When historians in 2050 look back and assess the years 2020 and 2021, the coronavirus pandemic and the digital and environmental revolutions will undoubtedly be the main protagonists of that retrospective judgment.
However, behind that general description, that grand headline, there are a multitude of nuances, of less profound developments, which are no less interesting. Let us consider, for example, the observed trends towards the renationalization of politics, economics, and finance, which will form part of this new post-COVID normal. Just as antigens and antibodies fight within our bodies, these opposing trends will also contend for ultimate hegemony; in this case, the struggle is between a global response to sustainability challenges versus tendencies towards isolation and the search for national solutions.
One such issue, which we might call a minor dispute when compared to the brutal cost of the pandemic, is shadow banking, or, using the current nomenclature that the Financial Stability Board assigns to this phenomenon, “non-bank financial intermediation.” As you are all aware, because I have already addressed this matter in this forum, it is a topic that causes me deep concern. The reason is none other than the patent ignorance, exacerbated over the years, of the harmful role that this type of financial activity played in the Global Financial Crisis of 2007/2012. Indeed, all attention was and continues to be focused on the role played by banks, but the crucial role of other non-bank structures present in the originate-to-distribute model is completely ignored: we refer to the essential role played, as accelerators of the crisis, by non-bank operators such as insurance companies (AIG), securities firms (Lehman Brothers), money market funds, investment vehicles (SIVs), or companies specializing in default risk coverage (monolines).
In part, this is explained by the fact that banks are at the heart of the financial system, and when it becomes unstable, it inevitably affects its core, the banks.
Regulatory efforts made after the Great Recession have been more successful in strengthening the resilience of the financial system’s core—that is, banks—than in strengthening the rest of the non-bank financial system. And while the COVID crisis has demonstrated the banking sector’s resilience, there are well-founded doubts as to whether financial stability has been guaranteed with a greatly strengthened banking core but an absolutely uncontrolled periphery.
Furthermore, developments around digitalization and sustainability only increase the complexity of this shadow banking ecosystem (Bigtechs, fintechs, and family offices) with the potential to generate fragilities given the interrelationships between this ecosystem and the banking sector. Is this an unfounded fear? Not at all; we have very recent examples of the fragility of these developments: consider Wirecard, Greensill, Archegos. But we also observe an increase in cyber risk and electronic fraud on smaller scales. Far from reflecting orderly commercial traffic, the financial system seems to be entering, hand in hand with shadow banking, a stage of dangerous anarchy and disorder.
If we pay attention to the press headlines regarding these cases, many of them focus on the losses they have caused banks through curious transmission mechanisms. For example, the collapse of a British operator, Greensill, led to the liquidation of a small bank in Italy. And undoubtedly, errors in counterparty risk management played a role in the greater or lesser extent of losses suffered by the affected banking entities. But the truly key question is whether these developments are merely anecdotal or reflect a problem of architecture, of design, in the regulation and supervision of the international financial system. In my opinion, the answer to this second question is affirmative.
In the next few minutes, I will explain why I believe we must reflect deeply on the regulatory architecture emerging from the Global Financial Crisis (GFC).
Two very powerful forces coexist in the financial system. On one hand, innovation, and on the other, regulatory arbitrage. Innovation drives the emergence of new financial instruments and intermediaries. Consider the recent development of Exchange Traded Funds (ETFs) or the recent Special Purpose Acquisition Companies (SPACs), but also new payment companies (some highly successful, like Ayden) and others whose fraudulent collapse is a cause for concern, like Wirecard, or new categories of financial instruments, such as cybercurrencies. And let us not only think about the realm of digital transformation or risk management, but also the area of Environmental, Social and Governance (ESG), where the volume of innovations in the form of instruments or new operators is considerable. Many of these innovations generate added value, and many others serve spurious purposes. What is relevant, perhaps, is that all of them pose a challenge, as they introduce significant changes and transformations in the financial system, with their positive elements, but also generating new interrelationships and fragilities.
Within these forces of transformation and innovation, the most potent and pernicious is regulatory arbitrage. Every rule has weaknesses that make it susceptible to evasion, in many cases, by financial agents operating outside the regulated sector who use innovation to obtain extraordinary returns, at least in the short term. Consider, for example, the recently emerged SPACs. Even if they present positive aspects, such as improving the financing of unlisted companies, they still represent an arbitrage of the rules governing the IPOs of start-ups.
Finally, we cannot ignore that, within this regulatory arbitrage, the concept of supervisory arbitrage fits. We must not forget that any regulation is only as positive and useful as the supervision that verifies its compliance. On countless occasions, I hear that a group of operators in the shadow financial system is subject to the same regulation as others in the regulated system when performing financial activities. The relevant question is who supervises the application of that regulation when, for example, a bigtech dedicates itself to providing financial services. Regulation without supervision is, simply, a dead letter.
Or, if I may be even blunter, it can be said that rigorous, detailed, and severe regulations and supervisions of the banking sector are of little use if activity in areas of the shadow financial system, which is currently greater than that of regulated banking intermediation, is carried out by operators subject to less stringent regulatory requirements and lighter or more distant supervision, not to say non-existent.
Another aspect, in my opinion key, is that of the new interrelationships arising from financial innovation, whether in the form of new instruments or new operators. Understanding these, and in particular how they impact the core of the financial sector, the banking sector, is vital to ensuring financial stability. In fact, we already saw this in 2007/2012, when problems in the shadow banking sector ultimately had a violent impact on the banking sector.
Shadow banking, or, according to the Financial Stability Board (FSB) nomenclature, non-bank financial intermediation (NBFI), is defined as financial activity carried out by non-bank agents (insurance companies, hedge funds, real estate funds, money market funds, and investment vehicles, among others) that exhibits characteristics typical of banking operations: leverage (intensive use of debt, i.e., little equity at risk), credit risk assumption, and maturity transformation (financing long-term investments with short-term liabilities). As such, and insofar as they do not take deposits, they remain outside banking regulation, although many of their risks are similar to those affecting banks.
Using the latest FSB data, banks, although as a subgroup they are the most significant institutions within the global financial system, only represent 38.5% of the total system and are trending downwards. In contrast, the growth of the most fragile part of this shadow banking system has far exceeded the growth observed in banks (in 2019 and 2020, 8.9% and 5.9%, compared to 5.1% and 3.8% observed in banks).
If measurement is a challenge, mapping interrelationships is simply an impossible mission. We can provide a static description of the new protagonists, whether instruments like SPACs or family offices like Archegos. But understanding the interrelationships, the flows, is practically impossible. I always mention the anecdote of a study carried out by the New York Fed, the only one I know of, to provide a synthetic description of these interdependencies. The graph describing these interdependencies is so detailed that it would require a printer capable of printing canvases the size of a dining table to see the details.
The performance of similar financial activities by different operators, some of them non-bank, leads to a situation where, de facto, the competitive balance among operators may be jeopardized. If regulatory arbitrage is such a powerful force, it is precisely because financial regulation and supervision are as necessary as they are burdensome.
Make no mistake. In this new financial world, the banking sector is at a disadvantage. As an example, in the EU, banks must share their customers with new payment operators (the famous third-party service providers); however, bigtechs are not obliged to share such data, hence the request from Spanish banks to move towards an open data architecture.
The regulatory architecture does not help either. We have a combination of activity-based regulation, but also entity-based, and, worse still, a combination of both approaches. For example, deposit-taking is an activity reserved for banks, institutions subject to banking regulation. The activity determines the subjection of the institution that takes deposits to a specific regulation, banking regulation. But there are quasi-banking financial institutions (not regulated as banks, but which take quasi-deposits and engage in maturity transformation with high leverage and, therefore, susceptible to generating bank-like panics), which are nevertheless not subject to the same rules as banks.
The regulatory reform completed after the Global Financial Crisis has tripled banks’ capital requirements (and up to ten times more for certain portfolios). Therefore, the incentive for regulatory arbitrage has increased threefold: whatever the cost of regulatory capital for banks, the potential gain from escaping the regulatory perimeter is proportional to the increase in regulatory capital.
It is obvious that when regulation—and not only capital regulation, but also others such as investor protection or anti-money laundering, among others—is very strict and entails high compliance costs, the incentives to escape it are equally powerful, although more difficult to calibrate than those derived from regulatory capital. And if we add the cost of stricter supervision to all this, it is undoubtedly very attractive to evade regulatory rigors, albeit to an extent also difficult to quantify.
However, the biggest problem is not the injustice in terms of competitive balance that arises (which does exist—as a Galician would say), but rather the impact this has on the proper regulation and supervision of the financial system as a whole. Perhaps we banks may have seemed annoyed by this type of unfair competition and have repeatedly expressed our complaints about it, and I believe, with every right. It is logical that any company operating in the market expects public administrations to guarantee balanced treatment with its competitors, to ensure that the best, and not the most protected, wins.
But that is not the key, nor does it reveal the true and complete dimension of the problem. The fundamental question is what good it does to have made banks safer from the point of view of solvency and liquidity, better managed from a risk perspective, with better corporate governance and more intensely supervised, if we are shifting risks to a part of the financial system that is less known, worse regulated and supervised, and with actors or products with a limited track record. I am talking about the displacement of activity not to markets—nothing to say there—but to the shadow financial system.
My message is clear: the displacement of activity from banks to the shadow financial system may be increasing the risks of financial instability, even the probability of another systemic crisis due to the presence of pseudo-banks outside the regulatory perimeter. And given the complexity of the shadow financial system and our still quite rudimentary knowledge of it, these risks are difficult to assess.
What can be done? The banking industry has summarized its proposals in one sentence: for equal activity and risks, regulation and supervision must be the same. This phrase, which has highlighted the problems of regulatory arbitrage and has been very effective in raising awareness among authorities about the need to abandon the policy of laissez-faire regarding large technology operators, has limitations as a practical proposition. It may not be desirable in all situations or may be impossible to implement in practice, even if it were desirable.
Achieving such regulatory equality would be highly desirable in the case of quasi-banking entities, that is, those that manage credit risk, with few own resources (and high indebtedness, highly leveraged), and finance long-term assets with short-term, even instant, redeemable liabilities, such as Money Market Funds. For this subgroup, which corresponds to the narrow definition of non-bank financial intermediation, any solution involves subjecting it to regulatory capital and liquidity measures typical of banks, and this, above all, for reasons of financial stability.
But perhaps this segment of shadow banking is the least relevant in practice. The more complex cases involve competition in specific segments, such as payment methods or consumer financing, or investment in redeemable instruments that are similar, though not equivalent, to bank deposits. These cases, which currently have different regulation and supervision for similar activities and risks, can create—and are, in fact, creating—competitive imbalances that end up driving operators subject to stricter rules out of the market. And if this happens, the financial system as a whole will be worse regulated and supervised, and citizens and businesses will be less protected.
The problem for regulated sectors, for incumbents, is that such competition, if it relies on more lenient consumer protection rules for new operators, can be classified as unfair. That is, if the price advantage of these new operators is not based on lower costs derived from the use of technology, but on a lightness of regulatory compliance costs, it will not only be unfair but potentially dangerous, because once digital challengers displace traditional operators and dominate these markets, consumer protection conditions will have degraded permanently.
Ultimately, it seems inevitable that authorities adopt a dynamic vision, taking into account the incentives for arbitrage that regulation and supervision create, and react proactively to potential problems arising from such arbitrage. Perhaps we should reformulate that phrase by saying that similar activities with similar risks should be subject to regulation and supervision that ultimately guarantee equivalent results in terms of preserving financial stability and minimizing long-term supervisory risk. As a phrase, it obviously has little future, though much more substance.
The digital revolution and the emergence of a thriving technological-financial industry, which will predictably drive the disappearance of borders between countries and sectors, will accentuate the challenges associated with the shadow financial system. If we saw capital arbitrage in the years leading up to the 2007 crisis, the emergence of the digital world will undoubtedly increase it.
In fact, the emergence of sustainability as one of the basic pillars of the post-COVID economy adds another layer of complexity to this problem. Indeed, and it is already being observed, the operators in this new space that is being created are increasing, while new instruments are appearing. And we must not forget, either, that the combination of the digital revolution and sustainability creates dynamic forces that reinforce each other: we are talking about fintechs, but also greentechs.
This world of innovation is an inseparable part of success in both areas of the digital revolution and the green revolution. That is, without innovation in the use of technology, and technology applied to solving the problem of sustainability, we will not be able, as a society, country, or planet, to successfully overcome the current challenge. I would not want my comments to be interpreted as digital or green Luddism, but quite the opposite.
But it is true that if the shadow financial system was tremendously complex before the 2007/2012 crisis, I fear it will be much more so in the coming decades. Perhaps the simplest example is that of bigtechs, characterized by their network externalities, which allow them, with a truly global scale, a capacity for competition with specialized operators that is difficult to overcome.
As we have indicated on other occasions, these large bigtechs are where they are due to their capacity for innovation compared to other challenger players who lacked the vision or failed to implement the vision necessary to succeed. They are not where they are due to a lack of their own merits. On the contrary, they are all formidable companies that, through their innovations, have changed the course of our economies and our consumption habits. But it is also true that their dominant position makes it very difficult for new competitors to emerge. This is a very different aspect from what has been observed in areas such as mobile telephony, where leadership has always been temporary and has changed hands (think of Motorola, Nokia, Blackberry, etc.), without affecting their capacity for innovation or competition.
Of course, when a bigtech offers financial services, it is subject to sectoral regulation. But how many inspections by the relevant sectoral supervisor do we know of that are effectively carried out on this type of company? Because, as we have already indicated, regulation without supervision or compliance is a dead letter.
Recent BIS studies indicate that 10% of these platforms’ revenues already originate from the provision of financial services. We are not talking about a theoretical issue or something that will happen in the future: 10% of their business is already financial, and they have only just started providing these kinds of services. It does not seem that the authorities have much time to react.
The emergence of the green revolution, undoubtedly one of the great positive news of the post-pandemic era, threatens to further complicate the financial ecosystem. Let us consider the area of sustainability in terms of new actors, regulatory measures from various authorities, global initiatives, or new wholesale and retail instruments.
On the side of new actors, we have:
Regarding regulatory measures and standards, sustainability initiatives already number in the thousands, rising to 5,500 if we consider broader aspects such as reporting, supervisory policies, stress tests, etc. Without aiming to be exhaustive, we can highlight:
In the area of instruments, we could highlight:
In short, the coming sustainable tsunami, not only regulatory, will exponentially increase the complexity of the shadow financial system. Hence my repeated calls for us to replace the apostles of climate change with the plumbers of climate change without further delay, to bring order to this entire new world, to regulate financial traffic, and to limit, as much as possible, the complexity and confusion that usually accompanies every economic revolution.
A brief review of financial newspaper headlines in recent months confirms a pattern seen before: problems in the shadow banking system that end up affecting the core of the financial system, i.e., banks. Indeed, Wirecard, Greensill, and Archegos are cases where activity on the periphery of the system ultimately impacts the banking sector. Since not all banks are affected equally (some are better and some worse at managing risks), and since in no case have viability problems been generated in the affected entities so far, it would be tempting to state that the financial reform implemented after the Great Recession has worked adequately. We could say that, by making banks more solvent and secure, the stability of the financial system has been preserved.
I sincerely believe that this is an erroneous conclusion. The evolution of the shadow financial system points towards greater complexity and diversity. We have moved from Shadow Banking 1.0, prevalent before the Global Financial Crisis, to Shadow Banking 2.0, developed in recent times, with new and old players. With the digital revolution, we will witness the birth of version 3.0, without, I fear, the regulatory or supervisory architecture having adapted.
Regulation and supervision must respond to this Brave New World, and ensure greater competitive balance between banks and players in the shadow financial system. It is not a matter of fairness, which it could also be, but of safeguarding the stability of the entire financial system. We have made banks safer, but I fear that in the future this will not be enough to preserve our economies from future financial crises.
José Mª Roldán Alegre, Chairman of the AEB
