I just returned from speaking at a panel at the Clearing House’s Annual Meeting in New York that focused on the regulation of shadow banking. My fellow panelists included Amias Gerety (Deputy Assistant Secretary for Financial Stability, U.S. Dept. of Treasury), Ed Greene (Senior Counsel, Cleary Gottlieb), Sandy Krieger (Executive Vice President, FRBNY), and Barney Reynolds (Moderator, Shearman & Sterling).

Our first bone of contention was whether shadow banking is actually a useful concept for financial regulation. I think it is, as I have written elsewhere.   Shadow banking describes how a series of financial instruments, markets, and institutions came to perform the same economic functions as banks:

• credit intermediation/credit risk transfer,
• maturity transformation, and  
• liquidity transformation (i.e. creating money-like instruments that have theoretically high liquidity and low credit risk) (see Morgan Ricks).

We discussed several of these instruments and institutions at the panel including: securitization, money market funds, repos, and prime brokerage. These markets not only performed similar economic functions as banks, in the Panic of 2007-08, they also suffered runs and solvency crises just like banks.

In response, the federal government refashioned some of the same conceptual tools historically used to address banking crisis to staunch a shadow banking crisis. What, after all, was TARP and the alphabet soup of Federal Reserve liquidity facilities other than the government:  

• acting as lender-of-last resort,
• providing deposit insurance to investors in shadow banking markets, and  
• resolving institutions that failed because of shadow banking investments (albeit resolution without wiping out existing shareholders).

So if it quacks like a bank, suffers runs like a bank, and is saved like a bank, it needs to be regulated like a bank.

The difficulty is how to narrowly tailor bank-like regulations (from capital requirements to liquidity regulations) to address the specific forms of risk posed by each kind of shadow market. As I put it, you don’t regulate a turkey the same as a duck or a chicken. This turducken problem led some of my co-panelists to believe a bottom-up approach to regulation (one that focuses on market failures of individual instruments) makes more sense than a top-down approach (starting with the conceptual problems of shadow banking and then figuring out how to tailor policy approaches to particular contexts).

I continue to think a top-down approach helps focus on what are the big picture market failures and systemic risks that we should care about – bank runs and liquidity crises; high leverage; and correlated risk-taking and herd behavior by financial institutions.

Here were my takeaway points from a great panel discussion:

• Size matters, but it ain’t the only thing: the Too-Big-To-Fail problem has obscured the dangers of many smaller financial institutions moving as a herd.
• The FSOC’s power to designate certain institutions as systemically significant, however has asset size as a threshold. It cannot subject an entire class of institutions or instruments to systemic regulation by the Fed. 
• This means that FSOC must deal with the danger of herd behavior or the systemic risk posed by smaller institutions through its recommendation power. The FSOC’s recent proposed proposals on money market reform will provide a test of this power.  
• One oft-overlooked problem is how securitization did not effectively transfer risk, because the financial institutions that securitized assets also purchased asset-backed securities. This daisy chain meant that much risk stayed within the regulated banking system. 
• Why did so much risk stay within the system? In part, this occurred because shadow banking instruments (particularly securitization, asset-backed commercial paper, and repos) were increasingly used not to transfer credit risk but to game bank capital requirements (aka “regulatory capital arbitrage”). 

The bottom-up approach may also obscure a couple of key problems, including:

• These markets – from securitization to repos to money market funds – have been tightly connected. For example, asset-backed securities often “collateralized” repo loans. Money market funds invested in asset-backed commercial paper and repo markets. A focus on instruments means less attention is given to the network as a whole.
• If you want to regulate a network, you focus on the hubs. Who were at the hubs of the shadow banking network? Investment banks! They have their finger in every shadow banking pot, including via: 
  • Securitizing assets off their own balance sheet;
  • Sponsoring securitizations and underwriting asset-backed securities;
  • Purchasing asset-backed securities;
  • Borrowing through repos...

I could go on – the whole business of investment banks is to “make markets” and serve as the intermediary of a web of transactions.  Focusing exclusively on instruments means we may overlook the role of critical institutions in making the plumbing of shadow banking work.

• Perhaps the greatest myth of the shadow banking system is that only unregulated entities were involved. In fact, regulated entities were deeply involved. Banks securitized assets off their balance sheets. Banks, investment banks, insurance companies, and a host of other institutional investors purchased asset-backed securities. They also issued securities that were bought by money-market funds, which, in turn, are regulated by the SEC.
• Indeed, the real sweet spot of the crisis, came not with heavily regulated institutions or unregulated institutions (like hedge funds), but less regulated affiliates of heavily regulated entities. Think AIG’s London affiliate that wrote all those credit derivatives or Bear Stearns’ hedge funds. These examples indicate that conglomerates were playing games to transfer the benefits of government guarantees (explicit or implicit) and other subsidies from regulated to less-regulated affiliates.
• In many cases, it was not a lack of regulation that caused shadow banking to flourish, but the presence of regulation. In other words, Congress and regulators often granted preferences that allowed the markets for various shadow banking instruments to flourish. For example, Congress exempted repos (and later swaps) from various bankruptcy rules. (see Roe) Or, to pick a hot topic, consider the 1983 SEC rule change that allowed money market funds to price their shares at a fixed Net Asset Value, which made these investments appear more safe and bank-deposit-like. (see Birdthistle).

Shadow banking provides a vital conceptual framework to remind policymakers why and what they should regulate. It also provides a field guide to studying new financial instruments. When new financial innovations arise, when should financial regulators take heed and what should they watch for.

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