Economics Finance Regulations

Risk In the Shadows

One sector of the financial world getting a lot off attention from economists these days is “shadow banking,” which is one term used to describe those financial institution that are not as regulated (or understood, some would argue) as the more well-known parts of the industry. In a recent post on the NY Fed’s web site, Samuel Antill, David Hou, and Asani Sarkar describe this fast-growing part of the financial world as follows:


The shadow banking sector comprises specialized financial institutions (such as asset management and securities firms) that perform credit intermediation services similar to traditional banks or depository credit institutions (DCIs), but without the explicit central bank liquidity support or public sector credit guarantees received by DCIs.

Some economists that believe that shadow banking firms contributed to the recent financial crisis through their facilitation of credit backed by illiquid assets (Cf. The reality is that just about every part of the financial sector contributed to the recession in some way, and shadow banking firms probably deserve their share of the blame; but that’s not, at least to me, the interesting point about these firms. What is interesting is, as the authors point out, that regulated firms not only continue to use these unregulated entities for various purposes but that use is expected to grow much faster than the regulated sector.

As the authors note:

Financial firms have had a lower valuation relative to business sector firms since the late 1980s, except for a brief period in 2000, and their relative valuation has been steadily declining since around 2003 (see chart below). Within the financial sector, however, shadow banking had a higher valuation than the business sector for the entire sample, and their relative valuation has been increasing since around 2003. The reverse is true for DCIs. These results suggest that the market expects shadow banks to grow faster than DCIs and/or to generate a more stable stream of earnings in the future.

Chart Source: NY Federal Reserve
Chart Source: NY Federal Reserve


It’s not too far of a stretch to speculate that as Dodd-Frank and other laws have clamped down (with questionable effectiveness) on some of the more risky activities in regulated banks, these banks have turned to shadow banking entities to continue taking on risks in ways that are not visible to regulators and the general market. As the authors also note:

Although the policy response to the growth and vulnerabilities of the financial sector has been to enhance supervision and regulation of large firms and visible financial sectors, our paper documents that, historically, growth has occurred mainly in areas outside the current regulatory ambit. If financial transactions migrate out of regulated sectors, as expected by some, then this trend is likely to persist. We need to improve our knowledge of these opaque financial sectors in order to understand what risks (if any) they pose to the economy.

The bottom line could be that the risk the regulators push out of  the “too big to fail” banks is just migrating into a parallel, fast-growing shadow banking sector that, some might argue, will be the source of our next financial crisis. If this is correct, then as a society we either need to accept that we are growing an opaque risk pool within Wall Street and demand that the players who access it prepare to absorb the losses of a possible crisis within that pool (my preference) or enhance regulatory scrutiny and oversight of shadowing banking (probably the administration’s preferred route). Simply allowing this sector to take on unknown economic and social risks in the U.S. and global financial markets is probably the one approach everything would agree is not acceptable.

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