In earlier articles we discuss several proposals for monetary reform such as full reserve banking, and gold standard systems.
Most of these proposals focus on abolishing the fractional reserve lending system used by traditional banks; however, this is not the only cause of financial instability in Canada and elsewhere.
In addition to the traditional banking system, there is also another banking system referred to as the Shadow Banking System.
This article analyzes the shadow banking system in greater detail.
Shadow Banking System
The shadow banking system consists of various financial institutions such as money market funds, private equity funds, hedge funds, securitizations, and investment banks.
Shadow banks often take on risks that traditional banks would either be unwilling to, or would be restricted from taking on as a result of tighter regulations.
The lax in regulations within the shadow banking system has meant that these institutions can provide credit to people or entities that would not otherwise receive such access.
Although shadow banks provide liquidity in a similar fashion to that of traditional banks, the method of offering loans through credit is fundamentally different.
One difference between the two systems is that with traditional banks, it is depositors that place their money into the bank. With shadow banks, it is investors that place their money into the bank.
The second big difference between them is the amount of regulatory oversight.
Traditional banks are regulated to protect depositors in the case of a bankruptcy. If a traditional bank were to experience bankruptcy, then depositors would receive their money back through depositors insurance (i.e. FDIC, CDIC)
This deposit insurance helps ensure bank runs are less likely because it provides a safety net for depositors, thereby guaranteeing against such an incident.
However, under a shadow banking system, there is no investment insurance provided by the government, thus these banks do not offer the same level of protection as traditional banks.
Another difference between the two systems is that the shadow banks often participate in areas that lack transparency and regulations such as dark pools.
Dark pools are exchanges where shares are bought and sold in a private market. Unlike public stock markets such as the New York Stock Exchange (NYSE), dark pools are not made available to the public.
All transactions carried out inside of a dark pool are kept hidden. Both the buyer and the seller are anonymous and do not interact with each other. Instead, they interact with an electronic computer system that facilitates all the transactions.
Dark pools represent a disadvantage for individual investors, since they are mainly used by large institutional investors (i.e. pension funds or private equity funds) and/or wealthy individuals (i.e. Warren Buffett).
There are two main concerns involving dark pools;
The first concern is that the dark pools are reducing trading activity and extracting liquidity from the public exchanges.
The second concern is that as the dark pools become more numerous, much more trading activity is kept hidden from public scrutiny.
If a large financial institution were to trade on the public market, this would invoke a reaction from individual investors since they may be affected by the trade. However, if the trading is done in private, individual investors are unaware of trades that may affect their investments.
Dark pools create a lack of transparency which disempowers the public’s ability to respond to changes in market trading activity.
Dark pools are used by shadow banking institutions in various parts of the world including the U.S. and Canada.
One of the most active dark pools coined ‘Sigma X’ is operated by Goldman Sachs in the U.S.
Compared to the U.S., Canada has a more sound level of transparency surrounding market trading volume. This is evident in the recent failure of Goldman Sachs latest dark pool operation titled ‘Sigma X Canada’.
As of May 2012, Goldman Sachs shut down its dark pool, since it did not gain enough trading activity to generate profits. Ironically, the dark pool only lasted less than a year when it was established in July of 2011.
Despite their loss, Goldman Sachs and other shadow banking institutions continue to pose a threat to Canadians since they operate outside the boundaries of ordinary banking regulations which Canada so desperately depends on.
Shadow Banking System of Canada
The size of the global shadow banking system is officially estimated to be between 25-30% of the global financial system.
In Canada’s case, the Shadow banking sector comprises of a large portion of its financial sector liabilities.
This is noted by scholars James Chapman, Stephane Lavoie, and Lawrence Schembri, in their paper titled: Emerging from the Shadows: Market-Based Financing in Canada.
The authors report presents the risks the shadow banking system poses to the Canadian economy. They outline the list of reforms that are necessary.
The authors formulate the following graph that compares the liabilities of the market-based financing sector (Shadow Banking Sector) with the traditional banking sector.
The graph illustrates that over time, the liabilities of the shadow banking system have begun to rival the liabilities of traditional banks.
This represents a systemic risk to the economy since half of the financial sector liabilities in Canada are unregulated within the confines of the shadow banking system.
The authors also present another graph of Canadian market based financing (MBF) depicting the activities of the Shadow banking sector, broken down into its individual components, before and after the financial crisis.
As illustrated, the most drastic finding is that there has been a large increase in the NHA (National Housing Act) mortgage backed securities, increasing 12% within just 3 years. Mortgage backed securities are a form of collateral that banks create when granting loans for home mortgages.
There has also been a slight increase in the repos (repurchase agreements) market as well. Repos are a form of short-term borrowing for dealers in government securities. The dealer sells the government securities to investors, usually on an overnight basis, and buys them back the following day.
A large call for stricter bank regulations following the 2008 crisis has created yet another unfortunate side-effect. It has pushed many financial institutions into shifting their financing and lending towards the shadow banking system since it lacks these regulations.
Certain individuals have spoken in favour of the shadow banking system, deeming it a ‘crucial’ function of the economy.
These shadow banking advocates assert that the advantages brought by the shadow banking sector include;
- Providing additional credit and liquidity support in the financial sector
- Undertaking risks that traditional banks are restricted from taking
- Increasing overall financial efficiency in the economy and financial innovation (CDS)
- Diversifying Credit sources available in the economy
- Providing competition to the traditional banking sector
These individuals claim that shadow bank financing spurs financial innovation since they are able to lend money into projects that traditional banks are restricted from engaging in.
Meanwhile, opponents of the shadow banking system argue that it causes a variety of systemic risks in the economy.
A major risk associated with the shadow banking system is when it converges with traditional banks.
Many of the world’s largest banks such as JP Morgan Chase and Citigroup have shadow banking business (investment bank business) and retail business (traditional bank business) all under the same roof.
If the shadow banking side of JP Morgan’s business were under threat from a lack of liquidity, then it could pose a significant risk for the retail banking side where depositor’s savings are kept.
Other risk issues present include a lack of transparency and oversight. Due to the lack of regulation, shadow banks can accumulate highly leveraged positions quite easily, as illustrated by JP Morgan Chase banks latest blunder.
In May 2012 JPMorgan had faced a $2 billion dollar derivatives trading loss. Estimates from other insiders point to a much higher trading loss. However this is only the tip of the iceberg.
In a report issued by the U.S. Office of the Comptroller of Currency, JP Morgan Chase has traded and gambled in over $70.1 trillion in derivatives.
The world GDP is over $63 trillion, which indicates that there is not enough money or productive capacity to cover losses in the derivative market. This is a clear indicator that many shadow banks are indeed ‘too big to fail’ and that they present a ‘moral hazard’ to the economy.
Several economists such as Post Keynesians Steve Keen and Paul McCulley have revealed the problems inherent in the shadow banking system.
Steve Keen argues that the shadow banking system finances Ponzi schemes and encourages rampant speculation in the market economy.
Keen outlines his arguments in a 2011 interview with financial journalist Max Keiser when he says,
The way you get an unreasonable living is not by financing genuine entrepreneurial activity but by financing Ponzi schemes, which is fundamentally what the shadow banking system has been doing for the last 30 years and inarguably since the end of the Second World War when the bankers were last put into their boxes.
McCulley argues that the shadow banking system poses a systemic risk to society due to the existence of money market mutual funds. Money market mutual funds are portfolios that hold a variety of different collateralized debt obligations. Collateralized debt obligations are securities that hold a variety of loans owed by individuals to the banks.
In a 2012 interview with financial economist Mark Jensen, McCulley reveals the dangers of money market mutual funds where he says,
The retail investor/bank customer wanted to have something just as good as an FDIC or FSLIC (at savings and loan) ensured deposit but wanted to have a market rate. Originally, there was the arbitrage around regulation Q, which is really what the shadow banking system is about [which] is arbitraging around some regulation…Money market mutual funds are driven by wholesale investors now who want to have an asset that is diversified against a portfolio of collateral held by a money market mutual fund because as we know FDIC insurance is only up to $250 thousand dollars. The Money market mutual fund industry is a huge industry and poses massive systemic risk to the system because it’s subject to runs, because it’s not just as good as an FDIC bank deposit. We found that out in spades in 2008.
In light of the 2008 financial crisis, McCulley calls for increased regulation in the shadow banking system.
Regulation and Reform
Several regulators have taken steps in implementing reform to the shadow banking system.
There are two ways to initiate this reform;
1. Monitor and regulate shadow banking activities
2. Improve the regulation of entities participating in shadow banking activities
1.) The Financial Stability Board (FSB) led by Governor of the Bank of Canada, Mark Carney, is working on regulating several specific areas of shadow banking, including securities lending and money market funds.
2.) Hedge Funds
The Canadian Securities Administration (CSA) have participated in the International Organization of Securities Commissions (IOSCO) in order to address the implications of the activities taken by shadow banking entities such as hedge funds.
The IOSCO focuses its efforts on collecting information about hedge funds in order to aid federal regulators in assessing the risks associated with them.
As of July 2009, the CSA has implemented mandatory registration for investment fund managers under National Instruments 31-103 registration requirements.
These registration requirements set out the guidelines through which investment fund managers must operate in Canada. One such guideline involves mandatory insurance on the assets they are managing.
2.) Credit Rating agencies
The aftermath of the crisis in 2008 revealed the collusion between credit rating agencies that were supposed to rate the securities held by investment banks and the investment banks themselves who were selling those securities to investors.
The crisis dragged on longer than necessary due to Credit default swaps (CDS) and collateralized debt obligation (CDO) against the securities that the rating agencies had rated. Credit default swaps (CDS) are a form of insurance that are used to protect institutions against the risk of defaults. Insurance companies offer the CDS insurance based on the ratings of the credit rating agencies.
Often, there was a conflict of interest present in which credit rating agencies were incentivized to give better credit ratings to these CDOs.
As of July 2012, the CSA has carefully assessed market conditions and has announced the adoption of National Instruments 21-101, which will impose requirements on credit rating agencies wishing to have their credit ratings eligible for use in securities legislation.
The rule establishes a regulatory framework for the oversight of credit rating organizations by requiring them to apply in order to become a “designated rating organization”. The credit rating agencies would also have to adhere to rules concerning conflicts of interest, governance, conduct, as well as a compliance function required in filings.
The shadow banking system in Canada has remained somewhat stable due to prudent regulations surrounding their financial institutions.
However, many more regulations are necessary in order to avoid the systemic risks the shadow banking system poses to the economy.
The next article concludes the series on monetary reform, and outlines the ideal solution for Canada to follow on its path for monetary reform.