Regulate the shadow realm like the traditional banks

Five years after a crisis that almost took down the world economy, regulators are still groping for a way to address one of the global financial system's most obvious weaknesses: the trillions of US dollars in banking activity that happens outside traditional banks.

Here is a suggestion. If it acts like a bank, regulate it like a bank.

The business of banking is inherently perilous. It turns short-term savings (such as customer deposits) into long-term investments (such as mortgages and corporate loans). This is risky: if too many savers want their money back at once, the bank cannot pay. It must either liquidate its assets or freeze its accounts, either of which can trigger a broader panic.

That is why governments insure bank deposits and central banks stand ready to make emergency loans. In return for the insurance, banks are asked to follow certain rules. They face limits, for example, on how much they can lend for each dollar of equity their shareholders invest. The bigger the equity cushion, the less likely it is that taxpayers will have to bear losses.

Regulating ordinary banks well is proving difficult enough, but there is a constellation of other financial intermediaries that gamble in much the same way - converting short-term liabilities into long-term assets - with no explicit government backstop. This so-called shadow banking industry is enormous. Its global assets are estimated to have been more than US$60 trillion at the end of 2011, making it about half the size of the traditional banking sector.

In this shadow realm, other forms of short-term borrowing such as shares in money market mutual funds play the role of deposits. Securities dealers, hedge funds and other financial firms buy longer-term assets such as bonds backed by mortgages or corporate loans. They employ the assets as collateral against further loans. The collateral gives creditors a guarantee they will be repaid.