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Wednesday, October 12, 2011

Regulating the Shadow Banking System

    The core mission of Bank Regulation is, in my point of view, to mitigate the systemic risk to the extent that everyone in the world can afford the cost of another financial crisis. Maybe a bit pessimistic, however I do subscribe to the belief that we cannot stop the current financial crisis from happening. What the regulators and all the market participants can do basically is to mitigate the scale of them and foresee them as early as possible. This is no time for myopia. Clarity of vision is essential.

    The recent global financial reform efforts that were proposed by the G20 Financial Stability Board, the U.S.A Dodd-Frank Act, and the UK Independent Commission on Banking, all reveal a clear and common tendency: to regulate those financial conglomerates that operate both in the traditional banking paradigm and via non-traditional banking activities.


    Either through prohibiting the insured banking entities from engaging in so called “proprietary trading” activities, or legally requiring retail banking functions be “Ring-Fenced” from universal banks, those reforms all aim to draw a line between the traditional commercial banking activities (deposit- taking, loan- granting) and whole sale banking activities and other shadow banking operation.


    Why are regulators around the world now so worried about whole sale and other shadow banking activities? The answer is not difficult to locate. Those non-traditional banking functions all play a “credit intermediation” role and are disproportionately outside of the regulatory boundaries, and have been so for decades.


    Counterparty default risk that is derived from credit intermediate activities is contagious by nature. Every business organization that needs outside credit sources to fund their operations basically runs its business in a highly leveraged context. And without question, those leveraged liabilities are never fully collateralized. Not surprisingly, one credit intermediary’s failure will lead to another’s failure and eventually bring the whole financial system crashing down. Hence, the aforementioned contagion. Simply put, “credit intermediation” is a fertile source of systemic risk that could easily jeopardize the whole financial market. More succinctly, the reason why worldwide banking regulators now turn their newly-acquired focus on the mysterious “shadow banking system” in which “credit intermediation” was vastly created by virtually unregulated non-banking financial institutions.


    Per the definition proposed by the FSB, shadow banking system is “a system of credit intermediation that involves entities and activities outside the regular banking system, and raises 1) Systemic risk concerns, in particular by maturity/liquidity transformation, leverage, and flawed credit risk transfer, and/or 2) Regulatory arbitrage concerns.” The scale of the “shadow banking” system was estimated as at least $16,000 billion dollars, according to research by the Federal Reserve Bank of New York. Its actors and activities include everything from hedge funds, private equity funds, derivatives, Repo, ABCP, money market funds, special‐purpose vehicles that hold complex securities (Securitization) and even ordinary corporations who used it’s excess cash to make direct loans to other companies (That is precisely what’s happening in China as I write this).


    The spectacular scale of the Shadow Banks is not the only reason why they are worthy of our attention in today's global financial environment. Stringent regulations promoted by global regulators have in fact triggered some universal banks separating their trading activities into a far less regulated arena, either through constructing new legal entities or selling parts of their business to other financial institutions. By escaping into the shadows, banks can not only bypass the annoying, annoying to their modus operendi, regulations but also strengthen their competitive advantages over other commercial banking competitors. In addition, the imbalance of credit supply to certain extent has exacerbated the potential threats the shadow banking system may bring to the global financial market. Just like Brooke Masters, Henny Sender and Dan McCrum articulated in their article in Financial Times, “On the lending side, the new shadow banks have targeted middle-sized companies, those too large to visit their local bank manager, but too small to attract the attention of the bond market – in the US that can mean those with annual sales in the $50m to $1bn range.” Such a phenomenon reflects two extreme and unhealthy problems in the contemporary credit market: 1) some corporations, small and medium sized enterprises in particular, who need credit urgently, can only access credit with a prohibitively high cost or can not get funding at all. 2) Some large companies who in fact do not need credit, can, nevertheless, get credit or loan with almost no cost (Such scenarios are far worse in China). These deficiencies further encourage risky and unsafe lending and investing behaviors among the shadow banks, and will inevitably bring us to yet another level of disastrous financial crisis.


    But can we really effectively regulate the shadow banking system? “Shadow banks” were basically operated by those who are very good at circumventing the regulatory standards. Full and detailed transaction information is needed to enable the regulators better informed insight of the regulatory perimeters and issues that derived from shadow banking activities. Nevertheless, mere disclosure and information collecting are not enough. Information can provide the regulators with a clarity on what the whole shadow system actually is, but to draw something meaningful and everlasting, regulators should rely heavily on how to “internalize” all the proposed regulations, either abstract or detailed, to make them a valid behavioral culture among the market actors in this adaptive and complex system.


    Sound “market culture” is also contagious in that it can easily be widespread within the entire system because by adopting and practicing such a culture, market actors can not only increase the reputational costs for other actors who meant to default but also immensely reduce the transactional costs in every deal. Market conducts are never easy to regulate unless the regulators can stimulate the actors to behave in an ethical and prudent manner. Corporate culture is just the prime factor that could transform the market actor to follow the rules or regulations spontaneously, voluntarily and instantaneously. Regulating the shadow banking system is a task more than simply reforming financial regulations: it is, in fact, a most human behavioral revolution.

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