Regulators must shine light on 'shadow banking'

In a Telegraph column, Lord Turner, head of the the UK's Financial Services Authority and member of the Financial Stability Board, calls for regulators to shine light on 'shadow banking'.

He proposes that regulators can do this by

considering five categories of further reforms focused specifically on shadow banking risks.  

The first category covers the risks shadow banking can pose to banks themselves. We need to ensure appropriate rules on consolidation of off-balance sheet exposures and appropriate capital regulation relating to bank exposures to non-bank financial institutions.  

The second is focused on money market funds. The working assumption is that if a money market fund promises to investors a constant net asset value, then it looks like a bank and quacks like a bank, and ought to be subject to bank-like liquidity and capital constraints, or to other regulatory rules which have equivalent economic effect.  

The third relates to the incentive problems inherent to the “originate and distribute” model. We need to ensure we are enforcing enough “skin-in-the-game” (and on a common enough basis across the world) to ensure strong incentives for good credit underwriting.  

The fourth stream of work is looking at other categories of firm, apart from money market funds, involved in shadow banking activities. It will identify where leverage and maturity transformation could enter the non-bank credit system, and propose appropriate controls if required.  

The fifth is focused not on specific institutions but on the complex web of secured funding markets – repo, prime broker finance, securities lending and cash collateral reinvestment – which interconnects commercial banks, broker dealers, asset managers, money market funds and hedge funds.  

There is a strong argument in principle that we should regulate “haircut” and margin practices in some of these markets, imposing minimum requirements that could constrain excessive exuberance in boom years. We need to consider carefully the options to achieve that objective.  

This reform programme, along with other relevant policy changes already in hand, will help to guard against the re-emergence of shadow banking risks. It is essential we maintain momentum and are adequately radical, not least because 10 years before the 2008 crisis we had a wake-up call but failed to respond adequately.

It is quite remarkable that Mr. Turner can call for shining light on 'shadow banking' and suggest five areas for reform without calling for transparency.

In fact, Mr. Turner's suggested reforms highlight what the Bank of England's Andrew Haldane called the 'Tower of Basel' problem.  This problem was addressing complexity in the financial system with further complexity.

Mr. Haldane called for not substituting mountains of regulations and regulators for the market where there were far simpler solutions that clearly fell in the category of 'less is more'.

Imagine that Mr. Turner has called for actually bringing transparency to 'shadow banking', rather than leaving 'shadow banking' in the shadows surrounded by so many rules that it is even more opaque than it currently is.  What would this have involved.

For structured finance securities, transparency requires that all activities, like a payment or default, involving the collateral backing an individual security are reported to all market participants before the beginning of the next business day.  This is the current information market participants need to value these 'opaque' securities and know what they own.

For financial institutions, transparency requires that banks disclose on an on-going basis, say before the beginning of the next business day, their current global asset, liability and off-balance sheet exposure details.   This is the current information market participants need to independently assess the risk of each 'black box' bank and to adjust their exposure to each bank based on this assessment.

Let's look at the impact of transparency on his proposed reforms.

Transparency eliminates the need for bank rules on consolidation or capital requirements for exposures.  With transparency, market participants can assess the risk of these exposures and exert market discipline to restrain the amount of each bank's exposure.

Transparency eliminates the need for money funds to have liquidity or capital constraints.  If money funds have to disclose their investments at the end of every business day, market participants can exert discipline on those funds that take on risk that threatens a constant net asset value.

Transparency eliminates the need for 'skin in the game' to enforce good underwriting standards.  With transparency, market participants can see exactly what underwriting standards were used and exactly how risky the loans are.

This allows the investor to chose their investment based on their risk/return preferences.  For example, some investors will want 'prime' loans and other investors will want 'sub-prime' loans.

Transparency reveals the complex web of interconnections in the financial system.  More importantly, it provides market participants with the information they need to assess the riskiness of each of their exposures.

Investors know that they are not going to be bailed out so investors adjust the amount of each of their exposures to what they can afford to lose based on the riskiness of the exposure.  It is this adjustment that ends the risk of contagion.

Finally, transparency ends any need for regulators to think about applying 'haircuts' or margin requirements in the secured funding market.  With access to all the useful, relevant information for assessing the risk of the borrower, market participants are fully capable of determining the appropriate 'haircut' for secured lending.