Opinion

James Saft

Shadow banking hangover still to come: James Saft

November 20, 2012

Nov 20 (Reuters) – Like a hangover that starts before you
even go to bed, the fact that the shadow banking system has
expanded since the crisis bodes poorly for what comes in the
morning.

Shadow banking, financial intermediation done in such a way
as to elude regulations imposed on traditional banks, has
actually grown since the onset of the financial crisis in 2007
and stands at $67 trillion worldwide, according to a new
accounting from the Financial Stability Board.

That’s hard to square with assumptions that investors, stung
by losses caused by a run on assets in shadow banking during the
crisis, have learned their lesson, much less that economic
growth is being crimped in part by falling credit and money
creation by shadow lenders.

One likely implication is that new credit and debt created
by the shadow banking system is an example of the law of
diminishing returns, spurring less growth per dollar than
previously. Another is that when regulation begins in earnest
worldwide, taking credit creation lower with it, growth will
face a headwind many thought it was already handling.

The FSB, charged by the Group of 20 leading economies with
orchestrating the regulatory approach to the crisis, is calling
for stronger oversight and regulation of shadow banking, which
in effect is an alternative universe of hedge funds, insurers
and other entities which do banking in ways intended to avoid
some regulatory costs.

Shadow banking grew at a 19 percent annual clip in the five
years to 2007, fueling the bubble by creating credit and
increasing leverage across the economy. After taking a slight
dip in the panic period, shadow banking resumed its upward
march, growing at about 4 percent yearly since.

This is serious money: that $67 trillion is 111 percent of
annual economic production of the countries the FSB is
monitoring.

To be sure, there is huge regional variation, and this is a
big part of the story. Shadow banking has actually diminished in
importance in the U.S., accounting now for a smaller share of
all assets than in 2005. In contrast, it has grown in Germany,
albeit from a lower base, and perhaps driven by the capital
crisis among banks there and elsewhere in the euro zone.

The case of the UK is particularly troubling; while shadow
banking was 9 percent of global totals in 2005, it is now 13
percent, almost certainly because key regulations and
enforcement are tougher elsewhere.

QUEST FOR SAFETY

While some point to figures showing an overall deleveraging
in the U.S since the crisis, it is possible that these numbers
are flattered by a movement offshore of shadow banking.
Certainly the abysmal growth in the UK in recent years implies
that its economy is not the end beneficiary of much of the
financing now being created there in the shadow system.

This raises interesting questions. What will happen to the
UK, which already has a huge financial system for its economy,
when the next crisis strikes? And what will happen to U.S.
growth if in fact tough global shadow banking regulation
actually comes into effect?

The latter impact will not be pretty, which is one reason to
bet that, when push comes to shove, the impact of regulation
will be blunted. And indeed the FSB report went some way in
stressing that the credit creation coming out of the shadow
banking system has its uses.

If the usefulness of new debt in spurring economic growth is
actually diminishing, much of this debate may prove less
important than we think. While you might be able to argue that
there are fewer excesses in the global financial system than in
2006, it is hard to argue that the rewards of leverage are as
high, much less that we are less dependent on debt for the
meager growth we are generating.

Gary Gorton, an economist at Yale, has argued that the
growth of the shadow banking system has been in part driven by a
demand for safe assets. Institutions want a safe place to put
money and modest interest in return, but the supply and demand
dynamics in the safest stuff out there – government debt -
created an opening for shadow banks, which create the next best
thing.

It may be that what we are seeing in the shadow banking
system is simply that; a heightened demand for safe places to
keep money, money which is moving less swiftly around the
economy even as more debt is created.

Comments
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If you read the original full report rather than the press accounts, you will find the “increase” in the shadow bank size estimate is due to wider coverage, not actual growth in its organic categories. Whole countries were not covered in the 2007 report, including sizable markets like Brazil and Hong Kong, but are included in the more recent figure.

You will also find they consider many things part of “shadow banks” that are not part of the usual sense of the term on the street. Specifically, they include mutual funds, even equity mutual funds, in that category. Only between half and two thirds of their total represent institutions most would consider “shadow banking”, under even the widest sense of the term (e.g. including all broker-dealer balance sheets).

In the US, the shadow banking system has fallen by half since the end of 2008, and total dollar debts outstanding have contracted by $3.4 trillion, almost entirely due to contraction in those line items. Meaning asset backed issuers, finance companies, and funding corporations. The other line item showing a large shrinkage is also a consumer of shadow banking paper – the money market fund industry.

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