Sizing up shadow banking
There needs to be universal agreement on what is shadow banking to tackle its regulation.
The Financial Stability Board (FSB) has defined shadow banking as the system of credit intermediation that involves entities and activities outside the regular banking system.
This suitably vague definition takes in firms that accept deposits, undertake maturity of liquidity transformation, transfer credit risk or use direct or indirect leverage. Shadow banking also encompasses how such non-bank enterprises fund themselves: securitization, securities lending and repo – the demon trifecta of the financial system since 2007.
This is a pretty broad sweep of financing activity, and while many commentators have rushed to warn of the dangers that the shadow banking system represents, the industry has trouble in agreeing on the size of the problem.
In July 2010, a study by the New York Fed said the US had a $20 trillion shadow banking sector, and threw in an extra $5 trillion to reflect the role of collateral. Estimates for the European shadow banking system varied from $13 trillion to $22 trillion.
The FSB has stated that the assets under management of institutions that could potentially participate in shadow banking activities worldwide is $60 trillion.
It is, however, puzzling that the estimates are still so large, given the contraction in many shadow banking activities since 2008. Before the credit crisis, the focus of shadow banking was on maturity transforming vehicles, such as asset-backed commercial paper conduits, and structured investment vehicles – highly leveraged and undercapitalized enterprises that blew up immediately their short-term funding froze. These enterprises no longer exist.
Although securitized credit was equal to 50% of US GDP by 2008, it has since slumped by 90% peak to trough in the US and 95% in Europe. The repo market in the US has halved to $2.7 billion.
Financial research firm Finadium released a report last month claiming that a more granular analysis of shadow banking enterprises reduces their AUM to $33 trillion worldwide; and an analysis of the products involved further lowers the size of the sector to $17 trillion.
One reason for this disparity is the treatment of the $6 trillion global money market industry. The regulators have lumped in these funds with the shadow banking sector due to their deposit-like characteristics and their vulnerability to massive redemptions – as witnessed when the Reserve Primary Fund broke the buck shortly after Lehman’s collapse in 2008.
In the US, the Securities and Exchange Commission recently put forward proposals to require the funds to set aside more capital and to limit immediate investor redemptions to 95%, with the remainder held back for 30 days. The proposals have been met with a furious reaction from the market.
The regulators have also deemed the fast-growing exchange-traded fund sector to be shadow banking.
Not surprisingly, many active in those two sectors vehemently disagree.
The Finadium research points out that money market funds are not shadow banks themselves; rather, they are purchasers of credit products that provide risk diversification for investors. It claims that the funds are actually a bundler of diversified short-term credit risk on behalf of investors. As such they are asset managers. To categorize their products as shadow banking is similar to saying that an equity mutual fund is responsible for the behaviour of the companies that it invests in.
How money market funds are treated is of great importance not least because of their size. As of March, $2.65 trillion were in US regulated 2a-7 funds, an additional estimated $1.5 trillion were held by regulated European funds and $800 billion by other regulated funds worldwide
There is no doubt that many activities deemed to be shadow banking pose a threat to the stability of the financial system: the procyclical threat of secured lending practices and mark-to-market accounting, the existence of long and complex intermediation chains and links between funding and market liquidity.
Regulatory proposals such as moving securities loans to a central counterparty, requiring banks to retain skin in the game for securitized deals, mandating minimum haircuts for repo transactions and creating a trade repository for shadow banking activities have all been designed to address that threat.
However, by adopting a definition of shadow banking so broad as to include anything from money market funds to ETFs to securitization, the regulation runs the risk of taking too sweeping an approach and not addressing – or even missing – the most pressing issues in each sector individually.
On March 19, the European Commission released its green paper on shadow banking, seeking feedback on how regulation of the sector should be tackled. A more bespoke approach is likely to be one of the recommendations.