Beware of the Shadow Banks

Investment Research Group

Devised by US economist Paul Krugman, the term refers to entities that have taken on banking tasks such as creating credit but are not subject to banking regulations. These unregulated entities are most likely to have caused the credit crisis.

He comes to this conclusion after reviewing the six most common reasons given for why the crisis occurred.

These are:

Size: Some financial institutions became too big to fail

Shadows: Institutions that fulfilled banking functions evaded regulation

Opacity: There were too many complex financial instruments that most people didn’t understand

Predation: Financial firms deliberately misled consumers and investors

Government intervention: Governments encouraged lenders to make bad loans, especially to the poor

Monetary mismanagement: The Federal Reserve kept interest rates too low for too long.

Looking at the size issue, he notes there was a massive increase in financial concentration, with a few true gigantic banks emerging.

Shadows: Deregulation allowed various entities to engage in core banking activities while escaping banking regulations. However, such institutions were equally vulnerable to a ‘run on the bank’.

Opacity: The emergence of securities and contracts with obscure, hidden risks

Predation: Krugman finds it no coincidence that the most complex, confusing loans were offered to those least able to understand them. There was probably also a substantial amount of deliberate selling of mortgage-backed securities to investors who didn’t grasp the risks.

Having identified shadow banking as the main culprit, Krugman looks at how effective proposed reforms will be.

One suggestion is to reduce government intervention and rely on market discipline. However, this may not work. In 1930 the USA let banks fail – and the result was the Great Depression.

A second version of reform calls for increased regulation, including a return to the post-Depression enforced separation of deposit and investment banking.
Krugman doesn’t think this is realistic. “Shadow banking isn’t going away. Like it or not... short-term debts now play a role in our economy comparable to that of bank deposits.”

The third option is to extend regulation to shadow banks.

If a regulator had the capacity to seize shadow banks like it can with depository institutions, that might help the problem.

However, regardless of what actions are taken, Krugman admits he is “not wildly optimistic” that any form of regulation can prevent another crisis.