Look beyond shadow banking for the real threat to financial stability
Andrew Sheng explains why using quantitative easing to shore up banking risks is misguided
Bond market guru Bill Gross coined the term "shadow banking" to identify the role of non-banking institutions in creating money-like credit that could implode and affect the traditional banking system, and last year, the Financial Stability Board gave its initial recommendations on how to oversee the shadow banking system.
The board's Global Shadow Banking Monitoring Report last month revealed that shadow banking accounted for roughly a quarter of total global financial intermediation. Its value rose from US$26 trillion in 2002 to US$67 trillion last year. Of this total, the US, the euro zone and Britain accounted for US$54 trillion, or some 81 per cent, with the US having the largest share, followed by the euro zone and Britain.
The term "shadow banking" is really a misnomer; the Financial Stability Board defines it as "credit intermediation involving entities and activities outside the regular banking system". This covers all the institutions that have always been visible to all of us, and were regulated in one form or other.
Shadow banking institutions are highly visible, such as money market funds, mortgage corporations, hedge funds, insurance funds, investment banks and securities houses. The global regulatory community has finally awakened to the fact these institutions carry risks - of their own and through their links with the banking system. They help banks to avoid regulation and can lead to a build-up of leverage and risks in the system.
A common problem with theoretically trained and model-driven bankers and regulators was that they tended to assume that what cannot be seen may not exist and what cannot be measured was not important. There is also a common belief that marginal increases in capital can deal with a sudden loss of trust in the entire financial system. Citibank had capital of 11.8 per cent of risk assets in 2008 - which would have been acceptable under the Basel III capital requirements (which will have effect from January 1) - when it got help.
In other words, even increasing capital of the banking system to 17-18 per cent of risk-weighted assets (which is Basel III's goal) may be insufficient if the system is over-leveraged.