Shadow Banking and Financial Regulation

Morgan Ricks is a visiting assistant professor at Harvard Law School. Through June 2010, he was a Senior Policy Advisor and Financial Restructuring Expert at the U.S. Treasury Department. The views expressed herein do not necessarily reflect the views of the Department of the Treasury or the U.S. Government. This post is based on his paper “Shadow Banking and Financial Regulation,” available here.

Without a safety net, banking is unstable. This proposition finds support in economic theory. In an influential analysis, Douglas Diamond and Philip H. Dybvig showed that banks without deposit insurance exhibit multiple equilibria—one of which is a bank run. [1] And financial history confirms this hypothesis. Banking panics were common in the U.S. before the enactment of deposit insurance, but nonexistent thereafter.

The apparent instability of banking has given rise to a standard policy response in the form of a social contract (a phrase borrowed from a marvelous speech by Paul Tucker of the Bank of England). [2] That contract entails certain privileges that are unavailable to other firms: most notably, access to central bank liquidity and federal deposit insurance. These privileges amount to a safety net, and they stabilize banking. The social contract also imposes obligations—activity restrictions, prudential supervision, capital requirements, and deposit insurance fees. These obligations are designed to counteract the moral hazard incentives implicit in the safety net and protect taxpayers from losses.

Historically, this social contract has been limited to depository banking—firms that take deposits and use them to invest in illiquid loans. This limitation is not surprising. At the time the social contract was established, and for decades thereafter, depository banking was the dominant form of credit intermediation in the U.S. financial system.

In recent years, however, this situation changed. A set of institutions emerged that performed the basic functions of depository banks, but without submitting to the terms of the social contract. Indeed, the very existence of many of these institutions has been predicated on being free from inconvenient constraints. Collectively, these institutions have come to be known as the “shadow banking” system.

The term “shadow banking” suggests something mysterious or elusive, but the reality is rather mundane. As used herein, “shadow banking” refers simply to maturity transformation—the funding of pools of longer-term financial assets with short-term (that is, money-market) liabilities—that takes place outside the terms of the banking social contract. A non-exhaustive list of shadow banking institutions would include: repo-financed dealer firms; [3] securities lenders; structured investment vehicles (SIVs); asset-backed commercial paper (ABCP) conduits; some varieties of credit-oriented hedge fund; and, most importantly, money market mutual funds, which absorb other forms of short-term credit and transform them into true demand obligations.

These institutions share a common feature: They obtain financing at short duration through the money markets, and they invest these funds in longer-term financial assets. This activity is the essence of “banking,” and the short-term financing sources on which it relies are the functional equivalent of bank deposits. The quantity of uninsured short-term liabilities issued by financial firms is the most meaningful measure of shadow banking. And, by this measure, shadow banking came to far surpass depository banking in its aggregate scale.

Importantly, while the social contract (and the associated safety net) applies only to depository banks, the instability of maturity transformation does not observe such formalities. Runs and panics are not limited to “banking” narrowly defined. Rather, they are more general phenomena. As the Diamond-Dybvig paper observes, any firm that funds long-term assets with short-term obligations will exhibit the same unstable qualities. Put differently, there is no characteristic unique to bank deposits that creates the propensity for liquidity crises. The short-term obligations of shadow banks are just as susceptible to runs and panics.

The instability of shadow banking became apparent in the recent financial crisis. Indeed, at the height of the crisis, very nearly the entire emergency policy response was designed to prevent shadow bank defaults through a series of “temporary” and “extraordinary” interventions. These interventions were very likely necessary to prevent an economic catastrophe and were skillfully executed. Their success is a testament to the determination and skill of a group of dedicated public servants. Still, no one views this situation as a triumph of policy.

The discussion above makes no claims to novelty. Various strands of this narrative have appeared in works by Timothy Geithner, Gary Gorton, Paul Krugman, and Paul Tucker, among other places. [4] But this discussion raises an obvious question: If the safety net is conducive to stability, why not extend it to shadow banks?

The conventional response is that the perimeter of the safety net should not expand—that it should, if anything, contract. The reason is moral hazard. Extending the safety net to shadow banking would vastly expand the government’s explicit commitments to the financial system. And safety nets encourage risky behavior, giving rise to inefficient resource misallocation and burdening taxpayers with losses once insurance funds are exhausted. This line of reasoning implies that, far from extending the safety net, we should look for ways to reinforce “market discipline” by short-term creditors of maturity-transformation firms. (Retail-oriented deposit insurance is generally admitted as an exception, on consumer protection grounds.)

Advocates of this conventional view often acknowledge that shadow banking poses a problem for financial stability. However, they typically propose that this problem be addressed not with a safety net, but rather with regulatory restrictions—such as risk controls, supervision, and capital requirements. In other words, their solution is to apply to shadow banks the obligations, but not the privileges, of the banking social contract. (The recent financial reform bill, insofar as it addresses shadow banking at all, more or less adopts this approach.)

But even proponents of this risk-constraint approach admit that it has shortcomings. First, regulatory risk constraints are costly from an efficiency perspective: They reduce credit formation and commercial activity. And second, there is no identifiable level of such constraints that is certain to ensure stability. Indeed, the Diamond-Dybvig view implies that only a safety net for short-term creditors can ensure stability by addressing the basic collective action problem that produces run-behavior. If this view is correct, then “market discipline” by the short-term creditors of maturity-transformation firms is inconsistent with systemic stability—indeed, runs and panics are the very manifestations of market discipline by short-term creditors.

This discussion seems to point toward a discouraging conclusion: Either we extend the safety net to cover shadow banking, resulting in a very substantial expansion of explicit government commitments to the financial system; or we seek to reduce the instability of shadow banking through regulatory risk constraints alone, and learn to live with a costly and incomplete response to the shadow banking problem.

But perhaps the question should be posed in a slightly different fashion. We have asked whether the social contract (including the safety net) should be extended to shadow banks—a question that implicitly takes the dimensions of the existing maturity-transformation industry as a given. But if the objective is to ensure that all maturity transformation takes place within the social contract, there is of course another alternative: We might disallow financial firms outside the banking social contract from engaging in maturity transformation—that is, preclude such firms from financing themselves in the money markets (i.e., require them to “term out” or rely on “term funding,” in industry parlance).

And, of course, it is possible to adopt a combination of both techniques. We might expand access to the social contract to include some categories of firms that are currently shadow banks, while disallowing the remaining shadow banks from conducting maturity transformation. In any case, the phenomenon of “shadow banking” would no longer exist. By definition, shadow banks brought within the social contract would no longer be “shadow” banks, but rather just banks. And shadow banks precluded from relying on money-market funding would no longer be shadow banks, but rather term-funded financial intermediaries of one type or another. (In reality, many of these institutions would not be economically viable on a term-funded basis.)

This approach would represent a significant departure from existing methods of financial regulation. It would impose legal funding restrictions on many types of financial intermediaries that traditionally have enjoyed unfettered access to the institutional money markets. And it would necessitate the development of functional policy criteria to determine eligibility to engage in maturity transformation.

The author’s recent paper, Shadow Banking and Financial Regulation, explores some of the implications of this approach to financial stability regulation from the standpoint of economic efficiency, and compares it with available alternatives.

The full paper is available for download here.


[1] Douglas W. Diamond and Philip H. Dybvig, “Bank Runs, Deposit Insurance, and Liquidity,” Journal of Political Economy (1983) 91, 401–19.
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[2] Paul Tucker, “Shadow Banking, Financing Markets and Financial Stability,” Remarks to BGC Partners Seminar (2010).
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[3] A shadow bank can exist within a consolidated group that contains one or more insured depositories. The most obvious examples are the dealer operations of the large money-center banks (JP Morgan, Bank of America, and Citigroup). Those operations rely heavily on overnight financing through the repo markets.
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[4] Timothy Geithner, “Reducing Systemic Risk in a Dynamic Financial System,” Remarks at the Economic Club of New York (2008); Gary Gorton, “Slapped in the Face by the Invisible Hand: Banking and the Panic of 2007,” paper prepared for the Federal Reserve Bank of Atlanta’s 2009 Financial Markets Conference (2009); Paul Krugman, The Return of Depression Economics and the Crisis of 2008 (2009); Paul Tucker, “Shadow Banking, Financing Markets and Financial Stability,” Remarks to BGC Partners Seminar (2010).
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  1. Dr. Oz
    Posted Sunday, September 19, 2010 at 6:02 pm | Permalink

    Wouldn’t the absence of a bank of last resort force banks to be on their best behavior?

  2. Cursos Forex
    Posted Sunday, September 19, 2010 at 7:35 pm | Permalink

    The instability of shadow banking became apparent in the recent financial crisis.

  3. Sheesh
    Posted Monday, September 20, 2010 at 7:41 pm | Permalink

    How can a government extend a safety net to the Shadow Banking System when said system is much larger than GDP?

  4. Boo-urns
    Posted Tuesday, September 21, 2010 at 9:44 am | Permalink

    3) I think you’re missing the principal-agent problems endemic in banking. Banks are always playing with other people’s money, as part of their business model. In any system of fractional reserve (leveraged) banking, you have the problem of the bankers taking risks with cash that is not their own. The part Morgan doesn’t delve into is the need for banking, including demand on the depositor side. But I think the argument for banking is pretty clear.

    5) The depository banking system was, I believe, larger than GDP as well, and the FDIC did quite fine with that. There’s obviously a difference between potential liabilities and expected losses (much like in any insurance scheme). Assuming capital buffers are in place and some semblance of good regulation as to risk and product type, you’d have minimal losses. Assuming that regulation was actually good, you’d expect zero losses, as we experienced from the 1930s to the 1970s.

  5. Radley
    Posted Monday, November 29, 2010 at 5:22 am | Permalink

    How much damage is done by Regulatory Capital – and why it leads to risk arbitrage and shadow banking.

    The use by regulators of an imposed amount of capital to mitigate risk (regulatory capital) rather than forcing the banks to calculate the actual capital required to mitigata risk (economic capital) has been a principle underlying cause of the banking crisis.

    While there can be no doubt that the aim of Regulatory Capital is correct and should provide the basis of prudent regulation of banks: the unintended consequences have been disastrous. This seems like an overly dramatic statement but an examination of the facts supports this view. The two main consequences of regulatory capital rules has been; firstly the creation of a shadow banking system and, secondly the transformation of ‘low risk’ lending into high risk lending – such as the sub-prime mortgage debacle – driven by a desire to find ways to profit from lending at high margins yet only setting aside low amounts regulatory capital.

    Banks measure their profits based on the cost of Regulatory Capital not on the basis of the actual risks they take. Bonuses are paid against Regulatory Capital costs and indeed many senior risk managers are rewarded based on their ability to lower a bank’s Regulatory Capital not on the basis of their lowering the bank’s risk profile or even aligning risk taking with the capital required to support the bank for those risks.

    Going back to first principles it is clear that banks should set aside capital to buffer themselves against both poor lending decisions and adverse market movements so that in the worst case they can repay their creditors, not default and cause systemic contagion through the financial system. The question is how to calculate this amount of capital and who should do the calculation.

    Setting a single amount of capital at the institution or bank level has some attractions and is perhaps inevitable but regulators need to be aware that by doing so they may encourage banks to transfer risk off their balance sheets to other non-bank institutions who are less able to estimate risk or absorb losses should they occur. While risk transfer to those who are best able to manage it is desirable – annuity funds buying corporate bonds for their long term stable cash flows – there are many cases where this risk transfer is done solely to avoid regulatory capital charges and may leave the losses to fall back onto the banking system as the risk transfer may have only been notional (perhaps to an off-shore non bank subsidiary or hedge fund with whom the bank has a prime broker agreement).

    An important element of finance is the ability of banks to securitise but this should only be done where investors can gain access to the underlying loan data so they can examine the risks for themselves rather than rely on complex hedging structures or simplistic credit grades from rating agencies. With the correct level of regulatory oversight and a stringent separation between banks and non-banks to ensure risk is fully transparent and transferred: setting regulatory capital at the Bank institution level is desirable but regulators should be aware and close arbitrage opportunities by making incomplete or artificial risk transfer illegal.

    Where there is a more significant issue is when regulators impose product or loan type risk ‘buckets’. For example, where regulators say loans to residential mortgages attract x% regulatory capital, loans to commercial real estate y% and loans to corporate customers z% regulatory capital. Lenders must decide where to channel their capital and clearly they will make more money if they can lend to the category which attracts the lowest level of regulatory capital – in the example above it is residential mortgages. But this will lead to a problem because every other bank will do the same so margins in those areas will naturally fall. The bank’s only option is therefore to find which part of the residential mortgage market offers the highest margin since its regulatory capital is fixed for this entire area of lending. In this example it is in the UK buy-to-let or in the US sub-prime both of which tend to be highly risky from a borrower point of view but also very sensitive to market risk due to either capital value changes or interest rate movements – neither of which are accounted for in Regulatory Capital. So in effect the bank is making large but illusory margins but this is not reflected in the amount of capital held so short-term profits and bonuses are high – until the inevitable losses occur.

    The greatest danger of these detailed regulatory rules is that banks fail to focus on managing risk but instead focus all their resources and intellectual fire power on finding ways to lower regulatory capital. Very little effort is spent on trying to understand the real risks they are taking – an example of this can be found in the fact that it has taken nearly three years for UK banks to gather the data they should have had at their fingertips on the loans they made to the Commercial Real Estate sector. The lay person could be forgiven for assuming that banks would keep up-to-date records of all the facts surrounding large loans made to property investors, such as leases, tenants, rental values and other details, but the vast majority of banks have been unable to assemble this information in a consistent and timely fashion because it has never been considered an essential part of calculating the loan profitability or risk. Risk managers spend most of their time working out how to respond to regulators and their rules so that they can reduce the amount of regulatory capital. Regulators cannot know or manage individual loans but they impose more and more rules to try to close every avenue resulting in more and more complex rules that risk managers are paid to circumvent. It is a very dangerous game and someone needs to break the vicious cycle.

    Regulators, central bankers and politicians do not want to appear to be weak on regulation so they are happy to issue more rules rather than examine the fundamental issues of what is needed to ensure a prudent but profitable banking sector. As long as banks measure and report their profitability against regulatory capital we will never solve this problem as the motivation to optimise this artificial notion of profit will overwhelm all attempts at reform.

    The concept of Economic Capital is well understood and accepted as the correct measure of bank profitability but it is not enshrined in the way banks are regulated or report their finances. The complaints made by bankers that it is too costly and complex to institute bottom up measures of risk so that Economic Capital can be calculated at the individual loan level should be ignored. We do not allow aircraft manufacturers to say that duplicated and costly safety systems damage their profitability we correctly say that if you want to fly passengers you must invest in appropriate safety measures and systems.

    Banks should be forced to measure bottom up the cost of how much capital they need to hold against each and every loan to ensure they can withstand unexpected losses. These measurements should be enshrined in the governance structure of the bank in the same way that other financial reporting is a statutory requirement. In a similar way that a Finance Director is responsible to the Board for the truthful and honest reporting of the P&L, a Board level Risk Director should have statutory responsibility for the forward measurement of risk, the models used and the numbers reported. These should be subject to the same level of rigour and external audit as statutory accounts.

    Regulators could then review or conduct their own audits of the bank’s risk systems and overall levels of Economic/Regulatory Capital held and if they feel that a bank is poor at estimating risk or is underestimating risk they should be able to apply a regulatory capital multiplier above the regulatory capital floor as laid out in Basel 111. Instead of trying to second guess every risk that could be taken – an impossible and never ending task – regulators should abandon any attempts to impose risk techniques or methodologies and force the banks to estimate their risk and then audit the results.

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