International regulators did the world a service by reporting that shadow banking remains an enormous force in the global financial system. Firms in the sector had $67 trillion in assets last year, the Financial Stability Board has just reported. But given the importance of the lightly monitored companies, the regulators’ prescriptions seem cautious.
Shadow banking is lending outside the conventional banking system, done by firms such as money market mutual funds, hedge funds, and securities dealers. It’s far less regulated than lending by normal banks, which take insured deposits. Many economists and financial experts say shadow banking was responsible for triggering the global financial crisis of 2008-09.
Regulating it isn’t easy, for two very different reasons. One is that shadow banking can’t be shut down entirely because it does some real good. “Non-bank financial entities can … be sources of long-term and short-term credit to businesses and households,” the Financial Stability Board wrote in a report released on Nov. 18 (PDF). The second reason is that the sector has political muscle. “We’re already seeing a contest of wills” over attempts to tighten regulation, says Erik Gerding, a law professor at the University of Colorado, Boulder who specializes in banking regulation.
The board’s five-step plan to fix shadow banking, which was released in conjunction with the report on the sector’s size, didn’t exactly stick its neck out. The board is seeking comment on the plan and plans to publish final recommendations in September 2013. Here’s a boiled-down version:
1. Keep banks from being infected by problems in shadow banking. On this point, the board mostly just endorsed existing plans from the Basel Committee on Banking Supervision, which wants banks to keep thicker buffers of capital against potential losses on loans they make to shadow banking organizations.
2. Make money market mutual funds less vulnerable to runs. In the U.S., the new Financial Stability Oversight Council is continuing to press for making the funds let per-share values float in line with the value of the underlying securities, making them less rigid and breakable. The Financial Stability Board said funds should switch to floating net asset values “where workable”—a phrase that leaves room for funds to keep things as they are.
3. Put some teeth into the rules for other shadow banking organizations. The board lays out a long-term agenda for reducing risks, other than those posed by money market mutual funds. To make sure countries can’t simply ignore regulations they don’t like, the board said tougher policies should “eventually” become a “membership commitment subject to peer reviews.”
4. Regulate securitization. When it comes to bonds backed by assets such as credit-card receivables or mortgages, the board advocated greater disclosure and said countries should “converge” on the amount of risk that a securitizer must retain to make sure it has an incentive to sell only high-quality securities. But it didn’t give numerical targets.
5. Regulate securities lending and repo lending. Most of the recommendations on the businesses of loans backed by stock or bonds are standard-issue, such as making sure that the collateral posted is adequate. On the most controversial issue—the preferential treatment of repurchase agreements and securities loans in bankruptcy court, which has contributed to their explosive growth—the board said changes “may be viable theoretical options” but concluded, “they will not be pursued for now due to practical difficulties.”
Lena Komileva, chief economist of London-based G+ Economics, an investment advisory firm, described the balancing act regulators face. “Bringing shadow banking out of the shadows recognizes the systemic importance of non-bank finance for the health of the global economy,” she wrote in an e-mail. “But regulators need to apply a surgical scalpel not an ax, so that the benefit of avoiding another Lehman, AIG (AIG), or Reserve Primary Fund does not come at the cost of the long-term efficiency and productivity of the financial system.”
