Congress and regulators are going to put a bunch of new rules in place, but they’re not going to articulate a coherent vision of what shadow banking should, or should not, be.
They’re going to clamp down on risk-taking at individual financial institutions, but they have no plan to protect the larger shadow banking system – like the FDIC protects traditional banking – from the runs that nearly collapsed the world’s financial markets in 2007 and 2008.
This hasn’t stopped some experts from trying to expand the conversation. A flurry of shadow banking reports has been published this year, with the best coming in April from the Federal Reserve Bank of New York, the Bank of England, and the Financial Stability Board in Basel, Switzerland.
But the road ahead seems set.
Congress and regulators say their goal is to keep the good side of shadow banking, which expands credit and grows the economy, without its bad side, which bubbles up and then gets flattened by crummy collateral and a panic. To achieve these goals, they will try to ratchet down risk and rebuild trust.
So, how’s that going ?
From Tarullo’s May 2 speech:
It is sobering to recognize that, more than four years after the failure of Bear Stearns began the acute phase of the financial crisis, so much remains to be done–in implementing reforms that have already been developed, in modifying or supplementing these reforms as needed, and in fashioning a reform program to address shadow banking concerns. For some time my concern has been that the momentum generated during the crisis will wane or be redirected to other issues before reforms have been completed …. this remains a very real concern.
Tarullo also said:
Finance and financial intermediation are not ends in themselves, but means for pursuing savings, investment, and consumption goals. Our debate about what we don’t want intermediaries and financial markets doing must be informed by a better articulated view of what we do want them doing.
Federal Reserve Chairman Ben Bernanke offered the following update on shadow banking reform in a speech at the 2012 Federal Reserve Bank of Atlanta Financial Markets Conference in Stone Mountain, Georgia, April 9, 2012:
Given the substantial stakes, I am encouraged that both regulators and the private sector have begun to take actions to prevent future panics and other disruptions in shadow banking. However, in many key areas these efforts are still at early stages.
He gave updates on four key areas:
1. Off-balance-sheet rules: Mostly done. Because of new accounting and banking rules that went into effect in 2011, it will be harder for banks to pretend they’re not on the hook for the firms they set up to securitize loans. It may also be more expensive for them to set up these securitizing firms. (Similar accounting rules are scheduled to go into effect on the Continent in January 2013.)
2. Capital, leverage, and liquidity: Proposed. This is the reform that U.S. regulators have often said is the most important to prevent runs, but its future is uncertain. Global bank regulators writing Basel III want to increase the amount of money a bank’s owners must contribute to the bank’s operations – and therefore have at risk. They also want to require banks to keep more cash or easily sellable securities on hand in case of a panic and to rely less on short-term borrowings. These rules are called capital (equity), leverage and liquidity ratios. Underway are battles to set how much money the owners must contribute, to define easily sellable securities, and to harmonize rules internationally. Bank efforts to dilute or game these ratios are also underway. For some examples, see here, here, here, here and here. These rules apply to traditional banks, but they will impact other shadow bankers as well because traditional banks are major players in the shadows, as New York Fed economists explain here and here.
3. Money market funds: Partially done. Leading up to the crisis, money market funds were leaders in making repo loans and in buying asset-backed commercial paper. After the crisis, the Securities and Exchange Commission set tighter limits on where money market funds can invest their money. Ironically, this is driving more of them to repos, often backed by collateral that regulators say money market funds can’t own even when a borrower defaults. Bernanke, SEC Chairman Mary Schapiro, Tarullo and others say money market funds are still vulnerable to runs and more reform is needed. The SEC is considering letting the value of shares fluctuate, instead of being fixed at $1; requiring each fund to set up its own financial safety net; and limiting depositors’ on-demand redemptions. Regulators discuss these ideas here and here.
4. Tri-party repo: Not done. JP Morgan and Bank of New York are still extending intraday credit to borrowers on the tri-party repurchase market, and the market is still vulnerable to the default of a major securities dealer, as it was with Bear Stearns and Lehman Brothers. These are risks the Federal Reserve has repeatedly said are of deep concern. When the industry couldn’t agree on reforms, the Fed said it may require tri-party borrowers to use only super safe collateral, and it may require the industry to fund a special bank that would give financial help to repo lenders who suddenly find themselves stuck with collateral from a defaulted borrower. Other experts recommend that tri-party repo be operated by a regulated utility, not by JP Morgan and Bank of New York.
In an example of problems that can be caused by the piecemeal approach to shadow banking regulation, the Fed wants tri-party borrowers to use long-term borrowing, while the SEC wants to restrict money market funds – who are key tri-party lenders – to short-term lending.
A fifth key reform was analyzed by New York Fed economist Tobias Adrian in “Dodd-Frank One Year On: Implications for Shadow Banking,” December 2011:
5. Risk retention: Proposed. Firms that make or securitize loans will have to retain at least 5 percent of the risk and can’t hedge it, unless the securities are backed by high-quality mortgages or regulators grant the securities an exemption. Underway are battles to define “risk retention” and “high-quality mortgage.”
A sixth reform, bank lending limits set by the Dodd-Frank Act (Congress’ response to the financial crisis), was discussed by University of Massachusetts economist Jane D’Arista in “Reregulating and Restructuring the Financial System: Some Critical Provisions,” October 2011. D’Arista thinks the limits can cut back on the dangerous interconnectedness of the shadow banking system, if regulators implement them properly.
6. Bank lending limits: Partially done. Since January 2012 banks have been limited in the amount of lending they can do to their own subsidiaries and to other financial institutions – limits that previously applied only to non-financial borrowers. Not yet final is a rule to limit “credit exposure” to any unaffiliated company, possibly including securitizing firms. Underway is a battle over how to calculate “credit exposure.” Repos, securities lending and derivatives transactions are counted for calculating both lending limits and credit exposures.
Following are other Dodd-Frank rules aimed in part at shadow banking. Key sources for this information are “Understanding the New Financial Reform Legislation: The Dodd-Frank Wall Street Reform and Consumer Protection Act,” Mayer-Brown, July 2010, and “Shadow Banking Regulation” by Tobias Adrian and Adam B. Ashcraft, Federal Reserve Bank of New York, April 2012.
7. Derivatives: In progress. Dodd-Frank dramatically overhauled derivatives trading and said most swaps must trade through clearing houses instead of bilaterally. Underway is a battle over how to manage this revolution.
8. Systemic risk: In progress. Dodd-Frank created the Financial Stability Oversight Council to spot risk and fix it before it erupts. Underway is a battle over who’s a “systemically important financial institution” and who’s a “financial market utility.” All will be subject to more oversight, restrictions, costs and government protection. (Thus, SIFIs and FMUs enter the financial lexicon.) Dodd-Frank says SIFIs are U.S. bank holding companies with at least $50 billion in assets and any non-bank financial company selected by the Financial Stability Oversight Council. If a systemically important financial institution fails, it will be seized and unwound by the FDIC, which can later charge all SIFIs a fee to cover cost overruns. This is different than traditional banking, where banks pay an upfront insurance premium to the FDIC, and the FDIC can use that money to cover its costs when it has to take over an insolvent traditional bank.
9. Data: Under study. Dodd-Frank created the Office of Financial Stability to improve data collection, including for shadow banking. The office is consulting with other nations. Dodd-Frank also ordered more transparency for securities lending and for securitizing firms.
10. Short-term debt: Waiting. Dodd-Frank gave the Federal Reserve permission to limit the amount of short-term debt at any institution the Financial Stability Oversight Council decides could pose a risk to financial stability (the SIFIs). This rule targets mainly repos and asset-backed commercial paper.
11. Credit rating agencies: In progress. Dodd-Frank hammered credit rating agencies and told regulators to find alternatives. Underway is a search for alternatives: Some financial institutions may now rate their own securities.
12. Wall Street trading: In progress. The Volcker rule will ban banks from proprietary trading and possibly from overseeing securitizing firms. Underway is a battle over the definition of “proprietary.”
13. Securitizing firms: In progress. In addition to the various provisions above, Dodd-Frank says securitizing firms have to divulge certain kinds of bad news; banks and nonbanks that oversee them have to avoid conflicts of interest with investors; and foreign banks and nonbanks that oversee them have to register with the SEC.
To summarize, here are the reforms intended to corral shadow banking:
–Banks: Take more financial responsibility for your securitizing firms, put more of your own money at risk, keep more cash and cash-like securities, don’t lend so much money to your subsidiaries or other financial institutions, and stop your risky trading.
–Securitizing firms or lenders: Retain 5 percent of the risk in any securities you sell unless they’re backed by high-quality mortgages.
–Securitizing firms and financial institutions that oversee them: Get ready for lots of new requirements, most of which can be handled by the proper paperwork, and make important new disclosures.
–Money market funds: Put your money in safer investments and … maybe something else.
–Swaps traders: Welcome to regulation. Use clearing houses. Credit default swap-ers, this means you.
–Systemically Important Financial Institutions: Prepare a suite of offices for a permanent team of in-house regulators. Reduce your short-term debt.
–Credit rating agencies: Clean up your act. We’re trying to replace you.
–Tri-party repo clearing banks: Watch out. The Fed is on the case.
–Everybody: Beef up your IT department to disclose more data. If you get into trouble, we’re going to take you over, not bail you out. Believe it.
Meanwhile on the global scene, studies continue. The Financial Stability Board, a research group for the G20 leading world economies, and the Financial Services Authority, the financial regulator for the UK, will issue their key recommendations by the end of 2012. Their decisions are important in the U.S., given the global nature of the financial markets. In the run-up to the financial crisis, UK and European banks played a key role in the U.S. shadow banking system, according to Princeton University economist Hyun Song Shin in “Global Banking Glut and Loan Risk Premium,” November 10–11, 2011.
A preliminary G20 wish list sounds a lot like what U.S. regulators are working on, but the devil will be in the details:
-Require that securitization by banks be done in-house, not in a separate securitizing firm.
-Limit transactions that traditional banks can do with shadow banks.
-Raise capital, leverage and liquidity levels for shadow banking transactions.
-Do something about money market funds.
-Watch shadow banking companies more closely, including securitizing firms, finance companies, mortgage insurance companies, and credit hedge funds.
-Make securitizing firms be more transparent and retain some risk when they sell securities.
-Do something about repos and securities lending and maybe limit reuse, or rehypothecation, of securities.
-Get more data.
-Require better underwriting.
-Stop using credit rating agencies so much.
(RepoWatch editor’s note: See the Finding a Fix tab on the RepoWatch home page for more detail on reform ideas and efforts since the crisis.)
The big question
The big question is whether these new rules will control risk, reassure investors, and allow shadow banking to be a stable source of credit for the U.S. economy in the future.
Especially, will they eliminate panics like the one in late 2008? At that time, frightened lenders fled the repurchase and securities lending markets. Buyers fled the asset-backed commercial paper market. Depositors fled money market funds. Hedge funds fled from securities dealers, where they had been keeping much of their securities and cash. And more. The entire shadow banking industry went into freefall.
Some economists say no.
From “A Proposal to Resolve the Distress of Large and Complex Financial Institutions” by Viral V Acharya, Barry Adler and Matthew Richardson, New York University, April 14, 2011:
As governments around the world rewrite financial sector regulation, a key issue that remains unresolved is whether the distress of large, complex financial institutions will be managed better in the next crisis than in the last one. …
In the United States, the Dodd-Frank Act sets out a series of insolvency procedures, and internationally Basel III establishes some resolution principles. But neither offers a clear prescription for how to prevent the next systemic crisis or for how to manage one should it materialize.
Besides, bankers can figure out how to get around these new rules, say New York Fed economists Adrian and Ashcraft in “Shadow Banking Regulation.” From their April 2012 report:
Since the financial crisis of 2007-09, a host of regulatory reform efforts have been undertaken. We expect shadow banking to adapt to these new regulations, and expect new forms of regulatory arbitrage and shadow banking to emerge.
But supporters believe the many new restrictions will make shadow banking less profitable, downsize it and gradually bring it under control.
D’Arista has said that we’ll know the reforms are working if bank leverage falls; banks do less proprietary trading; less credit flows to financial institutions and more flows to nonfinancial sectors; shadow banking shrinks and traditional banking grows; and giant banks get smaller.
If she’s right, signs are positive. Check out some of the news reports this year:
“Prime brokerages consolidate after ‘big bang‘” by Edward Krudy, Reuters, April 16.
“Broker-dealers unlikely to see renaissance” by Tracy Alloway in New York and Daniel Schäfer, Financial Times, April 9, 2012.
“Hedge funds keep a lid on leverage” by Sam Jones, Financial Times April 9, 2012.
“New Normal on Wall Street: Smaller and Restrained” by Peter Eavis and Susanne Craig, New York Times, January 19 2012.
“Bank Cuts Reflect New, Leaner Era” by Dana Cimilluca, David Enrich and Sara Schaefer Munoz, Wall Street Journal, January 13 2012.
“Global bank job losses rise above 130,000” by Reuters, January 12, 2012.
Clearly, something is changing. To some, these headlines are encouraging.
To others, they’re proof of an economy in decline and an opportunity wasted, when Dodd-Frank failed to structure a reliable shadow banking model to help supply credit.
They note that while parts of the banking system are contracting, the biggest banks, the banks whose failure would be the most damaging to the economy, are growing bigger than ever.
They fear Dodd-Frank will be like other well-intended reforms that relied on regulators, got watered down, were easily evaded, and ultimately failed.
Without more profound system reform, they say, more banking will eventually return to the unreformed shadows, in ways we don’t expect, and where runs and 2008-style panics will be inevitable.
From “Securitisation, shadow banking and the value of financial innovation,” a speech by Adair Turner, Financial Services Authority, April 19, 2012:
Hyman Minsky was, wisely, cautious of believing that any regulator could precisely offset the instability which the operation of private incentives, innovation and changing risk appetite would unleash.
“In a world of business men and financial intermediaries who aggressively seek profit, innovators will always outpace regulators ….”
From “Shadow Banking Regulation” by Adrian and Ashcraft, Federal Reserve Bank of New York, April 2012:
The dilemma of the current regulatory reform efforts is that the motivation for shadow banking has likely become even stronger …
From “Shadow banking – thoughts for a possible policy agenda” by Paul Tucker, Bank of England, April 27, 2012:
The issues here are very important since, as the international community reregulates the banking industry, more activity is almost bound to be booked outside banking.
From Tarullo’s May 2 speech:
… as time passes, memories fade, and the financial system normalizes, it seems likely that new forms of shadow banking will emerge. Indeed, the increased regulation of the major securities firms may well encourage the migration of some parts of the shadow banking system further into the darkness–that is, into largely unregulated markets.
Other reforms proposed
Critics’ have proposed several shadow banking reforms they believe would make the financial markets safer.
Among them are: Outlaw shadow banking, keep financial institutions smaller, levy financial fees and taxes, mandate clearing houses, and require more transparency.
Outlaw shadow banking: Some observers believe all banking – often described as borrowing short-term and lending long-term – should be done through traditional banks, with their heavy regulation and safety nets. We don’t need to stress over how to regulate shadow banking, these observers say. We already have a fine banking system.
From British Prime Minister Gordon Brown’s speech to Congress, March 4, 2009:
How much safer would everybody’s savings be if the whole world finally came together to outlaw shadow banking systems and offshore tax havens?
Those who don’t want to outlaw shadow banking say economies need the credit it supplies.
Smaller financial institutions: Some observers believe regulators will never be able to stay ahead of shadow banking, because it’s too complex and ever-changing. They believe giant financial institutions will get bigger, and regulators will not let them fail. They believe a Dodd-Frank provision that limits bank size to 10 percent of the U.S. market, measured by deposits or liabilities, is too lenient. They say the only solution is to reduce the size of the companies involved, so regulators can better control them and the FDIC can easily unwind them if they fail.
These observers want regulators to break up giant financial institutions, which Dodd-Frank says the Federal Reserve and the Financial Stability Oversight Council can do, or they want Congress to re-establish the 70-year ban on interstate banking that was finally undone in 1997 after caving piecemeal for years.
From Esther L. George, President of the Federal Reserve Bank of Kansas City, Hyman P. Minsky Conference, April 11 2012:
What we must remember, though, is that ending To Big To Fail is the only sure way to curtail the expansion of public safety nets and break the pattern of repeated and ever-escalating financial crises.
From “Choosing the Road to Prosperity, Why We Must End Too Big to Fail—Now”, Federal Reserve Bank of Dallas 2011 annual report, March 21, 2012:
Too Big To Fail institutions were at the center of the financial crisis and the sluggish recovery that followed. If allowed to remain unchecked, these entities will continue posing a clear and present danger to the U.S. economy. As a nation, we face a distinct choice. We can perpetuate Too Big to Fail, with its inequities and dangers, or we can end it. Eliminating Too Big To Fail won’t be easy, but the vitality of our capitalist system and the long-term prosperity it produces hang in the balance.
From “How big banks threaten our economy” by Warren A. Stephens, Wall Street Journal, April 30, 2012:
It is time we rid ourselves of banks that are too big to fail. The threat that these mammoth financial institutions represent to our economy is too great. Size and scale are not the advantages they were thought to be. In fact, they are the problem. Until real reform occurs, we face the danger of another crippling banking crisis.
(Editor’s note: See “A list: Experts who want to break up the big banks” for a list of economists, analysts and others who have called for big banks to be broken up.)
Those who don’t want to break up the big banks say global businesses need global banks and the U.S. needs them to maintain its leadership in world financial markets.
Financial fees and taxes: Some observers believe risky behavior in the shadow banking sector can be controlled through a flexible tax. Under this reform, regulators would levy a tax or fee on risk, a fee that rises as risk rises, perhaps levied against short-term instruments like repurchase agreements, asset-backed commercial paper, securities lending and derivatives. (The FDIC started a version of this idea April 1, 2011, when it began basing commercial banks’ insurance premiums on all liabilities, including repo loans, not just on deposits.)
From A Fair and Substantial Contribution by the Financial Sector, International Monetary Fund, June 2010:
After analyzing various options, this report proposes … a “Financial Stability Contribution” (FSC) linked to a credible and effective resolution mechanism. The main component of the FSC would be a levy to pay for the fiscal cost of any future government support to the sector. This could either accumulate in a fund to facilitate the resolution of weak institutions or be paid into general revenue. The FSC would be paid by all financial institutions, initially levied at a flat rate (varying though by type of financial institutions) but refined thereafter to reflect individual institutions’ riskiness and contributions to systemic risk—such as those related to size, interconnectedness and substitutability—and variations in overall risk over time.
Those who don’t want to levy a financial fee or tax say it would drive up the cost of credit and hurt economies.
Clearing houses: Some observers believe shadow banking can be kept stable if repos and other shadow banking agreements have to be transacted through a clearing house that will manage the transaction or stand in the middle, becoming the lender to the borrower and the borrower to the lender, and require plenty of collateral to protect itself and its member firms. This might mimic the new trading structure that Dodd-Frank put in place for derivatives.
From “Out of the Shadows: Central Clearing for Repo” by Jeff Penney, April 2011:
The principal benefit of a clearing house mechanism is the mutual obligation of its members to meet the obligations of any single member. This shared liability encourages members to allow the clearing house to enforce risk guidelines such as membership and trading rules, collection of performance bonds, timing of events, collateral haircuts, and the maintenance of a dedicated clearing fund in excess of the margin on individual trades. As a result, rating agencies have bestowed a AAA-rating on such entities.
In the U.S., the Depository Trust and Clearing Corporation, which has long operated a clearing service for repos collateralized by Treasuries, has just begun operating one for mortgage-backed securities.
Those who don’t want to force repos through clearing houses say it would concentrate the risk.
More transparency: Some observers believe the best way to avoid runs is simply for banks to be very transparent. No runs will happen if everyone can see that the bank is strong, they say. This is a strategy at least one securities dealer used successfully to prevent runs by its own lenders following the collapse of MF Global. But New York Fed economists Adrian and Ashcraft found that transparency doesn’t necessarily prevent a crisis.
From “Shadow Banking Regulation” by Adrian and Ashcraft, Federal Reserve Bank of New York, April 2012:
…it is worth noting that the market for commercial mortgage backed securities set the standard for depth and standardization of senior investor disclosure in securitization markets, and junior investors with market power had adequate information to fully underwrite the loan pool. However, this level of disclosure did not prevent a severe credit cycle in the asset class associated with a significant deterioration in underwriting and large scale defaults. … In the end, disclosure is unlikely to be an adequate reform of securitization on its own.