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:

…continue reading: Out of the Shadows and Into the Light

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.

…continue reading: Financial Regulation in General Equilibrium

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.

…continue reading: FSB Reports Regulatory Reform Is Advancing, But Slowly

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.

…continue reading: Shadow Banking Index

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.

…continue reading: Shadow Banking and Financial Instability

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.

…continue reading: Complexity, Innovation and the Regulation of Modern Financial Markets

How did the governance structure of banks perform during the financial crisis? In our paper, Corporate Governance and Banks: What Have We Learned from the Financial Crisis? we examine this question in light of recent academic work and policy discussions.

We begin by providing a twist on the usual question of what is different about banks by asking what differences are important to governance. Two themes are key: 1) the multitude of stakeholders in banks and 2) the complexity of the business. Besides shareholders, the stakeholders in banks are both numerous (depositors, debtholders, and the government as both insurer of deposits and residual claimant on systemic externalities) and large (over 90 percent of the balance sheet of banks is debt). Yet shareholders control the firm, and evidence shows that both the boards and the compensation package for CEOs represent the shareholders’ preference for increasing risks. Meanwhile, banks have become much larger and expanded dramatically into other businesses since the passage of the Gramm-Leach-Bliley Act in 1999.

…continue reading: Corporate Governance and Banks

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.

…continue reading: Regulating the Shadow Banking System

Without a safety net, banking is unstable. This proposition finds support in economic theory. In an influential analysis, Douglas Diamond and Philip H. Dybvig showed that banks without deposit insurance exhibit multiple equilibria—one of which is a bank run. [1] And financial history confirms this hypothesis. Banking panics were common in the U.S. before the enactment of deposit insurance, but nonexistent thereafter.

The apparent instability of banking has given rise to a standard policy response in the form of a social contract (a phrase borrowed from a marvelous speech by Paul Tucker of the Bank of England). [2] That contract entails certain privileges that are unavailable to other firms: most notably, access to central bank liquidity and federal deposit insurance. These privileges amount to a safety net, and they stabilize banking. The social contract also imposes obligations—activity restrictions, prudential supervision, capital requirements, and deposit insurance fees. These obligations are designed to counteract the moral hazard incentives implicit in the safety net and protect taxpayers from losses.

…continue reading: Shadow Banking and Financial Regulation

Chairman Dodd, Ranking Member Shelby and members of the Committee, I appreciate the opportunity to testify on behalf of the Federal Deposit Insurance Corporation (FDIC) on the importance of reforming our financial regulatory system. Specifically, you have asked us to address the regulatory consolidation aspects of the Administration’s proposal and whether there should be further consolidation.

The proposals put forth by the Administration regarding the structure of the financial system and the supervision of financial entities provide a useful framework for discussion of areas in vital need of reform. The goal of any reforms should be to address the fundamental causes of the current crisis and to put in place a regulatory structure that guards against future crises.

There have been numerous proposals over the years to consolidate the federal banking regulators. This is understandable given the way in which the present system developed, responding to new challenges as they were encountered. While appealing in theory, these proposals have rarely gained traction because prudential supervision of FDIC insured banks has held up well in comparison to other financial sectors in the United States and against non-U.S. systems of prudential supervision. Indeed, this is evidenced by the fact that large swaths of the so-called shadow banking sector have collapsed back into the healthier insured sector, and U.S. banks — notwithstanding their current problems — entered this crisis with less leverage and stronger capital positions than their international competitors.

Today, we are again faced with proposals to restructure the bank regulatory system, including the suggestion of some to eliminate separate federal regulators for national- and state-chartered institutions. We have previously testified in support of a systemic risk council which would help assure coordination and harmonization in prudential standards among all types of financial institutions, including commercial banks, investment banks, hedge funds, finance companies, and other potentially systemic financial entities to address arbitrage among these various sectors. We also have expressed support for a new consumer agency to assure strong rules and enforcement of consumer protection across the board. However, we do not see merit or wisdom in consolidating federal supervision of national and state banking charters into a single regulator for the simple reason that the ability to choose between federal and state regulatory regimes played no significant role in the current crisis.

One of the important causes of the current financial difficulties was the exploitation of the regulatory gaps that existed between banks and the non-bank shadow financial system, and the virtual non-existence of regulation of over-the-counter (OTC) derivative contracts. These gaps permitted lightly regulated or, in some cases, unregulated financial firms to engage in highly risky practices and offer toxic derivatives and other products that eventually infected the financial system. In the absence of regulation, such firms were able to take on risks and become so highly levered that the slightest change in the economy’s health had deleterious effects on them, the broader financial system, and the economy.

…continue reading: Strengthening and Streamlining Prudential Bank Supervision