Five ways to use or misuse the term "Shadow Banking" (Finadium subscribers only)

Reading the news this morning we were struck by how far Shadow Banking has spread into the popular financial lexicon. We point out five recent observations from the spot-on to the dubious.

We define Shadow Banking using the initial Financial Stability Board statement: “credit intermediation involving entities and activities outside the regular banking system.” Looking at these articles through this lens:

1. According to Reuters, “Banks will have to hold more capital to cover investments in some “shadow banks”, such as hedge funds and private equity, from January 2017, global regulators said on Friday.” Actually, this was in reference to a new Basel Committee publication, “Capital requirements for banks’ equity investments in funds – final standard” which does in fact mention Shadow Banking once but is really about three methodologies that banks can use for risk-weighting their investments in outside funds. As an aside, our favorite of these three methodologies is the FBA, or fall-back approach, which puts a 1,250% risk-weight on a bank’s equity investment in a fund. This might as well be called the Oh Sh&% approach.

2. The Telegraph reports that the Bank of England’s Mark Carney is concerned about Shadow Banking in emerging markets, with a veiled focus on China. This is a pretty legitimate use of the term Shadow Banking. As we noted in a post last November 27, 2012, the whole idea of Shadow Banking in China needs a lot more definition.

3. This one is dicier: Voice of America reports on the collapse of Russia’s mid-sized Master Bank last month. The title calls out Shadow Banking, but really this isn’t about Shadow Banking in our view; this is about the very large shadow or black market economy that exists in Russia and around the world. Is the street vendor selling tortillas in Guatemala part of the Shadow Banking world? How about money laundering? As analyst Maxim Osadchy of BKF Bank in Moscow notes in the article, “‘The fund for guaranteeing deposits isn’t limitless. I would even say that this system of black banking is too big to fail.'” Agreed; shadow economies can be huge and very meaningful. We will argue though that the line should be drawn between “Shadow Banking” vs. black market economies, and the use of banks to launder non-reported assets in whatever form.

4. Getting back to China, this use of Shadow Banking looks right to us: Reuters describes the efforts of Chinese regulators to limit bank-to-bank lending that funds credit and maturity transformation products that are unregulated and poorly traced on bank balance sheets. This type of lending now accounts for 11% of total corporate fundraising up from 2% in 2011, according to Reuters. Here’s a good example of the transaction: “In one typical interbank lending pattern, Bank A purchases a trust product issued by a trust company, then sells a so-called ‘trust beneficiary rights’ to Bank B. The beneficiary rights grant Bank B the right to income from the trust product, even as Bank A technically maintains ownership. This allows Bank B to record the beneficiary rights as an interbank asset, so the bank can hold less capital than if it purchased the product outright.” That’s Shadow Banking all right.

Reuters provides a second example that seems a little blurrier when looking at Shadow Banking as a credit or maturity transformation issue: “The new rules also ban so-called “drawer agreements” in which Bank B or another institution secretly guarantees its counterparty against losses on a trust product or other underlying asset.” This is credit transformation but it looks more like illegal banking than Shadow Banking. It’s an important difference.

5. Is peer lending Shadow Banking? If there is no credit transformation (lenders are exposed to the credit worthiness of the borrower) and no maturity transformation (lenders are paid as and when borrowers pay them back), then we don’t think so. So this article from HousingWire on the career move of former Citi CEO Vikrim Pandit to peer lender Orchard gets a thumbs down on the face of it. That said, the FT Alphaville blog thinks that at least one form of P2P lending “is shadow banking pure and simple,” but in this case the lender is relying on a bank note that could theoretically be re-sold.

One man’s Shadow Banking ceiling however can be another man’s other Shadow Banking floor. In a comment letter to the FSB earlier this year, the Spanish regulator CNMV’s Advisory Committee said that, “the shadow banking system is the network of financial intermediaries that conduct maturity, credit, and liquidity transformation without being subject to banking regulation and do not have formal access to central bank liquidity or public sector credit guarantees.” In that case, all of the above examples apply. This is a much broader definition however and one that should be evaluated carefully before using broadly.

Thankfully we have no record of Shadow Banking showing up on Sesame Street or in kids books. That’s when you know things are messy in global financial regulation.

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