The topic of shadow banking has been in the press lately, driven by the Financial Stability Board’s recent annual Shadow Banking monitoring update. This update was nothing if not full of gas and big numbers, but at least they pulled out an important point: some Shadow Banking matters and some doesn’t, so let’s get to the heart of the matter and figure out what’s worth worrying about. Maybe the rest should just stay in banks where it belongs for effective risk management.
This year the FSB adopted a more nuanced measurement of Shadow Banking figures. While it found US$80 trillion as a total shadowy figure, the real number of focus was more like US$36 trillion:
The new, economic function-based, narrow measure of shadow banking that may pose financial stability risks was $36 trillion in 2014, versus $35 trillion in 2013. This measure amounted to about 30% of the overall non-bank financial sector assets and 60% of the GDP of the 26 participating jurisdictions.
Federal Reserve Governor Daniel Tarullo followed this up with a speech last week on shadow banking. The parts that hit home for us were:
A key implication of the fact that the activities often grouped under the heading shadow banking are not monolithic is that the level of a particular activity is less important than the degree of vulnerability that it creates. Not all of what some might call shadow banking activity represents a market failure that creates excessive risk to financial stability, and so it would be wrong to assume that all shadow banking ought to be regulated to safeguard financial stability.
So far so good: not all Shadow Banking is inherently bad, and some parts serve an important market function.
One such consideration is whether the activity is high-risk, and whether banks have a good track record in addressing the attendant risks. Migration may be of less concern where banks historically have done a poor job of managing the risks of the activity. Another salient consideration is whether the activity at issue has significant synergies with core banking activities. If so, then migration out of the traditional banking sector could damage the efficiency of banks and increase their vulnerability.
Also good, as this gives hints that regulation may ease up on banks’ inabilities to conduct Securities Financing Transactions (SFTs).
We have observed some investment funds exploring the possibility of disintermediating dealers by lending cash against securities collateral to other market participants.
Direct Repo, both the branded and unbranded versions, in on the Fed’s radar screen.
We will be developing a regulation that would establish minimum haircuts for securities financing transactions (SFTs) on a market-wide basis, rather than just for specific classes of market participants. SFTs include repo, reverse repo, securities lending and borrowing, and securities margin lending–transactions that are the lifeblood of many kinds of shadow banks. SFTs are a key component of the healthy functioning of the securities market.
Whoa whoa, the train just took the wrong track! Instead of looking at how to improve market stability, Tarullo has gone for over-regulation as the cure all. Since the FSB’s original minimum haircuts for SFTs weren’t really a big deal, we don’t expect that these minimums will be either. The issue is that conceptually, instead of looking at where Shadow Banking should sit to be best risk-managed, Tarullo is talking about extending regulation to all market actors.
The problem of Shadow Banking regulation isn’t margin at all, although that may help with the Fed’s fire-sale risk concerns. The issue is that regulations have hurt, and will hurt further, the market’s ability to generate liquidity especially in times of stress. This isn’t about leverage or frothy markets; its about basic market functionality for SFTs. This is a capital cost issue for banks, not a margin issue to prevent fire-sale risk.
The core question for regulators should be what Shadow Banking is good and what isn’t. The FSB report is starting to hone in on that distinction (although work remains to be done). We and countless others have found conclusively over the years that some credit and maturity mismatch transactions that were not fully regulated, like SFTs, also brought great liquidity benefits to the markets. Some academic studies have gone to the point of evaluating which regulations were the “best of the worst” in terms of liquidity destruction. The FSB and the Fed shouldn’t be looking to add new regulations at this time. Rather, the point about which Shadow Banking activities should be kept for the purpose of stability and liquidity should be the big focus.
Regulators may well say that this is what they are doing, and want to forestall risky activity popping up in other places outside of banks due to regulatory arbitrage. Its a fair point. But if regulators want a risk-managed marketplace, then the focus really needs to be on what activities are risky (fire-sale risk? Inability to return capital to investors) and regulate that equally across the marketplace while also considering what value must be kept intact. Yes, Lehman was a disaster, but regulators can be smarter than versions 1.0 of Basel III and Dodd-Frank with the benefit of hindsight.
The non-bank Shadow Banking market is evolving as banks pull back due to capital constraints. Ease those constraints for business lines that add value, and regulators will get a better risk-managed marketplace. Its not obvious to implement but as a principles-based approach, its a pretty simply formula.