What is shadow banking?
The term describes borrowing and lending that goes on outside the regulated banking centre. The man who coined it is American economist Paul McCulley. In a 2007 speech at the annual financial symposium hosted by the Kansas City Federal Reserve Bank in Jackson Hole, Wyoming, McCulley explained the operation of banks that look like banks, and do what banks do, but aren’t, well, really banks. They are, as this helpful summary reveals, entities that are “in the shadows” and they include investment banks, money market mutual funds, hedge funds and mortgage lenders.
But hang on. Investment banks aren’t exactly in the shadows, are they? Nor are mutual funds and mortgage lenders. Or hedge funds, for that matter. Other kinds of shadow bank, like securitisation vehicles, might tend to be registered offshore for tax reasons, but they are known to exist. Their staff work in tangible buildings, they have CEOs, they’re in the news (heavens, some of the top men – they’re almost always men – make the annual Sunday Times Rich List) and sometimes they’re even on TV.
Aren’t their various operations (which include trading activity in the derivatives and repossession markets) conducted in the light, then?
Not quite. And this is the problem with shadow banks. They lurk on the margins – beyond them, in fact, their existence predicated on the creation of massive amounts of debt in times of economic growth.
They’re acknowledged to have been a major factor in the 2007-8 banking crash, which is why the news that the Financial Stability Board (FSB) is introducing new rules to shadow banks may be overdue but is still very welcome.
From 2017, the FSB will require shadow banks to provide a minimum level of collateral, such as stocks or bonds, when borrowing money from banks. As this BBC report puts it: “banks would have to impose a so-called ‘haircut’ or discount of at least 6% on the securities they receive from non-banks in exchange for a loan. The change means that if a hedge fund, for example, wants to borrow $100 from a bank, it must now provide collateral worth at least $106.”
Mark Carney, FSB Chairman, believes that “The regulatory framework for haircuts on securities financing transactions issued by the FSB addresses important sources of leverage and the level of risk-taking in the core funding markets. It has been carefully developed, finalised after rounds of public consultation and impact studies, and marks a big step forward in the FSB’s overall work programme to transform shadow banking into resilient market-based financing conducted on a sound basis.”
Is he right? Time will tell whether the impending changes curb the excesses of the shadow banks – or whether, like a shadow boxer hitting out at an imaginary foe rather than the real thing, the haircut makes no real difference.