Shadow banking and ghosts in the financial machine

Out of this total, the US, euro zone and UK accounted for $54 trillion or 80.6 per cent of total global shadow banking assets, with the US having the largest share (35 per cent, having dropped from 44 per cent in 2005), the eurozone (32.8 per cent) and the UK (13.4 per cent). 

The term “shadow” banking is really a misnomer, being a nice excuse for some regulators who “did not see it”, but the FSB defines it as “credit intermediation involving entities and activities outside the regular banking system”. This covers all the institutions that have always been visible to all of us, and were regulated in one form or other.

Shadow banking is seen in highly visible institutions, such as money market funds, Ginnie Mae and Fannie Mae (mortgage corporations), hedge funds, insurance funds, investment banks and securities houses. The global regulatory community has finally woken up to the fact these institutions have risks of their own, risks through links with the banking system; they help banks to avoid regulation, which can lead to build-up of leverage and risks in the system. 

A common problem with highly theoretically trained and model-driven bankers and regulators (before the crisis) was that they tended to assume that what cannot be seen may not exist, and what cannot be measured, was not important. There is also a common belief that has persisted beyond the crisis that marginal increases in capital can deal with a “tsunami” shock of a sudden loss of trust in the financial system as a whole. Citibank had capital of 11.8 per cent of risk assets in 2008 which would have satisfied Basel III capital requirements when it received help.     

In other words, even increasing the capital of the banking system to 17-18 per cent of risk-weighted assets (the aim of Basel III) may be insufficient if the system as a whole is over-leveraged. Between 2007-2009, the US real estate market dropped 18.7 per cent and lost $7.5 trillion in wealth, or nearly 50 per cent of GDP. Stock market wealth was reduced by 45 per cent of GDP.  That wealth loss by the system as a whole was borne by a banking system with liabilities of around 75.9 per cent of GDP. It was not surprising some banks failed. 

In Europe, the total financial asset/GDP ratio reached 551 per cent in 2010, among the highest in the world, with bank assets to GDP at 274.3 per cent of GDP. For euro-zone countries with fiscal debt around 100 per cent of GDP, an interest rate increase to 6 per cent would double the debt to 200 per cent of GDP in 12 years, which is clearly unsustainable.   

With real interest rates of over 6 per cent, the real estate market is crashing, as has happened in Ireland, Greece and Spain. By definition, the banking systems were be de-capitalised, and those governments had to stand behind these systems. This is precisely why the Eurpean Central Bank used massive quantative easing to keep the whole system afloat.

As Black Swan author Nassim Nicholas Taleb repeatedly reminds us all, don’t focus on the average but look carefully at the tail risks and the system as a whole. Assigning individual risks to risk assets and then allocating capital to these risks completely ignores the fact that you are not looking at uncertainty (non-measurable risks) and complex non-linear interaction between these individual assets, your bank and your environment, which are much more co-related than you think. So thinking that you are marginally increasing risk weights and risk capital without looking at the whole environment is like shuffling between decks on the Titanic. 

What is happening to the global financial system as a whole? 

First, according to an excellent Brooking conference on financial structures last month, the banking system (already highly concentrated before the crisis) has become even more concentrated after the crisis. Second, as the FSB data has shown, the shadow banking system has grown larger than before the crisis. Third, because the wholesale inter-bank markets are failing, the advanced-country central banks, through unconventional monetary policy, have de facto replaced their banking systems as the first provider of liquidity and even supporters of mortgage markets. The ECB and the Fed have balance sheets of nearly $3 trillion and are committed to increasing them as much as necessary to meet their unconventional targets, which now include unemployment levels. 

The trouble is that there is increasing research, especially from Japan, that shows the impact of unconventional monetary policy on the real economy is ambiguous at best. The real benefits are for the financial market, and that is not distributed evenly, with savers and pensioners bearing the brunt of subsidising borrowers. Japan has had more than a decade of experimenting with unconventional monetary policy.

The priority in this global environment is to keep our focus on the real sector – on promoting trade and growth, jobs and tackling social inequalities, such as providing more pension benefits and helping small and medium-sized businesses that account for the bulk of innovation, job creation and social stability.  

Worrying about shadow banking is like whether we should be worried about ghosts or a person telling us to worry about ghosts. My fear is not about ghosts, but about what the storyteller may or may not do. The greatest risks today are not business risks, but regulatory and monetary policy risks. 

Beware quantitative easing, because it promises more than it can deliver.

 

Andrew Sheng is president of the Fung Global Institute.