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Since the financial crisis of 2008, there have been persistent calls from regulators, academics and others for new regulations on something they call the “shadow banking system.” Although the contours of this system have not been rigorously defined, it certainly includes many firms that are active in the securities markets. Over the last thirty-five years, the securities market has supplanted commercial banking as the principal source of funds for the real economy, largely because securities intermediation is more efficient than deposit banking. The calls for additional regulation are overly hasty—a rush to judgment in light of the fact that both regulated deposit banking and the unregulated or lightly regulated securities market were overwhelmed by the financial crisis. In reality, the crisis was a sui generis event that says nothing about the inherent stability of the shadow banking system. To impose additional regulation on the shadow banking or securities system would add costs that will impair economic growth; it would not be sound policy to do so without evidence that the shadow banking system is inherently unstable.
Key points in this Outlook:
Since the advent of the financial crisis, US and international financial regulators and many others have been calling for regulation of “shadow banking.” Although the term has not has been defined with any rigor, proponents of regulation claim that the bankruptcy of Lehman Brothers and the rescue of several other nonbank firms demonstrate that these and other members of the shadow banking system pose a systemic risk to the stability of the US and global financial system. The broadest definitions of shadow banking suggest that the entire securities market is part of the shadow banking system and presumably should be subject to banklike regulation to assure its stability. For example, the Financial Stability Board, established by the G20 leaders at their 2009 summit, defines shadow banking as “credit intermediation involving entities and activities outside the regular banking system,” and notes that the concept is interchangeable with entities engaged in “market-based financing” or “market-based credit intermediation.”
The calls for new and presumably more stringent regulation of at least some portions of the securities system seem to be more than a bit hasty. There is not a long history of failure by firms that many include within the term shadow banking, or indeed even a single case before 2008 of a shadow banking firm causing a systemic event or endangering the stability of the US financial system. Instead, many observers rely on a single extraordinary event—the 2008 financial crisis—to claim that large portions of the securities market should be subjected to a system of regulation roughly akin to that employed for commercial banks.
Federal Reserve chairman Ben Bernanke was somewhat more specific when he both defined shadow banking and described what he saw as its dangers in an April 2012 speech at the Atlanta Federal Reserve Bank:
Although the shadow banking system taken as a whole performs traditional banking functions, including credit intermediation and maturity transformation, unlike banks, it cannot rely on the protections afforded by deposit insurance and access to the Federal Reserve’s discount window to ensure its stability. Shadow banking depends instead upon an alternative set of contractual and regulatory protections—for example, the posting of collateral in short-term borrowing transactions. . . . During the financial crisis, however, these types of measures failed to stave off a classic and self-reinforcing panic that took hold of the shadow banking system and ultimately spread across the financial system more broadly.
“The securities markets have grown substantially relative to traditional banking over the last thirty years because they offer a more efficient and less costly system than traditional deposit banking.”In reality, of course, deposit insurance and access to Fed’s discount window—the elements that Bernanke refers to as ensuring the “stability” of the banking system—did not work any more effectively for regulated banks than the absence of these factors worked for the nonbanks or shadow banks in the financial crisis. Four large banks (Citigroup, Wachovia, Washington Mutual, and IndyMac) and hundreds of smaller ones had to be taken over or rescued by the government; at the same time, three large nonbank financial institutions (Bear Stearns, AIG, and Merrill Lynch) were also rescued through purchase by banking organizations or with direct financial assistance from the Fed. One large nonbank financial institution (Lehman Brothers) was allowed to go into bankruptcy, and one money market mutual fund (Reserve Primary Fund) was unable to meet its obligation to redeem all its shares at $1 per share (an event known as “breaking the buck”). On this record, it would be difficult to say that the regulated and government-insured banking system was significantly more stable than what Bernanke called the shadow banking system.
This is a key point. The events of 2008 were so extraordinary that none of the mechanisms set up in advance to deal with financial risks—principally the risks associated with maturity transformation—was able to prevent the financial crisis. It is not, then, sensible to argue that we should abandon a highly successful system of financing economic growth to achieve greater stability by imposing more regulation. First, regulation, combined with access to the Fed’s discount window and deposit insurance, did not prevent highly adverse consequences throughout the regulated banking system. And second, as figure 1 shows, we will be buying stability at the expense of an innovative and diverse system of financing through the securities market that has proven itself over the last thirty-five years to be far more efficient and stable than deposit banking.
In this Outlook, I will argue that while shadow banking—regardless of its definition—was clearly a part of the 2008 financial crisis, it was no more at fault for what happened in the crisis than was regulated deposit banking. In reality, as I have argued previously, the financial crisis was caused by the government’s housing policy—implemented principally through the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac—which created financial conditions that simply overwhelmed both the regulated banking industry and the unregulated securities-based (or shadow banking) system. If, as we should, we treat the financial crisis as a sui generis, outlier event unrelated to how the various elements of the financial system are regulated, we will come to the right answer: the financial crisis itself does not provide a sound policy reason to impose greater regulation on the securities markets—whether or not they are a part of the so-called “shadow banking system”—that existed before the crisis occurred.
Why the Securities Market Grew and Banking Declined
Figure 1 records the most significant development in US finance over the last thirty years, the ascendance of the securities markets as the principal source of funding for the real economy and the commensurate relative decline of commercial banking. Technological developments and government regulatory policies are probably the principal reasons for this dramatic change in the financial markets.
Scholars have generally explained the intermediary role of banks as a result of their superior information about borrowers. For centuries, savers deposited their money in banks not only for safety but also because banks had information about the users of credit—primarily commercial firms—that savers did not have the resources to acquire. It should be no surprise, then, that the dominance of banks in the United States began its most serious decline in relation to the securities markets when the Securities and Exchange Commission (SEC) substantially increased corporate disclosure under the Securities Exchange Act of 1934 and improved communications technology allowed the rapid and widespread dissemination of this information in real time.
This made it possible for investors to assess the creditworthiness of companies for themselves without the intermediation of banks. With these new informational resources, individual and institutional investors were increasingly able to finance public companies directly by purchasing corporate bonds, notes, and commercial paper that they could easily liquidate in the active trading markets developing at the same time. Corporations, in turn, found it far more efficient to distribute fixed-income securities through securities offerings or private placements than to negotiate the complex loan arrangements banks required.
The process was accelerated when the SEC eliminated fixed brokerage commissions in 1976. This substantially increased individual and institutional participation in the securities markets and the value of corporate equities. These higher equity values supported larger issuances of fixed-income securities, resulting in the explosive growth of the securities markets shown in figure 1. In other words, the securities markets have grown substantially relative to traditional banking over the last thirty years because they offer a more efficient and less costly system than traditional deposit banking for bringing together savers and the users of savings. This added materially to the pace of economic growth. Accordingly, when we consider whether additional regulation of the securities markets would be good policy, we should also consider the effect of that regulation on the cost of financing and thus the rate of economic growth.
It is also far from clear that greater regulation, like that for deposit banking, delivers a more stable financial system over time. The caps on deposit interest rates under the Fed’s Regulation Q—authorized by Congress in 1933—generally provided banks with a stable source of funds for the years these caps were in effect, but when money market rates increased above the deposit caps, commercial banks and savings and loans (S&Ls) were unable to provide the necessary funds for business needs or mortgages, resulting in frequent recessions between 1948 and 1981. In those years, a recession occurred, on average, every 5.5 years, but since 1981—when the securities market has increasingly dominated credit intermediation—recessions have occurred every 8.2 years, on average. Moreover, the recessions in 1990 and 2001 were among the shortest and mildest on record.
The Fed’s Regulatory Record
It is more than ironic that Ben Bernanke should note that the unregulated shadow banking system, without access to the Fed’s discount window or deposit insurance, suffered substantial losses during the financial crisis. The losses of the regulated banking system were also substantial, and these occurred under the Fed’s supervision and as a result of shadow banking structures that the Fed approved. Beginning in the late 1980s, the Fed authorized banking organizations to sponsor off-balance-sheet vehicles, called asset-backed commercial paper (ABCP) conduits. At first, these vehicles held short-term assets and issued short-term commercial paper, often to money market funds (MMFs) that were competing with banks for deposits. ABCP conduits could be profitable for banks because they moved assets off bank balance sheets, reducing the banks’ capital requirements, and the banking organizations that sponsored these conduits earned fees that compensated for placing substantial assets in an off-balance-sheet vehicle.
Initially, ABCP conduits were small in relation to the commercial paper market as a whole. In 1990, for example, the entire commercial paper market was $558 billion, of which ABCP—mostly the result of bank operations—was only 5.7 percent. By 2007, however, the commercial paper market was $1.9 trillion, with 57 percent of the assets in bank-sponsored ABCP conduits. In the early 2000s, a major change occurred; the Fed permitted bank-sponsored ABCP conduits to hold long-term assets—including subprime mortgages—while still supporting these assets with short-term commercial paper. These structures were certainly what anyone would call shadow banks. Not only were they sponsored by banking organizations, but they exhibited the same asset-liability mismatch—called “maturity transformation”—that has always characterized banking. Once these conduits were permitted to hold long-term assets, the commercial paper they issued entailed more risk. To attract MMFs and other short-term financing sources, these conduits then sought and obtained guarantees or liquidity support from their sponsoring bank, enabling their ABCP to gain a AAA rating and tying the sponsoring bank directly to the liquidity, credit, and solvency risks of the ABCP conduits.
ABCP conduits ultimately grew into an extensive banking activity. By January 2007, regulators had authorized 296 bank-sponsored ABCP conduits in the United States and Europe. Commercial banks accounted for $903 billion—or 74.8 percent—of outstanding ABCP.7 The assets in these conduits varied but were dominated by mortgages, particularly subprime mortgages. This element turned the mortgage meltdown that began in 2007 into the financial crisis of 2008.
“Without better evidence that the shadow banking system is inherently unstable, it would not be sound policy to place further regulatory restraints on the securities market.”
In my dissent from the majority report of the Financial Crisis Inquiry Commission, I fully documented the role that subprime and other nonprime mortgages played in the 2008 financial crisis. The ability of banking organizations to create ABCP conduits that held these mortgages, together with bank commitments to back the conduits with guarantees or liquidity support, was the plumbing that connected the mortgage defaults to the banking system in both the United States and Europe. When large numbers of mortgage delinquencies and defaults began to appear in 2007, MMFs and other short-term lenders—concerned about the quality of the underlying assets in the ABCP conduits—refused to roll over their bank ABCP. As a result, banking organizations suffered huge losses when they had to make good on the liquidity support or guarantees that had qualified the ABCP for AAA or AA ratings. As one academic study about the origins of the financial crisis concluded, “This [liquidity] obligation raised concerns about counterparty risk among banks and caused interbank lending rates to shoot upwards. The crisis in asset-backed commercial paper quickly spread across the financial sector and affected banks worldwide.”
Of course, Bernanke would argue that, although this was shadow banking, it was regulated and subject to the various protections afforded by access to the Fed’s discount window and deposit insurance. But the Fed cannot have it both ways; it cannot claim that the ABCP conduits were in fact regulated banking and still claim that regulation reduces the risks associated with these vehicles. These conduits were as much a cause of the financial crisis as any unregulated nonbank entity. This simply further proves the general proposition that the financial crisis could not have been prevented by regulation; both the regulated and unregulated financial systems were overwhelmed by the losses that flowed from the collapse of the housing bubble that developed between 1997 and 2007 and the delinquency and failure of an unprecedented number of subprime and other nonprime loans that were the result of government housing policy.
Does Shadow Banking Require Regulation?
Are the collapse of Lehman Brothers and the rescue of AIG and Bear Stearns examples—as some regulators, academics, and others claim—of the instability and systemic risk inherent in unregulated securities market activity? What is missing from these arguments is any sense of history. First, the shadow banking system, broadly defined to include MMFs and virtually all of the securities market, has been remarkably stable in comparison to regulated banking for at least the last thirty-five years. There have been no events in the securities system that could be classified as systemic, even though there have been major securities firm failures (for example, Drexel Burnham Lambert in 1990) and one case of a MMF breaking the buck. In contrast, virtually the entire S&L system collapsed in the late 1980s and early 1990s, at a cost to the taxpayers of about $150 billion, and in the case of at least one bank failure (Continental Illinois in 1984), the institution had to be rescued by the Fed because of fear of a systemic collapse.
In addition, those who argue that the losses among the lightly regulated investment banks and AIG in 2008 demonstrate a need for more regulation seem to ignore the fact that all the resources of regulated banking—
prudential regulation, the discount window, and deposit insurance—were unable to prevent the need to rescue four major banks (Citi, Wachovia, Washington Mutual, and IndyMac), the failure of four hundred smaller banks, and the need to shore up with Troubled Asset Relief Program (TARP) funds the shaky condition of approximately three hundred other banks. What this suggests is not that bank regulation is inherently incompetent (although that argument can be made), but that the financial crisis was a sui generis event—something akin to a hundred-year flood. No system is built to deal with an event of this magnitude, so the failure of Lehman Brothers and the rescue of the other investment banks say nothing about the inherent stability of unregulated shadow banks or the danger that they might pose to the stability of the financial system.
The fact is that there were some unique elements about the period before the 2008 financial crisis that explain the unprecedented losses of the investment banks—as well as commercial banks—in the financial crisis. First, the panic that we know as the crisis began after the deflation of a bubble in the housing market of an unprecedented size and duration. The bubble that began to top out in 2006 and collapse in 2007 had grown for ten years; as shown in figure 2, by 2007, it had increased real US housing prices by almost 90 percent. This was nine times larger and three times longer than any previous housing bubble in the United States. When this bubble deflated, it drove down housing prices throughout the country and caused an unprecedented number of mortgage delinquencies and defaults. The losses that resulted from this decline in housing and mortgage values fell mainly on financial institutions—banks and nonbanks—which had invested in both mortgages and mortgage-backed securities (MBS) backed by subprime loans.
The housing bubble and its ultimate collapse were not the result of the normal functioning of the market but instead were brought about by government policy. In 1992, Congress adopted affordable housing goals for
Fannie Mae and Freddie Mac, then the dominant players in the US housing market, that were intended to increase homeownership by making mortgage credit more available to low-income borrowers. Over time, the quotas required by these policies caused the GSEs to reduce their underwriting standards so that they could acquire the subprime and other nonprime mortgages for which large numbers of low-income borrowers could qualify. The funds the government poured into the housing market through the GSEs and other government programs inflated the housing bubble.
By 2008, half of all mortgages in the United States—28 million loans—were subprime or otherwise weak and risky. Seventy-four percent of these nonprime mortgages (amounting to almost $3 trillion) were on the books of the GSEs, other government agencies, or government-controlled firms; the balance, about 26 percent, with an aggregate value of almost $2 trillion, were securitized by the private sector and held as investments by financial institutions in the United States and around the world.
The sharp, sudden decline in housing and mortgage values in 2007 and 2008 created a “common shock”—
a phenomenon in which virtually all financial institutions are weakened at the same time by the decline in the value of a widely held asset. Kaufman and Scott summarize this effect:
When one [firm] experiences adverse effects from a shock—say, the failure of a large financial or nonfinancial firm—that generates severe losses, uncertainty is created about the values of other [firms] potentially also subject to adverse effects from the same shock. To minimize additional losses, market participants will examine other [firms], such as banks, in which they have economic interests to see whether and to what extent they are at risk. The more similar the risk-exposure profile to that of the initial [firm] economically, politically, or otherwise, the greater is the probability of loss, and the more likely it is that participants will withdraw funds as soon as possible. This response may induce liquidity problems and even more fundamental solvency problems. This pattern is referred to as a “common shock” or “reassessment shock” effect and represents correlation without direct causation.
The unprecedented number of mortgage defaults in 2007 and 2008 produced a similarly unprecedented common shock to financial institutions like the investment banks. Mark-to-market accounting required them to write down the value of the assets they held for trading, substantially reducing their capital positions. Moreover, because of market concerns about the quality of the mortgages in the MBS they were holding, these assets were no longer available for repo financing, severely cutting their liquidity positions. The same factors required commercial banks to terminate their special investment vehicles and their ABCP conduits, resulting in debilitating losses as they either took the assets back onto their balance sheets or made good on their liquidity support or guarantees.
Although the market was temporarily calmed after the rescue of Bear Stearns in March 2008, it fell into a panic in September 2008 when the government reversed the policy established by the Bear rescue and allowed Lehman Brothers to file for bankruptcy. In the midst of this panic, the Reserve Primary Fund, a MMF that held substantial amounts of Lehman commercial paper, broke the buck; although this was only the second time such an event had occurred among MMFs, in the panicky conditions at the time, it set off a run on many other MMFs. As Kaufman and Scott had suggested, shareholders and investors ran from other MMFs suspected of holding the same questionable assets as Lehman or the Reserve Fund, rather than waiting to determine whether the entities holding the assets could be distinguished from others.
This narrative puts the financial crisis in a different light. It was the result not of a lack of regulation, irresponsibility by financial institutions, or the normal functioning of an unregulated market. Instead, it was the unintended result of government housing policies that encouraged a deterioration in mortgage underwriting standards and fostered the development of a housing bubble of unprecedented size. The common shock caused by the collapse of the bubble reduced the capital and liquidity positions of nearly all financial institutions and put investors and other market participants on edge. The panic that occurred after Lehman’s failure accounts for all the anomalies I have discussed: why bank regulation and the Fed’s discount window were no more effective than market discipline in protecting banks against loss, why the short-term assets of investment banks—consisting in large part of AAA-rated MBS—could not provide the liquidity they needed to maintain the market’s confidence, and why many shareholders withdrew their investments in MMFs after one broke the buck. It all goes back to the mortgage meltdown when the huge housing bubble deflated in 2007 and 2008.
Because of its unprecedented size and virtually uniform effect across both regulated and unregulated firms, the financial crisis proves nothing about the need for additional regulation of the securities market or the portions of that market that might be defined as shadow banking. If a bomb obliterates all the buildings in a city—both wood and stone—that is not a reason to rebuild the city with only stone buildings. The rescues of financial firms all occurred in the midst of, and were made necessary by, a financial panic. In the absence of a financial panic, which affected regulated banks and unregulated investment banks in the same way, there is no reason to believe that the investment bank business model—or other business models that have been called part of the shadow banking system—should be more stringently regulated.
The widespread calls by regulators, academics, and others for the regulation of shadow banks or the shadow banking system reflect a rush to judgment. Firms and financial institutions in the securities markets—some of which could be included in the ill-defined shadow banking system—failed during the financial crisis, but so did many regulated banks. Overall, there is no indication that the regulated banking system was better prepared to ward off the effects of the financial crisis than the lightly regulated or unregulated nonbanks characterized as shadow banks.
In reality, the financial crisis was a unique event that overwhelmed both the regulated and unregulated financial systems. Thus, it says nothing about the inherent stability or instability of the lightly regulated or unregulated firms in the securities market. Over the last thirty-five years, the securities market has supplanted the banking system as the principal supplier of funds to the real economy. Without better evidence that the shadow banking system is inherently unstable, it would not be sound policy to place further regulatory restraints on the securities market. Such a policy could substantially impair economic growth with no net benefit to the financial system.
1. Financial Stability Board, “Strengthening the Oversight and Regulation of Shadow Banking: Progress Report to G20 Ministers and Governors,” April 16, 2012, 1, www.financialstabilityboard.org/publications/r_120420c.pdf (accessed May 30, 2012).
2. Ben S. Bernanke, “Fostering Financial Stability” (remarks, 2012 Federal Reserve Bank of Atlanta Financial Markets
Conference, Stone Mountain, GA, April 9, 2012), www.federalreserve.gov/newsevents/speech/bernanke20120409a.htm (accessed May 30, 2012).
3. Peter J. Wallison, Dissent from the Majority Report of the Financial Crisis Inquiry Commission (Washington, DC: American Enterprise Institute, January 14, 2011), www.aei.org/files/2011/01/26/Wallisondissent.pdf.
4. “Length of Recessions: Historical Chart,” Trader’s Narrative (blog), April 3, 2009, www.tradersnarrative.com/length-of-us-recessions-historical-chart-2418.html (accessed June 7, 2012).
5. Marcin Kacperczyk and Philipp Schnabl, “When Safe Proved Risky: Commercial Paper during the Financial Crisis of 2007–2009,” Journal of Economic Perspectives, 24, no.1 (Winter 2010): 32.
6. Ibid., 33.
7. Ibid., 33, citing Viral Archarya, Philipp Schnabl, and Gustavo Suarez, “Securitization without Risk Transfer” (National Bureau of Economic Research working paper no. 15730, Cambridge, MA, February 2010), www.nber.org/papers/w15730.pdf (accessed May 30, 2012).
8. Wallison, Dissent from the Majority Report.
9. Kacperczyk and Schnabl, “When Safe Proved Risky,” 38.
10. Wallison, Dissent from the Majority Report, 9–20.
11. See, for example, Peter J. Wallison and Edward J. Pinto, “Free Fall: How Government Policies Brought Down the Housing Market,” AEI Financial Services Outlook (April 2012), www.aei.org/outlook/economics/financial-services/housing-finance/free-fall-how-government-policies-brought-down-the-housing-market/.
12. George Kaufman and Kenneth Scott, “What Is Systemic Risk, and Do Bank Regulators Retard or Contribute to It?” Independent Review 7, no. 3 (Winter 2003): 3.
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