In prior articles (see, e.g., Regulating Shadows: Financial Regulation and Responsibility Failure, 70 Wash. & Lee L. Rev. 1781 (2013)), I have argued that shadow banking is so radically transforming finance that regulatory scholars need to rethink certain of their basic assumptions. In a forthcoming new article, The Governance Structure of Shadow Banking: Rethinking Assumptions About Limited Liability, I argue that the governance structure of shadow banking should be redesigned to make certain investors financially responsible, by reason of their ownership interests, for their firm’s liabilities beyond the capital they have invested. This argument challenges the longstanding assumption of the optimality of limited liability.
Posts Tagged ‘Shadow banking’
On November 22, 2013, Federal Reserve Board Governor Daniel Tarullo delivered a speech at the Americans for Financial Reform and Economic Policy Institute outlining a potential regulatory initiative to limit short-term wholesale funding risks.  This proposal could increase capital requirements for and apply additional prudential standards to firms dependent on short-term funding, with a focus on securities financing transactions (“SFTs”)—repos, reverse repos, securities borrowing/lending and securities margin lending.
There is a growing consensus that new financial reform legislation may be in order. The Dodd-Frank Act of 2010, while well-intended, is now widely viewed to be at best insufficient, at worst a costly misfire. Members of Congress are considering new and different measures. Some have proposed substantially higher capital requirements for the largest financial firms; others favor an updated version of the old Glass-Steagall regime.
In A Simpler Approach to Financial Reform, forthcoming in Regulation, I suggest a different and simpler strategy. This simpler approach would be compatible with other financial stability reforms. However, in the first instance, it is better understood as a substitute for Dodd-Frank and other measures. The simpler approach would require new legislation. It consists of the following specific measures, starting from a pre-Dodd-Frank baseline:
Traditionally, law and finance has been concerned with investor protection. That would be enough if the future were predictable. However, because the future is in fact uncertain and unpredictable, the prices of financial assets are flawed and in the short run they may result in serious mistakes, if not widespread crises. Although these mistakes are corrected in the long run, a lot of harm may occur in the meantime. Drawing on the experience from the global financial crisis, I argue that financial law should be concerned not only with investor protection, but also with mitigating the temporary excesses of markets in allowing or restricting access to finance.
The challenge of this goal is to remedy market malfunctioning without undermining market discipline. This is possible if central banks backstop banks’ illiquidity during a crisis, provided that regulation preserves the central banks’ incentives to distinguish illiquidity from insolvency. Moreover, in order to prevent the backstop from resulting in moral hazard by financial institutions, regulation should police the incentives of both managers and shareholders. On the one hand, bank managers should not be allowed to cash in the profit of short-term success. On the other hand, corporate law should allow shareholders to commit to the long term via takeover restrictions, granting bankers private benefits of control to complement the deferral of performance pay.
For the last four years, regulators and law makers have been focusing extraordinary efforts on ensuring that financial regulation is adequate to protect the financial system from risks emanating from the banking sector. However, it is only more recently that policy makers have turned their attention towards possible systemic risk related to entities which carry out similar functions to the banking sector or to which the banking sector is otherwise exposed. Such entities have, for convenience, been grouped under the heading of “shadow banks”, although no precise definition or description of shadow banking has yet been agreed upon by policy makers.
At their November 2010 Seoul Summit, the leaders of the G20 nations requested that the Financial Stability Board (FSB) develop recommendations to strengthen the oversight and regulation of the shadow banking system in collaboration with other international standard setting bodies, and in response to such request, the FSB formed a task force with the following objectives:
In our recent NBER working paper, Financial Regulation in General Equilibrium, my co-authors (Charles Goodhart of the London School of Economics, Dimitrios P. Tsomocos of the University of Oxford, and Alexandros Vardoulakis of the Banque de France) and I explore how different types of financial regulation could combat many of the phenomena that were observed in the financial crisis of 2007 to 2009. The primary contribution is the introduction of a model that includes both a banking system and a “shadow banking system” that each help households finance their expenditures. Households sometimes choose to default on their loans, and when they do this triggers forced selling by the shadow banks. Because the forced selling comes when net worth of potential buyers is low, the ensuing price dynamics can be described as a fire sale. The presence of the banking and shadow banking system, and the possibility that their interaction can create fire sales distinguishes our analysis from previous studies.
The model builds on past work by Tsomocos (2003) and Goodhart, Tsomocos and Vardoulakis (2010) and uses many of the same ingredients as their general equilibrium model. In particular, the model includes two periods and allows for heterogeneous agents who borrow and lend to each other through financial intermediaries. When the borrowers default, the intermediaries suffer losses and tighten lending standards to future borrowers. Thus, the model also includes a possible credit crunch.
On June 19, 2012, the Financial Stability Board (FSB) issued a progress report to the G20 Leaders on the steps FSB member nations have taken to implement financial reforms designed to improve the stability of the global financial system. The FSB reviewed, among other things, its members’ Basel implementation, adoption of resolution-planning regimes, oversight of the so-called “shadow banking system,” reform of the OTC derivatives market, and the effectiveness of the FSB itself. The FSB concluded that its member nations have made significant progress in implementing globally agreed financial reforms, but large strides are still necessary – particularly regarding recovery and resolution planning – to protect the global economy against future financial crises.
What is the FSB?
The FSB is an informal body of financial regulatory authorities from the G20 nations and the former members of the Financial Stability Forum. It was established in 2009 – in the wake of the 2008 financial crisis – with the intent of improving global financial stability by coordinating the way in which the world’s major economies implement their own financial reforms. At present, the FSB is not an independent legal entity but acts under the auspices of the Bank for International Settlements (BIS), an international organization that assists central banks in promoting financial stability and serves as an international central bank itself. The FSB has no enforcement authority; it derives its legitimacy from the cooperative participation of its member nations. As described below, however, the FSB’s institutional power may be growing: the G20 Leaders recently granted the FSB authority to organize itself as an independent legal entity.
Shadow banking may help drive the day-to-day financial system, but it is a concept looking for a hard-and-fast definition.
Despite coming under intense scrutiny following the financial crisis, there have been disparate characterizations of what the shadow banking sector truly entails — with size estimates ranging from $10 to $60 trillion. At the same time, major regulatory efforts have either been enacted or are in the works to help reduce the size of this important sector, with no agreed-upon way to measure their effectiveness.
The purpose of the Deloitte Shadow Banking Index is to define and quantify the sector over time, including its components. This ongoing effort is designed to more closely measure size, importance, effect of market, and impact of regulatory actions, as well as a way to assess the potential impact of shadow banking on regulated markets.
What is shadow banking really? We started by including a multitude of nonbanking entities and activities and then applied specific criteria. For example, we posit that money market mutual funds (MMMFs) are part of shadow banking as they possess the “money-like” attributes of bank deposits. But they do not have bank-like insurance, nor can they access a central bank for liquidity support.
In autumn 2008 the developed world’s banking system suffered a severe crisis. In response the world’s regulators and central banks have focused on building a more stable banking system for the future: less leveraged, more liquid, better supervised and with even the largest banks able to be resolved without taxpayer’s support. The implementation of that bank-focused regulatory agenda is still unfinished, but much progress has been made.
Looking back to the year 2007/08, however, it’s striking that the crisis did not at first look like a traditional banking crisis, but rather one related to a new phenomenon: shadow banking. Initially the problems seemed concentrated in the US, where the development of non-bank credit intermediation was most advanced, and many of the events which marked the developing crisis related to non-bank institutions and markets.
The working paper, Complexity, Innovation and the Regulation of Modern Financial Markets, which was recently made publicly available on SSRN, was motivated by two observations.
First, the perfect market assumptions underpinning the canonical theories of financial economics – modern portfolio theory; the Modigliani and Miller capital structure irrelevancy principle; the capital asset pricing model, and the efficient market hypothesis – are increasingly unreflective of how many modern financial markets work in practice. More specifically, these theories share a common and highly stylized view of financial markets, one characterized by perfect information, the absence of transaction costs and rational market participants. Yet in reality, of course, financial markets rarely (if ever) strictly conform to these assumptions. Information is costly and unevenly distributed; transaction costs are pervasive, and market participants frequently exhibit cognitive biases and bounded rationality. Despite these seemingly uncontroversial facts, however, the empirically (con)testable assumptions of conventional financial theory have been transformed into the central articles of faith of the ideology of modern finance: the foundations of a widely held belief in the self-correcting nature of markets and their consequent optimality as mechanisms for the allocation of society’s resources.