MONSTERS THAT LURK IN THE SHADOWS OF WALL ST. / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( VERY HIGHLY RECOMMENDED READING )

Monsters that lurk in the shadows of Wall St

By Francesco Guerrera

Published: March 7 2011 18:13

Lobbying campaigns are like New York subway trains: you can hear the rumbling well before they arrive.

So when banks decided it was time to shift the regulatory focus away from them and towards hedge funds, private equity groups and other parts of the “shadow banking system“, words preceded action.

Jamie Dimon went first. In September last year, the outspoken head of JPMorgan Chase warned that the post-crisis reforms could create “non-bank monsters”. A month later Vikram Pandit, the publicity-shy Citigroup chief, was less colourful but more explicit. “Shifting risk into unregulated or differently regulated sectors won’t make the banking system safer,” he said. And in Davos in January, Gary Cohn, Goldman Sachs’ number two, made the mountain air even chillier. “What I most worry about,” he told me, “is that in the next cycle, as the regulatory pendulum swings, we are going to have to use taxpayer money to bail out unregulated businesses.”


These outbursts of concern come at an opportune time.


In the US, regulators are drawing up a list of “systemic” groups – cornerstones of the financial edifice whose failure would bring it tumbling down – that will be subject to tighter rules and oversight. All institutions with more than $50bn in assets will be automatically included. The question is whether smaller but risky players should join them.


The Financial Stability Board, a grouping of national watchdogs, is also trying to co-ordinate different countries’ rules for non-banks. Strangely enough, the idea of being regulated like JPMorgan and Goldman does not agree with “shadow bankers”.


“An absolutely dumb argument and ridiculous concern,” was the measured opinion of a private equity chief last week.

In his view, the banks’ lobbying is a cynical ploy to ensure hedge funds and PE groups do not steal the high-margin business, such as leveraged loans and proprietary trading, that is being driven away from Wall Street by the new rules.


The non-banks’ rationale for being left alone is predicated on two Ss: size and scope – or lack thereof. Their companies, they argue, are not big enough to drag down the global economy.


Take all the hedge funds in the world, add buy-out groups, and you end up with total assets under management of some $2,500bn, roughly the size of Bank of America’s balance sheet.


As for interconnectedness – a word that entered the financial jargon after Lehman Brothers’ failure in 2008 – neither hedge funds nor private equity groups have the tentacles into investors, consumers and governments that made the collapse of a Citi or a Morgan Stanley unthinkable. Plus, non-banks do not put taxpayers’ money at risk because they do not enjoy federal backstops, such as deposit insurance and credit lines from the Federal Reserve.


These arguments make sense. The real “shadow banks” were Lehman, Bear Stearns and AIG – groups that took on huge risks by exploiting a system that regulated Wall Street firms and insurers differently to (ie, less than) lenders.


Yet, non-banks’ perorations do not tell the whole story. For a start, focusing on just hedge funds and private equity is misleading: what about commodity trading companies, clearing houses and money market funds? If you include those, the US “shadow” banking sector is bigger than its “bright” counterpart – with assets of $16,000bn versus $13,000bn, according to the Fed. In the crisis, it only took one money market fund to hit the rocks for the US government to rush into action to prevent a run on the entire industry.


But the real danger lurking in the shadows of the financial system is “tail risk” – the possibility that a hedge fund, or even an insurer, might become too big or too reckless. It is true that hedge funds have, on average, less debt on their books than banks. But there is little stopping them from loading up on leverage if they want to juice-up returns. And, as Long Term Capital Management showed in 1998, one big failure is enough to shake the entire system.


But even if they do not cause a crisis, hedge funds can exacerbate a turmoil – just ask Morgan Stanley and Goldman, whose hedge fund clients withdrew billions of dollars in a few days in 2008. A rush to the exit by several leveraged funds trying to get out of the same trade could have devastating ripple effects.

The US rules acknowledge this problem by allowing the authorities to periodically add names to the “systemic list”. But expecting regulators to spot black sheep in a flock they do not shepherd is unrealistic. By the time the watchdogs realise a shadow bank is a threat, it could be too late to stop the contagion.

Cynical or not, Wall Street has reasons to be scared of its own shadow.


Francesco Guerrera is the FT’s Finance Editor


Copyright The Financial Times Limited 2011.