The shadow banking market is estimated to be worth $70,000bn – roughly equivalent to world gross domestic product. It follows that a hiatus in a market of that size (even if it is composed of many parts) would cause major disruptions to banks, companies, investors and even whole economies. This means that regulators cannot take a hands-off approach to shadow banking by assuming that entities that get into trouble can just be allowed to fail. Tighter regulation of banking has pushed many financial activities into the hands of non-banks. The more they grow and the more significant their role, the greater the dangers if they come unstuck.
If companies become dependent on loans from non-banks and this source of finance were suddenly removed, banks operating under tighter Basel III rules would be unable to step in and fill the gap. What’s more, banks would be affected as they would also have exposures to the troubled corporates.
Bank of Finland governor Erkki Liikanen (and the driving force behind the Liikanen report, which proposed separating trading from mainstream activities in EU banks) said recently that if non-banks grew to a size and significance whereby markets expected they would be bailed out, then regulation would be necessary. "Such proactive measures as applying systemically important financial institution definition and extending that regulation and supervision also to the shadow banking sector could be taken if necessary," said Mr Liikanen, as reported by Reuters.
But, with the banks lending less and the slack being picked up by the shadow banks, a too forceful approach to regulation would slow down economic growth. One way of solving the funding problem without creating additional risk would be a reform of the securitisation market, which comes under the Financial Stability Board’s (FSB) definition of shadow banking.
Ironically, given its role in the financial crisis, securitisation should be the ideal vehicle for transferring and diffusing risk among so many players and investors that structures could be allowed to fail. But there needs to be higher standards to ensure that the assets being securitised are properly assessed and the structure is sound.
In a study of future risks and fragilities for financial stability, Ernst & Young’s Patricia Jackson, who is head of financial regulatory advice for the firm, writes: “…much more urgency should be placed on the development of a new securitisation market, with new instruments, containing features making them less risky and more transparent – limited tranching, standard prospectuses, a summary of risk factors, transparency on risk in the pools, loans going through bank lending standards, cross-market default data and clear disclosure.”
Ms Jackson argues that the securitisation market needs the kind of push from central banks that the swap market enjoyed in its early days. Allowing the use of high-quality securitised instruments in Basel III liquidity pools and as collateral with central counterparties would be two such steps.
Given the dampening impact of most post-crisis regulation, some initiatives that fostered the development of a market in a stable fashion would be a welcome departure.
