Cats, Shadows and Mice

In a time in which the Financial Stability Board finds the shadow banking sector’s growth outpacing banks, growing 75% since 2010, totaling $52T, the cat-and-mouse synergetic chase between regulators and regulated is ever more crucial.

Photo: Has technological innovation propelled the growth of shadow banks? / Credits © Craig Cooper / Unsplash 

The mice in the shadows

This market comprises financial businesses which are regulated differently from conventional banks, but which cover some of their market functions — the plethora spans hedge funds, payday lenders, private equity firms, asset managers, fintech companies, mortgage servicers, insurance providers, and even Sotheby’s, which now makes loans to high-net clients.

When left unchecked on a systemic level, they can operate burdenless of regulation, risks, liquidity and capital requirements unlike traditional players.

The 2008 housing credit and subsequent debt crisis in the US are negative outputs of these risks.

The final report to the United States Bankruptcy Court, detailed how ‘Lehman’s business model was not unique; all of the major investment banks that existed at the time followed some variation of a high-risk, high-leverage model that required the confidence of counterparties to sustain.’

The bank had $700B of liabilites on $25B of capital, and later got sued for $1.2T by creditors. This was largely possible through an unchecked shadow banking system.

The Cats Chased

Since the Great Financial Crisis, regulators did not stand idly by; they closed many gaps for conventional banks, yet leaving a jigsaw regulatory environment for the shadow sector.

In their regard, most regulators adopted a function-based, or entity-based approach; or a mix of the two. The reasoning being these are the factors which make these players systemically critical to our economies.

When the puzzle pieces are interlinked, and the full picture is visible, these markets can be unregulated, partially regulated or fully regulated.

Thus, there are still those who operate at the fringe of visibility, such as Archegos Capital Management, and are deeply interlinked with traditional banks.

In this case, several of these acted as counterparties on total return swaps with Archegos (e.g. Credit Suisse), meaning they agreed to pay the latter the return on a bunch of stocks, whilst also providing credit for its exposure.

When the shadow bank capitulated, the counterparties had to frantically liquidate stocks to cover their exposures. To date, one single player costed conventional banks at least $10B.

Why? Because Archegos was leveraged. And widely so, they are not alone.

A recurring cycle?

According to a recent working paper by the World Bank, shadow banks originate over 50% of total new mortgage loans in the US. In turn, they are 70% funded by conventional banks.

What has propelled the shadow banks’ growth, besides regulatory pressure on traditional lenders, is technological innovation.

Some, like Quicken, one of the six shadow banks dominating the mortgage lending market, are entirely fintech driven in order to compete with incumbents.

Perhaps a Rome approach, which treats shadow banks with bank-equivalent regulation, risks stifling economic growth.

Nevertheless, unchecked, synthetic, over-levered growth will yield us only past woes.

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