The fallacy of Financial Regulation—neglect of the Shadow Banking System

Posted by on 31 May 2011


The message of this article is straightforward. In response to the crisis, the reforms in financial regulation address threats to the banking system by increasing capital and providing for liquidity in the banking system. This article argues that the measures miss the point of the recent crisis. The liquidity crisis in the shadow banking system was a major source of financial and economic instability. Liquidity built endogenously in the shadow banking system, and once liquidity evaporated, fire sales lead to downward revaluations of collateral. Basically a self-fulfilling endogenous liquidity built up on the way up, created a vicious spiral down. In a financial system increasingly dominated by market instruments, a collapse due to rapid revaluations or counterparty risk is a very high prospective risk. The liquidity and leverage ratios proposed by Basel Committee that are discussed in the next paragraph do not address the problem. 

Substantial progress has been made in strengthening regulation in the financial sector. But the work is far from over in several areas such as cross-border resolution and provision of liquidity. Reforms improving banking systems are a pressing issue regarding which very little has been done. The Basel Committee is introducing (a) a leverage ratio as a supplementary measure to the Basel II risk-based framework. The leverage ratio is 3% of total assets (b) a global minimum liquidity standard for internationally active banks that includes a 30-day liquidity coverage ratio requirement underpinned by a longer-term structural liquidity ratio. While the measures are welcomed, it should be noted that the capital accord is not of not help because it only targets the banking system capacity to absorb losses. Second, liquidity on the asset side of the shadow and formal banking systems balance sheets is conceptually different from liquidity requirements on the liability side and therefore requires a different treatment. Third, it should be noted the liquidity provisions are exceedingly generous- The proposed tier 1 leverage ratio of 3% would limit banks to lending 33 times their capital, is exceedingly high and the implementation takes  an exceedingly long time - 8 years – with a deadline of January 2019. <>.

The problem with the recent regulatory measures is that they have focused on the formally regulated financial sector, while the financial crisis erupted in an unregulated shadow banking that plays an increasingly large role in the U.S. economy. Shadow banking is the system of finance that exists outside regulated depositories, investment banks, or bond funds. The sector finances more than 30% of assets in the U.S, yet limited data is available and very little has been done to regulate it, including the provision of liquidity-- measures designed to ensure that liquidity does not evaporate in the shadow banking system are neglected in the present regulatory process. We are far from the point where regulators and markets participants can be confident that they will have secure access to liquidity at times of systemic crises.

The problem is as follows: enormous endogenous liquidity and leverage are created in the shadow banking system. As a clinical example, consider the process of securitization of mortgages: the mortgages get securitized as mortgage-backed securities (MBS); the infamous collateralized debt obligations (CDOs) are derived from a portfolio of MBS underlying assets. At each step along the way of the slicing and dicing, the securities get pledged as collateral for the next phase. An entire chain of securities relying on one underlying instrument lead to a pyramid of leverage in boom times that that can just as abruptly collapse when valuations go down and liquidity evaporates. The problem is gaining recognition. A good description is in Brunnermeier in “Deciphering the Liquidity and Credit Crunch 2007-08” focuses on the problems in the “repo market”.( His work recognizes that network effects suggest that financial institutions have an individual incentive to take on too much leverage, to have excessive mismatch in asset–liability maturities, and to be too interconnected.  Gary Gorton’s paper “The Panic of 2007” ( looks at the commercial paper market in the summer of 2007 and how it had all the characteristics of a traditional bank run, except that it was occurring in the “shadow” banking sector of investment banks and off-balance sheet vehicles. 
The regulatory responses- increased capital and liquidity in the banking system – are not addressing the problems in the shadow banking system. There are numerous possible explanations for this neglect: there isn’t adequate data on the shadow banking system; it’s heterogeneous; the operations are opaque; and the Basel Committee -whose core constituency is central banks and banking regulatory agencies- lacks expertise in the shadow banking, as evident in the crisis. 

Stan Fischer, and experienced and respected policy maker, expresses skepticism in Central Bank Lessons from the Global Crisis ( on the impact of capital adequacy in a market based system where prices spiral down rapidly. Other authoritative analysts such as Kashyap, Berner and Goodhart point out in the The Macroprudential Toolkit ( that there is a need for a new approach to financial stability that reflects fire sales.

Two causes can lead to the rapid evaporation of endogenous liquidity – a reassessment of counterparty risk, and a revaluation of prospects for a particular market such as credit card receivables or mortgages. During the crisis, the counterparty risk of a Bear Stern or Lehman hinders their capacity to mobilize funding and leads to fire sale of marketable assets. Similarly, it is enough for a small change in valuations in the prospects for credit card debt (consumer credit), auto, housing, and commercial real estate in a leveraged financial pyramid to trigger a cascading chain of revaluations, forcing rapid fire sales and in turn leading to calls for additional collateral that amplify the vicious cycle. 

Several half-hearted measures try to address the problems. Under an agreement at the Group of 20 summit meeting in 2009, regulators across the world agreed to require clearing and exchange trading for derivatives. In the US the Dodd-Frank financial regulatory law puts restrictions on derivatives trading. Those measures are designed to ensure better-defined margin requirements, planning for an orderly liquidation and removing counterparty risk. However the implementation is lagging even for this limited initiative designed to reduce counterparty risk due to global trading in derivatives. (Derivatives without Borders vs. Dodd-Frank ( Another effort addresses Tri-Party Repurchase Market Infrastructure Reform. It focuses on margin requirements, liquidity and intraday credit, are aimed at making security repurchase transactions more secure.

It is important to note that prospectively shadow banking is bound to take on a greater role in lending vis-à-vis the banking sector because banks will be limited by the new capital regulations.  Therefore more stringent measures are needed to harmonize the regulation of the shadow-banking and traditional-banking sectors. Among them there is need for a new approach to supervision that focuses on markets and instruments as opposed to institutions. For instance, there is a need for examination “through instruments” from origination to distribution to identify vulnerabilities. Policy makers need to redouble efforts to address the excessive liquidity build up in shadow banking