A final set of recommendations for regulating the shadow banking system will be ready by the September 2013 meeting of the Group of 20 nations in St. Petersburg, the Financial Stability Board said today. Whether it meets that deadline to take control of such an important and growing source of funding is a big question.
That’s because the shadow banking system is a sprawling, growing, complex system not given to a one-size-fits-all regulation; money market funds are different than government sponsored entities, which in turn are different than repo and REITs (see chart below). In its latest update to the G-20, the FSB said “vigilant oversight of shadow banking activities will be required to respond to inevitable market mutations,” adding that the Board has “well in train a monitoring process for these activities.”
Liabilities of Financial Business
Source: FRBNY
Although the Board has listed what it intends to do in capturing all the entities involved in shadow banking – i.e., mitigate the spillover effect between the regular banking system and the shadow banking system, reduce the susceptibility of money market fund runs, mitigate systemic risks by other shadow banking entities and dampen risk, etc – how they accomplish this is far from clear.
The primary goal of course is to prevent a repeat of 2008 when money ostensibly outside the preview of regulators (in the shadow) exacerbated the crisis. “While … the amount of credit funded through shadow intermediation even at the peak is modest (approximately 10 percent),” wrote Tobias Adrian and Adam B. Ashcraft of the Federal Reserve Bank of New York in the recent report, “Shadow Banking: A Review of the Literature.” “[T]he growing importance of shadow money in the aggregate supply of money was an important factor in amplifying the shocks to the economy more broadly.”
Nonetheless, over the course of about 70 years, funding from banks has declined dramatically while shadow banking has increased (again, see chart).
Much of that increase, it should be noted, has been fueled by the governments’ use of shadow banking. “In many ways, the modern shadow banking system originated in the government sector,” Messrs. Adrian and Ashcraft wrote in their report. “Securitization was first conducted by government-sponsored enterprises (GSE), which are comprised of the FHLB system (1932), Fannie Mae (1938), and Freddie Mac (1970). The GSEs have dramatically impacted the way in which banks are funded and the way in which they conduct credit transformation: The FHLBs were the first providers of term warehousing of loans, and Fannie Mae and Freddie Mac pioneered the originate-to-distribute model of securitized credit intermediation.” So what regulations will be able to get a handle on Fannie and Freddie – what many call two of the main contributors of the 2008 crisis? Also, as two firms that Dodd-Frank failed to address.
Despite its fairly stern intention to regulate the shadow system, the FSB does acknowledge that its approach should be balanced. “Our objective is to ensure that shadow banking is subject to appropriate oversight and regulation to address bank-like systemic risks that emerge outside the regulated baking system, while not inhibiting sustainable and resilient non-bank financing models,” the Board said in its statement.