Shadow banking ... or ghosts in the machine?

  • Business
  • Saturday, 22 Dec 2012

IN 2007, bond market guru Bill Gross coined the term “shadow banking” to illustrate the role of non-bank institutions in creating money-like credit that could implode and affect the traditional banking system.

Four years later, the Financial Stability Board (FSB) finally gave its initial recommendations on how to oversee the shadow banking system to G20. Last month, FSB published its Monitoring Report on Global Shadow Banking, revealing that the system rose from US$26 trillion in 2002 to US$67 trillion in 2011, roughly 25% of total global financial intermediation.

Out of this total, the United States, eurozone and UK accounted for US$54 trillion or 80.6% of the total global shadow banking assets, with the United States having the largest share (35%, having dropped from 44% in 2005), eurozone (32.8%) and UK (13.4%).

The term “shadow” banking is really a misnomer, being a nice excuse for some regulators that they did not see it, but FSB defines it as “credit intermediation involving entities and activities outside the regular banking system”. This covers all the institutions that have always been visible to all of us, and were regulated in one form or other.

Shadow banking involves highly-visible institutions, such as money market funds, Freddie Mac and Fannie Mae (mortgage corporations), hedge funds, insurance funds, investment banks and securities houses.

The global regulatory community has finally woken up to the fact that these institutions have risks of their own, risks through links with the banking system, help banks to avoid regulation and can lead to build-up of leverage and risks in the system.

A common trouble with highly theoretically trained and model-driven bankers and regulators (before the crisis) was that they tended to assume that what could not be seen might not exist and what cannot be measured was not important. There is also a common belief that has persisted beyond the crisis that marginal increases in capital can deal with a “tsunami” shock of a sudden loss of trust in the financial system as a whole. Citibank had capital of 11.8% of risk assets in 2008 that would have satisfied Basel III capital requirements when it received help.

In other words, even increasing capital of the banking system to 17%-18% of risk-weighted assets (the aim of Basel III) may be insufficient if the system as a whole is over-leveraged.

Between 2007-2009, the US real estate market dropped 18.7% and lost US$7.5 trillion in wealth or nearly 50% of GDP and stock market wealth was reduced by 45% of GDP. That wealth loss by the system as a whole was borne by a banking system with liabilities of around 75.9% of GDP. It was not surprising some banks failed.

In Europe, the total financial asset/GDP ratio reached 551% in 2010, among the highest in the world, with bank assets/GDP at 274.3% of GDP.

For eurozone countries with fiscal debt of around 100% of GDP, an interest rate increase to 6% would double the debt to 200% of GDP in 12 years, which is clearly unsustainable.

With real interest rates of over 6%, the real estate market is crashing, as has happened in Ireland, Greece and Spain respectively. By definition, the banking systems would be de-capitalised, and their governments had to stand behind these systems. This is precisely why ECB used massive quantative easing to keep the whole system afloat.

As Black Swan author Nassim Nicholas Taleb repeatedly reminds us all, don't focus on the average but look carefully at the tail risks and the system as a whole. Assigning individual risks to risk assets and then allocating capital to these risks completely ignores the fact that you are not looking at uncertainty (non-measurable risks) and complex non-linear interaction between these individual assets, your bank and your environment, which are much more co-related than you think.

So, thinking that you are marginally increasing risk weights and risk capital without looking at the whole environment is like shuffling decks on the Titanic.

What is happening to the global financial system as a whole?

First, according to an excellent Brooking conference on financial structures last month, the banking system (already highly concentrated before the crisis) has become even more concentrated after the crisis.

Second, as the FSB data has shown, the shadow banking system has grown larger than before the crisis.

Third, because the wholesale inter-bank markets are failing, the advanced country central banks, through unconventional monetary policy, has de facto replaced their banking systems as the first provider of liquidity and even supporters of mortgage markets. The ECB and the Fed have balance sheets of nearly US$3 trillion and are committed to increasing them as much as necessary to meet their unconventional targets, which now include unemployment levels.

The trouble is that there is increasing research, especially from Japan, that the impact of unconventional monetary policy on the real economy is ambiguous at best. The real benefits are for the financial market, and that is not distributed evenly, with savers and pensioners bearing the brunt of subsidising borrowers. Japan has had more than a decade of experimenting with unconventional monetary policy.

The priority in this global environment is to keep our focus on the real sector on promoting trade and growth, jobs and tackling social inequalities, such as providing more pension benefits and helping SMEs that account for the bulk of innovation, job creation and social stability.

Worrying about shadow banking is like whether we should be worried about ghosts or the person telling us to worry about ghosts. My fear is not about ghosts, but about what the story teller may or may not do. The greatest risk today is not business risks, but regulatory and monetary policy risks.

Beware quantitative easing, because it promises more than it can deliver.

> Tan Sri Andrew Sheng is president of Fung Global Institute.

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