Shadow Banks Pose Major Threat to Financial Stability

Shadow Banks Pose Major Threat to Financial Stability

The recent Dodd-Frank financial reform legislation takes important steps toward stabilizing the financial sector, but it may have created a false sense of security. There is a large and worrisome vulnerability to bank runs that the legislation did not address, and we are not as safe as we could be from another financial panic.

The problem is not the traditional type of bank runs your grandparents might have told you about. Rather, modern bank runs occur in the shadow banking system. The shadow banking system includes major investment banks, money market mutual funds such as Fidelity, Vanguard and Schwab, and securities dealers such as those that can be found at JP Morgan, Bank of America and Citigroup.

These banks, which control trillions of dollars in assets – money market mutual funds alone were worth $3.8 trillion in 2008 — serve as intermediaries between borrowers and lenders, and hence function like traditional banks, but they are not subject to the regulations that exist in the traditional sector to protect against problems such as bank runs.

A bank run within the shadow banking sector was at the heart of the 2008 financial meltdown that led to one of the worst recessions in U.S. history, and it’s a problem that could happen again if we don’t take steps to prevent it. Shadow banks manage 401(k)s, insurance policies, pension funds and other consumer investments, and problems in this sector can devastate retirement, education and other investments that consumers rely upon for security.

Why Bank Runs are a Problem in the Shadow Banking Sector
Bank runs occur when there are real or imagined worries about the ability of a bank to repay its depositors. In the traditional banking sector, deposit insurance solves the bank run problem, but it can create other problems in the process. In particular, deposit insurance gives banks protection on the downside, and hence gives them an incentive to take on too much risk. Because of this, traditional banks are subject to strict regulation to limit the amount of risk they can carry.

Shadow banks are also vulnerable to bank runs and other problems. The cataclysmic problems at Bear Stearns and Lehman Brothers are prime examples of this, but they weren’t subjected to the same regulation as traditional banks. In fact, these types of banks have hardly been regulated at all. Why is this?

Industry leaders and lobbyists have argued that more regulation would make them less competitive, and prevent them from delivering returns on investments. However, the economic argument that market discipline will force shadow banks to self-regulate has had more influence on policy. The idea is that monitoring by depositors worried about losses will prevent the accumulation of excessive risk. And if problems occur anyway, the monitoring will ensure that the banks hold enough high quality financial assets in reserve to prevent bank runs, and in any case the problems will be confined to the few banks causing the trouble.

But there are three problems with this argument. First, large shadow banks have an implicit government guarantee due to their too-big-to-fail status, and this gives them the incentive to assume too much risk despite the monitoring.

Second, an informational market failure created by lack of transparency and highly complicated financial assets makes it impossible for investors to monitor the quality of the loans, investments, and the financial assets held as reserves. Prior to the financial meltdown, investors relied upon the ratings agencies to do the monitoring for them, but that turned out to be a mistake. Many of the assets held in the shadow banking system turned out to be much riskier than their rating suggested, and when that fact was revealed, a bank run followed.

Third, banks were far more interconnected than regulators realized. They held too few high quality reserves to prevent bank runs, and the problems were not confined to the financial sector.

Making the Shadow Banking System Safer
As Gorton and Metrick document, the shadow banking system has grown substantially since 1980. For example, money market mutual funds have grown from around $4 billion in the late 1970s to $3.8 trillion in 2008, and the percentage of securitized bank loans — an integral part of the shadow banking system — has grown from 0 percent in 1980 to over 60 percent today. This growth paused briefly during the latest recession, but has now picked up again. Thus, we are still vulnerable to a bank run in the shadow banking sector and the catastrophic consequences for the larger economy that come with it.

So how do we stop this from happening again? In the traditional banking system, deposits are guaranteed by the federal government up to $250,000 per depositor per bank, and that is enough to prevent bank runs on small deposits. In the shadow banking system, deposits are also insured, but instead of a government guarantee, the insurance is in the form of financial assets held in reserve as collateral against the deposits. Presently, the allowable collateral generally holds its value when a single institution experiences trouble. The problem occurs when systemic problems arise in the banking sector, and the value of financial assets generally — including the collateral — begins to deteriorate and create doubts about the safety of deposits. Once those doubts arise, there is a rush to withdraw deposits, and a widespread and destructive bank run is the outcome.

One approach to solving this problem is to provide deposit insurance in the shadow banking system that mimics the insurance available to traditional banks. But regulators are reluctant to expand the explicit government commitments to the financial system to this degree. A more likely approach is to restrict the allowable collateral to ultra safe assets such as Treasuries, and there is good news along these lines. The Federal Reserve Bank of New York is working on a proposal to make shadow banking safer by tightening up collateral requirements.

However, it is not yet clear what types of collateral that shadow banks will be allowed to hold against deposits, and the potential bad news is that the inevitable howls and protests from the financial industry about how the economy will be harmed if their activities are restricted may fall on sympathetic ears. When combined with the large amount of political influence the shadow banks have, the result may be an outcome that is not as restrictive as needed to keep the system safe.

So far, all of this has gone largely unnoticed by the public, and that gives shadow banks the opportunity to make their case unopposed. Thus, it’s important for the public to be aware that these changes are happening, and to make sure the public interest is fully reflected in the outcome. As it stands, there’s no guarantee that will happen.