!DOCTYPE html PUBLIC "-//W3C//DTD XHTML 1.0 Strict//EN" "http://www.w3.org/TR/xhtml1/DTD/xhtml1-strict.dtd"> Streamline Training & Documentation: What to Do about the Shadow Banking System

Wednesday, April 07, 2010

What to Do about the Shadow Banking System

If you've been following discussions of the players involved in the financial crisis, you're aware that broker/dealers in the headlines, such as the now defunct Bear Stearns, are referred to as members of the "shadow banking system."

The shadow banking system consists of nonbank financial firms that borrow funds — often through the short-term money market and commercial paper market — and then lend those funds to borrowers such as corporations or use the funds to purchase relatively long-term assets such as mortgage-backed securities.

A key point is that such firms do not take deposits and, therefore, are not subject to the regulations that depository institutions — commercial banks, savings institutions, and credit unions — must adhere to.

In addition to broker/dealers, the shadow banking system includes such entities as government sponsored enterprises (GSEs), e.g., Fannie Mae and Freddie Mac, GSE and other mortgage pools, finance companies, and issuers of asset-backed securities.

In a July 2009 paper (pdf), Tobias Adrian, an economist at the New York Fed, and Hyun Song Shin, a professor of economics at Princeton, analyze in reasonably accessible fashion, how financial regulations might be revised in order to reduce the potential for the shadow banking system to exacerbate financial instability in the future. Adrian and Shin note that, as of the end of June 2007, the shadow banking system's $16.6 trillion in assets stood well above the assets of the conventional banking system, which amounted to $12.8 trillion.

After detailing the way in which leverage of financial firms grows to an excessive level during a boom period, Adrian and Shin argue that this market failure should be mitigated through regulations that constrain systemic risk, especially since systemic risk has risen substantially as a result of burgeoning securitization.

Adrian and Shin explain:
One element of improved regulation will be a ... systemic regulator who could take on two important tasks. First, the system regulator should gather, analyze, and report systemic information. This will require reporting from a broader range of financial institutions, such as hedge funds, and the shadow banking system. Second, the systemic regulator will operate capital rules [rules regarding how much capital a firm must hold relative to the amounts of various types of liabilities on its balance sheet] with a systemic focus. ... Given the central bank's intimate connections with the financial market through its monetary policy role, it is likely to have the best market intelligence in performing the role of the macroprudential regulator. Furthermore, the fact that the central bank is the lender of last resort (LOLR) gives it the capacity to intervene in the market when necessary. ...

In the new, post-crisis financial system, many familiar features of the system before the crisis will cease to be in place. The role of securitization is likely to be held in check by more stringent financial regulation and the recognition of the importance of preventing excessive leverage and maturity mismatch [short-term liabilities funding long-term assets] in undermining financial stability. Institutional changes and the conduct of monetary policy will flow from the recognition of the role of the financial system as the servant of the real economy, rather than an end in itself. In particular, we might see the return of a more staid "utilities" version of banking based on the model of banking as a support to the real economy.
Adrian and Shin emphasize that the effectiveness of regulations such as those they discuss depends on the diligence of the regulators. It remains to be seen exactly what new US regulatory legislation emerges from Congress, which is currently working on Senator Dodd's proposed bill, a more strict bill having already passed in the House of Representatives.