What is the shadow banking system and should it be regulated?

The main difference between traditional banking and the shadow banking system is that the latter are not subject to the same regulatory requirements that apply to traditional banks. Traditional banks in most countries are regulated by the central bank – RBNZ in New Zealand, Federal Reserve in the USA. The shadow banking sector are not structured or regulated as banks and include: investment management companies, pension funds, hedge funds, money market funds, mutual funds, payday lenders and others. However they still offer the same activities as traditional banks – loans, deposit taking etc. See graphic below from Better Markets.

Because of the fact that there is so little regulation the shadow banking sector has been growing and since the GFC in 2008 their share of global financial assets has grown form 42% to 50% by 2020. Therefore the shadow banking sector should no longer continue to be as unregulated. In the traditional banking system stringent capital and liquidity requirements as well as deposit insurance which makes them less susceptible to panic. However the recent collapse of SVB showed how poorly regulated it was and bank credit contracted $311 billion—or 1.77% in just two weeks The main concern with shadow banking is that because there is little regulation they take on more risk which means greater tendency to have less liquidity in reserve and more exposure to debt. On the flip side, shadow banks can offer a broader range of borrowing options which many industries now rely on for financing.

Source: Better Market – March 24, 2022 The Increasing Dangers of the Unregulated “Shadow Banking” Financial Sector

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The collapse of Silicon Valley Bank

Been covering banking and the bond market with my A2 economics class and we talked about the collapse of Silicon Valley Bank. Below is a video from the WSJ on the whole SVB saga and the history behind bank regulation under Obama but deregulation under Trump. What is interesting is the fact that 94% of SVB’s deposits (see graph) were above the $250,000 which is insured by the Federal Deposit Insurance Corporation – government corporation supplying deposit insurance to depositors in US commercial and savings banks. However you do wonder why depositors kept so much money in a bank when you would want to spread your risk. Although you may need cash for day-to-day transactions, money could be put into a market fund and brought back into a bank account when needed.

WSJ talk about bonds and below are some notes on how bond yields work. This is part of the A2 syllabus Unit 9 – interest rate determination: loanable funds theory and Keynesian theory.

How do Bond Yields work?
Say market interest rates are 10% and the government issue a bond and agree to pay 10% on a $1000 bond = annual return of $100.
100/1000 = 10%
If the central bank increase interest rates to 12% the previous bond is bad value for money as it pays $100 as compared to $120 with the a new bond. The value of the old bond is effectively reduced to $833 as in order to give it annual payment of $100 a year the price would have to be $833 to it a market based return.
100/833 = 12%

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PBS: Mervyn King and the future of global finance.

Another good video from Paul Solman of PBS ‘Making Sense of Financial News’.

In his new book, “The End of Alchemy,” Mervyn King still worries that the world banking system hasn’t reformed itself, eight years after its excesses led to collapse. He states that it’s easy with hindsight to look back and say that regulations turned out to be inadequate as mortgage lending was riskier than was thought. Furthermore, you are of the belief that the system works and it takes an event like the GFC to discover that it actually doesn’t.

Paul Solman asks the question that a large part of the problem that caused the GFC was the Bank of England and the US Fed were not able to keep up with the financial innovation that was going on in both of these countries. King refutes this by saying that there were two issues that were prevalent before the GFC:

1. Low interest rates around the world led to rising asset prices and trading looked very profitable.
2. Leverage of the banking system rose very sharply – Leverage, meaning the ratio of the bank’s own money to the money it borrows in the form deposits or short-term loans.

Central banks exist to be lenders of last resort. Problem: Too big to fail. And that’s what began happening in England, just like America, in the ’80s and ’90s. There needs to be something much more robust and much more simple to prevent the same problem from happening again. King makes two proposals:

1. Banks insure themselves against catastrophe by making enough safe, secure loans so they have assets of real value to pledge to the Central Bank if they need a cash infusion in a hurry.
2. Force the banks to keep enough cash on hand to cover loans gone bad as during the crisis banks didn’t have enough equity finance to absorb losses without defaulting on the loans which banks have taken out, whether from other bits of the financial sector or from you and I as depositors.

He finally states that the Brexit vote doesn’t make any significant difference to the risks facing the global banking system. There were and are significant risks in that system because of the potential fragility of our banks, and because of the state of the world economy.

Do we still have a “Too Big to Fail” mentality?

The Institute for New Economic Thinking – INET – held its annual conference this week at Bretton Woods, New Hampshire at the historic Mount Washington Hotel – the site of the 1944 conference that launched the World Bank and established a new post-war global economic architecture. The theme of the conference was:

“Crisis and Renewal: International Political Economy at the Crossroads.”

Some notably speakers including Paul Volcker (former Fed Chariman), Larry Summers (Harvard Prof and former Treasury Secretary under Clinton), George Soros (Investment Banker and Philanthropist). However one speaker who has been getting particularly good raptures is Simon Johnson Professor of Entrepreneurship at MIT Sloan School of Management. He basically said we are no further down the track with regard to diminishing the “Too Big To Fail” state of the banking sector – in fact the banks are getting bigger. Worth a look.

Buffers for Banks

In a meeting in Switzerland last week the Committee on Banking Supervision, comprising the US Federal Reserve Chairman, Ben Bernanke, and representatives of 26 other countries recently proposed steps to immunise the financial system from future crises. The new rules would:

*make banks double their amount of capital set aside as a buffer against possible losses,
*slash stockholder dividends and executive pay if the stockpile falls short,
*limit lending during economic boom times

The committee decided that a bank’s common equity – the basic capital requirement, money invested by a bank’s owners and stockholders that is available to absorb losses – would increase from an amount equal to 4% of an institution’s loans and other holdings to 7%.

According to the Washington Post 2.5% of that would be considered a buffer to be spent in poor economic conditions. The committee also decided that during periods of excess credit growth each country could raise the capital requirement by as much as 2.5%.

The changes are intended to stabilise the system against sudden shocking losses