Shedding Some Light on Shadow Banking. By Tony James
Don't let a vaguely sinister label for this useful financing prompt harmful regulations.
WSJ, Mar 04, 2014
The term "shadow banking" is one of those Orwellian terms that can undermine critical thought. It has a negative, vaguely sinister connotation about a source of financing that is an essential and desirable part of the financial system. As discussion about the regulation of nonbank entities begins in earnest, it's time to clear the air about what these institutions are and how they operate.
Shadow banking—or more accurately, market-based financing—is simply the provision of capital by loans or investments to some companies by other companies that are not banks. Examples include insurance companies, credit investment funds, hedge funds, private-equity funds, and broker dealers. These institutions do not operate in the dark. Market-based finance in the U.S. amounts to trillions of dollars and is significantly larger than the country's entire banking system.
Mark Carney, Governor of the Bank of England, has correctly noted the role of shadow banking in "diversifying the sources of financing of our economies in a sustainable way." For example, traditional bank financing is not always available for many small- and medium-size companies. Market-based financing has fueled the creation of companies (and thousands of jobs) in many industries. It has rescued companies on the edge of bankruptcy and saved the jobs associated with them. And market-based financing has built warehouses, manufacturing plants and hotels, such as the Four Seasons Hotel and Residences in downtown New York City, when traditional banks could not, or would not, provide capital.
Large banks concentrate risk in relatively few hands, which can pose a risk to the economic system. That is not the case for market-based financing. Risks are safely dispersed across many sophisticated investors who can readily absorb any potential losses. Unlike traditional banks, market-based funds do not borrow from the Federal Reserve, nor do they rely on government-guaranteed deposits. Substantially all their capital comes from well-advised institutional investors who know what they are getting into, and understand the associated risks. Bank depositors (and taxpayers) on the other hand, do not typically know what a bank's investments are or how risky they may be.
Typically, market-based funds also lack the elements that are sources of systemic instability, including high leverage and interdependence. Each investment within a fund is independent and not cross-collateralized or supporting a common debt structure. Losses in any one fund are without recourse to any other fund or to the manager of the capital.
In addition, investors in many market-based funds, including credit investment funds, hedge funds and private-equity funds often cannot instantly withdraw their capital, unlike depositors in banks. Large, sudden withdrawals can lead to runs on the bank or force "fire sales" of assets. With stable, in-place capital, these funds can provide a critical source of liquidity to trading markets in times of turmoil.
Of course, some regulation may be appropriate for nonbank entities that present bank-like risks to financial stability or that lend to consumers. But let's not forget that it was the regulated entities that were the source of almost all the systemic risk in the financial crisis.
Regulations are far from a panacea and would need to be carefully constructed to ensure that the enormous economic benefits of market-based financing are not lost through inappropriate and stifling regulatory policies established for large, deposit-taking banks.
While banks in the U.S. are better capitalized and much safer today than before the financial crisis, market-based financing—shadow banking, if you prefer—still brings enormous economic advantages to a wide range of businesses and employees, and fills a real gap in the market.
In Europe, where banks are less well capitalized, the need for market-based financing is even more critical. As the G-20's Financial Stability Board noted in its policy framework last August, market-based financing creates "competition in financial markets that may lead to innovation, efficient credit allocation and cost reduction."
It is critical that any misunderstanding of the shadow banking system does not result in regulations that undermine the many thousands of companies and jobs that need market-based financing to survive and grow.
Mr. James is president and chief operating officer of Blackstone, a global investment and advisory firm.