Shadow banking: Help is on the Way

 

Despite being recognized as a primary culprit of the financial crisis, shadow banking has continued to flourish. According to the Financial Stability Board (FSB), shadow banking has grown since the onset of the crisis from $62 trillion in 2007 to $67 trillion[i]. Fortunately, the FSB plans to release regulatory recommendations by the end of the year. This article will summarize the risks inherent with shadow banking, the effects of the Dodd-Frank Act, and possible reforms designed to mitigate these risks and any inadequacies of Dodd-Frank.

Shadow banking refers to largely unregulated bank-like activities performed outside of the traditional banking sector by non-bank financial institutions (NBFI). NBFI include: hedge funds, investment banks, money market funds, and other devices that aggregate and hold financial assets. Banks engage in financial intermediation between savers and lenders by using deposits to finance long-term assets, including loans and mortgages. This conversion of short-term liabilities into long-term assets is known as maturity transformation[ii]. Similarly, NBFI use maturity transformation to provide financial intermediation. However, NBFI do not use cash deposits, but rather deposit instruments (“money-claims”[iii]) like repurchase agreements (repos) or commercial paper[iv]. Since they do not use deposits, shadow banking is largely unregulated, which allows them to leverage disproportionately more than traditional banks[v]. This allows for large profits during a bubble, but ultimately severely hinders liquidity allowing for Great Depression-like runs. Furthermore, systemic risk builds up throughout the entire market because traditional banks use NBFI for investment purposes, so a run on shadow banking leads to bank losses.

 

The fundamental problem with shadow banking is the volatility of the money-claims market[vi]. While it is easy to target all short-term lenders, it is crucial to specifically target the ones responsible for systemic risk[vii]; over-regulating would have harsh economic repercussions by greatly reducing benefits derived from responsible short-term lending[viii]. Risk-constraint regulations, the lender of last resort, and the Dodd-Frank Act (DFA) each fall short is stabilizing the money-claims market. Furthermore, the DFA potentially over-regulates by grouping private equity funds together with hedge funds[ix]; and by allowing the Federal Reserve to serve as a lender of last resort for NBFI creates a moral hazard[x]. A potential solution to this mess may actually be logically simple, appropriately expand the current regulations imposed on banks to include all money-claims through a public-private partnership (PPP)[xi].

 

The PPP provides a viable alternative to ineffective policies containing ex ante risk constraints and/or ex post support subsidies. First, the PPP proposal allows only the licensed issuance of money-claims. Second, licensed entities will be required to abide by portfolio and capital restrictions. Furthermore, the government is to stand behind these private entities (money-claims insurance, as opposed to deposit insurance), eliminating run externalities; this public support will be largely financed by risk-based fees paid by these licensed entities[xii]. Only issuers of money-claims would fall under these restrictions, reducing the risk of over-regulating. Meanwhile, since this would cover all institutions performing bank-like operations, the regulatory arbitrage observed following previous banking regulations would be null.

 

Despite the potential upsides of the PPP, like all regulatory proposals on shadow banking, implementation could prove to be very cumbersome. Two key difficulties arise at the outset: 1) pricing of the risk-based fee and 2) flexibility of the fee to update as portfolio risk changes. If a fee is underpriced with respect to risk, then riskier firms will effectively be subsidized for incurring extra risk. This problem can be resolved by the government writing a put option priced at a firm’s outstanding claims with the fair premium designed to increase with volatility increases and decrease with capital increases [xiii]. Therefore, the fee will be effectively lowered by reducing risks. Consequentially, it is important that the government is able to quickly adjust to changes in a firm’s portfolio; otherwise firms will simply increase risk after the fee has been set. This dilemma is reduced by the PPP’s inclusion of ex ante portfolio and capital constraints; resembling the standard insurance model of paying risk premiums and satisfying covenants against risk taking[xiv].

 

After implementation, another difficulty will arise when calibrating the constraints and fees so as not to eliminate the benefits obtained through money-claims. For portfolio restrictions the safety needs to be weighed against the benefits of maturity transformation realized by a level of risky investments. Next, is to set capital requirements at a level consistent with the PPP’s purpose of generating additional investments capital beyond traditional banking[xv]. So, requiring money-claim entities to reserve too much capital would infringe on this goal. However, since run externalities are absent in the PPP, moral hazard would increase if the capital requirements were too low. Ultimately, capital requirements should be proportional to portfolio risk in order to strike the appropriate balance.

 

Existing regulations may provide some level of support to shadow banking, but they are ultimately incomplete. Under Dodd-Frank, nondepository banks would only be eligible for support in extreme circumstances[xvi]. Furthermore, both ex ante constraints and ex post support are needed to curb moral hazard, run externalities and optimize the effectiveness of maturity transformation. The PPP regime mirrors the successful regulations imposed on bank. Careful defining of the term money-claims should prevent over-regulating and also chances of regulatory arbitrage by under-regulating. The PPP is just one of many proposed regulatory schemes for shadow banking; by the end of the year the FSB will have submitted its recommendations.