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Regulating ordinary banks well is proving difficult enough, but there’s a constellation of other financial intermediaries that gamble in much the same way -- converting short-term liabilities into long-term assets -- with no explicit government backstop. This so-called shadow-banking industry is enormous. Its global assets are estimated to have been more than $60 trillion at the end of 2011, making it about half the size of the traditional banking sector.
In this shadow realm, other forms of short-term borrowing such as shares in money-market mutual funds play the role of deposits. Securities dealers, hedge funds and other financial firms buy longer-term assets such as bonds backed by mortgages or corporate loans. They employ the assets as collateral against further loans, which they get from money-market funds, banks and one another. The collateral gives creditors a guarantee they’ll be repaid.
The shadow banks’ leverage is limited mainly by the amount of money they can borrow against a given amount of collateral. Before the crisis, they could borrow $97 against each $100 in mortgage-backed securities -- a “haircut” of 3 per cent, the equivalent of putting just $3,000 down on a $100,000 home loan. Such high leverage amplifies risk: If the price of the security falls just 3 per cent, the creditor’s margin of safety is wiped out.
How can this system be made more resilient? Mark Carney, the new governor of the Bank of England, offered a sense of what regulators are thinking in a speech last week: Give shadow banks the same access to emergency central bank loans that traditional banks enjoy. This is a dangerous idea, with the potential to produce the kind of speculative boom that would end very badly. Imagine the risks investors would be willing to take if they knew the central bank would always provide cash if private lenders balked.
Granted, Carney noted that this expansion of public insurance would have to be accompanied by expanded regulation, but he was vague about it. What he should have said is this: If an entity engages in banking activity, and hence is vulnerable to runs with potentially systemic consequences, it must register as a bank, with all the backstops and capital requirements that entails.
As for hedge funds and other institutions that would remain in the shadows, minimum requirements for haircuts -- combined with proper capital rules for the regulated banks that often lend to them -- should suffice to keep leverage from getting out of control. The Financial Stability Board, an international group of regulators, has proposed a set of global minimum haircuts that individual countries would do well to build upon. There’s ample evidence that extreme leverage presents a threat to markets and the economy -- and zero evidence that it provides any benefits.
“Shadow banking” is really a misnomer. Regulators know what’s going on and understand the threat it poses. They ought to stop discussing the problem and start acting to solve it.