New threat emerges from the shadows

 Shadow banking was not born of the financial crisis but was a fundamental cause.

Story highlights

  • The "shadow banking" system has recovered more rapidly and is poised to usurp banks
  • Shadow banking was not born of the crisis but was a fundamental cause
  • Lightly-regulated mortgage originator wrote bad loans but sold them on to buyers
  • Some worry that the growth of non-bank lending may drag down the economy.

When it came to reforming the global financial system, regulators focused on the banks. Weakened by the 2008 crisis, destabilised by the eurozone sovereign debt mess and then hit with higher capital requirements, traditional lenders are on the retreat.

The "shadow banking" system, meanwhile, a phrase used to encompass a broad range of institutions and mechanisms, from hedge funds to "repo" markets, has recovered more rapidly and is poised to usurp banks in a variety of ways. Regulators are now grappling with how to deal with a vast sector that has, as its name suggests, little or no supervision.

"You cannot address systemic risk unless you tackle things other than banks," says Vikram Pandit, chief executive of Citigroup, himself a former hedge fund manager.

"We've gravitated from a hub-and-spoke world, where everything used to go through large financial institutions, to a network of millions of points of contact with each other," says Mr Pandit. "You need a network management approach. The trickier question is how do you do that and how do you think about it."

Shadow banking was not born of the crisis but was a fundamental cause; it is a not separate phenomenon from banking but a deeply related one. In the run-up to 2008, Countrywide, a lightly-regulated mortgage originator, wrote bad loans but sold them on to buyers including banks. AIG, ostensibly an insurance group, wrote credit default swaps against mortgage-backed securities held by banks. The banks used repo markets to leverage and fund their investments for as long as they could.

But the post-crisis world has seen banks selling assets to non-bank financial groups to improve their capital ratios, meet regulatory requirements and reassure their own lenders -- such as money market funds, themselves a fundamental part of shadow banking -- that they are sufficiently resilient.

"One of the many unintended consequences of the brutal regulatory crackdown on banks is that there is now a massive incentive to be a shadow bank," says the chief executive of a big European bank.

This has stimulated growth in previously small areas of lending, especially in Europe and Asia. In parts of Europe large retailers and industrial groups have begun providing funding to smaller companies, including their suppliers. A similar trend away from bank finance has benefited credit hedge funds and in the leveraged finance world, new bespoke funding suppliers have sprung up.

Yet the resurgence of non-bank financial groups is constrained by difficult markets. "We have created the conditions which allow the rise of the shadow banking system," says Mr Pandit. "Some is already happening. Some of it takes time because shadow banking needs funding. The fact is if you get to a normalised market then it's going to grow quickly."

Critics of the changing shape of finance say regulators have underestimated the distortive effect of tightening the rules for banks -- a distortion that could sow the seeds of the next crisis.

Some worry that the growth of non-bank lending and the practice of borrowing short-term to lend long-term simply allow new, unmonitored bubbles to grow unchecked until they once again drag down the banking system and the larger economy. The Financial Stability Board, a global group headed by Mark Carney, head of the Bank of Canada, is working on several specific areas of shadow banking, including money market funds, securities lending and securitisation, and will undertake consultations over the next few months.

The UK has specifically charged its new stability regulator with patrolling the regulatory boundary with an eye toward expanding the rules to take in new sectors. And, as a result of the US Dodd-Frank legislation, there is now a Financial Stability Oversight Council, which has the power to supervise very large non-bank institutions that might pose a threat.

The European Commission plans to bring forward a set of proposals by the end of this year for enactment in early 2013. "Shadow banking represents 25-30 per cent of the world's financial sector," Michel Barnier, the EU commissioner overseeing financial services, said earlier this month. "I'm not attributing any ulterior motives to people working in this parallel sector -- they can provide a useful service and finance. I'm not waging a war against the system. [But] like all financial players, they must be covered by regulation."

On these pages we look at the key elements of the shadow banking world and how they have developed since the crisis started in 2007.

Additional reporting by Tracy Alloway in New York