FSB: To Be or Not To Be

Siddhidatri Mishra of the Financial Times writes on the Lehman Brother’s role in the ‘Great Recession’ and risks, problems and solutions to shadow banking. 

The term shadow banking was first coined by Paul McCulley of the investment management firm PIMCO and consists of all banking activities which are similar to traditional banking activities, but are conducted outside the purview of traditional banking activities and its related regulations. These include the repo market, mortgage and investment firms, hedge funds, money market mutual funds and private equity funds.

But contrary to the view, it is also not a new phenomenon. As early as the eighteenth century, Netherlands had an international financial systems in place, with credit intermediation being provided on collateral. Alternative forms of banking had started emerging in the United States of America in the late 20th Century. This was due to the imposition of Regulation Q which capped interest payments on bank deposits, making investors look for alternative investments giving them higher returns. This led to the formation of credit vehicles outside the system, such as near banking.

The first Basel Accord set an international minimum capital standard and introduced incentives to reduce risks off banks’ balance sheets by means of securitisation. This, in turn, led to the formation of the modern forms of structured products that form a crucial part of the modern system of shadow banking.

Shadow banking came under the ire of the international community after the 2007-2008 financial crisis. The crisis, which had emerged in USA, had shaken the World economy and showcased the many vulnerabilities of the financial system. Assets that had been thought of as safe proved to be risky and illiquid and the level and spread of risks was unclear. The example of the fall of Lehman Brothers just about sums it all.

Lehman Brothers, founded in 1850, had been a global financial services firm until it declared bankruptcy in 2008. The housing boom in the US in 2003 and 2004 prompted the firm to invest heavily in the sector. But soon enough its decision proved disastrous as the subprime mortgage crisis hit the market. Lehman’s high degree of leverage: the ratio of total assets to shareholders equity which was an all-time high of 31 in 2007 made it even more vulnerable to deteriorating market conditions. Eventually, with more losses, the firm ultimately filed for bankruptcy. The filing is the largest bankruptcy filing in US history and is thought to have played a huge role in the unfolding of the ‘Great Recession’.

It is evident that shadow banking comes with many risks. It is more likely to lead to financial instability as it is neither subject to regulations, nor eligible for emergency facilities designed by the Government to assuage financial inconsistencies in the economy. Also, the banking activities are spread across borders and geographical jurisdictions, making it impossible to curb these activities. The steps carried out during the process are not as transparent as those of a traditional bank, and even a modest shock to the system can set off a chain of unpropitious events.

But eradication of the system of shadow banking is not an option as it is beneficial as well. Shadow banking has led to the increase in the number of investors by providing alternative means of funding and risk diversification. It also helps convert illiquid assets to liquid assets and support smaller companies. In fact, shadow banking has helped achieve the macroeconomic aims laid down by the Government by providing some part of the population with an alternative means of livelihood and reducing the borrowing of money from the Government.

The sector was valued for over $80 trillion in 2014 and it also forms the financial backbone of countries such as the USA and United Kingdom. It has also encouraged a larger number of investors to come into the fold and take risks. In view of its indispensability, the only solution before us is to bring in regulation sufficient enough to mitigate risks of a market crash yet to keep room for ensuring an alternative investment scenario.

For example, in India, shadow banks (termed as Non-Banking Finance Companies in the country) fall under the regulatory purview of the Reserve Bank of India and allows the bank to regulate companies that are involved in investment, insurance, chit funds, etc. This has reduced the risk associated with shadow banking considerably. Another area of concern is the functional overlap between shadow banking and traditional banking. In order to insulate the traditional banks from the vagaries of shadow banking it is imperative that such transactions between the two systems are properly recorded, monitored and analysed regularly. Peer reviews and confidence building mechanisms for investors by introducing some amount of transparency are also important aspects for sustenance of a stable financial economic environment.

As George Bernard Shaw once said, “If history repeats itself, and the unexpected always happens, how incapable must man be of learning from experience?”

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