Unfair Advantages of the Shadow Banking System

by: Vernon Hill

We’ve written for some time about the unfair advantages the shadow banking system (notably money market funds and investment banks) enjoys as it competes with the real banking system. The shadow system operates with essentially no regulation, pays no deposit-insurance fees, and isn’t saddled with mandated social missions imposed by legislation such as the Community Reinvestment Act.

The result? Shadow banks weaken the actual banking system by using their advantages to skim off the financial services industry’s most profitable business. Money market funds in particular can offer premium returns to bank deposits and promise bank-like safety--without the cost or safety of the FDIC insurance system

This is no idle objection I’m making. As the past two years have shown to anyone who might still harbor doubts, the health of U.S. banks is critical of the health of the economy as a whole. Competition from the shadow banking system only added to the banking system’s problems during the credit crunch, and has hampered the industry’s slow recovery as the crunch finally eases. It is as unfair to the banks as it is unsafe for the financial system.

It turns out that I’m not the only one with this complaint. Now comes former Fed chairman Paul Volcker to offer the same view:

Paul Volcker, the former Federal Reserve chairman who is an adviser to President Barack Obama, said money-market mutual funds undermine the strength of the U.S. financial system and should be regulated more like banks.

“Banks remain the functioning heart of the financial system, and they are protected and regulated,” Volcker said in a telephone interview last week from his New York office. “To the extent they have competitors that have different ground rules, kind of free-riders in my view, weakens the financial system.”

Amen to that! Volcker sensibly argues that MMFs should be forced to operate under bank-like regulation. “In my vision of the new financial system, you obviously want to protect banks and have strong banks, and I don’t think they should be put at a competitive disadvantage vis-a-vis money-market funds,” he tells Bloomberg.

Defenders of MMFs also argue that the funds provide crucial support for the commercial paper market. So what? All the CP market is is another part of the shadow banking system; it allows big corporations to borrow outside the regulated banking system--at the expense of the economy in general, and especially small business in particular.

The shadow banking system simply skims deposits and loans from the real banking system, to the detriment of the financial system and the economy overall.

If it looks like a duck, walks like a duck, and quacks like a duck, isn’t it a duck?

Of course it is. Money market funds accept deposits, make loans, and provide liquidity.

Is that not the definition of a bank?

If the administration wants to reform the financial system, it should start by reforming shadow banking system.