Bringing shadow banking out of the dark

By Simon Richards | 10 December 2014

The sinister-sounding ‘shadow banking’ sector may conjure notions of secret accounts and underhand transactions, but it’s in fact a legitimate industry now worth a staggering $75 trillion.

But this somewhat opaque market is moving into the spotlight amidst calls for greater regulation – and warnings that it may pose a threat to the wider financial system.

To assess whether the scaremongering is justified, it’s important to explore why shadow banking has captured regulators’ attention.

The rise and rise of shadow banking

Composed of borrowing and lending that falls outside the regulated banking sector, shadow banking includes the likes of crowdfunding, hedge funds and private equity firms.

In the wake of the financial crisis, banks have tightened up lending and today face far stricter regulation as governments look to bring more transparency to the industry. With traditional credit sources under more pressure, shadow banking has proven to be an attractive and viable option for businesses looking to gain access to funding and it’s growing at break-neck speed, having grown by $5 trillion in the past year alone.

Stringent rules for banks have helped encouraged this shift of lending into the ‘shadows’, but within shadow banking itself we’ve witnessed a shift towards activities that are ‘less well understood or monitored’.

What’s more, shadow banking does not exist in isolation. This market and the traditional banks are closely interlinked meaning that an issue with one can negatively affect the other. Bodies that extend credit beyond the traditional banking system therefore have the ability to directly impact the entire financial sector.

Despite this influence, shadow banking is far less transparent than regulated borrowing and lending. Dodd-Frank – the landmark legislation aimed at strengthening our financial ecosystem to help prevent another financial crisis – has arguably done little to address the fact that risk is increasingly moving into the non-regulated areas of finance.

So what needs to change?

Regulating the unregulated

Far from lowering standards for banks, it’s clear that more needs to be done to pool knowledge and regulate this murky sector, because regulation is playing catch-up with explosive growth and innovation within the shadow banking sector.

And knowledge is limited. Every financial crisis is preceded by rising debt levels, but it could be said that we know less about where debt lies than we did before the financial crisis of 2008. Shadow banking has grown to about the same size as the traditional banking sector, with little to no transparency over its large holdings of illiquid assets.

It’s little wonder, then, that Financial Stability Board research implies the next financial crisis could come from shadow banking.

Now is the time to closely review the sector and monitor its boundaries with regulated lenders. Shadow banks rely on traditional, regulated banks, and regulation must ensure banks are not over-lending to shadow banks – and won’t be endangered by issues within the shadow banking sector.

Global regulators are already making moves to cut the risk beyond the confines of the regulated banking sector. From the end of 2017, ‘shadow’ institutions such as private equity firms will be required to provide a base level of collateral when borrowing from banks.

It’s a positive step aimed at preventing a repeat of the excessive-lending we saw in the run up to the last financial crisis. But the regulation only applies to transactions between banks and non-banks, so there’s much to be done to address deals taking place between shadow firms themselves.  

The Bank of England Deputy Governor Jon Cunliffe has perhaps best summarised the shadow-banking predicament. In his words, we ‘don’t know enough about the system’ to conclude that it’s a threat to the financial system – but we also don’t know enough to conclude that it isn’t.

That’s why, in parallel with greater compliance in the financial sector, we also need close monitoring of any rise in systemic risk factors within the non-bank sector that might put financial stability at risk. We need appropriate and effective oversight, but we must ensure regulation does not inhibit the growth of those firms which pose no risk and are a welcome alternative to traditional funding routes.  

It’s time to bring shadow banking out of the dark.
 

By Simon Richards, CEO, Fonetic USA

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