April 10, 2012

When it comes to “reforming the global financial system”, regulators have focused on banks. Weakened by the 2008 crisis, destabilised by the eurozone sovereign debt mess, and then hit with higher capital requirements, traditional lenders are on the retreat. Meanwhile, the "shadow banking" system, a phrase used to encompass a broad range of institutions and mechanisms, from hedge funds to "repo" markets, has recovered more rapidly and is poised to usurp banks in a variety of ways. Regulators are now grappling with how to deal with a vast sector that has little or no supervision. Shadow banking was a fundamental cause of the banking crisis; it is not a separate phenomenon from banking but a deeply related one. In the run-up to 2008, Countrywide, a lightly-regulated mortgage originator, wrote bad loans but sold them on to buyers including banks. AIG, ostensibly an insurance group, wrote credit default swaps against mortgage-backed securities held by banks. The banks used repo markets to leverage and fund their investments for as long as they could. But the post-crisis world has seen banks selling assets to non-bank financial groups to improve their capital ratios, meet regulatory requirements, and reassure their own lenders -- such as money market funds, themselves a fundamental part of shadow banking -- that they are sufficiently resilient. This has stimulated growth in previously small areas of lending, especially in Europe and Asia. In parts of Europe large retailers and industrial groups have begun providing funding to smaller companies, including their suppliers. A similar trend away from bank finance has benefited credit hedge funds, and in the leveraged finance world, new bespoke funding suppliers have sprung up. And Regulators have underestimated the distortive effect of tightening the rules for banks -- a distortion that could sow the seeds of the next crisis. Some worry that the growth of non-bank lending and the practice of borrowing short-term to lend long-term simply allow new, unmonitored bubbles to grow unchecked until they once again drag down the banking system and the larger economy. Here we go again.