Shadow Banking Is Still Here and Risky As Ever

With U.S. banks reporting today, I went back to re-read an article by one of my favorite financial experts, Lord Adair Turner, former head of the Financial Services Authority (FSA) in Great Britain and an investment banker with deep experience.  The article is a Cass Business School case of March 14, 2012, "Shadow Banking and Financial Instability."

Lord Turner uses the NY Fed's 2010 estimate of the shadow banking industry's size as being in the order of $25 trillion.  The SBS today is not separate from the traditional commercial banking sector, nor is it a parallel, "shadow" system any longer.  SBS is inextricably intertwined with commercial banking, whose leaders like JP MorganChase and Wells Fargo, reported earnings today.  Therefore, the shadow system cannot be regulated separately nor ring-fenced from the commercial banking system, as some commentators suggest. 

Turner defines the shadow banking system as one which creates credit flows outside the banking system, while at the same time, sharing some of the distinctive features of the commercial banking system: leverage, thin layers of equity, volatile assets, and maturity mis-matches between assets and liabilities.  Both systems therefore perform the value-added service of maturity transformation.  The SBS, however, distinctively does it through multple, opaque steps rather than through one single, corporate balance sheet. 

It's huge impact on transforming financial markets can be seen in a few statistics:

• Between 1980-2008, the share of bank-originated mortgages which were retained on bank balance sheets went from 80% to 35%.
• Over the same period, global securitised credit went from 6% of GDP to 80% of GDP.

In the U.S., the incredible expansion of mortgage credit was driven by the following factors, according to the author:

• The insistence on providing a 30 yr., fixed rate, repayable at any time mortgage to the market.
• The effect of Regulation Q, which gave money market mutual funds (MMFs) a huge advantage in being able to participate in financing this mortgage boom and getting higher yields.
• The repeal of Glass-Steagall and the simultaneous practice of lightly regulating the broker-dealers, who were rapidly increasing their shadow banking functions.

The author notes that the crisis "was triggered by high levels of losses in U.S. subprime residential mortgage lending."  He also points out that the magnitude of the losses while very large, were not cataclysmic by themselves.

The European crisis, by contrast, was not precipitated by securitised lending, but by traditional bank lending, lax underwriting standards, and a concentration of the portfolio in residential and commercial real estate. 

Turner points out that the volume of securitised credit has fallen by 90% globally from peak-to-trough in the U.S. and by 95% peak-to-trough in Europe.  However, he says, this is simply a result of the global economic downturn and a significantly reduced demand for credit.  When the world economy recovers, then Turner says that the SBS will gear up again, with the same risk transmission mechanisms in place as before.  This is really not good news, even as markets are rising today.

The Volcker Rule, by itself, will not be effective, and it now appears to have little chance of being implemented.  The Financial Stability Board is supposed to propose regulations to the G20 by the end of 2012.  Although the quality of their output may be better than Dodd-Frank, it will be delivered to politicians whose qualities are no better than our own. 

The author makes an interesting comments about credit default swaps, a much ballyhooed "pricing mechanism" for risk.  Financial journalists dutifully reported CDS spreads on major banks in the run-up to the crisis, suggesting that there was little cause for alarm.  Unfortunately, these prices are not really a  market price because they are "self referential," in the words of the author who writes, CDS spreads for banks "provided no useful  pre-crisis warning of the impending disaster."  So, let's leave this indicator for the traders.