Shadow Banks, Systemically Important & TBTF

Professor Mark Thoma pulls the covers off a subject that has been well camouflaged by other issues around the topic of financial stability. In his article at The Fiscal Times he reminds us of shadow banks and the danger they pose to financial stability. Just recall the speed, or velocity, of shares of everything being sold in the early weeks of the financial crisis during Q4 2008. Some of the momentum was unexpected because the lack of visibility about the amount of, and surprisingly poor quality of, the financial derivative securities shadow banks were invested in. Shadow banks enjoy the freedom from oversight and judgement from investors on their risk taking. Shadow banks can be thought of as a risk averse conventional bank that has created an unregulated alter ego. The alter ego takes on more risk in pursuit of juicing profits for the conventional bank. The alter ego is going to look like a bank sponsored broker-dealer, a non-bank mortgage lender like GMAC, and include bank sponsored hedge funds and money market mutual funds.

Another professor, Bill Black, describes the vulnerability further in his video interview here. Here is a link to an MP3 file with Chris Whalen, a risk analyst with expertise in the banking sector. Shadow banks compound the danger from systemically important or "too big to fail" financial intermediaries because they are separated from the conventional financial system only by accounting cleverness. They are still a danger on the road to financial stability being restored.

The following is excerpted from Thoma's article:

"One approach to solving this problem is to provide deposit insurance in the shadow banking system that mimics the insurance available to traditional banks. But regulators are reluctant to expand the explicit government commitments to the financial system to this degree. A more likely approach is to restrict the allowable collateral to ultra safe assets such as Treasuries, and there is good news along these lines. The Federal Reserve Bank of New York is working on a proposal to make shadow banking safer by tightening up collateral requirements." 

"However, it is not yet clear what types of collateral that shadow banks will be allowed to hold against deposits, and the potential bad news is that the inevitable howls and protests from the financial industry about how the economy will be harmed if their activities are restricted may fall on sympathetic ears. When combined with the large amount of political influence the shadow banks have, the result may be an outcome that is not as restrictive as needed to keep the system safe."