“Shadow banking” refers to financial intermediation carried out through credit, leverage (limited equity and a predominance of external funding), and maturity mismatches (financing long-term assets with short-term callable liabilities). Shadow banking played a prominent, and even decisive, role in the build-up to the 2007–2008 global financial crisis. This article reviews, from a critical perspective, the efforts made to control the risks that emanate from it. The conclusion is that, despite those efforts, nothing guarantees that such risks are under control. The causes of this failure lie in problems in the architecture of financial regulation, in asymmetric measures (the current stringent regulation of the banking sector has not been extended to shadow banking), and in the transformation driven by the Fourth Industrial Revolution.
For all these reasons, it seems obvious that relying solely on the banking sector’s leverage is not enough to control all the risks arising from the financial system. Therefore, before continuing to talk about regulation—more regulation or better regulation—it is necessary to address immediately the problem of shadow banking, that is, to include within the regulatory perimeter all financial agents that generate systemic risks. Regulation must treat all agents according to the risks their activity represents, regardless of whether they are banks, asset managers, or other types of funds. Same activity and same risks, same rules. And this also applies to new financial participants from the digital world, in particular the bigtechs, the major technology operators, which, due to their size, can generate systemic risks, in addition to collusion issues that limit competition and consumer protection.
Another corollary is that we must prevent the re-emergence of inappropriate developments around the “originate-to-distribute” model. That has been, among other things, one of the objectives of the regulation introduced after the crisis. However, it is paradoxical that the new regulation is creating incentives for regulatory arbitrage, that is, for shifting activity from banks to the shadow financial system, by directing the new rules at entities (banks, insurers, etc.) rather than at types of transactions (raising short-term liabilities that finance long-term credit risk). The key question is whether the emergence of pseudo-banks outside the regulatory perimeter is increasing the risks of financial instability, or whether customer protection issues may arise as a result of these new intermediaries (who not only take advantage of the benefits of capital arbitrage, but also of the rules relating to the protection of financial customers).
With the regulatory reform recently completed and still in the implementation phase, it is still too early to provide an answer, but it is contradictory that we are making banks much safer at the cost of shifting risks to parts of the financial system that we neither see nor control.
In addition, the bigtechs pose an even greater challenge due to their universal (non-national) nature, their enormous capacity for innovation (which no one doubts), but also their ability to circumvent the constraints under which other sectors operate (for example, in terms of data protection).
In short, the issue of the regulatory and supervisory treatment of shadow banking is far from resolved. Given the role it played in the build-up to the 2007–2008 global financial crisis, this vulnerability should feature prominently in the deliberations of those responsible for financial stability at both global and local levels.
José María Roldán, Chairman of the Spanish Banking Association
