Big Banks’ Shadow Dance

WASHINGTON, DC – One of the great myths propagated by very large financial institutions is that, if they were to become effectively regulated again, many investors and financial transactions would flee to “shadow banks.”

That sounds bad. Anything that lurks in the shadows must have nasty intent, potentially dangerous consequences, or both. And it's very shadowiness implies that nothing can be done about it – whatever is there must be beyond the reach of regulation or effective supervision. So perhaps financial-system risk would increase, not decrease, if we regulated very large non-shadow banks properly.

So much for scary fairytales. In reality, there are three kinds of “shadow” activities, all of which are obvious, operate in plain sight, and could be controlled in a straightforward and responsible fashion. Whether we have the political will to implement effective controls is, as always, another question – in large part because the big banks are very powerful and they would like the shadows to remain as shadowy as they are now.

The first set of shadow activities includes those conducted by the banks themselves, for example, as a way to reduce the amount of equity funding that they need. The people who run big banks like leverage: More borrowed money (and less of their own) means that they get more upside, in the sense of a higher return on capital, unadjusted for risk. When things go against them, it also means more losses. But that is why it is good to be big – you can get more downside protection from the Federal Reserve or other official sources.

For example, Citigroup created so-called “special-purpose vehicles” to invest in mortgage-related securities prior to 2007. They funded this activity with a lot of short-term debt and a wafer-thin cushion of equity. When the market boomed, such schemes’ authors were heralded as geniuses. But when house prices fell and mortgage-backed securities (and derivatives based on them) became illiquid, Citigroup took the liabilities back onto its balance sheet – and then needed to be rescued through massive, repeated bailouts.

These shadow activities were the work of Citigroup and other large complex financial institutions that are subject to regulation. Their boom-and-bust character reflected nothing more than the relevant regulators’ failure – or refusal – to understand the risks involved. The regulators were “captured” – meaning that they identified so closely with the intellectual perspective and worldview of large complex financial institutions that they were persuaded to allow something that was actually very dangerous.

Unfortunately, despite all we have been through in the past five years, these big banks’ shadows survive in various forms today – and regulators do not seem sufficiently inclined to turn on the lights.

The second set of shadow activities involves banking-type activities that really are conducted outside banks. The most prominent example is money-market mutual funds. These entities take money from investors and buy various kinds of assets, some of which may be risky – like short-maturity corporate debt.

The problem is that these funds create the impression that anything invested with them is just as safe as a deposit at an insured bank. You can write checks on a money-market account, and your monthly statement shows it to have a stable value – just like your bank account. In fact, the value of assets held by such funds fluctuates, and it is only an accounting convention – permitted by regulators – that allows them to report a stable value. As a result, when the possibility arises that a money-market fund will be unable to pay investors in full – as happened after the collapse of Lehman Brothers in September 2008 – all hell breaks loose.

There were similar fears recently when it became known that US-based money-market funds had lent heavily to European banks. And some leading US banks also rely on money-market funding; here, too, the “shadows” and the banks have aligned interests.

There is a simple fix to this problem – require money-market funds to show the actual floating value of their assets, so that everyone understands that it is not a fixed number. Some US regulators are pushing in this direction. Unfortunately, the money-market funds – and their friends in the big banks – are pushing back hard.

The third set of shadow activities includes those that may yet emerge. We should not underestimate the creativity of financiers seeking to escape capital requirements and leverage up. A brilliant book by Anat Admati and Martin Hellwig, The Bankers’ New Clothes, demonstrates the pervasiveness of this problem and highlights its potentially devastating consequences for the economy.

The right approach is to search for and prevent excessive systemic risk wherever it manifests itself. The US authorities now have a legal mandate to do this. But will they be able to stand up to the powerful lobby of big banks and their shadowy allies?

Simon Johnson is a professor at MIT’s Sloan School of Management.

Copyright: Project Syndicate, 2013.

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