Allow me to begin this conference by thanking the organizers for their kind invitation. Today, I intend to discuss the shadow banking system, why I believe it is important for authorities, both supervisory and those responsible for financial stability, to pay attention to this area, and, more importantly, to be prepared to act if necessary. I fear that, despite the somewhat sensationalist nature of the terminology used, this is an arid subject, especially if one approaches it with rigor.
The background is well known. The financial crisis has led to a considerable tightening of banking regulation—let’s not mince words—and particularly of the minimum capital requirements imposed on banks. As just one example, and as I have mentioned on other occasions, the new Basel III regulation multiplies capital requirements for trading portfolios by seven, according to data from the UK’s “Prudential Regulation Authority”. If we add the new requirements of Basel III to those for Bank Resolution, the requirements become even greater. In short, after the crisis, banks are required to hold significantly higher minimum capital levels than those in force before the crisis. There is nothing more to say about this, at least not today.
However, we know that the financial system is not static but dynamic. That is, it is alive and does not remain stable in the face of structural changes such as those related to regulation. Not only do we have financial innovation and capital arbitrage as major drivers of change. We must also consider that risks tend to shift towards sectors where regulation is more lax, and this includes both solvency regulation and rules of conduct, such as those aimed at consumer and investor protection.
We are talking not just about new products, but about new financial institutions, or shifts in the composition of product portfolios (investment funds, private equity funds, or pension funds). It is precisely this dynamic nature of the financial system that complicates the work of financial regulators and supervisors so much.
But perhaps the main obstacle to limiting regulatory arbitrage lies in the very approach to financial regulation or supervision. While financial risks mutate in appearance and can manifest as banking, securities, or insurance products, financial regulation is established based on the nature of the sectors—banking, securities, or insurance—to which it is directed. That is, although financial risk cannot be sectorally labeled, both regulation and supervision are defined sectorally: the same product with a different sectoral label will be governed by different sectoral regulations, and two financial companies, with the same characteristics and the same financial business, will be regulated and supervised according to their sectoral affiliation.
This argument, of course, allows for nuances. Life insurance, where premiums are collected before the insured event, is not the same as an immediate repayment bank deposit. And for this reason, banks are prone to liquidity crises, while insurance companies are not. Therefore, it makes sense for them to be regulated differently.
However, as long as institutions remain true to their original activity, the problems are limited. But in the obscure frontier of shadow banking, the danger lies precisely in the fact that, when incentives are very strong, insurance companies can end up failing by taking on credit risk (the bankruptcy of AIG, probably the largest of any insurance company in history, was not the result of its main activity, insurance, but of its ancillary activity, credit risk insurance).
The problems arising from solvency rule arbitrage are always more delicate: after all, we are talking about the potential failure of financial entities. But let us not forget that arbitrage of conduct rules, of investor-consumer protection, can be a powerful temptation (given the demands of the regulations approved after the crisis) and can have tremendously undesirable consequences (insofar as it exposes the investor to unvalued or unstated risks). Although from the point of view of financial stability the first type of arbitrage is more dangerous, from an ethical point of view, it is the second that should concern us.
Allow me to recap, because the subject is, without a doubt, arid. We have mentioned the notable tightening of banking regulation, solvency, and conduct rules after the crisis, as well as the dynamic nature of the financial sector, characterized by innovation. We have referred to the regulation and supervision of financial companies and financial products, which is more focused on the form or sectoral wrapper than on the substance, that is, on the characteristics of financial risks. Furthermore, we have highlighted the danger of regulatory arbitrage and the irresistible temptation that can lead to engaging in it.
Before describing why the shadow banking system can present potential risks, we must define what we are talking about. The International Monetary Fund, in its October 2014 Global Financial Stability Report (GFSR), defines “shadow banking” as credit intermediation that occurs outside the traditional banking sector. Using this broad definition, we are talking about 25% of total global financial intermediation, and close to 200% of GDP in the case of the US or the Eurozone (in the United Kingdom it reaches more than three and a half times GDP). And it shows almost exponential growth. In 2013, shadow banking grew by $5 billion to reach $75 billion (almost €60 billion) globally, according to the aforementioned report. The growth of this industry, which includes, among others, hedge funds, real estate funds, and off-balance sheet investment vehicles, is supported not only by the willingness of creditors operating outside the controls of banking regulators to lend, but also by investors’ search for profitability in a very low interest rate environment.
The Financial Stability Board (FSB), for its part, points out in its report that shadow banking is growing particularly rapidly in Argentina, with a 50% surge. China follows, a country with high regulatory challenges in its financial sector, with a 30% rebound. In the United States, the weight of shadow banking decreased last year to 33%, compared to 41% in 2007, while in the Chinese economy its weight has advanced to 4% from 1%.
Meanwhile, the latest issue of “The Economist” mentioned that peer-to-peer lending platforms in the US are generating new loans at a rate of $10 billion per year, and that a single new technology operator in Germany grants financing for a volume of $120 million per year. In short, all these figures, and particularly those referring to flows related to the annual increase in activities, indicate that we are not talking about a small economic activity.
Furthermore, shadow banking plays an important role in financing the real economy, either by financing sectors that, due to their high risk, fall outside traditional banking channels, or by providing long-term financing for credit risk, over periods in which banks, due to new regulations, can no longer participate. In the US, this sector finances the real economy by a volume equivalent to that of banks, while in the Eurozone it already represents more than 25% of financing to the real economy. In short, the solution to the problems of the shadow banking sector does not lie in its suppression, as that would lead to a credit crunch of considerable proportions. And the potential problem does not arise, obviously, from this function of financing the real economy, which is complementary to that performed by banks, but the key question is whether this activity generates unknown and uncontrolled risks.
This broad definition of shadow banking allows us to assess the sector’s importance, but says little about its potential risks. This is where a more precise definition of the shadow banking system needs to be introduced, in line with that used by the Financial Stability Board (FSB): not only is credit risk intermediated, but that credit risk is financed with shorter-term liabilities (there is a maturity mismatch) and in an leveraged manner. Let’s consider that this is a definition of a bank: banks finance loans through deposits, with a very low ratio of own funds to borrowed funds. Therefore, this narrow definition of shadow banking points to financial entities that, while not banks, perform functions with similar risks to banks, but without the guarantees offered by banking regulation or the ability of a solvent bank experiencing temporary liquidity difficulties to turn to the central bank for emergency funding (ELA, in central bank jargon).
This narrow definition points to that segment of the shadow banking system that is potentially unstable and can, therefore, pose a danger to financial stability. The problem arises because, while it is easy to identify non-bank credit intermediation, we do not have sufficient information to identify the sub-segment of the shadow banking system that may prove dangerous. We can cite some specific institutions, such as “Constant Net Asset Value Money Market Funds,” or other cases of “shadow banks” that have ended in crisis, but we do not have a complete or dynamic map of that sub-segment.
And this should be a cause for concern: the growth of shadow banks is more intense when banking regulation tightens, and thus the benefits of regulatory arbitrage increase. In fact, the data from the IMF study I referred to earlier seem to point in that direction.
Because it’s not that the dangers of the shadow banking system are unknown to us. We must not forget that the beginning of the harshest phase of the crisis we have overcome started with the bankruptcy of Lehman Brothers and the bailout of AIG, both textbook cases of shadow banking activity. The case of AIG is clear: it was an insurance company with such a large exposure to credit risk that it had to be rescued to prevent the collapse of the global financial system. It is argued, not without reason, that the activity that caused its downfall was not traditional insurance, but the innovative OTC derivatives for credit risk hedging. But this is no consolation: it also shows that regulatory arbitrage not only shifts credit risk to other parts of the financial system, but also goes where the capacity to evaluate it is lower.
On the other hand, Lehman Brothers, despite being an investment bank, was not strictly a bank: it was subject to SEC supervision and regulation, did not take deposits, and did not have access to the Fed’s liquidity facilities. However, it did intermediate credit risk, financing it in a leveraged manner and with shorter maturities than its assets. It was closer to what a brokerage firm is in Spain than to a bank.
We could extend the list, mentioning the role played at the beginning of the crisis by “US Money Market Mutual Funds” or by certain complex securitization structures (“Collateralized Debt Obligations”), but the aim is not to provide an exhaustive description of the role played by “shadow banks” at the onset of the crisis, but simply to illustrate that they were at the genesis of the crisis.
Of course, it cannot be denied that this initial trigger caused a deep and widespread banking crisis among developed countries, albeit also selective, in the sense that some banks managed to weather the crisis without resorting to public aid. In some cases, this was explained by corporate governance weaknesses, in others, by financing structures excessively based on markets (and not on deposits), and in all cases, against the backdrop of the implosion of the real estate bubble.
All of this led to a tightening of banking regulation and supervision which, while presenting obvious dysfunctions, was inevitable given what had happened.
The key question is whether the regulatory tightening process is making the international financial system safer. The undisputed answer for banks is yes; without a doubt. Today’s banks are much more liquid and solvent than before the crisis, and from that perspective, that of the banking sub-sector, the system is safer, less prone to banking crises, and with lower costs for society in the event of a crisis of a specific bank. Has the same progress been made in controlling the dangers arising from the shadow banking system? The answer is, without a doubt, no. Moreover, the progress made in controlling risks from banks increases the risks of the shadow banking system, as the latter shows greater vigor the tougher banking regulation becomes.
One of the practical difficulties is the lack of detailed statistical information on “shadow banks,” for two reasons. First, because global knowledge of their evolution, size, etc., may indicate little about systemic risks, as only a sub-sector presents systemic or financial stability risks (the one that finances credit risk with few own resources and a lot of short-term financing). The second is that a dangerous development of shadow banking activity can arise in the form of any financial company: insurance companies, money market funds, securitizations (or “Special Purpose Vehicles” in more technical jargon), private equity funds, brokerage firms, hedge funds, etc.
Both the FSB (Financial Stability Board) and the IMF are making titanic efforts to obtain the essential statistical information needed to monitor the evolution of risks in the shadow banking system. Furthermore, they have identified the warning signs that can turn a shadow banking actor into a dangerous one from the perspective of financial stability. These warning signs include:
In addition, new developments within the shadow financial system are being identified:
As a complement to these statistical and analytical improvements in identifying those shadow entities that may pose a systemic risk, the Financial Stability Board has launched a process for identifying Systemically Important Financial Institutions, or SIFIs, for which reinforced regulation and supervision (including resolution) have been foreseen, as their failure would cause effects throughout the system, as the name itself indicates. The process is very advanced in the case of banks. Regarding identification, criteria such as size, interconnectedness, business and balance sheet complexity, cross-border activity, and, finally, substitutability (i.e., whether there are other banks that could replace them in the different business segments in case of failure) are used. With this, the FSB identified, in 2014, 30 banks considered SIFIs, and for which, in addition to reinforced supervision, different degrees of additional solvency requirements are established (from 1% to 2.5% more capital on risk-weighted assets or RWAs).
This SIFI identification process is being extended to insurance companies (in 2014, 9 insurance companies were identified as globally systemic), albeit with a lesser degree of detail compared to the bank process, and a proposed methodology for identifying non-bank and non-insurance SIFIs has been published. This latter group potentially comprises a varied set of candidates: financial companies, securities broker-dealers, investment funds, hedge funds, and asset managers.
Again, we find a precise regulatory framework for the banking sector, in this case for systemic banks, and a much more imprecise and developing framework for actors outside the banking sector. It is essential to complete this general framework for SIFIs if we want to avoid the risks of regulatory arbitrage. Or, in other words, we must implement a surveillance system that will allow us to detect a case like that of the American company AIG in the future. Our global financial stability for the coming years, if not our lives, depends on it.
I understand that my stance on shadow banking may be seen by some as a reflection of a certain nervousness about the emergence of competitors. But nothing could be further from the truth, and from my position on competition: on the contrary, healthy competition, not based on advantages or asymmetries, is a key pillar of a strong, efficient, and profitable banking system. Allow me to take a few minutes to dispel that mistaken perception.
As part of the response to the crisis, European authorities are promoting a transformation of the financial system that diversifies the sources of financing for the real economy. Specifically, the aim is to move towards a financial system with a greater emphasis on market-based financing for households and businesses. That is, compared to the current scheme where three-quarters of the real economy’s financing comes from banks, the goal is to move towards a more balanced model (although it may not be necessary to reach the US model, where three-quarters of the real economy’s financing comes from markets). Projects such as the Juncker Commission’s “Capital Markets Union” should be analyzed from this perspective. The banking sector understands and supports this transformation of the financial system towards a greater role for markets, and is willing to assess the role it can play in this new financial paradigm and how it can help its clients successfully finance themselves within it.
Nor is there an attitude of resistance to the emergence of new technology operators that compete with banks in certain business segments. This process, which I have called the deconstruction of the banking business, is probably unstoppable. And, furthermore, the banking sector has the resources to face this increased competition and do so successfully.
However, it is obvious that this transformation of the financial system, with a greater weight of market financing and increased competition from new operators, cannot be carried out at the expense of either financial stability or consumer and investor protection. That is, if the only basis for new developments is capital and conduct rule arbitrage, this new financial system of the future that Europe wishes to build will have feet of clay.
Therefore, it is not just about competing on a level playing field in terms of regulatory requirements applied to banks versus other sectors, but about preserving the stability of the financial system. Given the inevitable interconnectedness among all agents operating within it, a problem in one part of the system can spread to other, in principle, healthy parts. And we are not talking about a hypothesis to be tested: remember, again, the role played by shadow banking in the genesis of the last financial crisis. Or, if I may be a little sarcastic, as we say in Aragon, I can already see myself in a few years, when shadow banking enters a crisis, everyone will forget the qualifier “shadow” and will indiscriminately criticize banks for causing another crisis. Let my words, then, serve as a future warning.
Allow me to conclude this conference, in which I have tried to address a topic as complex as it is relevant. The reaction of the authorities, after the outbreak of the crisis, has led to the approval of regulatory and supervisory changes that have considerably tightened the legal regime applied to banks. However, outside the banking sector and specifically in the area of shadow banking, progress is more limited, if not very limited. Global financial authorities should advance in this area with greater speed and determination, because if we do not close the financial system to arbitrage, we will end up with a very safe, stable, and smaller banking system, but a large, growing, opaque, and potentially unstable shadow financial sector will have been created that will undoubtedly be the cause of the next financial crisis. Let us, therefore, put in place the appropriate means to prevent it.
José María Roldán, Chairman of the Spanish Banking Association
