Do we have to kill the shadow banking system?

[Boulos]

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It seems amazing now, but practically no one in the 1990s thought it odd that Enron's spectacular success was built on "off-balance-sheet transactions." The phrase itself practically hollers a warning, yet investors didn't bat an eye when Enron's reported revenue went in one year from $40 billion to $100 billion.
Enron collapsed, along with its accounting firm, but the lesson didn't seem to sink in. Investors, government officials, and (let's not forget) the press slumbered as Citibank and other big financial firms built a much larger house of cards with "structured investment vehicles" and other "off-balance-sheet" entities that added up to $400 billion--now gone. When Citi trumpeted huge earnings based on "off-balance-sheet transactions," everyone again ignored the neon warning sign.
Likewise, perhaps someone should have wondered about the rapid growth of "the shadow banking system," the parallel world of investment banks, hedge funds, and other institutions outside the regulated banking system. Doesn't the name raise any questions? If the financial system depends on transparency and confidence, is something that lurks in the shadows completely trustworthy?
Alan Greenspan apparently thought so. Throughout his 18 years as Federal Reserve Board chairman, Greenspan celebrated the growth of the shadow banking system. He commended its innovation, welcomed the growth it helped finance, and defended it from sporadic regulatory efforts. He wasn't alone, of course. Democrats and Republicans alike bought the argument that market discipline--the judgment of investors--would be enough to prevent excessive risk taking. Individually, investors bought the same belief: The combined wisdom of crowds of investors would keep everyone safe.
It is obvious that the financial crisis will fundamentally alter Citigroup and other major banks, beginning with the disappearance of familiar names and including the construction of a new regulatory system. But even greater changes are likely in the shadow banking system, also known since the 1990s as the "nonbank banking system"--a name that would have fit neatly into the works of Franz Kafka. Will stabilizing the financial system require the death of shadow banking as it came to be? Can the global economy thrive without it?
The shadow banking system consists of financial institutions that act like banks but aren't subject to the same regulations. It includes investment banks--traditionally, the giant firms on Wall Street--along with hedge funds; other private equity funds; structured investment vehicles (often called SIVs) and other "special-purpose entities" (Enron used these); pension funds; and money-market funds that are regulated, but not as banks. Add in a handful of "credit" conglomerates such as GMAC and GE Capital, which do almost everything imaginable with money but don't take deposits. These players engage in a dizzying variety of transactions, including "repurchase agreements" whereby one party effectively lends cash to another for a very short period of time, often overnight.
"This trend in banking, really for centuries, is toward innovation outside'' regulated channels. --Robert Litan, Kauffman Foundation
How big is the shadow banking system? In 2008, when Treasury Secretary Timothy Geithner headed the Federal Reserve Bank of New York, he offered this inventory of the American side of things: Structured investment vehicles and related entities were $2.2 trillion, he said; "repos," or repurchase agreements, were $2.5 trillion; hedge funds, $1.8 trillion; investment banks, $4 trillion. "In comparison, the total assets of the top five bank holding companies in the United States [in early 2007] were just over $6 trillion, and total assets of the entire banking system were about $10 trillion." Geith-ner didn't do the math, but this count means that before the crisis, the shadow banking system was slightly bigger than the real banking system.
The shadow trillions, along with trillions of dollars more from nonbank entities overseas, circulate through the global economy in pretty much the same way that bank lending does--in part because banks themselves are involved in handling and even sometimes creating this money. The most important thing to remember about the shadow system is that it exists to bypass banking oversight--regulation that was eased by the 1999 Gramm-Leach-Bliley Act and by regulatory rulings that allowed banks to get in on the "nonbank" action. Big Fed-regulated banks must keep a cushion of 8 to 10 percent of their lending in cash, but hedge funds and investment banks aren't required to. Before Bear Stearns got into trouble, it routinely had 3 percent in reserve, opening the door to a run on the bank at the first sign of panic.
Some of the biggest dominos to fall in this crisis were pillars of the shadow system--structured investment vehicles that were heavily invested in subprime mortgage-backed securities, the "toxic assets" that many banks are still saddled with. The credit default swaps that ruined American International Group were hundreds of billions of dollars of bets by shadow bankers that corporations would remain solvent; collectively, they were a huge wager that a crisis could never happen.
Change has come already to the shadow system, in the form of subtraction. All five of the dominant investment banks have disappeared in liquidation, merger, or conversion to banks regulated by the Federal Reserve. Structured investment vehicles are history, and most of the value of their toxic assets is gone (even if the owners haven't admitted it). The willy-nilly creation of trillions in derivatives such as credit default swaps has slowed to a trickle, as investors wait to see which aspects of the old shadow system will survive. In 2007, shadow banking created $480 billion in "collateralized debt obligations," which included many mortgage-backed securities. In 2008, the total was $50 billion.
Glen Hutchins, co-chief executive of Silver Lake, an investment firm, says that new financial regulations will necessarily have to rein in the shadow system. "We need the same kind of confidence we need in the banking system, so that we don't have the runs on the nonbank banking system we've had before. So it is pretty clear that the bank/nonbank distinctions, from a regulatory point of view, will be judged to be a false distinction, and they will all be brought into the same kind of regulatory framework."
Hutchins says, for example, that nonbank mortgage lending--including the abuses that turned subprime lending into a cancer--will completely change. Home mortgages, and the companies that issue them and sell them, will be regulated in a comprehensive way for the first time. "That will be an industry that will be fundamentally restructured" he said, "because it was really the epicenter of the bubble."
Greenspan was correct that the shadow banking system was a font of entrepreneurship and innovation, operating outside a banking system that hadn't changed much since the 1930s. Using increasingly complex mathematical formulas, investors were able to hedge their risks on changes in interest rates or stock prices, and that allowed them to take even bigger risks.
"I made some of those mistakes in my own thinking and writing. And it was exploited by opportunists in the financial sector." --Adam Posen, Peterson Institute for International Economics
At some point, most investors stopped understanding the math and the risks, but they kept on innovating because almost every investor was gaining. The experts best prepared to warn us came to believe in the limitless power of innovation, according to one of those experts, Adam Posen of the Peterson Institute for International Economics. "A vast majority of the mainstream economics profession either actively or passively believed in financial innovation as a good thing," Posen wrote recently on National Journal's Economy expert blog. "Some of this was intimidation and peer pressure, but most of this was genuine." Economists who placed their faith in innovation need to face facts: "This was MISTAKEN [the emphasis is Posen's]. I made some of those mistakes in my own thinking and writing. And it was exploited by opportunists in the financial sector. Ultimately," Posen said, "we have to recognize the intellectual failure's role and correct that."
But even Hutchins, who implies that new regulations will extend to much of the shadow system, said that dismantling that system is unthinkable. "The innovation in finance has gotten a bad name recently because people think that means credit default swaps, when there is a huge amount of innovation in finance that is broadly important to all of us. We don't want to throw out the baby with the bathwater."
Robert Litan is the vice president for research at the Kauffman Foundation, created to spur innovation and entrepreneurship. He sees the need for new rules for the shadow system, but he says that regulators will have to adopt as a guiding principle the idea that innovation must be allowed to continue, outside the most heavily regulated banks. "There was innovation before [collateralized debt obligations]," Litan said. "You've got to come up with a system that allows socially useful innovation but also knows how to deal with SIVs 2.0," the new version of off-balance-sheet abuses.
Shadow banking was built on the principle of "regulatory arbitrage"--the creation of businesses and transactions to avoid regulation, allowing larger risks and potentially larger rewards. Litan says that any new regulation of shadow banking will have to consider this inevitable impulse. "This trend in banking, really for centuries, is toward innovation outside" regulated channels, he says.
Although the Obama administration hasn't put forward its regulatory plans, two major alterations to American banking regulation are likely, each designed to reduce the most-dangerous innovations of the shadow banking system.
First, the United States will probably shift away from a system that largely regulated institutions--banks, as we think of them--and toward one that combines institutional regulation with regulation of financial transactions. Litan says, for example, that it is very likely that many derivative contracts will soon be traded on exchanges, with prices and transactions disclosed to the public. Now, quadrillions (this is not a misprint) of derivatives, including credit default swaps, are bought and sold without such disclosure, creating the potential for the paralysis that set in for some derivatives in 2007. With disclosure, the bubble of "swaps" probably would never have grown as large as it did.
The second development is the creation of a body to separately supervise what Litan calls "Si-Fi's," for Systemically Significant Financial Institutions. A leading candidate for this "systemic regulator" is the Federal Reserve, although some in Congress fear that this authority could conflict too much with the Fed's other responsibilities or award too much power to an unelected body.
A systemic regulator would have more closely scrutinized the operations of the banks and other companies deemed "too big to fail," the theory goes, preventing the fatal accumulation of mortgage-related bets that destroyed Bear Stearns or the huge volume of AIG's credit defaults swaps that has triggered $130 billion in government aid. If a new company issued a particular kind of security fraught with risk, the systemic regulator could lasso that firm or even, perhaps, target the transactions.
In the near term, the biggest changes to shadow banking may remain those imposed by market forces. In addition to the disappearance of trillions of dollars from the financial system already, other shoes may fall, Litan says. So far, for example, the crisis hasn't seriously affected collateralized loan obligations (cousins of CDOs), but CLOs account for hundreds of billions of dollars in the commercial real estate market, which is only now plunging the same way the residential real estate market did, Litan says. Securities tied to consumer credit cards are likewise threatened.
Once the economy recovers, these losses, and the potential for regulation to initially go too far, could indeed contribute to a credit shortage, Litan says. "We could go too far, yes," he said. "On the other hand, finance has shown an amazing ability to overcome" these barriers. Excessive regulation in the United States has always tended to be short-lived, so basic is entrepreneurship to American life. "I think," Litan said, the U.S. "will still be leading the shadow banking system."

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[Boulos]

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