There is much confusion about what shadow banking is. Some equate it with securitisation, others with non-traditional bank activities, and yet others with non-bank lending. Regardless, most think of shadow banking as activities that can create systemic risk. This column proposes to describe
shadow banking as ‘all financial activities, except traditional banking, which require a private or public backstop to operate’.
Backstops can come in the form of franchise value of a bank or insurance company, or a government guarantee. The need for a backstop is a crucial feature of shadow banking, which distinguishes it from the “usual” intermediated capital market activities, such as custodians, hedge funds, leasing companies, etc.
An alternative – ‘functional’ – approach treats shadow banking as a collection of specific intermediation services. Each of them responds to its own demand factors (e.g., demand for safe assets in securitisation, the need to efficiently use scarce collateral to support a large volume of secured transactions, etc.). The functional view offers useful insights. It stresses that shadow banking is driven not only by regulatory arbitrage, but also by genuine demand, to which intermediaries respond. This implies that in order to effectively regulate shadow banking, one should consider the demand for its services and – crucially – understand how its services are being provided (Claessens et al. 2012).
The challenge with the functional approach is that it does not tell us what the essential characteristics of shadow banking are. While one can come up with a list of shadow banking activities today, it is unclear where to look for shadow banking activities and risks that may arise in the future. And the functional approach is challenged to distinguish activities that appear, on the face of it, similar, yet differ in their systemic risk (e.g., a commitment to provide for credit to a single firm vs. liquidity support to structured investment vehicles). Related, most studies focus on the US and say little about shadow banking elsewhere. In Europe, lending by insurance companies is sometimes called shadow banking. ‘Wealth management products’ offered by banks in China and lending by bank-affiliated finance companies in India are also called shadow banking. How much do these activities have in common with US shadow banking?
Acknowledging the need for a backstop as a critical feature of shadow banking offers useful policy implications:
First, it gives direction on where to look for new shadow banking risks: among financial activities that need franchise value or government guarantees to operate.
Non-traditional activities of banks or insurance companies are ‘prime suspects’. It is hard to point to the shadow banking-like activities which may give rise to future systemic risks conclusively, but one example could be the liquidity services provided by sponsor banks to exchange traded funds, or large-scale commercial bank backstops for leveraged buyouts.
Second, it explains why shadow banking poses significant macro-prudential and other regulatory challenges.
Shadow banking uses backstops to operate. Backstops reduce market discipline and thus can enable shadow banking to accumulate (systemic) risks on a large scale. In the absence of market discipline, the one force which can prevent shadow banking from accumulating risks is regulation.
Third, it suggests that shadow banking is almost always within regulatory reach, directly or indirectly.
Regulators can control shadow banking by affecting the ability of regulated entities to use their franchise value to support shadow banking activities (as was done in the aftermath of the crisis by limiting the ability of banks to offer liquidity support to structured investment vehicles). Or by managing the (implicit) government guarantees (as is attempted in the US Dodd-Frank Act by limiting the ability to extend the safety net to non-bank activities and entities; or by general attempts underway to reduce the too-big-to-fail problem).
Finally, it suggests that the migration of risks from the regulated sector to shadow banking – often suggested as a possible unintended consequence of tighter bank regulation – is a lesser problem than some fear.
Shadow banking activities cannot migrate on a large scale to areas of the financial system that do not have access to franchise values or government guarantees. This by itself does not make spotting the activity occurring within the reach of the regulator necessarily easier, but at least it narrows the task.