Shadow banking
“Banks say it’s their way to manage risk and be innovative. Regulators say it obscures the risks banks take.”

As regulators attempt to get to grips with the controversial shadow banking system, they are finding that it’s difficult to regulate what can’t first be defined. Rowan Morrison examines the next likely steps.

There are two huge problems with “shadow banking”. The first is its clever ability to elude definition. Just when you get to within grabbing distance, it swirls a metaphorical cloak around itself and vanishes. And that leads to the second problem: because it’s so hard to define, it’s a real headache to regulate.

But it’s too significant to leave alone. At the start of the 2007-08 global crisis, it’s said that the US shadow banking systems alone had already become almost as big as the traditional depository banking system. And, in just the first quarter of 2011, the European Central Bank was estimating that the aggregated assets of special purpose vehicles set up in the euro area amounted to E2.3 trillion, representing “about onetenth of the total assets of all non-bank financial intermediaries”.

Sizing up securitisation

Conventionally, shadow banking comprises entities which are not “regular” banks in that they don’t take deposits but, crucially, incur the same level of risk. These include asset-backed commercial paper conduits (ABCPs) and structured investment vehicles, or SIVs. Investment banks, hedge funds, conduits and money funds all come under the cloak of shadow banking. “Shadow banking has been around for years,” explains Robert Webb, Head of Accounting, Finance and Risk, Glasgow Caledonian University. “It’s simply another term for what I’d call off-balance sheet business.”

Then there’s securitisation – the practice of packaging loans and selling them as assets to investors. Thought to have played a key role in the sub-prime mortgage slump that precipitated the global financial crisis, this is why regulators are now seeking greater transparency in shadow banking in an effort to avoid another dangerous accumulation of risk. This is easier said than done.

Says Webb: “The banks will say it’s their way to manage risk, be innovative, increase opportunities in the market, increase profitability and make more liquidity available for people in the system. A regulator will say it’s using conduits and hedge funds and derivatives to obscure what banks are doing. And, because they can’t see the risk positions the banks are taking, it could bring down the banking system – as we’ve seen.”

When it was tasked by the G20 with recommending how to manage “shadow banking” in November 2010, the Financial Stability Board (FSB) promptly acknowledged there was no “commonly agreed definition”, partly because of the huge differences between countries and their banking systems, but also because the shadow banking system is “fluid” and “evolving”.

The FSB recommendations, due this October, should coincide with updated guidelines from the UK’s Financial Services Authority (FSA) about how much exposure banks should have to “shadow” entities such as SIVs and ABCPs. But the issue has always been slippery. By the time the Basel I regime came into force in 1992, the banking sector, ever mobile and ever mutating, had already innovated past it.

Following the crisis, the priority has been ensuring that “traditional” banking is appropriately regulated and monitored through the Basel 3 regime. But, once more, the worry is about “regulatory arbitrage” – clever bankers using the shadow system to innovate their way around Basel 3.

Good, bad and evil

So, the regulators and the G20 now want enforceable rules covering what Webb calls “all the banking which is out of sight of both the regulator and the general public”. It’s not going to be easy. “Things move very quickly,” he emphasises. “This money goes through the system before anyone can possibly catch it, let alone track it and thoroughly monitor it.”

Jonathan Herbst, Financial Services Partner, Norton Rose LLP, agrees. “Shadow banking is incredibly difficult to pin down. There’s a huge number of offshore funds which are impossible to get a handle on, or even work out exactly what they are.

“The concern is that it’s so hard to distinguish structured products which make up shadow banking from other activities of the bank and the impact those activities have on the balance sheet.”

This raises a further crucial question – is all shadow banking activity inherently bad? Would effective regulation (and it’s looking like regulation can really only go so far in this area) actually strip crucial liquidity out of the system, resulting in a lack of available funds for other types of more visible banking business? Webb thinks this is a definite danger: “It’s a point not often made, but it’s an important one – regulating shadow banking will reduce liquidity and available funds for mortgage lending and SME funding, and other areas. It’s all linked together.”

Clearly, those pushing this part of the industry out of the shadows must be careful to keep in mind that such action will have an impact, and ensure that, when exposed to the light, the good parts of shadow banking don’t turn to dust along with the bad.

Back to Special Report contents
Back to Magazine contents