James Saft, Reuters Columnist
Shadow banking, financial intermediation done in such a way as to elude regulations imposed on traditional banks, has actually grown since the onset of the financial crisis in 2007 and stands at US$67trn worldwide, according to a new accounting from the Financial Stability Board.
That’s hard to square with assumptions that investors, stung by losses caused by a run on assets in shadow banking during the crisis, have learned their lesson, much less that economic growth is being crimped in part by falling credit and money creation by shadow lenders.
One likely implication is that new credit and debt created by the shadow banking system is an example of the law of diminishing returns, spurring less growth per dollar than previously. Another is that when regulation begins in earnest worldwide, taking credit creation lower with it, growth will face a headwind many thought it was already handling.
The FSB, charged by the Group of 20 leading economies with orchestrating the regulatory approach to the crisis, is calling for stronger oversight and regulation of shadow banking, which in effect is an alternative universe of hedge funds, insurers and other entities which do banking in ways intended to avoid some regulatory costs.
Shadow banking grew at a 19 percent annual clip in the five years to 2007, fuelling the bubble by creating credit and increasing leverage across the economy. After taking a slight dip in the panic period, shadow banking resumed its upward march, growing at about 4 percent yearly since.
This is serious money: that US$67trn is 111% of annual economic production of the countries the FSB is monitoring.
To be sure, there is huge regional variation, and this is a big part of the story. Shadow banking has actually diminished in importance in the U.S., accounting now for a smaller share of all assets than in 2005. In contrast, it has grown in Germany, albeit from a lower base, and perhaps driven by the capital crisis among banks there and elsewhere in the euro zone.
The case of the UK is particularly troubling; while shadow banking was 9% of global totals in 2005, it is now 13%, almost certainly because key regulations and enforcement are tougher elsewhere.
Quest for safety
While some point to figures showing an overall deleveraging in the U.S since the crisis, it is possible that these numbers are flattered by a movement offshore of shadow banking. Certainly the abysmal growth in the UK in recent years implies that its economy is not the end beneficiary of much of the financing now being created there in the shadow system.
This raises interesting questions. What will happen to the UK, which already has a huge financial system for its economy, when the next crisis strikes? And what will happen to U.S. growth if in fact tough global shadow banking regulation actually comes into effect?
The latter impact will not be pretty, which is one reason to bet that, when push comes to shove, the impact of regulation will be blunted. And indeed the FSB report went some way in stressing that the credit creation coming out of the shadow banking system has its uses.
If the usefulness of new debt in spurring economic growth is actually diminishing, much of this debate may prove less important than we think. While you might be able to argue that there are fewer excesses in the global financial system than in 2006, it is hard to argue that the rewards of leverage are as high, much less that we are less dependent on debt for the meagre growth we are generating.
Gary Gorton, an economist at Yale, has argued that the growth of the shadow banking system has been in part driven by a demand for safe assets. Institutions want a safe place to put money and modest interest in return, but the supply and demand dynamics in the safest stuff out there – government debt – created an opening for shadow banks, which create the next best thing.
It may be that what we are seeing in the shadow banking system is simply that; a heightened demand for safe places to keep money, money which is moving less swiftly around the economy even as more debt is created.
As long as that lasts, and there is no sign of it stopping, growth too will be slow, and recessions easier to fall into.
(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com)