What The Shadow Banking System Knows

By: Andrew_McKillop

GLOBAL REACH
PIMCO's Paul McCulley defines the shadow banking system as follows; “I coined the term “shadow banking system” in August 2007 at the (US) Fed’s annual symposium in Jackson Hole. Unlike conventional regulated banks, unregulated shadow banks fund themselves with uninsured short-term funding, which may or may not be backstopped by liquidity lines from real banks. Since they fly below the radar of traditional bank regulation, these levered-up intermediaries operate in the shadows”, outside the regulated conventional bank system.  Paul McCulley summarized shadow banking as: "The whole alphabet soup of levered up non-bank investment conduits, vehicles and structures". These financial intermediaries operating off the radar screen of international financial regulators were therefore “unknown” to, and credited by the official banking system with a near-zero role in 2002, but were worth about $60 trillion and turnover-wise represented about 25% of the global bank-finance system at end-2011.

Key players in shadow banking include finance companies, entities offering some kinds of banking services (such as loans, credits and money transfers) using asset-based commercial paper, the large and dark category of Structured Investment Vehicles (SIVs), hedge funds supplying credit to certain clients and also aiding their tax evasion, money market mutual and other funds, major infrastructure and natural resources firms operating commercial trade, stock and share-based lenders, special “limited purpose” financial companies (called LPFCs), and Government sponsored enterprises (GSEs).

This last category, since 2008, now effectively includes a large slice of the world's private banks, due to repeated and ongoing “bail outs” of nominally-private banks, by governments. This also shows the sequence of change. Since about 2000 real banking and shadow banking have met, mixed and mingled. Certainly by 2008, this is the reality and implies that “repairing and restoring” the global financial system will be much harder than we are told to believe.

Not exactly all we need to know about the SBS, but underlining its power to bring down the Temple, the markets for mortgage-backed securities were great examples of the SBS, before the 2008 financial crisis. Entities playing these markets borrowed from investors in liquid short-term markets, using their cash to buy long-term supposedly safer mortgage-backed securities, generating a profit on the difference or 'spread' in interest rates/rate of return. The main characteristic of the SBS – extreme rapid change from growth to contraction – was shown by the way shadow banking entities reacted to the turnaround of mortgage-backed securities as interest rates rose. They sold “everything which wasn't nailed to the floor”. This squeezed the spread on “subprime loans” for housebuying in the US, triggering the 2008 crisis.

IN MAY, SELL AND GO AWAY
This old adage of stock exchange players in fact happened in June 2013 rather than May – possibly due to climate change making June feel like a chilly May or the delayed response of global financial players, groggy with junk information. By late June 2013 there is now clear daily powerful action to “nudge up equities”, but this not necessarily victorious action operated by the “PPT” (plunge protection team) to stop the rot and to keep equities (and oil, but not gold) flying, ignores the way the SBS responds and reacts to financial uncertainty. It also forgets the new and real power of the SBS.

How the SBS reacts and responds to the US Fed's taper-down promise or threat will be critical. Our previous experience of how the totally-unregulated “informal” SBS react to any clear signal of End of Party Time shows that its basic profile and 'raison d'exister' - low reserves and high leverage - means it always liquidates and sells out at the slightest hint of a major turnaround in trading conditions. The key threat of the SBS “repairing and restoring” its own finances poses a direct threat to the pie-in-the-sky efforts to repair and restore Humpty Dumpty global finance markets and their traditional players – the regulated private banks. Basically this results from the leverage that SBS players employ - by not holding anywhere near as much reserves as regulated traditional banks. This delivers them high profits during good times – and the exact opposite during bad times.

Leverage is a proverbial double-edged sword as any banker (shadow or otherwise) knows.

Copybook examples of how the SBS pulled down the Temple, or massively intensified a stock exchange panic phase, extend back well before 2008 and the “subprime crisis”. On example was the US energy trader Enron Corp. and its linked scandal (Enron filed for bankruptcy in Dec 2001), where structured investment vehicles (SIVs) were used to hide losses caused by off-balance-sheet operations. These SIVs, created literally from thin air by major US and international banks (especially French, German, Japanese),  were essentially designed to lever up the apparent value of shareholder equity in Enron, to as much as 25 – 90 times its value in real terms, based on share price values preceding and following the scandal. The complex fraud operated by Enron's “architects” including Lay, Skilling and Fastow utilised various SBS bank-equivalent shell entities including trusts to firstly understate all liabilities while overstating shareholders' equity, and secondly to circumvent all “harmful” (that is truthful) accounting rules.

Actual or net losses from the Enron collapse are hard to quantify in a similar way to losses from another example of “pure and simple fraud” but not including the SBS – the Bernie Madoff scandal. The Enron scandal, much more sophisticated than the Madoff scam, fully applied the power of the SBS and was a worldwide operation. China's shadow banking system, today, is a great current example of the “systemic” risks generated by the SBS. Over recent years (2010-2013) some estimates, for example by KPMG of only the category “trusts” in China indicate a growth rate in nominal assets of at least 50%-per-year. Back-to-back with China's partly unregulated insurance industry, another key player in the SBS, these two categories of “shadow banking” in China probably control assets equivalent to 33% of the Chinese “formal” and regulated bank sector. As Chinese authorities know very well, its national SBS is extremely leveraged, not regulated, and sets a systemic rising risk to the economy.

REGULATING THE SBS – ALWAYS TOO LATE
We can suggest the global SBS grew so fast, so explosively that it outstripped all and any attempts to regulate it. To be sure, we can also add the guile, subterfuge and lying of SBS players using every trick in the book to keep afloat.

Since the turn of the century, the number, type and range of SBS structures and “operating modes” has also exploded, extending down to operations as apparently marginal or high-risk as the Bitcoin craze and “penny banking” in Bangladesh. Extending upwards and posing a direct threat to the future, SBS ideology is now embedded in the world's central bank-private bank duopoly, the IMF and BIS.

Attempts at regulating the SBS, in the US, were especially triggered by the Enron scandal we can note. New banking rules originating in the US include the BIS-related “Basel rules”, which concern attempts at raising capital requirements for banks “exposed to” unregulated financial institutions, that is the relationship of regulated private banks to unregulated SBS entities. These Basel rules, after mulling and modification by the BIS, essentially seek to transfer risk from SBS players, to private banks, through increasing the latter's obligatory capital reserves.

In other words, this is an outright victory for the SBS.

Due to the degree of danger now being better known, Basel rules for private banks are far from the only attempts being made to reduce the exposure of the global financial system to the SBS. Rules designed to regulate the shadow banking industry itself may be forthcoming from the US Financial Stability Board, Securities and Exchange Commission (SEC), the Chinese Banking Regulatory Commission,  UK, German, French and European regulators, the European Commission, and even at UN level. The recently strengthened international financial reporting standards (IFRS) for accounting will likely be extended on a much broader basis, in an attempt to capture the extent of operations and impose some control on certain or main segments of the SBS. Linked and rapidly-increasing action by national regulators (for example the US FATCA) and at G8 level to track down and repress tax dodgers, especially tax evasion by the operation of hedge funds is another example.

THE IDEOLOGICAL QUANDARY
The SBS and its fantastic growth – and power to do harm – was only possible because of ideology based “de-regulation” of finance markets, a process that has operated since the start of the “neolib revolution” at the start of the 1980s.  The free market ideology is for the least ambiguous about banking and especially formal-versus-informal banking.

By decentralizing lending, shadow banking can have both positive and negative consequences. Decentralization can increase consumer welfare by expanding the variety of funds and financial products available to users, allowing them more choice in “tailoring” their portfolios to their own preferences. If the financial system was “totally decentralized” it might in theory be more robust in the face of negative shocks by distributing losses among many small financial institutions, with smaller firms failing but without threatening overall market stability. This would be the radical opposite of the TBTF or "too big to fail" syndrome affecting the large private regulated banks.

As with all “neolib ideology” however this rosy outlook breaks down completely when scale increases: small sized decentralized banking works – both in history and in less developed countries today – when market size, turnover, financial product complexity (and other parameters) are small. The SBS applied to giant globalized financial markets of today is an insanely risky gamble, and a fitting tribute to the bankrupt (and bankrupting) ideology of neoliberalism.

The reasons why allowing a huge SBS system to emerge and evolve, the seeing its role from the Enron scandal to the 2008 subprime crash – and panicking – is the real world sequence of institutional and political response to shadow banking, and can be explained several ways. One major factor is complexity. The SBS is extremely complex and operates at all scales of financial operations, from the tiniest to the biggest. Various kinds of “ex post facto” regulatory attempts like the US Dodd-Frank Act only seek to regulate SBS activity in the financial derivatives market, proving for starters the SBS is heavily present in this “large and sophisticated” financial market. For many analysts and academic experts looking at SBS, such as finance law expert Steven L Schwarcz, one key basic weakness of the SBS is “information failure”, or as Schwarcz puts it: “Some parts of the shadow-banking network are so complex that even some finance experts view them as incomprehensible”. In brief, the financial assets and operations concocted by the SBS, at its “high end”, are so arcanely complex they probably have no meaning, making it impossible to understand them or assign any meaningful risk (or reward) to them. Information failure is therefore hard-wired, almost certain, and also easy.

As the Bitcoin craze however shows, and a host of latterday Internet non-bank operators (like Paypal and Skype) also show, the SBS is going to be very hard to eradicate. Also, formal regulated banking is most surely and certainly going to keep mutating or evolving towards SBS methods and structures. This will be need to be recognized and then formalized – but until then the huge potential for the SBS to “pull down the Temple” will remain.

By Andrew McKillop

Contact: xtran9@gmail.com

Former chief policy analyst, Division A Policy, DG XVII Energy, European Commission. Andrew McKillop Biographic Highlights

Co-author 'The Doomsday Machine', Palgrave Macmillan USA, 2012

Andrew McKillop has more than 30 years experience in the energy, economic and finance domains. Trained at London UK’s University College, he has had specially long experience of energy policy, project administration and the development and financing of alternate energy. This included his role of in-house Expert on Policy and Programming at the DG XVII-Energy of the European Commission, Director of Information of the OAPEC technology transfer subsidiary, AREC and researcher for UN agencies including the ILO.

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