much regulation could inhibit these valuable functions, the IIF fears. 

While some past reforms have been rushed and ill-considered, the IIF suggests that they could be more effective if they:

“were based on a more thorough analysis of the risks; were consistent and connected with each other as part of a system-wide macroprudential appraisal of the risks; and were more internationally consistent and coordinated.”

A one-size-fits-all approach simply can’t work when dealing with a concept as inherently nebulous as shadow banking.

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