The Financial Stability Board v. The Shadow Banking System

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Since the start of the recent financial crisis, many have been thinking seriously about the way that the global financial system is structured. The threat of the shadow banking system has become a particular cause for concern. With the most recent report from the Financial Stability Board (FSB) pinning its size at $67 billion, it is clear that this risk-ridden financial colossus will not go silently into the night.

The FSB has determined that one of its main goals is to bring shadow money flows into the light through a new regulatory framework. This framework would be catered to the economic functions that the current shadow system fulfills such as facilitation of credit creation, provision of loans that are dependent on short-term funding and three other key areas outlined in their November 18th report. It is a lesson in nascent regulation to see the types of policies that the FSB proposes to use to regulate the shadow banking system. The use of the words "limit" and "restrict" is particularly instructive.

Though the report acknowledges that money market funds, repo markets and other such functions are economically useful, the FSB apparently believes that it has (or is able to gain) the knowledge that is necessary to determine the boundaries within which these functions will still be useful without posing excessive risk to the system as a whole. Even though the FSB did not have the wisdom to foresee the void that has now been filled by the shadow banking system, it believes it will be able to control it. Regulation is always a few steps behind innovation.

If one takes a large step back to observe the rise of the shadow banking system and to think about its purpose in creating credit and liquidity in markets that previously were either illiquid or nonexistent, then a proper conclusion would be to realize that regulators are dealing with private money creators rather than some other sort of financial entity. Historically, the way that private money creators have been dealt with is through taxation. By levying a tax on private or sub-sovereign issued currencies, governments have driven out the competition in the name of standardization.

What the shadow banking system has created, though, is a much higher technology for private credit creation, and one that is just a breath away from becoming a liquidity solution that is hard-wired into the global financial system. The question is, who is the ultimate counterparty to this private money? The answer that I take from the recent FSB report is, "We think that we are, but we really don't want to be, so we're going to regulate this beast in such a way that we hope will never have to become the backstop." Another bailout of the shadow banking system like the one that the Federal Reserve undertook with its alphabet soup arsenal (remember the TALF, AMLF, MMIFF and PDCF?) is something the FSB is trying to avoid. They are clearly unwilling to disavow previous interventions and simply regulate for the purpose of transparency.

I do not mean to say that they do not already wish to achieve a higher level of transparency with their efforts. A key pillar of their plan is to hold participants of the shadow banking system to a uniform standard of disclosure. However, the requirements regarding leverage, asset concentration and liquidity that the FSB is exploring are issues that could be left up to the market to determine once the proper level of transparency is reached.

Though perfect market efficiency cannot be assumed, greater levels of disclosure concerning these markets would help to create a self-regulating environment rather than the shadowy system that played such a large role in the recent financial crisis. The web created by packaging and re-selling securities can be understood if counterparty disclosure is increased. By reducing these information asymmetries, market players would be able to better assess the quality of this credit.

If the expansion of the shadow banking system was an innovation that rode a bubble and then collapsed, then it should self-correct within new boundaries determined by the market. This would include new standards for liquidity preference, leverage levels and asset quality. Whether this market will ultimately be self-regulating or not depends on the nature of the regulation it falls under.

The FSB has the opportunity to play the role of a market facilitator or a market suppressor. They currently are planning to take the suppressor role without fully realizing the moral hazard that is inherent in such a regime. The AIGs of the world may not be gone forever, but an implicit bailout guarantee will not help the stabilization effort of the Financial Stability Board.


Daniel Bunn is a research fellow with the American Principles Project, a Washington policy organization.  

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