A Socio-Legal Analysis of Shadow Banking in the US & Europe
April 16, 2023
Shadow banking systems have only been around for a few years, but they have swiftly become the focus of attention. If the contours of a financial crisis appear on the horizons of stock markets, their designation may seem extremely foreboding. But why do shadow banking systems’ institutions have such a bad reputation? This means that although the shadow banking business is critical to the economy’s financing, its activity outside of standard banking laws raises worries about the dangers of the financial system. The author of this paper aims to address these difficulties while also providing an introduction to the shadow banking system and then describing the shadow banking systems of key international economies.
For more than a decade, shadow banking has been an important and highly debated topic in financial literature. Its macroeconomic consequences and institutional importance have piqued the interest of academics and business experts alike. Scholars, policymakers, and business executives all have shadow banking on their minds after the Global Financial Crisis of 2007–2008 (GFC). Many academics believe that the GFC began in the shadow banking sector, and that shadow banks were the primary cause of the catastrophe.The vulnerability of the shadow banking industry was in its use of short-term borrowings to fund hazardous, long-term, and illiquid assets, culminating in a credit market breakdown that compelled shadow banks to liquidate long-term holdings at fire-sale prices.
Some studies, however, claim that shadow banks were not fully to blame for the subprime mortgage crisis during the Great Recession. Furthermore, if a liquidity crisis caused by traditional banks occurs in the future, shadow banks may be important to minimizing damages. There’s also evidence that the shadow banking system offers commercial banks additional loanable money while also taking on some of the risks of loan origination. As the future of shadow banking and new financial innovations inside it hangs in the balance, some advocate taming the wild horse, while others advocate letting it run free. To that end, Wallison contended that shadow banking’s diversified financial innovation may be regulated out of existence, leaving us with boring banking.
On the other side, some argue that if shadow banking is left unregulated or regulated differently from traditional banking, the next global financial disaster will occur. As a result, this article aims to sketch out these arguments by providing a socio-legal analysis of shadow banking in major world economies. This study is broken into two sections: an introduction to shadow banking and a look at the shadow banking systems of major world countries. This article will look at definitions of shadow banking, the evolution of shadow banking, and shadow banking characteristics as part of the overall subject of shadow banking. Meanwhile, this study will examine the shadow banking systems of the United States and Europe when analyzing the shadow banking systems of major world economies.
According to the FSB’s broad definition, “Credit intermediation involves entities and activities outside the traditional banking system.” According to the FSB’s narrow definition of shadow banking, “it involves developments that increase systemic risk (in particular maturity/liquidity transformation, imperfect credit risk transfer, and/or leverage), and/or indications of regulatory arbitrage that is undermining the benefits of financial regulation,” The scope of this broad definition has been restricted to focus on certain entities and actions.
Shadow banking refers to bank-like operations (mostly lending) that occur outside of the formal banking sector. It’s currently known as non-bank financial intermediation or market-based finance on a global scale. The shadow banking system played a key part in the development of housing lending prior to the 2008 financial crisis, but it has since increased in scale and largely avoided regulatory regulation. The shadow banking system is a web of specialized financial firms that use a variety of securitization and secured funding strategies to move funds from savers to investors.
Although shadow banks perform credit and maturity transformations in the same way that traditional banks do, they do so without access to the Federal Reserve’s discount window or the Federal Deposit Protection Corporation’s direct and explicit public sources of liquidity and tail risk insurance. As a result, shadow banks are intrinsically vulnerable, similar to the commercial banking system prior to the establishment of the public safety net. Bond funds, money market funds, finance businesses, special purpose entities, investment banks such as Goldman Sachs and Morgan Stanley, mortgage lenders, and insurance/reinsurance companies are examples of shadow banking entities.
Evolution of Shadow Banking
The shadow banking system, according to McCulley, began in the 1970s with the introduction of Money Market Mutual Funds (MMMFs). In the early 1990s, some authors reported the “emergence of an unregulated parallel banking system” (presumably the shadow banking system).The rise of the shadow banking system, according to Gorton and Metrick, was fueled by regulatory and legal changes that benefited three types of institutions: “MMMFs to capture retail deposits from traditional banks, securitization to move traditional banks’ assets off their balance sheets, and repurchase agreements (repos) that facilitated the use of securitized bonds as money.”Others believe the shadow banking system arose to fill a void in the financial system.
The shadow banking system, on the other hand, varies from standard bond markets in six ways. In addition to providing credit, each of the six categories of shadow banking instruments has several, if not all, of the following six additional features:
Intermediation: These instruments, unlike bonds, act as a middleman between borrowers and investors.
Pooling: Intermediation allows multiple loans or financial assets’ cash flows and financial risks to be pooled together.
Structuring: These instruments’ complex contractual provisions allow for “structuring.” Structuring is the process of unbundling, rearranging, and reweaving the cash flows and risks of underlying loans or assets into new instruments sold to investors. As a result, these products can provide investors with particular risk and reward combinations that are suited to their needs.
Maturity transformation: Another feature enabled by intermediation and structuring is “maturity transformation.” This feature illustrates how some shadow instruments effectively convert longer-term assets, such as loans, into shorter-term instruments that investors can buy.
“Money” creation: When pooling, structuring, and maturity transformation are combined, some shadow banking instruments can theoretically provide investors with low-risk and high liquidity. These instruments exhibit one or more of the three canonical economic characteristics of “money”: serving as a medium of exchange, a unit of account, and a store of value, to varying degrees.
Opacity: Finally, the presence of one or more intermediaries between borrowers and investors produces an opacity that makes it difficult for investors to determine how financial risk, particularly credit risk, flows from underlying assets to the instruments they have acquired (the “opacity” feat).
The Shadow Banking Systems in Developed Economies
The United States of America
The shadow banking system arose in the United States as a result of the combined effects of three major elements. On the one hand, the government contributed to this by regulating commercial banking activity through economic policies. On the other hand, the strengthening of deregulation processes had a big role in the creation of the shadow banking system in the United States, as a result of the impacts of which a large financial innovation process has begun. Separating commercial and investment banking activity was continuously on the agenda in the United States during the twentieth century.
Following the 1929-33 financial crisis, the first stage was to completely separate commercial and investment banks through legislation. Commercial banks were required to sell their investment banking units under the 1933 Universal Banking Act, also known as the Glass-Steagall Act. The statute stated that federal banks, with the exception of government securities, are prohibited from engaging in commercial activities involving securities, just as state banks are prohibited from doing so. However, if a commercial bank decides to engage in securities trading, it loses its right to take deposits. The act also included another key rule, the previously stated Regulation Q.
According to this regulation, commercial banks are not required to pay interest after the current account balance – i.e. the demandable account – of retail and corporate clients. Aside from that, an interest rate ceiling was established within the framework of the regulation, which regulated the maximum amount of deposit loans that could be given during commercial banking activities in relation to deposits and other types of bank deposit-like savings. The goal was to limit excessive profit competition between banks while still keeping credit interest rates reasonable. By driving a rise in credit demand, low credit interest rates can have a major positive impact on the growth of a particular economic system.
If, on the other hand, interest competition could have been started at the level of deposit interests and in a low-interest-rate environment, the impacts of this procedure would have boosted credit interests in a short amount of time. Senator Glass, for whom the Act is named, suggested an amendment to the Act two years after it was enacted. His endeavor, however, was a failure, and the rigid separation of commercial and investment banking activity would not begin to ease until 1963. Commercial banks were authorized to manage commingled accounts of private clients from that point on, in which they could keep track of their purchased securities or bonds, and the clients could also trade with municipal bonds.
Since the 1970s, neoliberal economic policy has acquired increasing traction among the most powerful economic entities in the United States. The idea that underpins deregulation originally emerged during Ronald W. Reagan’s presidency. The neoliberal method was based on Adam Smith’s metaphor, according to which the market economy is flawlessly governed by an invisible hand, allowing it to self-regulate completely. This was also the basis of the neoliberal economic wave’s argument, which emphasized the necessity for less regulations. This culminated in a period of significant deregulatory activity in US law during the next 20-25 years.
Until the development of the 2007-2009 financial crisis, the process continued unabated. Although George H. Bush, Bill Clinton, and George W. Bush all played a role, the major figure was Alan Greenspan, the former chairman of the Federal Reserve. The persistent signs of capital market crises since 2002, on the other hand, cast a different perspective on the phenomena of deregulation and expose it to significant scrutiny. In contrast to China, the United States attempted to limit the leeway for maneuvering the shadow banking industry following the regulatory waves of 2008-2010. These restrictions, however, cannot be considered substantial, given that prior deregulatory measures, which lasted more than fifty years, had removed various guarantee limits relating to the functioning of the banking system.
The secondary mortgage market crisis in the United States from 2007 to 2009 exposed three major regulatory flaws. One of these was the rethinking of regulations governing hedge funds, which are financial institutions that are part of the shadow banking system. In their case, ensuring that operations are transparent became a primary goal for investor protection.
The minimization of the potential systemic risk of hedge funds by putting most of their operations under the supervision of regulatory authorities was a key point of action. The goal is for the supervisory organs to have all of the essential information on risks that affect the whole financial system, and to have it at the right moment. The rationale behind this is that preventing a crisis involves fewer economic and social costs because before problems become crises, they can be avoided by involving, at the sectoral level, and at the expense of the actors in the particular area.
The second significant regulatory area, which was also a part of the shadow banking system, was the submission of OTC derivatives transactions to the Commodities Trading Futures Commission – CFTC. The CFTC gained a lot of expertise in detecting and dealing with market abnormalities during its supervision of exchange-traded derivatives. The stock exchange trading and maintenance rules allow for speedy increases in equity guarantee items while raising trade risks and market volatility. This option does not eliminate the possibility of individual market players failing, but it does lessen the probability of losses spreading and, as a result, systemic risk.
The regulation of excessively bloated financial institutions is the third regulatory area that is closely related to the shadow banking system. In his speech on March 8, 2013, Richard W. Fisher, president of the Federal Reserve Bank of Dallas, drew attention to this regulatory flaw once more. He made the surprising advice that financial institutions that grew too huge be parcelled up, and he also put it open to considering whether these financial firms should be stripped of the FDIC’s deposit protection system and the FED’s temporary liquidity support. Financial institutions would have been compelled to inform their clients about the lack of these protective components based on the advice.
The speech of the acting chief prosecutor, Eric Holder, before the United States Senate Committee on the Judiciary, was before this one, which could be considered an outburst rather than a professionally grounded proposal. He really asserted in his address that the leaders of the world’s largest financial organizations enjoy de facto protection from prosecution investigation in the United States since the number of such inquiries has dropped to a level last seen twenty years ago.
However, on July 20, 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) went into effect, with the express goal of preventing taxpayer-funded interventions. As a result, it is apparent that the legislator failed to achieve his or her goals. The big financial institutions were still able to abuse their influence, resulting in moral hazard in the financial system as a whole. They proceeded to take on greater risk as part of their risk management and business strategies, safe in the knowledge that the FED – and, if necessary, other central banks – would be eager to assist them due to their size in the financial system. There are just four places in which this mindset can be changed.
The most radical solution is parceling out the extremely large banks, as proposed by the president of the Federal Reserve Bank of Texas; the other is risk reduction through stricter regulations; the third is the imposition of a special tax to cover the damage and costs; and finally, supervisory monitoring activities must be tightened and expanded.
Because the value of their assets can reach 50% of the country’s GDP, the failure of large financial institutions would have a significant impact on the whole financial system. The failure of huge financial institutions can be especially catastrophic if certain national economies grow leveraged to the point of reaching or exceeding annual GDP because a country’s debt over 100% of GDP can only be lowered to 50% of GDP extremely slowly. As a result, a separate deposit guarantee scheme or the candidate tax would be an appropriate option for these financial institutions.
In terms of risk characteristics, the Dodd–Frank Act was able to drastically reduce leverage, bringing it down to half of its prior levels. The legislator’s restriction on proprietary trading80 within the area of commercial banking activities was also appreciated, as proprietary trading losses placed a direct burden on the bank, eating a portion of the equity supplying deposit and non-performing loan guarantees. The bank, on the other hand, is always entitled to a dividend after transactions carried out on behalf of clients, and the danger of losses is a drain on clients’ savings.
The European Union
The European shadow banking system, like the European Union, has a variety of personalities. The share of the shadow banking system in the financial system is lower than in the United States. However, the average amount of 30% varies significantly. In the Netherlands, for example, this percentage is 45 percent, while in the United Kingdom, it is 20 percent.
The shadow banking system in the European Union developed in a close relationship with the traditional banking system because the universal banking system provided traditional banks with new opportunities to collect deposits through credit issuance, securitization, money market funds, and securities. The huge exposure of European banks during the financial crisis of 2007-2009 brought to light a previously unknown feature of the European banking system. The great European banks have amassed inexpensive resources65 in the United States through their money market funds, a significant portion of which was invested in securitized mortgage-market assets by their New York and London offices in order to achieve higher profits.
As a result, money market funds had to deal with liquidity issues while also suffering severe capital losses on securities covered by toxic mortgage market assets. While the degree of securitization in the United States radically decreased in one year, from 2006 to 2008 (to USD 400 billion, or one-fifth of the previous year’s result), the number of newly issued securities portfolios covering mortgages in Europe grew continuously from 2006 to 2010, albeit from a lower base rate.
The United Kingdom, the Netherlands, Spain, and Italy were at the forefront of this process. The growth of the real estate market in these countries was aided in part by the securitization process, whose effects – which were felt when the mortgage market collapsed – are still felt by the banking systems involved. In the case of Europe, it is obvious that the growth of the shadow banking system was driven by a regulatory arbitrage that employed securitization to avoid the formation of reserves, resulting in a more attractive yield and a greater return for traditional banking system stockholders.
This is in stark contrast to the rise of the shadow banking sector as a result of deposit and credit interest rate regulation. This is in stark contrast to the growth of the shadow banking system as a result of deposit and credit interest rate regulation, which has been a feature of the United States and developing economies, particularly China, since the early 2000s.
Following the global financial crisis of 2007-2009, the G-20 launched a process in which the Financial Stability Board (FSB), the body representing the financial authorities and central banks of the most developed countries, was asked to conduct an all-encompassing examination of the shadow banking system and make recommendations on necessary regulatory measures at the 2010 Seoul conference. In a report published on October 27, 2011, this board provided suggestions for the strengthening of rules relating to the shadow banking system. The thirty largest financial institutions in the world will have to comply with new legislation as of 1 January 2019 as a result of the FSB’s recommendation, which was agreed in November 2015.
According to the recommendation, the number of assets capable of bail-in in proportion to risk-weighted assets should be increased to 16 percent until the beginning of 2019, and subsequently to 18 percent after a year. The involvement of roughly USD 1,2 billion in capital usually takes the form of bond issuance, after which non-payment of interest does not count as a bankruptcy occurrence. As a result of this the inner capital consolidation of financial institutions will occur, since during the conversion of bonds the raising of capital takes place automatically, without the involvement of external sources.
By this, they expect in the United States and the European Union that no state intervention will be needed in the future. While governmental interventions – especially central bank interventions – were common before the 2007-2009 financial crisis, new regulatory measures following the crisis would lay the burden of loss absorption on shareholders and bondholders. Legislators hope to reduce the role of states and central banks around the world by creating a multi-level and sensible safety net, boosting equity requirements, and engaging in limited-risk activities.
However, this procedure could have negative consequences, because bond funds would become a systemic risk, as the prominent elements of the shadow banking system, right next to money market funds. In its Directive 2009/111/EC (III. Directive on Capital Requirements), the European Union established direct regulations governing shadow banking activities through the regulation of banks and insurance firms. The EU implemented precautionary measures to prevent financial institutions (banks and insurance firms) from circumventing the existing capital requirement legislation during issuance. As a result of the directive, issuing securities is limited to the prescribed equity ratio, and financial institutions must furnish additional asset elements as a guarantee. At the same time, the directive broadened the scope of current prudential standards to include shadow banking firms.
Finally, the Alternative Investment Fund Managers Directive is an essential piece of European legislation (AIFM Directive). According to the rule, trust businesses must constantly monitor liquidity risks while also operating a liquidity management system. The AIFM Directive established new objectives88 for the alternative investment fund sector. The first and most important is the management of macroprudential risks. The macroprudential strategy aims to reduce systemic risk in a specific sub-sector of the financial system by establishing regulations that obligate the sub-operators sector to avoid a possible cross-sector spread.
As a result, the new regulation’s goal is to prevent the occurrence of macro-level risk by coordinated data collecting. The acquired data is then processed by prudential authorities in the context of cross-border cooperation. Macroprudential risks that arise at the level of service providers and their services, on the other hand, must be managed. Because there were no suitable regulatory requirements for alternative investment fund risk management techniques and procedural norms, the management of macroprudential risks was critical in the European Union.
However, flaws in risk management practices constitute a threat to investors and contracting partners, as well as the entire market. A uniform regulatory framework can reduce the risk to investors and contractual partners in market sectors where the risk is higher than the average market risk, while a cross-border framework can reduce the likelihood of exploiting differences in supervisory agencies (regulatory arbitrage).
After analyzing the concepts of shadow banking, its evolution, and its characteristics, as well as evaluating the shadow banking systems of major international economies, with a focus on the United States and Europe, it is apparent that there are differing perspectives on the socio-legal issues surrounding shadow banking. Some people argue that the shadow banking industry should be regulated since it has a significant impact on national economies and, if not properly handled, can lead to systemic danger and another financial disaster. Some argue, on the other hand, that the shadow banking sector should not be regulated because it is self-regulatory. Shadow banking arose as a result of traditional banks’ stringent regulation and the need to engage in activities that were not permitted. As a result, shadow banking regulation will prevent the shadow banking system from functioning fully.
Cornel Ban and Daniela Gabor, Review of International Political Economy, 2016, vol. 23, issue 6, 901-914
Christopher L. Culp, Andrea M. P. Neves, Shadow Banking, Risk Transfer, and Financial Stability, Journal of Applied Corporate Finance, Vol. 29, Issue 4, pp. 45-64, 2017
Peter J. Wallison, Government housing policy and the financial crisis, The Cato Journal 30(2):397-406 DOI: 1142/9789814651257_0004