Coming out of the shadows

There are two ways to regulate shadow banking and the repurchase market to prevent a repeat of the credit crisis in 2007 and 2008, says economist Viral Acharya in a March 8 article in The Banker, “Coming out of the shadows.”

Acharya is professor of finance at New York University Stern School of Business and the lead author of a book on the crisis, “Regulating Wall Street.”

-One way is to insure shadow securities, like the FDIC insures commercial bank deposits. In return, shadow bankers would pay a fee, their ability to take risks and borrow money would be regulated, and if they got into financial trouble regulators could take them over and wind them down, just like the FDIC does now. Acharya says shadow securities are repurchase agreements, ABCPaper, money market fund shares and securities lending instruments.

-Another way is to leave shadow banks alone until there’s a crisis. Then let regulators move in to stop a run and make loans, to keep cash flowing into the financial markets and to keep credit markets from freezing.

He also calls for Basel regulators to change capital rules so bankers can’t hide debt by moving into the shadows, as they did in the years leading up to the crisis. “The loopholes involving different accounting and regulatory capital treatments of on- and off-balance sheet assets should be removed at the earliest opportunity as they facilitate leverage build-up in the shadow-banking world in opaque forms,” he writes.

From the article:

Does history tell us anything about how to regulate the shadow banking system? During the panic of 1907 and the various banking panics between 1930 and 1932, uncertainty and lack of information about which financial institutions were insolvent led to system-wide bank runs. In response to these, the government created the Federal Reserve with its lender of last resort facility, the Federal Deposit Insurance Corporation (FDIC) and deposit insurance, along with a number of banking and investment acts. Arguably the most important part of the legislation was that depositors no longer had to remove deposits in panic because they had a government guarantee.

Acharya doesn’t say which fix he prefers for shadow banking, but in “Regulating Wall Street,” on page 345, he and his co-authors argue for creating a repo resolution authority, with access to the Fed’s discount window, that in the event of default by a repo borrower would repay the repo lender, liquidate risky collateral, pay out claims and force the parties to take a financial hit. 

In a March 10 article in The Banker he expresses concern about the moral hazard in government guarantees, the risk that the guarantees encourage banks to take, and the failure of government to make banks pay in advance for the guarantees. He believes creditors would do a better job of monitoring bank performance if banks were not protected by a government guarantee.

“In the absence of market discipline, deposit insurance and coarsely designed capital requirements are an imperfect proxy. The former tend to be mispriced, the latter can easily be gamed. It is therefore ironic that the very guarantees that induced banks to take on excessive leverage and risk – and endanger our jobs and savings – must be sharply increased to escape from the mess,” he writes.

From the article:

Only if regulators charge suitably for the guarantees will banks price them in to their loans and leverage decisions. Otherwise, the resolution of the most severe financial crisis of our lifetimes might soon turn out to be a Pyrrhic victory.