Shadow Banking in the US SUmmarized \u00a0\u00a0Prior to the 2008 financial crisis, the Federal Reserve had an important role \u2013 to solely act as a \u201clender of last resort\u201d to traditional commercial banks. But during the crisis, the financial support was extended to many non-banking firms like money market mutual funds, the commercial paper market, mortgage-backed securities market and the tri-party repo market. Besides the extensive lending, non-commercial banks (also known as shadow banks) like Bear Stearns and Lehman Brothers were first to fail, triggering one of the worst financial crises across the world.<\/p>\n
The US accounted for the largest shadow-banking sector, with $14.2 trillion in 2014.<\/p>\n
Economist Paul McCulley, in his 2007 speech at the Annual Financial Symposium hosted by the Kansas City Federal Reserve Bank in Jackson Hole, Wyoming, coined the term \u201cshadow bank.\u201d Traditional commercial banks have been the driving force for creating liquidity in the economy. They accept the illiquid liabilities of both nonfinancial and financial entities for their own liquid liabilities and have access to the emergency funding of the Federal Reserve.<\/p>\n
The shadow banking system, in contrast, introduced activities that generated liquidity through capital markets without public guarantees and provided access to the central bank as the \u201clender of last resort.\u201d Unlike traditional commercial banks, shadow banks are unregulated and not subject to the traditional banking regulation system. This means that they cannot borrow in an emergency from the Federal Reserve, unlike traditional banks.<\/p>\n
Investment banks, structured investment vehicles, hedge funds, non-bank financial institutions, money market funds, mutual funds and exchange-traded funds are all a part of the shadow banking system and are not required to maintain any reserves or emergency capital. \u201cNo regulations\u201d in a \u201cregulated environment\u201d could be the biggest worry of the shadow banking system. Often beyond the control of regulators and monetary policy, shadow-banking activities can resort to risky lending. According to the New York Fed, shadow banks have \u201cincreased the fragility of the entire financial system.\u201d While the total of non-bank financial intermediaries decreased immediately after the 2008 financial crisis, the number of shadow banks have picked up in recent years.<\/p>\n
The vulnerabilities of the traditional banking system to the unregulated risks undertaken by the shadow banking system continue to threaten the financial system in 2016. According to the Financial Stability Board\u2019s Global Shadow Banking Monitoring Report 2015, the United States accounted for the largest shadow-banking sector, with $14.2 trillion in 2014. With more than 80 percent of shadow banking activities residing in the advanced economies of North America, Asia and northern Europe, shadow banking could be one of the biggest threats to the current financial system. The report identifies the difficulty in assessing the amount of risk involved due to the lack of detailed data. The Financial Stability Board, an international board that monitors the global financial system, said the shadow-banking sector posed a huge risk of $36 trillion across 26 jurisdictions across the world in 2014.<\/p>\n
Introduced in 2010, the Dodd-Frank financial regulations have been strict in reforming the \u201ctraditional part\u201d of the banking system, but the regulations of shadow banks remain neglected. Along with many other rules, the big banks must maintain higher capital requirements and adhere to annual stress tests conducted by the Federal Reserve. But the tightening of commercial banks through banking regulations has encouraged a shift toward shadow banking.<\/p>\n
In 2016, while traditional banks face the strict regulations of Dodd-Frank and Basel III (capital restrictions imposed on banks by the Bank for International Settlements to restore financial stability), shadow banks remain largely unmonitored and deeply entwined with the financial system. Federal Reserve Gov. Daniel Tarullo said in a speech in November 2015 that there is a possible risk in the financial stability \u201cfrom activities mostly or completely outside the ambit of prudentially regulated firms.\u201d He added, \u201cShadow banking is not a single, identifiable \u2018system,\u2019 but a constantly changing and largely unrelated set of intermediation activities pursued by very different types of financial market actors. Indeed, the very rigor of post-crisis reforms to prudential regulation may create new opportunities for such activities.\u201d While traditional commercial banks may have benefitted from the Dodd-Frank law, large sections related to shadow banking remain largely neglected.<\/p>\n
Democratic presidential hopeful Hillary Clinton has vowed to strengthen the Volcker Rule (a rule that prohibits an insured depository institution from engaging in proprietary trading) by \u201cclosing the loopholes that allow banks to make speculative gambles with taxpayer-backed deposits.\u201d<\/p>\n
She also has called for a new risk fee to be imposed on the nation\u2019s largest banks. But while the Volcker Rule tries to separate banking activities from proprietary trading, interestingly, it excludes this distinction for non-banking financial companies. Hence, shadow banks continue to operate unregulated, without being subjected to any such prohibition under the Volcker Rule.<\/p>\n
In order to address the issue of shadow banks, many politicians have been pushing for the restoration of the Glass-Steagall Act. Prior to the Great Depression in the 1930s, commercial banks were blamed for getting very speculative and greedy, since they were not only investing their assets, but also buying new issues for resale to the public. This led to a collapse of the banking system, which slowly became irresponsible and chaotic. One of the functional reforms that came in the form of banking regulations was called the Glass-Steagall Act, and it clearly outlined the objective of the banks.<\/p>\n
The proposal was to limit their activities by separating commercial and investment bank functions. The underlying belief of the Glass-Steagall Banking Act of 1933 was that it would reduce risk and create a healthier financial system. Under the Glass-Steagall Act, institutions were given a year to decide whether they would specialize in commercial or investment banking. This Depression-era law was in place for 60 years until Congress and President Bill Clinton repealed it in 1999 under the Gramm-Leach-Bliley Act.<\/p>\n
The elimination of the Glass-Steagall Act under the Clinton administration happened after many banks lobbied to remove the restrictions imposed by the act. Supporters of Gramm-Leach-Bliley believed that Glass-Steagall had worked post-Depression and it was time to remove certain restrictions on banks. President Clinton agreed that the act was \u201cno longer appropriate to the economy in which we live. It worked pretty well for the industrial economy \u2026 But the world is very different.\u201d<\/p>\n
The repeal allowed banking activities to combine with non-banking activities. Glass-Steagall had helped in creating a safety net for commercial banks and allowed the central bank to act as a lender of last resort to commercial banks. But the repeal of Glass-Steagall blurred the distinctive lines between regulated banking functions and shadow banking functions.<\/p>\n
During a policy address on January 5, 2016, Sen. Bernie Sanders said, \u201cShadow banks did gamble recklessly, but where did that money come from? It came from the federally insured bank deposits of big commercial banks \u2013 something that would have been banned under the Glass-Steagall Act.\u201d The Glass-Steagall Act has taken center stage in many 2016 presidential debates with Sen. Bernie Sanders and former Maryland Gov. Martin O\u2019Malley supporting the \u201c21st Century Glass-Steagall Act,\u201d an updated version of the 1933 law, which aims to reduce the likelihood of future crises by clearly separating traditional banking activities like savings and checking from riskier, non-banking activities like insurance, swaps dealing, and hedge fund and private equity activities.<\/p>\n
Estimating the size of shadow banking is difficult to quantify for the simple reason that many of the entities do not report to any government regulators and therefore remain outside the purview of lawmakers. The growing size of shadow banks remains a threat to the financial system as long as they are unregulated. The matter worsenswith the integration of commercial and investment banking activities as financial holding companies actively facilitate the growth of shadow banks.<\/p>\n
In 2016, even with strict regulations under the Dodd-Frank Act, shadow banks remain highly leveraged (promising higher returns but with outsized risk) and wholly unregulated. More control of this unregulated section of the financial system is necessary to achieve accountability and transparency in the banking system. Addressing the issue of shadow banks will not only curb the risk associated with these unregulated banks, but also it will tackle the ongoing problem of financial institutions being \u201ctoo big to fail.\u201d<\/p>\n","protected":false},"excerpt":{"rendered":"
Shadow Banking in the US SUmmarized \u00a0\u00a0Prior to the 2008 financial crisis, the Federal Reserve had an important role \u2013 to solely act as a \u201clender of last resort\u201d to traditional commercial banks. But during the crisis, the financial support … Continue reading