Future ECB head Mario Draghi Worries About Shadow Banking System

Reuters reports that Mario Draghi is concerned that increasing regulation on the traditional banking system will drive risk to the unregulated shadow banking system. [emphasis added]

The head of the Swiss-based Financial Stability Board, Mario Draghi, said on Thursday that regulators must turn their attention to the lightly regulated shadow banking sector, according to a source at a closed-door meeting where he spoke. 

Draghi, also the governor of the Bank of Italy, told a conference in Paris that increased regulation on the traditional banking system increased incentives to use other less regulated areas of the financial system. 

He also said that the FSB was looking at areas of the shadow banking sector that remain largely uncovered by oversight, citing in particular credit intermediation, using financial instruments to create new products with different maturities and leverage. 

In the financial markets, regulation and oversight is frequently an inadequate, expensive substitute for the combination of genuine transparency and market discipline.

The US Savings & Loan crisis and the Less Developed Country Debt crisis discredit the notion that heavy regulation and oversight on the traditional banking system is superior to light regulation in maintaining financial stability.

As Alan Greenspan discovered with the recent credit crisis,  market discipline without genuine transparency is not a substitute for oversight and enforcing existing regulations.

Given what has been tried to date, is financial stability, light regulation, oversight and equal treatment to both the traditional and shadow banking systems possible?

Yes, as frequent readers of this blog know.  The solution is to fully implement the FDR Framework globally across both the traditional and shadow banking systems.  This would require that all useful, relevant information is made available in an appropriate, timely manner to all market participants.

Whether it is a bank or a structured finance security or a covered bond, it should disclose current asset-level data on an observable event basis.  With this data, market participants could independently analyze the risk and value of the bank or security.

Disclosure has many benefits.

• It is flexible enough to apply to both the traditional and shadow banking systems.  

• It provides market participants with the information they need to properly assess the risk and reward of a bank or security.  

• It increases oversight from just regulators to all market participants and this in turn improves the stability of the whole financial system.  

• It is inexpensive and, thanks to 21st century information technology, easy to comply with.