November 19, 2012
Shadow Banking System Grows as FSB Issues New Recommendations to Tame It
Posted by Erik Gerding

Yesterday, while the world was busy watching football of one shape or another, the Financial Stability Board issued a series of new reports and recommendations on the shadow banking system (a subject close to my heart). 

Bottom line: the system is getting bigger. The FSB estimates that shadow banking markets had $67 trillion in assets by the end 2011 (which it says would equal 111% of the aggregated GDP of all 24 FSB member countries, the remaining nations in the Euro area, and Chile). That is about five trillion bigger than its size in 2007, before the crisis hit full bore.

The FSB collected reams of other valuable data on shadow banking in its annual monitoring exercise. Data collection alone is invaluable to understand the scope and dimensions of shadow banking. As G.I. Joe says, “knowing is half the battle.”

The FSB also issued a series of recommendations on how to regulate shadow banking (an ongoing research interest of mine and lately a blogging topic too). Here are some key takeaway points:  

  • The FSB may have provided some more ammunition to the FSOC and SEC Chair Mary Schapiro when it recommended converting fixed NAV money market funds to floating “where workable.”
  • Of all the elements of the shadow banking system, the FSB seems to be making the most progress in the area of securities lending and repos. Its separate repo report contains a lot of helpful, if somewhat vague and high level recommendations, including 
    • Advocating for greater disclosure; 
    • Minimum haircuts to control leverage; 
    • Restrictions on cash collateral reinvestment and rehypothecation of collateral; 
    • Studying a move towards central clearing of repos 
    • These proposals sound great in the abstract, but are couched in terms of “more study.” Each of these moves would likely encounter fierce resistance when translated into concrete rules.
  • The FSB beats a strategic retreat on the issue of changing the bankruptcy treatment of repos. While not surprising, this is ducking a large issue. When Congress exempted repos from much of the bankruptcy regime in 1984, it added jet fuel to this market and gave financial institutions a powerful new avenue to increase short-term lending. At the same time, the FSB makes noises about reducing excessive reliance by financial institutions on short term lending. Instead of out-and-out punting, the FSB should at least try to connect the analytical dots a little more; a legal preference jumpstarted the repo market, just like the same kind of bankruptcy preferences created meteoric growth in the swaps market two decades later

There are a number of items I wish the FSB devoted much more time on, including:

  • Consolidating weakness: Putting more pressure on the Basel Committee to ensure better rules for when financial institutions need to consolidate securitization vehicles. Off-balance sheet accounting games are a nightmare that keeps recurring. The FSB and Basel need to devote more intellectual firepower to this, and to the related issue of when financial institutions have implicit support (moral recourse) for entities. (For example, when Bear Stearns bailed out the hedge funds it sponsored or when asset-backed commercial paper or money market fund sponsors rode to the rescue of their failing funds). 
  • Show me the money supply: strangely, the FSB speaks little about coordinating the prudential regulation of the shadow banking system with monetary policy. It clearly recognizes the research that the leverage of shadow banking instruments like repos can have profound expansionary monetary effects. In other words, shadow banking, like depository banking, serves as a “transmission line” for monetary policy. The growth of shadow banking means the monetary system grew a turbojet engine. Integrating monetary and prudential regulatory policy has not just been a crusade of mine, but a drumbeat of “macroprudential” banking economists too.
  • Credit derivatives are part of shadow banking too: In its separate document on “shadow banking entities,” the FSB lists a series of other entities that could constitute part of the shadow banking system, including securitization vehicles, credit investment funds, credit hedge funds, and finance companies. It also lists: “credit insurance providers/financial guarantors.” This sounds like “bond insurers.” But how is this not credit derivatives by any other name? I have argued that we need to think about credit derivatives as an integral piece of the shadow banking plumbing.  But perhaps the FSB doesn’t want to be so explicit for fear of courting more resistance. 
  • Reduce the Addiction to Short-term Funding: Short term financing via repos and other shadow banking markets, makes banks less stable. The FSB makes noises about reducing this dependency, but offers nothing concrete. 
  • Back on the Chain Gang: Similarly, the FSB highlights the risks that come with long chains of shadow banking instruments (think mortgage-backed securities to CDOs to CDO squared to CDO cubed), but offers little concrete proposals to disfavor longer concatenations. Does the marginal additional social utility in terms of liquidity and risk spreading between a CDO and a CDO squared justify the additional opacity and systemic fragility? 
  • Correlated risk-taking: The FSB spills a little ink on reducing the concentration of bank investments in certain asset classes. It would be helpful to put the intellectual frame around the problem though. Leverage and liquidity are huge concerns in banking – whether of the depository or shadow varieties. But so is correlated investment and risk-taking. This has been another longstanding concern of the macroprudential movement, but one that curiously has not received much airtime with the FSB shadow banking working groups. 
  • Which of these is not like the other? Securitization and “skin in the game”: In reading previous FSB materials on shadow banking, I was struck by how the analysis of “skin in the game” rules for securitization seems out of place. After all, bank regulators want banks to unload as much risk as they can via securitization (albeit not take it back on by investing in asset-backed securities). Studies have also questioned the evidence that less-skin-in-the game led to deterioration in credit underwriting standards. In this latest raft of FSB documents, the skin-in-the-game analysis again seems tacked on to the end and maybe a little half-hearted. It might be better to invite a knock-down-drag-out fight over this particular policy proposal rather than muddle through.

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