The business of banking is inherently perilous. It turns short-term savings (such as customer deposits) into long-term investments (such as mortgages and corporate loans). This is risky: If too many savers want their money back at once, the bank can’t pay. It must either liquidate its assets or freeze its accounts, either of which can trigger a broader panic.
That’s why governments insure bank deposits and central banks stand ready to make emergency loans. In return for the insurance, banks are asked to follow certain rules. They face limits, for example, on how much they can lend for each dollar of equity their shareholders invest. The bigger the equity cushion, the less likely it is that taxpayers will have to bear losses.
Regulating ordinary banks well is proving difficult enough, but there’s a constellation of other financial intermediaries that gamble in much the same way—converting short-term liabilities into long-term assets—with no explicit government backstop. The global assets of the so-called shadow-banking industry are estimated to have been more than $60 trillion at the end of 2011, making it about half the size of the traditional banking sector.
In this shadow realm, other forms of short-term borrowing, such as shares in money-market mutual funds, play the role of deposits. Securities dealers, hedge funds, and other financial companies buy longer-term assets such as bonds backed by mortgages or corporate loans. They employ the assets as collateral against loans, which they get from money-market funds, banks, and one another. The collateral gives creditors a guarantee they’ll be repaid.
Before the 2008 financial crisis, shadow banks could borrow $97 against each $100 in mortgage-backed securities—a “haircut” of 3 percent, the equivalent of putting only $3,000 down on a $100,000 home loan. Such high leverage amplifies risk: If the price of the security falls just 3 percent, the creditor’s margin of safety is wiped out.
How can this system be made more resilient? In a recent speech, Mark Carney, the new governor of the Bank of England, suggested that shadow banks be given the same access to emergency central-bank loans that traditional banks enjoy. This is a dangerous idea. What he should have said is this: If an entity engages in banking activity, and hence is vulnerable to runs with potentially systemic consequences, it must register as a bank, with all the backstops and capital requirements that entails.
As for hedge funds and other institutions that would remain in the shadows, minimum requirements for haircuts—combined with proper capital rules for the regulated banks that often lend to them—should suffice to keep leverage from getting out of control.
“Shadow banking” is a misnomer. Regulators know what’s going on and understand the threat it poses. They ought to stop discussing the problem and start acting to solve it.