Markets Insight
November 22, 2011 6:05 pm
Risks emerging from shadows look worryingly like 2008
By John Plender
The risk managers who contribute to the Bank of England’s regular systemic risk survey are twitchy. The probability of a future high impact event in the UK financial system has, they believe, increased sharply in the second half of 2011 to stand at the highest level since the survey began in July 2008.
No doubt in common with their counterparts in continental Europe and North America, these market practitioners see sovereign risk and the risk of an economic downturn as the most worrying threats to the financial system. The one change in the top five risks identified in the survey since the first half of the year is that the risk of financial institution failure has put in an appearance.
All this feels uncomfortably like 2008 when fear triumphed mightily over greed. The implicit risk in all these perceived risks is that they become self-fulfilling prophesies.
Nobody will spend and invest if they think we are back in a financial hurricane. Lower economic growth could then make the sovereign debt crisis even harder to resolve. The sense of déjà vu is reinforced by the insouciance of bankers who set absurdly ambitious targets for return on equity and continue to pay out big bonuses. Another less noticed, but worrying, throw back to pre-crisis days concerns the structure of the financial system – namely that the shadow banking system is in great shape.
A recent report by the Financial Stability Board, the Basel-based global watchdog, points out that the assets of non-bank credit intermediaries in Australia, Canada, Japan, Korea, the UK, the US and the eurozone grew from $27,000bn in 2002 to an astonishing $60,000bn in 2007. This opaque sector, which plays host to many of the banks’ more toxic securitised activities, then took a knock, declining to $56,000bn in 2008. Yet by 2010 it had bounced back to $60,000bn.
The FSB reckons that the shadow banking system constitutes 25-30 per cent of the total financial system. Predictably enough, the US has the largest shadow banking sector, with assets of $24,000bn in 2010, although its share of the total assets in 11 leading countries studied by the FSB has declined to 46 per cent from 54 per cent in 2005. Equally predictably, the UK comes second with a 13 per cent share of the total. And this understates the scale of the systemic issue because some non-banks that are not credit intermediaries engage in proprietary trading that could damage counterparties in the conventional banking system.
Much of this activity outside the regulatory perimeter involves credit intermediation chains in which conventional banks play a part. The shadow banks also run risks such as maturity transformation, liquidity transformation, credit risk transfer and leverage. This poses a huge challenge for regulators because there are limitations in the flow of funds data that make it hard to identify these risks. And there must be every possibility that in seeking to meet their over-ambitious return on equity targets bankers will push more business into the shadows to escape the tougher capital requirements that result from re-regulation.
The irony here is that the growth of the shadow banking system was powered in the first place by the Basel capital adequacy regime, which encouraged banks to economise on capital by pushing assets off the balance sheet into the shadows. The latest version of the rules – Basel III – will, if anything, increase the incentive to engage in regulatory arbitrage because it has raised capital requirements.
The FSB’s efforts to map the shadow banking system and monitor non-bank credit intermediation are welcome, as are its efforts to improve the quality of the data.
Yet the most intractable problems in bank regulation are those that involve cross-border risks and boundary problems. That, incidentally, raises questions, too, about the efficacy of the ring fencing approach recommended by Britain’s Independent Commission on Banking, for if a financial system is divided between low risk and high risk sectors, the onset of risk aversion could arguably make a crisis worse. This is because panic usually starts in the high-risk sector as it did in 2007 with structured investment vehicles and conduits. Creditors withdraw money and put it into the lower risk part of the system, which increases funding pressure at the high-risk end. That in turn leads to forced sales and downward price spirals.
As Charles Goodhart of the London School of Economics has argued, the existence of a boundary almost guarantees a cycle of flows into the less regulated sector during cyclical expansions and disruptive reversals during a crisis.
The law of unintended consequences applies as much to re-regulation as to liberalisation – especially where opacity rules, as in the shadow banking system.
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The writer is an FT columnist
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