What (non)Banks do in the Shadows and the Regulatory Climate of (in)Stability

The term shadow banking is loosely used to describe financial activities that go very lightly regulated, if at all.  Let's not forget that it can include unregulated activities being conducted by regulated entities.  But part of the trouble is that everyone's definitions are different.

One group of researchers who published a piece in the Journal of Financial Economics defines 'shadow banking' as, "credit intermediation involving activities outside of the traditional banking system."

It carries a very loose and ambiguous connotation, which is something many politicians love: a blanket Boogeyman label that can be tossed out to blame for criminal negligence and regulatory failures.  It's much easier to blame a poorly defined and ill-regulated concept than to name names and criminally prosecute or indict people (see my post on Accountability as the Hot Potato nobody wants to touch.)

But regulators have the tough position of writing and enforcing the laws around that phrase...

Evidence from China suggests that entrusted loans (lending from non-bank creditors such as commercial companies) were the largest component of the shadow banking sector up until 2014, when China's largest shadow-banking component became WMPs (wealth management products.)  As a measurable segment of the Chinese economy, shadow-banking made up about 82% of China's GDP by the first half of 2016.  This is tremendously difficult to wrap one's head around, but when you consider the relationship that PBoC has with borrowers as a lending agency, the rise in non-bank borrowing makes total sense.

China loans - TSF: PBOC data for Jan showed first increase in shadow banking in 11mths -

Bberg pic.twitter.com/XhV3ygRdoJ

— EMgist 🗣I.O.U-kinda-M.O.U (@EMgist) February 22, 2019

Meanwhile in Europe, regulators have seen what's been happening in China and other countries with large segments of unregulated lenders, and are trying to get ahead of the curve.  ECB policymaker Hernandez de Cos said earlier today (26 Feb. 2019) that Europe needs to implement Pan-European banks to consolidate the lending power of institutions.

European Central Banker Hernandez de Cos; (image credit: Bloomberg, LP)

By doing this, the hope is that regulatory oversight will operate much more smoothly and provide the Euro area with greater stability.

Over in the U.S., regulators have shifted their understanding of the definition itself, effectively creating a legislative delay, and (for the time-being) gave large amounts of discretion to various agencies as to how they choose to investigate and prosecute.  The U.S. Federal Reserve last year produced a compelling report that drew an empirical parallel between shadow banking and its source.  It's a nail-biting thriller of a read, but spoiler alert: undercapitalized banks (especially ones subject to higher capital requirements) have a tendency to reallocate credit to partner non-banks, which they describe as a risk transfer maneuver.  Because regulators squeezed banks so tightly with policies and capital requirements after the '08 crisis, lenders that weren't subject to those rules came in to sweep up.

What does all of this tell us?  First, internationally uniform language needs to be agreed-upon between major, developed economies with the stipulation that smaller (and as a generalisation, more vulnerable to corruption) governments must follow suit.  This sets the stage for an enforceable platform of regulations so that violators of these policies aren't playing the banking cartel equivalent of Whack-a-Mole by jetting off to the next least-regulated place on the map.  This is at least someplace reasonable that regulators can start.

Also, sharing information across borders and between agencies is critical for authorities, and current levels of info-sharing are poor at best (though they have improved from pre-2008 levels.)

Last, any institution that lends out capital beyond the capital-ratio capacity of banks should be required to obtain a loan-default guarantee from their sponsor-bank where the credit spillover originated.  This keeps a continuity in accountability where there is currently a shadowy gap, and while does not eradicate the dangerously high endemic risk posed by this issue, it does tie some liability to institutions that currently roam unaccountable.