Shadow Banking and Financial Instability

In a speech to the CASS Business School the Chairman of the Financial Services Authority (FSA), Lord Adair Turner, set out how the ‘shadow banking’ sector contributed to the financial crisis, the risks it still poses to financial stability and the importance of a sufficiently comprehensive and radical policy response.

Present speech has comprehensively covered various dimensions of Shadow Banking and contribution towards global financial instability, gist of present speech as follows:

In autumn 2008 the developed world’s banking system suffered a severe crisis. In response the world’s regulators and central banks have focused on building a more stable banking system for the future: less leveraged, more liquid, better supervised and with even the largest banks able to be resolved without taxpayer’s support. The implementation of that bank-focused regulatory agenda is still unfinished, but much progress has been made and Shadow Banking one of the strong reform components for Regulator.

While determining Shadow Banking, Lord Turner described there are three main conclusions:

• First, that we need to understand shadow banking not as something parallel to and separate from the core banking system, but deeply intertwined with it.
• Second, that the way in which shadow banking contributed to financial instability reflected fundamental developments in our financial system which are as relevant to banks as to shadow banks, which remain important today, and which could produce new problems in the future.
• Third, that as a result we should not take the decline in some specific indicators of shadow activity which has occurred since 2008 as suggesting that the risks have gone away.

The Financial Stability Board (FSB) has defined shadow banking as entailing ‘credit intermediation which occurs outside or partially outside the banking system, but which involves leverage and maturity transformation’.

The financial system intermediates flows of finance between non-financial providers of funds (typically households and corporates) and users of funds (typically households, corporates and governments). These flows can be in debt form (loans, bonds or other credit securities) or in equity form, or in various hybrids of the two.

‘Shadow banking’ occurs when we have credit flows outside or partially outside the banking system which do involve these distinctive features. This is the case when, for instance, a money market mutual fund lends money to an asset backed commercial paper SIV, which buys the tranched debt issued by a special purpose vehicle – a chain of intermediation which is functionally equivalent to banking, and which introduces both leverage and maturity transformation, but in multiple steps, rather than within one bank balance sheet.

Why did these developments occur? Lord Turner stated that in US Shadow banking is result of residential mortgage market which combined a commitment to provide 30-year fixed rate but repayable mortgages and the peculiar part-public/ part-private role of the government sponsored enterprises – Fannie Mae and Freddie Mac, existence until the mid-1980s of Reg Q limitations on bank deposit interest rates and the development of US financial regulation, which combined a dismantling of the Glass-Steagall separation between commercial and investment banking with a continued light touch regulation of the investment bank broker-dealers, a combination which enabled them to grow leverage far faster than the commercial banks.

However, in Europe seeds of Shadow banking is still different from US market. In Europe shadow banking is result of limited growth of residential mortgage securitisation – most European mortgages continuing even at the pre-crisis peak to be held on balance sheet, limited and somewhat different role for money market mutual funds and a much greater role of bank balance sheets in European credit intermediation.

And it is indeed important to be clear that much of the financial crisis in Europe did not involve shadow banking activities such as securitised lending, but plain old-fashioned on-balance sheet lending. Unlike in the US, losses on securitised mortgage lending in Europe have been relatively minor, with a bigger hit to bank balance sheets arising from commercial real estate loans – in particular in the UK, Ireland and Spain – primarily lent in the traditional fashion by traditional banks.

what we label ‘shadow banking’ suggests five interrelated factors which make the modern financial system inherently unstable:

• The interaction of secured lending practices and mark-to-market accounting, which exacerbates the risk of procyclicality and the volatility of credit creation.
• The creation of long, complex intermediation chains, which can increase the dangers of funding runs, and which make it difficult for authorities to see the development of excessive maturity transformation.
• The important links between funding liquidity and market liquidity, which can increase contagion risk across apparently separate markets.
• Increasing demands for ‘liquidity’ in asset holdings, and thus for cross-system maturity transformation, arising in part from practices and incentives within the asset management industry.
• And the danger that increasingly self-referential approaches to credit pricing, combined with inherently myopic and unstable assessment of tail risks can further increase procyclicality and instability.

In conclusion, Some of the specific measures required have already been introduced as part of the Basel 2.5 and Basel III reforms of banking regulation – higher trading book capital requirements, higher capital and liquidity standards overall. Some appropriate separation of market based activity and bank balance sheet activity will also be achieved by either Volcker or Vickers style reform.

One of the odder sounding recommendations to appear recently in an official report on shadow banking, is that made in the July 2010 report from the Federal Reserve Bank of New York, where the authors state clearly ‘We recommend putting the accompanying map of the shadow banking system on a 36 inch by 48 inch poster’. But it’s a necessary recommendation given the sheer complexity of the system they have mapped. Any system this complex will defy complete understanding and any belief that we can precisely calibrate our response to it will therefore be a delusion. Given the enormous cost which instability can produce, and given the uncertain benefits which this complexity has delivered, our regulatory response should therefore entail a bias to prudence – a bias against complex interconnectivity, against procyclical market contracts, and against allowing maturity transformation or high leverage to develop in unregulated institutions or markets.