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The rationale underpinning current regulatory initiatives to cover non-bank credit intermediation

To highlight the remarkable dichotomy between the functional justification of banking regulation and the almost literalist application of existing prudential rules, this essay proceeds with a closer look at the definitions of shadow banking that inform the regulatory initiatives and bear on the bank-like nature of shadow banking activities (section 8.2.1). It then reiterates the most important ends of banking regulation (section 8.2.2) in order to finally synthesise these findings with the concerns motivating regulatory efforts to cover shadow banking (section 8.2.3).

In search of an operative definition

Despite the ostensibly global consensus to tighten regulation and the rather rapid progress in drawing up specific measures, it should not be overlooked that the transnational initiatives were launched from epistemologically shaky ground. It is indicative that the FSB-appointed group of high-level experts led by then UK Financial Services Authority (FSA) chairman Adair Turner and

Bank for International Settlements (BIS) general manager Jaime Caruana deemed it necessary to issue a ‘Background Note’ which delineates the scope of the task force’s mandate and outlines the perceived perils that result from insufficient oversight and regulation in those parts of the financial system enigmatically referred to as ‘shadow banking’ (FSB 2011a).

In its determination of which activities constitute appropriate targets for regulatory intervention, the FSB task force follows a two-pronged test to identify potential epicenters from which devastating waves for the global financial system could originate. In this view, the targeted endeavours belong to ‘a system of credit intermediation that involves entities and activities outside the regular banking system and raises i) systemic risk concerns, in particular by maturity/liquidity transformation, leverage and flawed credit risk transfer, and/or ii) regulatory arbitrage concerns’ (FSB 2011a: 3). The definition has already shaped the perception of important regulators (EC 2012: 3-5) and is mirrored in other influential contributions on the subject by the staff of both, the European Central Bank (ECB) and the N.Y. Fed (Bakk-Simon et al. 2012: 8; Pozsar et al. 2010: 6). Where alternative descriptions of what constitutes shadow banking are proposed, they share the key insight of the FSB task force that the pertinent activities involve residual (undiversifiable) risks that raise financial stability concerns as a function of investors’ preferences. This is particularly true for descriptions of shadow banking as activities that require a private or public backstop to show that they can absorb tail-risks that the ultimate claimholders do not wish to bear (Claessens and Ratnovski 2014: 4-6).

In spite of the task force’s rhetoric which suggests that the expert group’s approach casts ‘the net wide’ (FSB 2011a: 3), even the first prong of the definition—and the alternatives that conform with it in substance (Claessens and Ratnovski 2014: 4-6)—already excludes certain operations that are sometimes regarded as grave threats for the financial system’s viability. This applies, for instance, to the activities of those hedge funds that do not, directly or indirectly, extend credit but follow strategies based on equity trading or foreign currency transactions.[1] Regardless of the merits of amending the institutional framework for other agents in global finance as well,[2] the task force’s definition clearly indicates that its regulatory initiative is centred on the function that is traditionally served by depository institutions and is now partly absorbed by the disintegrated intermediation chain of the shadow banking sector. It thus pursues goals along the customary lines of prudential bank regulation: that is, it seeks to foster the resilience of those agents, old and new, that provide the economy with (a beneficial amount of) liquidity (see section From this point of view, it can be said—in a variation of an influential piece that summarises the prevailing justifications for prudential banking regulation (Corrigan 1982)—that shadow banking is not special at all vis-a-vis traditional credit intermediation when it comes to justifying regulatory intervention.

The contours of the prevailing ‘classic’ approach become even more evident once the second prong of the expert group’s definition is taken into account and supplemented with context. It is worthwhile noting that the two risks invoked as the cornerstones of shadow banking activities that are deemed relevant from the regulatory vantage—to wit that of systemic risk and that of regulatory arbitrage—do not constitute independent concerns. In fact, regulatory arbitrage marks less of a discrete aspect when it comes to regulating shadow banking but more of an angle of the essential systemic risk problem: where prudential banking regulation promulgated to improve the financial system’s safety is avoided by shifting certain potentially hazardous activities to arguably unregulated sectors the original perils for the system re-arise.6 Similarly, where activities that require a backstop are deliberately conducted in entities and through transactions without direct access to the pertinent facilities the perils for financial stability constitute the ultimate concern whereas regulatory arbitrage is one important way to conjure up the spectre.

As a consequence, the task force’s and other players’ self-conceived regulatory aims focus on risks that threaten the macro-economically important provision of liquidity insofar as these risks originate from non-bank credit intermediation broadly understood.7 With this in mind, it becomes an important

funds are not necessarily rooted in financial stability considerations but may also relate to general efficiency concerns (investor protection, compliance etc.) (Danielsson et al. 2005: 527-8; Paredes 2006: 990-998; Sklar 2009: 3251).

  • 6 It is precisely this interdependency that the FSB task force delineates when it argues that regulatory arbitrage could increase leverage in the financial system to undesirable levels and points to the well-known examples of how banks avoided capital requirements for regular bank lending by resorting to asset-backed commercial paper financing (Acharya et al. 2010: 7-9; Bratton and Levitin 2013: 836^41; FSB 2011a: 5). It does not cast doubts on the gist of the argument that earlier contributions did not identify the specific use of off-balance sheet vehicles as a major flaw in securitisation transactions prior to the financial crisis (Schwarcz 2009: 1316-24).
  • 7 This overarching theme should not be blurred despite some contributions’ narrow understanding of credit intermediation as deposit-taking and lending (Claessens and Ratnovski 2014: 4). In their economic substance, securitisation, repo, and securities lending transactions represent the extension of credit and the inherent tail-risks are precisely those observed in bank-based credit intermediation.

query why, despite the functional rationale for prudential bank regulation that has been well-established for a long time, important bank-like activities arguably fall outside the scope of current rules and standards promulgated to serve these very ends.

  • [1] In an interview, then president of the German financial watchdog, Bundesanstalt farFinanzdienstleistungsaufsicht (BaFin), Jochen Sanio posited that excluding non-credit hedgefunds from the global regulatory initiative would usher the next catastrophe as these entitiesconstituted the most dangerous actors in the shadow banking sector (Sanio 2011: 21-2).
  • [2] (Non-credit) hedge funds typically have equity and debt withdrawable on relatively short noticeand pursue long-term investment strategies, i.e. they spawn maturity and liquidity mismatchesthat make them susceptible to runs (Engert 2010: 343). An abrupt loss of confidence in theirviability can compel non-credit hedge funds to liquidate their portfolio holdings, which in turncan destabilize the affected asset markets as a whole and through this channel bear on otherfinancial and non-financial actors. It has to be noted though that the reasons for regulating hedge
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