Regardless of where one comes down on the desirability of any one of the raft of new regulations mandated by the Dodd-Frank Act, there is no question that their cumulative impact will be to constrain banking for the next several years.
No single regulation is so problematic in and of itself as to put a straitjacket on the system, but imposing such a considerable blanket of new regulations is bound to put a meaningful drag on the banking industry.
Thus constraining the banking system has broad implications, one of which is likely to be a boost for the shadow banking system.
Even after its decline following the financial crisis, shadow banking continues to be a major force in the economy. According to a 2011 IMF working paper, the share of U.S. financial sector assets controlled by the shadow banking sector — those entities engaged in leveraged maturity transformation outside of the federal financial safety net — has increased from about one-tenth in 1980 to about one-quarter in January 2011. In its recent examination of international banking, the Economist pointed to a post-crisis resurgence of fixed-income hedge-fund activity and other alternative-asset managers growing "much faster than banks." And as the Wall Street Journal noted last week, a number of private investment firms have started making home loans to borrowers who don't meet banks' requirements — in other words, subprime lending may well be making a comeback in the shadows of the regulated financial services industry.
On the one hand, this resurgence is somewhat surprising because shadow banking gains its oxygen — funding and liquidity — not from insured deposits, but from the capital markets, which remain queasy. On the other hand, the shadow banking sector has become more attractive due to the virtual lack of regulatory increase it has experienced, versus the regulations in place and coming down the pike for banks.
Today, while banking figures out how to make sound profits with greatly increased regulatory restraints and increased capital charges, shadow banks can continue to increase leverage; 20-to-1, 30-to-1, even 50-to-1 leverage is still part of this shadow industry.
As if this were not worrisome enough, spreads have narrowed greatly since the crisis. Global shadow derivative activity is robust. And, it is often hard to determine how the risk is worth the reward.
One way the shadow banks could gain a competitive advantage was spotlighted recently in this newspaper ("
Over time, if there is not an immediate financial crisis involving the shadow banking system, this "system" is likely to grow and perhaps grow very rapidly. Banking will be constrained by the new rules; at the same time, the capital markets will come back and become increasingly active, feeding non-bank financial activity. Indeed, the very fact that banks will be constrained, makes capital markets solutions all the more likely and attractive.
The hope has been, of course, that constraints on the banking system would rein in shadow banking, but this is unlikely to prove successful. First, this same mechanism has been tried - even before the Long Term Capital Management rescue — but with little success. Second, constraints on banks are likely to make them somewhat less able to control the capital markets.
The Wild West of the shadow banking system might be fine if it were not for the reality that a meltdown in the shadow banking system today — even at its smaller, post-crisis size — would produce adverse economic consequences for everyone. Why is it, again, that we want to heavily regulate the banking system and push more activities into the shadows?
Eugene A. Ludwig is a founder and the chief executive of Promontory Financial Group LLC. He was the comptroller of the currency in the Clinton administration.
