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
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
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"
"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."
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.
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