‘Shadow banking’ refers to unregulated financial markets in which firms and investors provide bank-like services of credit intermediation (i.e., extending credit) and maturity transformation through alternative means such as money market funds, complex securities markets, structured investment vehicles (SIVs) and special purpose entities (SPEs), hedge funds, private equity, and the overnight repo market (FSB, 2011a, 2011b; Gorton, 2010, 2012). Lenders and borrowers transact bank-like business but outside the regulated commercial banking space, with no prudential oversight and no capital to strengthen the system. The size of shadow banking markets is massive. In 2011, it was estimated at US$67 trillion, or equivalent to 111 percent of the G20’s GDP (FSB, 2012d, p. 3).
The crisis demonstrated that these markets and the actors within them could be potentially dangerous if the combination of a firm’s actions, size, leverage, and interconnection to others (especially commercial banks) in the financial system resulted in contagion and creating systemic risks to the wider economy (Maclean and Nocera, 2009).
At the Seoul Summit in 2010, G20 leaders tasked the FSB with building a framework to address the potential systemic risks posed by the shadow banking sector. They tasked the FSB Task Force on Shadow Banking (Chaired by Adair Turner from 2010 to 2012) to develop recommendations. The FSB-BCBS community hoped to contain the risks of the shadow banking sector indirectly by discouraging and/or restraining commercial banks from entering shadow sector activities via mechanisms like onerous capital charges for risky assets (in Basel III), and avoid aggressively regulating the entire shadow sector. There was also a more prosaic reason for a delay. Key FSB policy makers within this small community have only so much technical and intellectual bandwidth. It is simply not possible for the limited number of leading FSB figures to target all regulatory failings and all gaps simultaneously. So they dealt with the most pressing issues in 2008 and 2009 (bank capital and regulation), and in late 2010 focused on shadow banking.
The task force report in October 2011 concluded central banks and supervisors should cast the net wide in terms of what non-bank activities they were monitoring, but also
simultaneously to narrow the focus (FSB, 2011d) to the systemic actors and activities dealing with maturity transformation, liquidity transformation, risk transfer, and leverage, which posed most serious risks going forwards. This FSB analytical framework implies in the future
not greater regulation. Should firms and markets grow in size and interconnectedness to an extent they pose a risk to the wider economy, then regulation could still follow. But if supervisors can see what is going on within markets, and inside large systemically important firms, they can (it is hoped) make an informed judgment about future systemic risk and the need for reporting or possibly action. The Task Force recommended a series of high-level principles for monitoring the shadow banking system, which set out matters of scope, process, data gathering, monitoring innovations and mutations, and regulatory arbitrage issues to be considered by national regulators.
In this instance, a principles approach was seen as more appropriate for a number of reasons. First, what poses risk in one country within the shadow banking sector may be entirely different in another. In the U.S., an unregulated non-bank housing sector was the source of contagion. In another G20 country, the conditions may be entirely different and the risks may emerge in other financial industries.
Second, what is of concern today may diverge from what is most dangerous tomorrow—the next black swan of Taleb’s imagined night time terrors (Taleb, 2010). The FSB is, therefore, seeking to aid domestic supervisors with frameworks for the analysis and understanding and measuring future risks. These are tools, not rules.
Third, since prohibition of shadow banking activity is off the table as a regulatory approach within the FSB, the only way to aid central bankers in getting their arms around these markets is via a general scoping process aiding national deliberations and determinations of who and what may pose systemic risk in a market at one point in time.
Fourth, it is national supervisors who must identify and regulate the actual shadow banking firms and look into their risk-taking activities. The FSB has neither the manpower nor the necessary crystal ball to do so. So a framework for a common understanding of what factors to consider in making the decisions is the default. The FSB does not want to create moral hazard by implying responsibility for all actors in yet more and more financial markets. So they seek to be vigilant and yet specific and focused in their actions, as Turner’s Task Force urged them to be.
Placement in the policy matrix: The shadow banking sector had never been regulated
quadrant signifying ‘very weak’ standards. Since the task forces’ recommendations are not supposed to be applied but are instead to provide analytical guidance to policy makers, they cannot be said to move the policy forward to a great degree, and movement across the landscape is therefore not seen at this time, even though analytical frameworks and tools are, of course, needed and potentially valuable.
Very Weak Weak Strong Extremely Strong
Strongly Globally Harmonised Strongly Nationally Based Weakly Globally Harmonised Regionally Harmonised Shadow Banking (Advisory Only) X‐Axis ‐ Represents strength of regulatory response