If Mark Carney wonders when his honeymoon as new governor of the Bank of England might come to an end, he needs to look into the shadowy corners of the City of London. Alternatively, he might just put on his spare hat as chairman of the Financial Stability Board, the Swiss-based global banking regulator.
Last month, the FSB said it would forge ahead with plans to recommend that governments get a tighter grip on "shadow banking." These are non-bank financial entities that as part of their investment business act as credit intermediaries. The FSB is charged with shaping rules that reduce the systemic risk in global banking and avoid another financial catastrophe, such as in 2008. But the FSB has noticed a vast hinterland of small and large businesses that deal in credit by lending to big banks and others, using funds raised from private investors and pension funds.
These are money-market funds, hedge funds and special purpose vehicles set up by banks but operating at arms length in the repo market where banks and other institutions can borrow money short term by pledging financial assets, such as sovereign bonds. The scale of these "shadow banks" is enormous, their total assets worldwide are estimated to be $67-trillion and there is a hint of panic among regulators that these shadow lenders may be an accident waiting to happen.
Mr. Carney signalled in January that the FSB was putting its spotlight on the shadows and in November Lord Turner, chairman of Britain's Financial Services Authority, said the FSB wanted to get a grip on the non-bank short-term lending market and introduce liquidity standards for shadow banks. "If it looks like a bank and quacks like a bank, it has got to be subject to bank-like standards," he said.
This is all very well but Mr. Carney will encounter some stiff resistance to his welcoming regulatory embrace. Hedge fund managers smugly point out that it was not them that caused the 2008 collapse but the stupid behaviour of conventional bankers and their inadequate understanding of risk. Rather than increasing risk, it is argued, money-market funds reduce the exposure of global banks. Shadow banking adds liquidity, for example, by shifting credit risk from bank depositors to investors in the money markets or hedge funds.
However, it is the sheer scale of the activity that causes regulatory jitters. In September 2011, at the height of the European sovereign debt crisis, the big French banks began to suffer liquidity problems when money-market funds began to withdraw from lending to French institutions. The French had been sourcing short-term funds from the repo markets to match their short-term asset finance business.
Rather than seeing monsters lurking in the shadows, Mr. Carney should be nuturing these creatures because what is clear as water is the global financial system now depends on the shadow banks to do the business the big banks can no longer provide.
Credit is drying up for small and medium-sized enterprises. In Britain, net new lending to businesses by banks fell by more than £13-billion ($20.8-billion) last year. Rather than see a bank manager, companies are moving to alternatives. Those with large balance sheets tap the money markets and smaller firms try unconventional routes, such as a new breed of peer-to-peer internet lenders that match savers directly with borrowers.
The market is finding solutions to credit and banking problems and there is a real risk that heavy-handed regulation could nip the solution in the bud. The world is fed up with the clumsy and negligent behaviour of banks; it would be a shame if the regulatory net strangled a new world of credit in order to save failing and discredited bankers.
Carl Mortished