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What do we do about the shadow banks or, more politely, alternative finance sources? David Reilly brings us some of the regulatory dilemma in the Wall Street Journal, "Too Big to Fail Casts a Very Long Shadow."

The question is, "Should the U. S. Government look to backstop even more of the financial system than it already does?" The financial system is expanding. The financial system has already expanded.

Reilly writes that "the shadow-banking system is estimated at between $10 trillion to about $24 million, depending upon the activities included." According to Federal Reserve System, the commercial banking system holds a little more than $13 trillion in assets.

According to the Federal Deposit Insurance Corporation (FDIC), the total of asset held by all FDIC insured institutions is a little more than $14 trillion. According to Gary Gorton, Yale economist, in his latest book, "Misunderstanding Financial Crises: Why We Don't See Them Coming," the shadow banking system totaled something around $10 trillion to $14 trillion in the summer of 2008, just before the financial crisis started.

In June, 2008, the assets of the commercial banking system totaled just over $11 trillion; assets in all FDIC insured institutions totaled just over $13 trillion. Alternative financial institutions are something to deal with. And, alternative financial institutions are attracting more and more attention.

The issue about shadow banking is one about systemic financial collapse. And, in other words, as Federal Reserve Governor Daniel Tarullo stated before the Senate Banking Committee last week, the regulation of this part of the financial system is the issue "we should be debating in the context of too big to fail."

Reilly writes, "While banks have faced tighter oversight, the shadow banking market remains a source of potential instability. It is worth remembering that runs here, rather than traditional bank runs, were a cause of the crisis and led to seizures of credit markets."

Gary Gorton, in the book mentioned above, describes this run in the financial system in 2008. So, according to Tarullo, and William Dudley, President of the Federal Reserve Bank of New York, we need to regulate alternative finance.

Dudley stated, in a speech earlier this month, that there are two ways to contain shadow banking. The first is "to curtail short-term, wholesale financing that takes place outside the regulated banking system." The second "would be to expand backstops to such activities. In other words, give some of the protections open only to banks, such as access to the Fed's discount window, to certain products or nonbank financial firms."

Of course, this latter path would include more regulation and examination! I have written about this situation over and over again in the past four years or so.

What about more and more regulation? We have seen plenty of that since the financial crisis hit in the fall of 2008. And, of course, we have produced that monstrosity of a camel of a regulatory structure called Dodd-Frank. And, what has happened? Well, the first thing we have to remember about regulation is that regulation is designed to protect against the problems that used to exist in the financial system. Regulation is backward looking.

The consequence of this regulation? The biggest of the commercial banks have moved on. They have the expertise and the connection with the latest information technology to go where the regulations are not. In this world today with the information technology we have, the biggest organizations with the most talent on hand can find ways -- new ways -- to get around what the government and the regulators are trying to do.

What is it that these big organizations are doing? We don't know yet -- and won't know until after-the-fact. We are going to regulate something we don't know? Come on, get real! But, all these new regulations are paralyzing the small- and medium-sized banks. Regulatory costs have sky-rocketed and these small- and medium-sized banks don't have the human capital to respond to them.

I have had the opportunity to move out into the community banking community and talk with some bankers. They aren't lending. What is the reason they are not lending? Well, for one, regulatory costs and examination oversight cause them to do only what they are absolutely sure they can do, and they really are not certain about this. Why lend within such an environment, especially if you have other problems within the bank to deal with?

So do we need regulation to extend to the shadow banking system? Remember, any regulations that are extended to the shadow banking system will only be backward looking. And, imposing the burden and costs of regulation, if the regulation is effective, to these institutions will only raise expenses, make borrowing from these firms more expensive, and restrict credit extension in a pretty important segment of the credit market.

The other issue has to do with the ability to regulate these institutions. Shadow banks are not like small- and medium-sized commercial banks. They have not been regulated for years, they have younger, more talented, more sophisticated employees than do the small- and medium-sized commercial banks, and the companies are lighter and more mobile that these small- and medium-sized financial institutions.

What to do with alternative finance is an issue that is not going to go away. It is on the cutting edge of where finance is going in the future. As readers of this blog know, finance, to me, is just information, nothing more than 0's and 1's, and how do you control that. What is money in such a world? These are issues we will be dealing with more and more in the future.

Source: Damn Those Shadow Banks!