Shining a light on shadow banking

More than 10 years since the financial crisis, how safe is the world’s financial system?

On one hand, we can agree that conventional banks are more regulated, better capitalised and less leveraged than they were a decade ago. Are they regulated enough? That’s debatable. But at least there are constraints, and the banks’ activities are closely monitored. We have a pretty good idea of what they are up to.

On the other hand, the same can’t be said of what’s come to be known as ‘shadow banking’. The very term sounds mildly sinister, suggesting something hidden from plain sight. It hints at a threat. Some people may object that this is an exaggeration. I disagree. If it sounds dangerous, that’s no bad thing: in some cases, I believe it genuinely is.

For here we have a whole range of institutions – from hedge funds, asset managers and pension funds to insurers, money market funds, real estate funds and many others – doing exactly what conventional banks routinely do: take money from one party and lend it to another. To use the formal, if inelegant, term, they are in the business of financial intermediation, doing what banks have done for centuries.

Yet many of these activities remain in the shadows, not subject to the scrutiny and prudential regulation imposed on banks. At the same time, they raise all the issues associated with any relatively lightly regulated financial intermediation. 

In most jurisdictions, there are few, if any, limits on leverage, allowing shadow institutions to borrow as heavily as they like without regulatory constraint. 

There is also the issue of ‘maturity transformation’ – taking money that is invested short term to put into assets whose value will mature only in the long term. This issue has a close cousin, ‘liquidity transformation’, whereby money from short-term depositors is turned into illiquid assets, preventing them from cashing out when they need to.

These issues have posed real problems in the past. For example, in the wake of the UK Brexit vote, investors feared that commercial real estate prices would tumble, causing open-ended real estate funds (where investors can ask for their money back from the fund at any time) to place a temporary ban on repayments. 

It takes time to sell an office block. Shadow banks undertaking maturity and liquidity transformation run the same risk that brought Northern Rock to its knees: fatally, Northern Rock relied on short-term deposits from savers and borrowings on the wholesale money markets to lend to house-buyers who wouldn’t repay their mortgages for years.