Shining the Light on Shadow Banking for Better Governance to Support a Thriving Capital Markets/New Innovation/ Democracy

Shining the Light on Banking Shadows for Better Governance to Protect Depositors and Investors and Support the Capital Markets 

How big is Shadow Banking?

According to the Financial Stability Board, the shadow banking system—which the FSB calls the nonbank financial intermediary (NBFI) sector—grew 8.9% in 2021, well above its five-year average of 6.6% annual growth. At $293.3 trillion, the NBFI sector's share of total global financial assets reached 49.2% in 2021.

According to the Wall Street Journal (April 26, 2023)- Since the start of 2008, private credit has grown almost sixfold, to $1.5 trillion, according to the IMF—bigger than the high-yield bond or leveraged-loan markets. At $4.4 trillion, those three markets are worth more than all banks' commercial and industrial loans, at $2.7 trillion. Banks are the most TRANSPARENT debtholders, BUT, collectively, just as much debt is held by pension and mutual funds, private-credit funds, life insurers, business-development companies, hedge funds, and other non-banks—or, as they are sometimes called, SHADOW BANKS (SB).

Why is SB important to the U.S. economy and new financial innovation to better support the public interest?

Banks’ shadow, or “money creation by banks” go beyond traditional loans and play an important financial role in America’s money-creation process, creating a number of new challenges to both monetary policy operations/ support of the economy and financial management/governance/ needed for the capital markets to help meet the needs of the public.

State-chartered industrial banks have existed in the United States for over a century. In the 1980s, Congress made all industrial banks eligible for deposit insurance and expressly adopted an exception to the Bank Holding Company Act permitting a parent company to own and control an industrial bank without becoming subject to regulation and supervision by the Federal Reserve Board as a bank holding company, based solely on such control -- an SB.

The SB system continues to play a major role in the expansion of housing credit after the 2008 financial crisis. SB today continues to grow in size but has largely avoided government oversight since then, posing some potential risks to the global financial system. But with the right regulatory mediation in other areas - innovation and bipartisan support can be utilized to better support transparency, accountability and governance for all American in a balanced way.

SB benefits include - defined by the EU Parliament recently noted:

·     Enhanced support to the real economy, as additional sources of funding are provided to households and non-financial companies;

·     Additional asset classes and risk/return combinations for investors; and

·     Efficient channeling of resources via specialization and economies of scale. Shadow banking, however, also raises numerous concerns:

What are the key elements of SB innovation: 

SB includes several “critical” elements: money market mutual funds and other mutual funds using leverage and derivatives, financial corporations engaged in lending, securities and derivatives dealers, entities performing securitizations, securities financing transactions and derivatives. Some new segments of the financial system also lie close to shadow banking, including digital lenders/marketplaces and cryptocurrency. What we know is Shadow banking is difficult to review/ analyze but with better regulatory oversight and technology - transparency can be utilized.

According to the Financial Stability Board, the shadow banking system—which the FSB calls the nonbank financial intermediary (NBFI) sector—grew 8.9% in 2021, well above its five-year average of 6.6% annual growth. At $293.3 trillion, the NBFI sector's share of total global financial assets reached 49.2% in 2021.

What can be done for better governance/transparency for systemic risk to the shadow banking?

To strengthen shadow banking supervision, America’s key banking regulators should closely track the evolution of various SB channels, clearly on- and off-balance sheet / accounting/auditing. Consequently, macroprudential regulation tools, such as asset reserves and risk reserves, should be utilized separately to the American shadow banking sector. This includes specific macro-prudential regulation tools, such as asset reserves and risk reserves, that can be applied separately to banks and traditional SB.

What we know SB can do to support the business economy:

Shadow banks lengthens the social financing of the financial supply-chain (where functions are broken down among several interdependent institutions) is accompanied by non-transparent and non-standard accounting practices, leading to possible information imbalance and increasing the instability to a banks’ liquidity demand. Facing an infrastructural shortage of liquidity, finance regulators rely mainly on liquidity conditions in the banking system to control total social financing. Nevertheless, the instability of banks’ demand for liquidity can be induced by SB finance efforts making it more difficult for the monetary regulators to oversee the monetary marketplace through better liquidity control. This is the main objective facing America’s money market as interest rates fluctuate widely over the past several months...

What is happening now facing shadow banking liquidity issues:

SB entities were characterized by a lack of disclosure and information about the value of their assets (or sometimes even what the assets were); opaque governance and ownership structures between banks and shadow banks; little regulatory or supervisory oversight of the type associated with traditional banks; virtually no loss-absorbing capital or cash for redemptions; and a lack of access to formal liquidity (for example, central bank funds) support to help prevent fire sales. Source: IMF

What could be done now to better support SB?

SB should consider using the deduction approach, meaning -- comparing this with the aggregation approach commonly used in reference showing that the deduction approach can avoid miscalculation issues such as “double-counting” and “overestimation…” More directly -- AB banking funds are used mainly for local government funding vehicles, enterprises with excess capacity, and real estate developers. SB is closely related to the money creation reducing the accuracy of the nation’s M2 – (the M2 is defined by U.S. Federal Reserve's estimate of the total money supply including all of the cash people have on hand plus all of the money deposited in checking accounts, savings accounts, and other short-term saving vehicles such as certificates of deposit (CDs). Retirement account balances and time deposits above $100,000 are omitted from M2) –

AS A POSSIBLE POLICY MEASURE. Over the past decade, finding that, although SB drives up banks’ credit risk, banks have not adequately assessed that risk or taken the appropriate countermeasures to understand the scope of discovery. Therefore, monetary policy challenges posed by American SB and reports showcase that recent trends to possibly modify regulation and use of new technologies/ discovery currently used on transparent/accountability related regimes for banks.

Could US and international banking regulators suggest to more closely monitor  the movement of SB channels, both on- and off the balance sheet to better mitigate systemic banking risk? To strengthen oversight -- separate financial regulatory regimes/ fintech tools that could be utilized  for better SB banking systemic risk mitigation/ introduction of internal controls and better board independence/governance?

What Could be in the US Banking Sector?

Moving forward - the critical nature of overseeing regulatory oversight of America’s SB system could be NOW used to strengthen the regulatory internal audit/ independent external auditor to better oversee banks. What we know is both from SB and traditional banking -- BOTH are intricately linked with the U.S. banking system that could ultimately funded to support banks as the nation's main funding source. U.S. banking regulatory agencies should seek to increase their macro-prudential management of the banking system to preempt future excessive growth of financial material risks to better protect depositors as well as the public interest > possible surgical risk intervention (with joint regulators) and don't throw the baby out with the bathwater through better measurement and disclosure.

What is the U.S. Congress doing now to address shadow banking?

In December 2022, Sen. Sherrod Brown (D-OH), Chair of the US Senate Committee on Banking, Housing, and Urban Affairs, along with Sen. Bob Casey (D-PA) and Sen. Chris Van Hollen (D-MD), introduced the Close the Shadow Banking Loophole Act, -- legislation to require companies that own an industrial loan company (ILC) to be subject to the same rules and consumer protections as traditional banks.

Key provisions of the proposed Senate legislation would require companies that acquire an ILC to be subject to the same supervision by the Federal Reserve as any other bank holding company under the Bank Holding Company Act. It would also provide a carve-out for existing ILCs. A one-pager of the bill is available here. The bill text is available here.

Key provisions of the Close the Shadow Banking Loophole Act include:

Traditional banks, with their regulatory safeguards, are at a competitive disadvantage with ILCs. To maintain a level playing field in the banking industry, protect consumers, and ensure the safety and soundness of the financial system, legislation is needed to limit agency overreach and close the ILC loophole. Many commercial companies which previously explored ILC charters with the FDIC ultimately sought FDIC-insured national bank charters with the OCC and consolidated Federal Reserve supervision at the holding company level. This is proof that commercial companies do not need loopholes, special charters, or special treatment. Congress must close this loophole to make sure entities that engage in banking are required to follow the same rules and consumer protections as every other bank.

The EU Parliament’s Policy Department for Economic, Scientific and Quality of Life Policies Directorate-General for Internal Policies has also provided better regulatory oversight on how SB can be built to safeguard and better support the capital markets. These include:

Make it safe, then make it work - The debate on macroprudential regulation has often highlighted a dichotomy between vitality and stability, speed and safety. This is a misleading perspective: vitality and stability are actually two faces of the same coin. For shadow banking to deliver economic development via new sources of credit and better risk-sharing practices, policy makers must first ensure that it adopts business models that are not plagued by inconsistencies, conflicts of interest and moral hazard, and therefore remain viable over the long term.

Reduce the risk of a sudden deleveraging: Macroprudential regulations address situations where institutions and market participants behave in a way that is rational for individual investors but triggers negative externalities associated with system-wide reactions leading to sharp deleveraging and market disruption. The risk of sudden drops in leverage and liquidity squeezes should be addressed by imposing minimum buffers in times of financial expansion. Rule makers should also avoid mechanisms that create cliff effects, as is the case when the eligibility criteria for collateral are associated with discrete ratings or when other regulatory mechanisms are associated with binary thresholds.

Draw clear lines as shadow banking thrives in ambiguity: SB is built on the expectation that the liabilities issued by a non-bank entity - or chain of entities - remain liquid under most market scenarios. Ambiguity is key to this configuration: external support by the official banking system and the central bank is not paid for, but investors assume that it will be there when needed. Accordingly, to discipline SB, it is essential that regulation be unequivocal and that grey areas are minimised.

Regulate banks to address shadow banking: In financial services there is a limit to the desirability of “letting one thousand flowers bloom”, that is, of letting market forces and novel technologies find an equilibrium through competition between new players and the incumbents. SB is not, in itself, destabilising, nor is it an intrinsically more efficient form of financial intermediation: it should co-exist with banking within a diversified ecosystem, not supersede it because of lower regulatory costs.

Consider bold decisions to bring down complexity: Regulation tends to provide incentives for financial institutions to evolve towards desirable models without imposing straight restrictions. This has led to complex rules dominated by a “whack-a-mole” syndrome, where new, detailed provisions are introduced each time new market practices needed to be addressed. Simple “don’ts” that apply across all forms of financial intermediation should not be left out of the policy debate.

The Center for American Progress providing some additional suggestions recently related to this topic that includes:

"ILCs operate under a special exemption in federal law that permits any type of organization – including a large technology company or commercial firm – to control a full-service FDIC-insured bank without being subject to the same oversight and prudential standards or limitations on the mixing of banking and commerce that Congress has established for the U.S. financial system.  

When this exception was initially created, ILCs were typically small financial institutions, and companies used the charter for the limited purpose of providing small loans to industrial workers who could not otherwise obtain credit.

However, since that time, large commercial companies have used the ILC charter to gain access to the U.S. financial system and control entities that have essentially all of the powers of a full-service commercial bank, including the ability to accept deposits, make consumer and commercial loans and effectuate payments.  

Although ILCs have the powers of a commercial bank, their corporate owners — unlike the owners of commercial banks — are not subject to consolidated supervision and regulation by a federal banking agency, which can allow risks to build up in the organization outside the view of any federal supervisor. Simply put, this regulatory loophole creates safety and soundness risks for the institution, risks to the financial system and additional risks for consumers and taxpayers. Currently, ILCs of any size can collect FDIC-insured savings from retail customers and offer mortgages, credit cards and consumer loans, which enable them to operate as full-service banks. 

The risks to consumers and the financial system from ILCs are not theoretical. It should come as no surprise that several large companies that used the loophole to acquire ILCs, evading the type of consolidated supervision meant to ensure soundness and regulatory compliance, then subsequently required public bailouts during the 2007-2008 financial crisis. 

Moreover, the loophole provides a way for large technology firms offering a wide variety of services to acquire a full-service bank along with all of the privileges of a bank — even though Congress has generally prohibited the mixing of banking and commerce. These large technology firms thereby gain access to FDIC-insured deposits and potentially a vast trove of consumer financial information all without being subject to the information security and prudential standards that apply to regulated bank holding companies. In addition, because the corporate owners of ILCs are not considered bank holding companies, they also evade the limitations imposed by Congress on the ability of banking organizations to expand into new activities if their insured depository institution subsidiaries have a less than Satisfactory record of performance under the Community Reinvestment Act. 

Recognizing that some firms have previously acquired an ILC in reliance on the exception and in the spirit of fairness, the legislation, similar to legislation passed on a bipartisan basis by the House Financial Services Committee, “grandfathers” existing ILCs to remain supervised by the FDIC while closing the loophole for the parent companies of any future ILCs, while prohibiting other commercial companies, as well as other companies not subject to a BHC-equivalent regulatory regime, from acquiring an existing ILC. We feel that this is a balanced approach and commend the effort to seek a compromise to satisfy other stakeholders. 

Possible SB and cryptocurrency risk issues:

Like SB, cryptocurrency is also still unregulated, so many SB in the US remain reluctant to provide financing for digital assets as collateral. 

According to Bank for International Settlements (BIS) issued the following Working Papers No 1013 -- Banking in the shadow of Bitcoin? The institutional adoption of cryptocurrencies. BIS key recommendations regarding crypto currency and shadow banks:

1.    Ongoing digitalization of finance and interest in DeFi could spur the growth in, and systemic risk of, the crypto shadow financial system. While market activity has started from a relatively low base, the growth and trends over the past years underline the potential for cryptocurrencies and other forms of digital money (eg stablecoins and central bank digital currencies) to scale up quickly and become widely used. This, in turn, requires a proactive and forward-looking approach to regulating and overseeing such markets. As such, cryptocurrencies and their intermediaries, including crypto exchanges, should be subject to the same types of regulation and oversight as economically equivalent asset classes and institutions, including with regards to financial stability, consumer protection, and AML/CFT standards.23 The purportedly decentralised nature of cryptocurrencies does not render these safeguards dispensable.24

2.    While most cryptocurrencies have originated from outside the traditional financial system, risks from cryptocurrencies could easily transfer to banks and other established financial institutions. Indeed, banks and asset managers could potentially be exposed to cryptocurrencies through a number of direct and indirect channels over the coming years. Initiatives to promote regulatory clarity on the treatment of these potential exposures, such as ongoing efforts by the BCBS (BCBS (2021)), could help to ensure a more level playing field and the prudent management of risks. This calls for both comprehensive regulation and supervisory oversight of crypto exchanges with regard to the provision of financial services and a conservative prudential approach to the treatment of banks’ cryptocurrency exposures.

3.    Data gaps risk undermining the ability of authorities to oversee and regulate cryptocurrencies holistically. While some of these blind spots reflect the decentralised setup of cryptocurrencies, there is scope to enhance the systematic collection and publication of cryptocurrency data in a more rigorous and robust manner. One option for such a framework is “embedded supervision”, developed in Auer (2022), which harnesses information in distributed ledger based-finance. The aim is to increase the quality of data available to supervisors and to reduce administrative costs for firms.

Stay tuned as we learn more about SB and about new regulations/oversight/ governance for a better vibrant financial services sector using existing fintech governance/ data analytical transparency and accountability tools to support a thriving capital markets and future risks such as cybersecurity and cryptocurrency governance in the capital markets.