Inside investment: Shadow play is dangerous
Banking supervisors and other regulators are determined to bring so-called shadow banking within their purview.
An unoccupied and unfinished Irish housing estate after the global recession
Shadow puppetry is said to have originated in China during the reign of Emperor Wu, who ruled from 156 BC. Shadow banking is rather more à la mode. The first reference in the Financial Times appears to date from September 2007, when erstwhile Pimco managing director Paul McCulley said the incipient credit crunch represented, “a run on the shadow banking system”.
Many listeners (and this was a very informed audience, at the Jackson Hole seminar – the central bankers’ Glastonbury) will have scratched their heads. No more. A quick look at the Factiva database of news sources over the last year reveals 4,643 headlines and shadow banking even made a brief appearance in the second debate between would-be Democrat presidential nominees.
Shadow banking is no longer in the shadows. But what is it? The “run” McCulley was commenting on largely related to money market funds, structured investment vehicles, conduits, hedge funds and other entities that provide bank-like services. At this point, banking supervisors would add: “with bank-lite regulation”. This has almost become a mantra in regulatory circles, but in reality it is a misapprehension.
SIVs and conduits, often backed by asset-backed securitiehttp://www.euromoney.com/Article/3495778/Securities-under-the-microscope.htmls, were typically off balance-sheet vehicles operated by banks. Asset managers operate money market funds and are regulated. Hedge funds have traditionally been less subject to supervisory scrutiny. But alternatives are now becoming mainstream. Hedgies running funds in Ucits or US mutual fund formats are subject to the same regulation as any other fund manager.
The light regulation of shadow banks is largely a myth. So is the lazy assumption that they do harm. SIVs, conduits and structured finance, such as ABS and collateralized debt obligations, were pariahs in the crisis. All SIVs were either restructured, unwound or defaulted.
It is arguable that much of the intermediation in markets by non-banks is far from shadowy – it is becoming essential. One good example is lending to real estate projects, both commercial and residential. The capacity of banks to lend has been curtailed by stringent new capital requirements and the whole panoply of regulation around risk-weighted assets.
Fellow Inside Investment columnist Lincoln Rathnam recently sent me a stark example. The Irish real estate market has largely recovered from the financial crisis. Once bankrupt developers have seen their animal spirits revive as empty office buildings in Dublin and the “ghost estates” scattered around the suburbs of many cities have been filled. Ireland needs 30,000 new homes a year to meet demand. That implies an investment of €6 billion annually.
In 2015 Irish banks will lend developers €424 million. The domestic banking industry is meeting a meagre 8% of demand. Real estate is an asset class that offers long maturity inflation-adjusted yields. These characteristics meet the profile of what many pension funds are demanding.
The same is true of infrastructure projects. After a few false dawns it seems that progress is finally being made. The UK Pensions infrastructure Platform (PiP) has raised £1 billion of its £2 billion target. And, in his last budget, George Osborne announced plans to turn 89 local-authority pension funds into six “British Wealth Funds” with assets of around £25 billion each. The intention is that these large schemes will have the clout and expertise to invest in infrastructure.
Only the most anxious regulator could regard these developments as anything but good news. The biggest threat to financial stability is not how banks are regulated; it is economies getting stuck in recession and deflation. If the intention of regulators has been that banks become more like utilities they have achieved their goal. That is certainly how they trade.
Before the crisis a double-digit return on equity was the norm. For the more aggressive banks ROE between 20% and 30% was not unusual. The current ROE of Goldman Sachs is 8%. High ROEs were driven by the denominator (shareholder equity) which was far too low. The new Basel rules have dealt with that.
But there remains unfinished business. Leverage levels could still pose a systemic risk. According to the accounting standards of the time, Bear Stearns was 42 times leveraged and Lehman Brothers 30 times. The new Basel III leverage ratio adds off-balance sheet exposures that would have added to the leverage of institutions at the epicentre of the financial crisis.
At 3% the leverage ratio prevents banks from accumulating assets of more than 33 times their capital level – still a jaw-dropping amount compared with what is now available to hedge funds. To put it into context, an erosion of capital of 2% would leave a bank 100 times leveraged.
Would bondholders hang around? Or would they dump their holdings at the first whiff of trouble precipitating a death spiral? In the new regime bondholders are supposed to take the hit, but a crisis is rarely visited on one bank at a time. How confident are supervisors that they have the right measures in place to avoid further government-backed bailouts?
Compare and contrast this systemic threat with a fund backed by 100% equity capital.
If this fund is investing in areas once the preserve of banks – loans to SMEs, real estate development, infrastructure – it is likely to earn the pejorative label ‘shadow bank’. That seems like a paradox when these supposedly shadowy entities are lessening the fragility of the financial system and helping the real economy.
Andrew Capon has won multiple awards for commentary and journalism on markets, investment and asset management. The views expressed are the author’s own.