Regulating the Shadow Banking System

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Wednesday October 6, 2010 at 8:54 am
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Editor’s Note: The following post comes to us from Gary Gorton, Professor of Finance at Yale University, and Andrew Metrick, Professor of Finance at Yale University.

In the paper Regulating the Shadow Banking System, which was recently made publicly available on SSRN, we propose principles for the regulation of shadow banking and describe a specific proposal to implement those principles. The “shadow” banking system played a major role in the financial crisis, but was not a central focus of the recent Dodd-Frank Law and thus remains largely unregulated.

We first document the rise of shadow banking over the last three decades, helped by regulatory and legal changes that gave advantages to the main institutions of shadow banking: money-market mutual funds to capture retail deposits from traditional banks, securitization to move assets of traditional banks off their balance sheets, and repurchase agreements (“repo”) that facilitated the use of securitized bonds in financial transactions as a form of money. All of these features rely on an evolution of the bankruptcy code that allows securitized bonds to be used as a form of privately created money in large financial transactions, a usage that can have significant efficiency gains and would be costly to eliminate.

History has demonstrated two successful methods for the regulation of privately created money: strict guidelines on collateral (used to stabilize national bank notes in the 19th century), and government-guaranteed insurance (used to stabilize demand deposits in the 20th century). We propose the use of strict rules on collateral for both securitization and repo as the best approach for shadow banking, with compliance required in order to enjoy the safe-harbor from bankruptcy.

The full paper is available for download here.

  1. Unfortunately, yet another analysis and set of suggestions for how to fix securtization with little to no refelction on the economic motivations of buyers and sellers of structured finance (“securitization”) products.

    Cure for Securitization?

    This week’s meeting of the FDIC to announce their proposal for managing its liquidation powers under the Dodd-Frank law may represent a good time for all the regulators, lawmakers and pundits to pull the car off the “Road to Recovery” for a few minutes, stretch their legs, and look back on where we have come from.

    A rationale observer to the proceedings of the last three years including, the vast debate, the subsequent invention of alternative “cures” and the passage of a set of prescriptions for how to fix securitization and prevent the taxpayers from ever having to go through such an episode again might be inclined to ask exactly why or how this will actually fix anything.

    The medicines of the day include, Safe Harbors, Skin-in-the-Game and Fair Value. These measures all sound very rationale and very attractive. Here’s the problem:

    Where’s the economics for an originator of assets to utilize a very expensive financing structure, such as securitization, if they cannot offset the structuring costs by “selling” the assets “off the balance sheet”? What these new laws and regulations WILL ensure is a much smaller US financial services market, with fewer “investors” participating in the generation of financial assets. If that is the intent of the new laws then bully for the authors.

    Why should we have any more confidence that the regulators who will oversee these new regulations are any more capable or, worse, motivated to ensure that these regulations are followed? Sure there is much fanfare today but what about next year or three years out? No one can argue with the fact that there were plenty of laws and regulations on the books, prior to August 2007 that could have or should have prevented most or even all of the faulty asset originations and the faultiest structuring. Who will put their hand on their heart and swear that the regulators will not fall asleep again. Can anyone deny that if the FDIC, SEC, the Federal Reserve and/or state regulators were even modestly diligent in their administration of the US mortgage markets and the laws and regulations “already on the books” in 1999, 2000, 2001, 2002, 2003, 2004, 2005 and 2006, we wouldn’t have had an “August 2007”? This is not even a close call.

    This does remind one of the “Noble Experiment” of Prohibition in the United States in the early part of the last century, which culminated in the ill-advised passage of the Volstead Act. Essentially, you had one group of well meaning adults telling another group of adults what was best for them, when this second group had no interest in this well meaning advice. The analogies are rather interesting:

    Largely non-partakers make some misguided assumptions for how and why the market operates and why people participate (“imbibe”).

    The new laws and regulations actually have the reverse affect and push the activity outside the public markets where it becomes even harder to observe (and regulate).

    The little guy (“Joe Consumer”) is actually hurt the most because he is the one who has to figure out a way to avoid the law (find a drink or in today’s terms, a loan), while the big guys find a way to corrupt the system and have the regulators look the other way.

    Over a period of several years, even the most ardent supporters of Prohibition came to admit that they had gone too far and that the market was far better at regulating itself with the right touch of federal and state governmental oversight. And along the way, creating some valuable tax revenue.

    The Volstead Act provision in the 18th Amendment was the law of the land from 1920 until 1933, when rationality returned to vogue, and Congress passed the Cullen-Harrison Act as part of the 21st Amendment.

    I would predict the same fate for many of the provisions related to securitization in the Todd-Frank law and the new Fair Value accounting standards. My concern is that we cannot wait the 13 years it took to fix Prohibition. Banks, insurance companies and other “creators” of consumer and institutional assets must be allowed to sell those assets into the secondary market at pricing levels and under structures which make them economically attractive. If there is no incentive to do so, then why in the world would they do it? You cannot “wish” the securitization markets to return. The market simply won’t recover unless the regulatory environment is both predictable and provides competitive economics to the issuer/originators of these programs.

    For more than 25 years the securitization industry created a valuable outlet for the growth and expansion of the US financial services industry, making the United States the unrivaled world leader in financial services. This IS our legacy. Providing a robust US “balance sheet” IS our role on the Global Stage of the 21st Century. Let’s not forget who we are.

    Mark F. Ferraris
    securitization monitor

    Comment by mark ferraris — October 8, 2010 @ 11:50 am


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