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May 30, 2011
Shadow Banking Scrutinized for Role in Financial Crisis
    by Robert Kropp

A report from Standard & Poor's details the effect of unregulated financial institutions on the financial crisis, and calls for regulatory oversight based on function rather than institutional charter.

The Dodd-Frank Wall Street Reform and Consumer Protection Act contains a number of provisions intended to increase regulatory oversight of the traditional banking industry. According to a recently published report by Standard & Poor's (S&P) entitled Shadows No More: The Shadow Banking System Steps into The Spotlight, the "legislation aims to strengthen traditional banks and help protect the US financial system by boosting capital-adequacy standards, restricting certain of the more-risky bank activities, and increasing consumer protections and transparency."

What Dodd-Frank does not do is increase regulatory oversight of what the report terms shadow banking. In a webcast, Managing Director Nik Khakee of S&P said, "The shadow banking industry includes any firms that transact in any of the types of products or functions that banks do. For example, it includes hedge funds, money market funds, private equity funds, and structured finance."

The report states, "Shadow-banking players differ from traditional banks in three important ways. They don't typically operate under bank regulatory supervision and thus often operate under differing capital, leverage, and liquidity guidelines. They don't normally benefit from government capital support, such as deposit insurance. And they don't benefit from the liquidity support available to regulated banks, such as the ability to borrow from the Fed."

Khakee observed, "There is nothing in Dodd Frank that is going to eliminate this two-tiered structure" of regulated banks and shadow banks. Furthermore, although the report focuses on conditions on the US, it states, "The two-tier system of banking and shadow banking is a global condition."

"By 2007, 40% of total financial assets were being financed in the shadow banking sector," Khakee said in the webcast. When the financial crisis struck in 2008, however, "Some large funds and investment vehicles could only stay in business by selling assets at steep discounts," the report states. Furthermore, while banks "received liquidity support from central bankers, including the Federal Reserve…some shadow-bank players, ineligible for this support, collapsed."

An example of such a collapse occurred in September 2008 at the Reserve Primary Fund, a giant money market fund, when its net asset value "broke the buck" by falling below one dollar after writing off debt issued by the recently bankrupted Lehman Brothers. In response, institutional investors withdrew billions of dollars from money market funds, and the Treasury Department took the unprecedented step of providing $50 billion to guarantee the funds against losses that would force their share prices below a net asset value of one dollar.

The retrenchment following the crisis brought the shadow banking sector back down to 30% of total financial assets, according to Khakee. "But 30% is still a sizable portion of total financial assets," he said.

Today, as the crisis recedes in the memories of some and financial institutions seek a return to business as usual, the regulatory oversight of banks mandated by Dodd-Frank may well lead banks to off-load such activities as proprietary trading and hedge-fund investing into the shadow banking system, according to the report. "The derivatives business, for example, where banks issue interest rate, currency, or credit-default swaps, is a high-profile area of finance in which the shadow banking system might gain at the expense of banks," the report states. "If that happens, the impact of such a shift, in our view, could be counter to the regulatory objective of increasing the transparency of potentially risky financial activities."

New reporting requirements mandated by Dodd-Frank are intended to increase transparency in the financial reporting of traditional banks. However, the requirements do not apply to the shadow banking sector, where, the report observes, transparency remains a "mixed bag" at best.

"Fuller transparency in segments of the shadow system could alleviate the potential for (a financial crisis) to happen again," the report states. "One way we see this happening would be if financial entities were regulated by function rather than institutional charter, so that a build-up of risk in any given product is not overlooked."

"Making bank and shadow-banking corporate lending disclosure more consistent and comparable could reduce the transparency trade-off that exists in the two-tier system," the report concludes.

"Three of the things we should focus on are differences in capital requirements, differences in liquidity requirements, and differences in transparency with regular reporting," Khakee said. "What types of information do we want to see available to investors, and available to the public?"

Efforts to increase regulatory oversight of the shadow banking sector appear to be well underway in Europe, where the Financial Stability Board (FSB) recently issued recommendations to strengthen the oversight and regulation of the sector. The recommendations include "possible regulatory measures to address the systemic risk and regulatory arbitrage concerns posed by the shadow banking system," FSB stated.

"Authorities should cast the net wide, looking at all non-bank credit intermediation to ensure that data gathering and surveillance cover all the activities within which shadow banking-related risks might arise," the Board continued.


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