In Mary Shelley’s Frankenstein, the eponymous doctor repents mournfully over the monster he has created. He warns: "You seek for knowledge and wisdom, as I once did; and I ardently hope that the gratification of your wishes may not be a serpent to sting you, as mine has been." These words seem to be echoing in the ears of financial regulators.
Since the apex of the financial crisis in 2008, there has been a headlong dash to slap new controls on banks. The strictures of Basle III, Dodd-Frank and the European Banking Authority have accelerated the process of deleveraging and forced banks to sell assets and raise capital. The net effect, according to the Financial Stability Board, is that global bank assets have steadily declined. By some estimates they are set to fall by a further $3.25 trillion in the next couple of years.
However, shadow banking – defined as "credit intermediation involving entities and activities outside the regular banking system" by the FSB – is back to its 2007 peak of $60 trillion in assets. This constitutes about a quarter of the entire global financial system. This unintended consequence is causing regulators to fret that they have spawned a monster.
Michel Barnier, the European Union’s commissioner for the internal market, told an audience at the Guildhall in London last month: "We don’t want Basle III to drive banking and other financial activities into shadow banks, or unregulated entities that lend funds like banks." Mark Carney, the chairman of the FSB and governor of the Bank of Canada, has given a similarly forceful message to the Financial Times.
Much of the ire of regulators has rightly been directed at products originated by banks, such as ABCP conduits, the main purpose of which are regulatory arbitrage and hidden leverage. Given that the ultimate goal of regulation is to shrink the size of banks and their systemic threat, this sort of business was always going to be under existential threat.
Money market funds and the operation of the securities lending and repo markets are other parts of shadow banking that merit careful scrutiny. In the former case, an activity that looks like deposit taking (and sells itself as such) can be subject to runs with knock-on effects for the broader financial system. Similarly, because of the interconnectedness of the institutions involved, disruption in securities lending, repo and collateral markets can have systemic consequences.
What is less clear is whether or not the process of credit intermediation – non-banks providing financing to other corporate entities – requires additional regulatory oversight.
The retreat of the banks from corporate lending has two related dynamics.
First, large companies have been accessing investors via the capital markets directly. In 2009 bond issuance exceeded loan origination for the first time; at the start of the crisis in 2007, the loan market was 4.5 times larger. Even in loan-dependent Europe, the share of the bond market in financing companies increased from 20% in 2007 to 33% last year, according to Oliver Wyman. In the US, 80% of corporate borrowing is non-bank debt.
Secondly, investment managers are an increasing source of finance. Hedge funds have been important providers of liquidity in the secondary market as banks have shrunk their loan books. Private equity firms have long been providers of bridging finance. There are also well-established standalone specialists operating in the senior loan and mezzanine finance markets, such as BNY-Mellon Alcentra ($17 billion in assets under management) and ICG ($15.6 billion).
More fund managers are getting involved. M&G Investments, best known as a retail manager, set up the $2.5 billion UK Companies Financing Fund in 2009 to provide loans to SMEs. BlueBay Asset Management, the $44 billion in assets fixed-income specialist, established a private lending business last October. Other firms, including Babson Capital Management, are reportedly preparing funds.
Supervisory authorities should welcome these new entrants. They are subject to the full panoply of regulation. Fund structures mean that shareholder capital is at risk. If the loans go sour, they will bear the loss. The financial system, depositors, the coffers of governments and the pockets of taxpayers are not put in danger. Funds are also inherently long-term forms of capital. They are not reliant on short-term financing markets in a way too many banks have been.
One of the most important lessons of the financial crisis is that homogeneity is dangerous. When the US sub-prime market turned it was clear that many banks were running similar businesses, holding related assets and using the same risk-management models and assumptions. The whole system became distressed at once and funding markets closed.
Regulators should welcome diversity. Many of the goals of the FSB, particularly the emphasis on greater transparency, are sensible. But when considering its macro-prudential role of regulating the system, it should look at the statistics buried in its own report. The economy with the biggest shadow-banking sector is the US, where other financial intermediary assets make up 54% of the total. This compares with an average of 3.5% in the four biggest eurozone economies.
Is it a coincidence that the US is recovering faster than they are?
|Andrew Capon has won multiple awards for commentary and journalism on markets, investment and asset management. He welcomes comments from readers and can be reached at email@example.com.