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Just as the European banking sector is scrambling to recapitalize, an old familiar foe is rearing its ugly head again, bringing back memories of the not too distant past. The anaemic lending appetite by banks is once again creating a setting ripe for shadow banking to re-emerge. Most will argue that it never went away, it just became smaller and stealthier. We are not concerned about where it went or if it did at all, but rather that is once again on our doorstep and could threaten to destabilize global finance.

What is the "shadow banking system"? The term was coined by PIMCO's Paul McCulley in the summer of 2007 at the Fed's annual symposium at Jackson Hole. It describes bank-like activities, mainly lending, conducted through non-regulated entities and/or mechanisms. It includes hedge funds, money market funds, and securitization vehicles to name but a few. These institutions fund themselves through short-term sources such as unsecured debt, asset-backed debt, commercial paper, repos etc. and use this funding to provide leverage for various activities ranging from securities trading to corporate finance.

The problem began with their success. The fact that these "unregulated banks" were providing cheap, fast financing to borrowers and high ,stable returns to investors created the illusion of safety. In fact the providers of funding to shadow banks begun to see them as being "as good as deposits" simply because they had not failed (yet).

This was, of course, infamously accentuated by the seal of approval lent to them from the rating agencies, which assigned top ratings to various such entities. Whether these ratings were a result of an incestuous relationship between agencies and issuers or an inability of those agencies to comprehend and correctly estimate their risk is another matter. The fact remains that this "seal of approval" resulted in such instruments being bought up by money market funds, pensions, banks, and a whole array of regulated and otherwise prudent market participants. In other words, a whole new financial system was created, which operated outside the realm of regulation - and more importantly, this market was huge and had penetrated the traditionally "safe" regulated financial market.

The idea of having a government backstop (ultimately provided by taxpayers) is that such institutions will adhere to certain regulations governing their prudent behavior and will be bailed out for the greater good. The shadow banking system has no need or incentive to adhere to such regulations, but ultimately the damage from their imprudent activities was paid by the same taxpayers. In fact, McCulley considers the unravelling of the shadow baking system to "lie at the root of the current global financial system crisis."

The problem today is that shadow banking appears to have recovered faster than the traditional banking industry that was bailed through massive capital injections from taxpayers. This comes at a time that banks are licking their wounds and preparing to meet new, more stringent capital requirements.

European banks, in particular, need to raise €115bn by the end of this quarter to meet stricter core tier 1 ratio requirements, and by 2019 need to adhere to even tougher criteria set by the Basel III accord. This has meant that they are shrinking their balance sheets (already shrunk by 20% in the first quarter of 2012) and therefore their lending capacity. This is like steroids for shadow banks; their competition is shrinking, and clients are starving for debt.

Stupidity is defined as the insistence in repeating the same task while expecting a different outcome, yet this is what we are allowing to happen. We allowed shadow banking to throw us into the worst financial crisis since the Great Depression, and are now creating the perfect environment for it to thrive once more.

Vickram Pandit, CEO of Citigroup (NYSE:C), puts it very simply and clearly: "You cannot address systemic risk unless you tackle things other than banks." It is important for us as market participants to understand the need and use of regulation and be prepared to pay for lower risk and get paid for greater risk.

Moreover it is vitally important for our banks to understand that their lack of confidence in lending to industry is setting them up for their next fall. If they do not lend to industry, others will, and there is no effective way of protecting themselves from the destabilizing effect of such practices, as we have all seen.

Source: Beware The Rebirth Of The Shadow Banking System