Commentary: The big banks, not the shadow banks, are the problem

Shadow banks do not pose a threat to the future. It’s the giant traditional banks that are the threat, and new regulations may have them cornered.

That seems to be the view of Roy C Smith, professor of international business at New York University’s Stern School of Business, expressed in a Financial News column March 28.

He ticks off a list of restrictions on both shadow and conventional financial institutions that have been put in effect since the financial crisis and that will, he believes, keep risk in check. But he does not note that the problem in 2007-2008 was the interconnectedness of the institutions, mainly with repurchase agreements, and little has been done to fix that vulnerability.

Still, his column does highlight an important point: The big risk is not in the shadow banking system, it’s in the big bank holding companies.

From his column:

The idea that the next meltdown will occur in the widely distributed shadow banking sector is nonsense, now that its riskier aspects have been addressed. …

The heart of the problem remains the 10 largest banks that manage about 75% of global capital market transactions. These banks averaged $1.8 trillion in total assets in 2010, with the top five averaging $2.4 trillion, nearly 50 times the Dodd-Frank measure for systemic risk. …

Overall, the shadow banking system does not present much by way of systemic risk to the financial system because it is so widely distributed over so many different types of risk, trading strategies and independent managers.

The world’s largest banks remain too big to fail despite regulatory and political efforts to deny such a category still exists. To be sure they don’t fail, regulators in the US and Europe have decided to make them “fail-safe” by imposing extra heavy capital requirements and restricting some trading and other activities.

Assuming regulators are more alert than they were last time, these banks will be unable to take on life-threatening exposures in loans or marketable securities.

(RepoWatch comment: That’s a big assumption.)

They are being driven to become the solid, sensible public utilities of finance at the centre of a system that distributes risk to thousands of institutional investors with different appetites for risk that operate beyond the centre. Bank executives, of course, wish to resist being turned into public utilities.

The transfer of risk from the centre of the system, where it is concentrated, to its outer edges, where it is widely disbursed, has been one of the important safety features of the global financial system that has developed through capital markets over the past 40 years.

(RepoWatch comment: The “system that distributes risk to thousands of institutional investors” turned out to be a myth in 2007-2008, as one-fourth of the risk was held by the banks that supposedly were selling it to institutional investors.)

The system must be protected against another meltdown, principally by restricting the biggest banks, but the capacity of capital markets to generate competition and innovation needs also to be preserved. For this the shadow banks should be welcomed, not feared.