Shadow Banking Down From Crisis, But for How Long?

May 31, 2012
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The so-called “shadow banking system” that was at the heart of the financial crisis has seen its value fall by more than half over the last few years, according to a new report [PDF] released this week by the Deloitte Center for Financial Services.

In the months before the financial crisis, the value of the nation’s shadow banking system peaked at more than $20 trillion — eclipsing the size of the traditional banking system by $5 trillion, as well as U.S. gross domestic product by roughly $6 trillion. But Deloitte’s analysis estimated its value at $9.5 trillion at the end of 2011.

Shadow banking can take many different forms, but in general, it refers to the various kinds of financial institutions and activities that exist outside of traditionally regulated banking channels. Think collateralized debt obligations, certain kinds of mortgage-backed securities, and so-called repo agreements.

At its best, the system provides crucial liquidity for borrowers, but because the bulk of the money used in such transactions is not federally insured, lenders require collateral to secure loans. And that is why the system can be so risky. As The Wall Street Journal‘s Francesco Guerrera notes:

Supposedly ‘safe and liquid’ collateral is often anything but that. The need for borrowers to post more collateral in turbulent times exacerbates their problems (look at AIG in 2008 or MF Global Holdings Ltd. in 2011), and the opacity of markets, where prices aren’t set publicly, makes it difficult to value assets and liabilities, triggering panic reactions during stressed periods.

Indeed, “If you look closely, the turmoil in 2008 and 2009 in the U.S. wasn’t a ‘banking crisis.’ It was a shadow-banking crisis that engulfed traditional banks,” Guerrera writes.

Federal Reserve Chairman Ben Bernanke echoed that point in an address last month.

“An important lesson learned from the financial crisis is that the growth of what has been termed ‘shadow banking’ creates additional potential channels for the propagation of shocks through the financial system and the economy,” Bernanke said.

Deloitte’s report points to a range of factors for the drop-off in shadow banking since 2008, including a “backdrop of economic crisis and volatility, increased regulation, and significant changes in the regular banking system.” Moving forward, however, “regulatory headwinds” will be the “No. 1 influence” on the direction of the industry, Don Ogilvie, the chairman of Deloitte’s financial services center, said in a statement.

The bulk of those headwinds will come from the Dodd-Frank financial reform law. The law established the Financial Stability Oversight Council, which will have the authority to supervise large, non-bank institutions that deal exclusively in shadow banking, and which may pose a threat to the broader economy.

Yet early signs seem to suggest elements of Dodd-Frank are working to strengthen the industry. The law forced stricter capital requirements on traditional banks. To meet those requirements, many firms have begun selling assets to shadow institutions.

Other banks have cut back on lending altogether, driving many businesses into the shadows. Take the example of Rentech, a clean energy business in Los Angeles that in 2010 was turned down for a loan by its longtime banker. With few other options, the firm turned to multiple hedge funds to borrow $100 million at an interest rate of 12.5 percent.

That kind of activity has regulators nervous. As Federal Reserve Board Member Daniel K. Tarullo told an audience in New York earlier this month:

Although some elements of pre-crisis shadow banking are probably gone forever, others persist. Moreover, as time passes, memories fade, and the financial system normalizes, it seems likely that new forms of shadow banking will emerge. Indeed, the increased regulation of the major securities firms may well encourage the migration of some parts of the shadow banking system further into the darkness – that is, into largely unregulated markets.

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