Of the most commonly used terms to categorize financial institutions, it is a toss-up as to whether the term "hedge fund" or the term "shadow banking" is the more misleading.
The classic hedge fund is quite the opposite from what its name implies. It is a heavily leveraged business model designed to maximize returns on investments with small spreads. Such a result can only be achieved with careful maximization of interest rate arbitrage and very heavy leveraging. But I am not holding my breath waiting for the industry to relabel itself "leverage funds."
The term shadow banking was reportedly coined in 2007 at the Federal Reserve Bank of Kansas City's annual Jackson Hole conference and was used to identify nonbank entities engaged in "maturity transformation" that is, converting short-term maturity deposits into longer maturing investments. Previously these nonbanks were outside the regulatory reach of banking regulators and not eligible for liquidity funding by the Federal Reserve. Since that time, the term has become more widely used to define all financial institutions that are less regulated than banks.
By even the most conservative estimates and using a narrow definition for shadow banking, this nonbank market is significantly larger than the U.S. banking system. The most recent FDIC Call Report data estimated the asset size of the U.S. banking system at $14 trillion. In 2011, the shadow banking system was estimated at $24 trillion and the global estimate was in the range of $60 trillion. So if the definition of "shadow" includes a large object blocking the light that otherwise would shine on a smaller object, then perhaps banking itself should be identified as the shadow entity.
Opining on the appropriate name for the nonbank financial services industry would be an interesting, but ultimately pointless exercise were it not for the important public policy issues the discussion raises. A useful starting point for this discussion is to remember one important axiom: financial institutions are intermediaries, which is to say they exist to facilitate commerce and the financial goals of others.
The financial marketplace does not wait for the regulated system to provide the means to financial goals. Instead, it finds the most expedient and efficient means to achieve financial goals. The danger in identifying the nonbank sector as "shadow," and thereby casting it in a pejorative light, is to suggest that it is an unsavory or less desirable alternative.
Even the most cursory examination of alternative financial products and intermediaries provides many examples of the market searching for less regulated and, therefore, potentially more efficient alternatives. Bitcoin as an alternative currency is an obvious example of this process. The willingness of entrepreneurs to use "crowd-funding" as a source of equity capital is another.
Perhaps the most often cited example occurred in the early 1980s, when billions of insured deposits left the banking and thrift industries for the uninsured money market mutual funds. This exodus occurred because Regulation Q precluded the banks and thrifts from offering a combination of market rates and ready liquidity. Until that point, many bankers had convinced themselves consumers would not leave the safety of insured deposits, even for higher rates. The market movement demonstrated quite the opposite.
Almost daily we read stores of retail financial products, such as residential mortgages and automobile loans, being funded outside of the banking system. Commercial lending in the small-medium enterprise market is growing rapidly outside of traditional commercial banking system.
Will financial regulators, exercising the will of Congress through implementation of ever-tougher banking bills, be able to pull less regulated entities under the regulatory umbrella? There is some evidence that progress is being made. The recently passed Dodd-Frank Act gives regulatory tools to identify, examine and, to some degree, regulate for systemic risk even when the risks are outside the historic purview of supervision. This is a clear improvement over the more siloed historic approach to regulatory oversight.
But bankers will mislead themselves if they expect that banklike supervision will ultimately catch up with and provide oversight to nonbanks in an environment consistent with the level of oversight that they experience. With the speed with which financial products can now be created, and the huge pools of capital standing ready to be committed to financial product innovation, it is banking that runs the risk of being lost in the shadows.
It will be years if not decades before the industry again goes through a significant deregulatory cycle. Banks should accept the non-bank competitive market as the near-term norm and expect to compete accordingly.
Mark W. Olson is chairman of Treliant Risk Advisors LLC and can be reached at firstname.lastname@example.org. His former positions include Federal Reserve Board governor, chairman of the Public Company Accounting Oversight Board, chairman of the American Bankers Association and bank president and CEO.