Shadow Banking In The Crosshairs

by: Martin Lowy

If you read the financial press today (Monday), you are likely to read about the Financial Stability Board (FSB) report (pdf) on "Shadow Banking" released yesterday, November 18, 2012. The New York Times report had this lead paragraph:

The so-called shadow banking system, blamed by some for aggravating the global financial crisis, grew to a new high of $67 trillion worldwide last year, a regulatory group said on Sunday, calling for tighter oversight of nonbank institutions like hedge funds, private equity firms and other investment companies.

The Financial Times report bore the headline: "FSB aims to tame shadow banking-Regulators push to tame $67tn industry." The FT report's lead paragraphs read as follows:

Non-bank lending markets face unprecedented levels of government intervention under sweeping new proposals to tame "shadow banking" laid out by global regulators meeting as the Financial Stability Board.

"The Basel-based regulatory group made clear on Sunday that it intends to push for tighter oversight of any part of the $67tn sector that takes on bank-like attributes such as using short-term assets to fund longer-term lending, known as "maturity transformation". They also intend to set global capital and liquidity standards for non-banks that could be subject to investor panics akin to a depositor run.

The FSB, based in Basel, has representatives from substantially all the major financial regulators in the world. Its goal is, through "macroprudential" regulation, to prevent liquidity and similar crises such as occurred in September 2008.

With that kind of a goal, the FSB almost inevitably will promote over-regulation of non-bank financial institutions. Its members cannot want to be remembered as the group that missed the boat on how to prevent the next crisis.

The Impact of Basel 3

The new report notes that the more stringent capital rules imposed on banks by Basel 3 are likely to drive some kinds of financial activities out of banks and into less regulated forms of doing business. This, the FSB seems to say, is regrettable. I think it is not regrettable at all. If that was not a purpose of Basel 3, then the worthy regulators of the world who designed Basel 3 have no idea what they are doing.

Almost Everything Financial Is a Shadow Bank

The FSB casts a very wide net in this report. Its $67 trillion number for total shadow banking assets includes not only money market mutual funds, which account for only 7% of the total, but also all mutual funds, hedge funds, private equity funds, finance companies, broker-dealers, conduits, and corporate borrowing vehicles registered in the Netherlands (Antilles) for tax purposes. The FSB does not propose new regulations for all these types of entities, many of which already are subject to fairly extensive regulation in their home countries, but it seems to be looking for excuses to impose new regulations.

For example, the FSB apparently believes that if an entity engages in "maturity transformation" then it needs to be regulated like a bank. The FSB might seek to impose capital requirements on any of a variety of types of institutions on this ground. The idea that maturity transformation requires regulation is backwards and close to bizarre. Maturity transformation is one of the major things that make banks dangerous; that is true. But regulators, particularly in the U.K., look to banks to accomplish just that - maturity transformation - also known as borrowing short to lend long. It is risky per se. But why regulate private parties who choose to borrow short to lend long? Their investors take the risk in the hope of profit. If they fail, they fail. What is the benefit to the economy in preventing people from knowingly taking risks? If regulators are afraid that banks are going to lend imprudently to such maturity transformers, regulate the banks, not their borrowers.

In case you were wondering, I hate the term "shadow bank." It implies something sinister about a field that includes many useful types of businesses.

The Banks Want Their Competitors To Be Regulated

I smell a rat. The large banks that are the FSB representatives' basic clients, who are screaming like stuck pigs about what Basel 3 has imposed on them, are seeking to protect their profit margins by getting the world's regulators to impose capital and other requirements on their competitors. It is an old trick but sometimes it works.

There is one huge difference between banks and almost all of the other types of entities listed as shadow banks: Government subsidy. Banks receive various types of government al subsidies, including lender-of-last-resort access, deposit insurance, and payments system direct access. The largest banks also get too-big-to-fail. I would agree that any other entity that gets governmental subsidies like these should be regulated based on those subsidies. But those that do not get subsidies and that are not TBTF should be allowed to go their own way and compete with the banks. That will make the banks safer, not riskier, because it will tend to deter the banks from competing where risks are high. Those are areas that are better left to the truly private sector.

The FSB properly worries about banks lending to shadow banks and about shadow banks as bank counterparties in large transactions. But those are banking problems, not problems of the other institutions. If the other institutions do not have the benefit of the governmental safety net, they should be allowed to fail and their investors should be allowed to take the consequences. Bear Stearns and Lehman Brothers are instances of non-bank failures that either did bring down or could have brought down the financial system as a whole. I do not agree that that is what happened. But even if it did, those investment banks did have capital regulation and parts of them did have liquidity regulation and none of that did any good because they had borrowed short and invested in illiquid assets. You cannot legislate against greed. Greed happens, and when it fails, it fails spectacularly.

Mutual Fund Re-Pricing and Leverage

The mutual fund structure probably is the safest structure that has been designed. Basically, it has no leverage (except that closed end funds may have limited leverage) and is priced every day based on a basket of fairly liquid assets. The problems arise when the basic premises are violated: money market funds that do not re-price, funds that use derivatives to imitate leverage, and ETFs that have leverage characteristics that their investors do not understand. These are problems for the financial system as a whole only in the case of money market funds, and there is a simple fix for that problem that the industry has rejected: re-price like other mutual funds. That will come about in the fairly near future even though the SEC did not adopt it a couple of months ago. Today's Wall Street Journal endorsed it in its lead editorial, so the fix is in.

The leverage issue is one for investors. Do ETF investors and investors in other types of funds that use derivatives to imitate leverage understand what they are investing in? That is a disclosure issue and a decision-making issue, not a systemic issue.

Markets Can Work If Consumers Fulfill Their Roles as Policemen

I feel like the regulators keep thinking something like, "The market seems to work here. There must be something wrong. We have to find something to regulate so we won't be blamed."

Markets do work most of the time. Even financial markets work if governmental subsidies are understood and compensated for (as they were not in the pre-2008 period) and disclosure is good. Good disclosure always is an issue. Some products are too complex to be understood by their buyers. Outside the financial field, for example, almost no one who uses an iPad knows how it works. It works and we use it. If it didn't work, no one would buy it. We read reports in the press on whether the thing works etc. and talk with people who own them. If we are misled, we throw the thing away and buy something else.

In the financial field, there are products built on derivatives that almost no one can understand. As an investor, it is your job either to understand them or not to buy such products. And it is our job-people who write for investors, as we do at S.A., to warn investors about overly complex products or-even better-to explain in simple terms what they are and how they work so you can buy them knowledgeably. I urge you to go through your portfolio and ask whether you own investments that you do not understand. If you do not understand something, I urge you to be a good consumer. Either learn it or sell it. Police the market. That way the market will not need more regulation.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.