The shadow banking system and regulatory challenges

A remarkable feature of the global economy in the last two decades has been the rapid growth of the non regulated part of the financial system. As Jamie Dimon, CEO mentioned in JP Morgan’s 2008 Annual Report. The role of banks in the capital markets has changed considerably. And the change is not well understood – in fact it is fraught with misconceptions. Traditional banks now provide only 20% of the total lending in the economy. Right after World War II, that number was almost 60%. The other lending has been provided by what many call the shadow banking system.”
More importantly, the formal and the shadow banking system are too closely interlinked. Indeed, authorities across the world are realizing that the financial system cannot be managed by dividing it into two segments – core banking institutions that need to be tightly regulated and others such as hedge funds, brokers and structured investment vehicles that can be left to operate on their own since they do not use public money. The “core” and the “shadow banking” segments have become far too interconnected. It is estimated that by the summer of 2007, the assets of the six largest US commercial banks were about $6 trillion while the shadow banking system controlled assets worth $4 trillion. The two systems have become so closely intertwined that the collapse of a shadow banking entity can send ripples across the formally regulated banking world.

The shadow banking system is increasingly coming under scrutiny from regulators across the world. Many European politicians are pressing for curbs on offshore tax centers and hedge funds. The ECB president, Jean Claude Trichet mentioned recently that reforms need to be holistic and regulation must be extended to all important markets that pose fundamental risks to financial stability. The latest round of proposals by the US Treasury in May 2009 seem to echo this sentiment.

But we cannot be too sure whether such an approach represents a long lasting and permanent solution. Curbs on the shadow banking system may allow a new “wild west” to form at the periphery. Moreover, the financial system has always been good at finding loopholes in the existing legal and regulatory framework and moving into segments that bypass regulation. Besides, for a well functioning and liquid market, different participants must have different views towards holding and transferring risk. If all entities try to manage risk and liquidity in the same way, the dynamism of the market will be threatened. The current cyclicality bias in the regulatory system may then be further amplified.