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.
In Europe, the total financial asset/gross domestic product ratio reached 551 per cent in 2010, among the highest in the world, with bank assets at 274.3 per cent of GDP.
For euro-zone countries with fiscal debt around 100 per cent of their GDPs, an interest rate increase to 6 per cent would double the debt to 200 per cent of GDP in 12 years, which is clearly unsustainable. With real interest rates of over 6 per cent, the real estate market would crash, as happened in Ireland, Greece and Spain. Their governments had to stand behind these systems. This is why the European Central Bank used massive quantitative easing to keep the whole system afloat.
But as The Black Swan author, Nassim Nicholas Taleb, reminds us, look carefully at the tail risks and the system as a whole. Assigning individual risks to risk assets and then allocating capital to these risks ignores the uncertainty (immeasurable risks) and complex non-linear interaction among these individual assets, the bank and the environment, which are much more interrelated than one thinks. So, thinking that you are marginally increasing risk weights and risk capital without looking at the whole environment is like shuffling decks on the Titanic.
What is happening to the whole global financial system?
First, according to a recent Brookings conference on financial structures, the banking system (already highly concentrated before the crisis) has become even more concentrated after the crisis.
Second, as the Financial Stability Board data has shown, the shadow banking system has grown larger since the crisis.
Third, because the wholesale interbank markets are failing, the advanced country central banks, through unconventional monetary policy, have de facto replaced their banking systems as the first provider of liquidity and even supporters of mortgage markets. The European Central Bank and the Federal Reserve System have balance sheets of nearly US$3 trillion and are committed to increasing them as much as necessary to meet their unconventional targets, which now include unemployment levels.
The trouble is that increasing research, especially from Japan, indicates the impact of unconventional monetary policy on the real economy is ambiguous at best. The real benefits are for the financial market, and that is not distributed evenly, as savers and pensioners are having to subsidise borrowers. Japan has been experimenting with unconventional monetary policy for more than a decade.
The priority in this global environment is to keep our focus on the real sector - on promoting trade and growth, jobs and tackling social inequalities, such as providing more pension benefits and helping small and medium-sized enterprises, which account for the bulk of innovation, job creation and social stability.
Worrying about shadow banking is like worrying about ghosts when we should be worrying about the person telling us to worry about the ghosts. My fear is not about ghosts, but about what the storyteller may or may not do. The greatest risk today is not business risks, but regulatory and monetary policy risks.
Beware quantitative easing, because it promises more than it can deliver.
Andrew Sheng is president of the Fung Global Institute