In an
April 13 address, Ben Bernanke, Chairman of the Board of Governors of the Federal Reserve System, made clear that he sees the system of shadow banking as a key vulnerability that makes another catastrophic economic crisis nearly inevitable. In Bernanke's view, the increased importance of the so-called shadow banking system is the primary reason for the severity and pervasiveness of the financial crisis, and the regulatory gaps in which shadow banking activities operate must be addressed by policy makers.
As became apparent during the crisis, a key vulnerability of the system was the heavy reliance of the shadow banking sector, as well as some of the largest global banks, on various forms of short-term wholesale funding, including commercial paper, repos, securities lending transactions, and interbank loans. The ease, flexibility, and low perceived cost of short-term funding also supported a broader trend toward higher leverage and greater maturity mismatch in individual shadow banking institutions and in the sector as a whole.
Looking back, we now know that the presumption by investors and regulators that shadow banking activities were protected from runs and panics by contractual, regulatory, or credit rating agency assessments was false, and perhaps a bit naive.
While banks also rely on short-term funding and leverage, they benefit from a government-provided safety net, including deposit insurance and backstop liquidity provision by the central bank. Shadow banking activities do not have these safeguards, so they employ alternative mechanisms to gain investor confidence. Among these mechanisms are the collateralization of many shadow banking liabilities; regulatory or contractual restrictions placed on portfolio holdings, such as the liquidity and credit quality requirements applicable to money market mutual funds; and the imprimaturs of credit rating agencies. Indeed, the very foundation of shadow banking and its rapid growth before the crisis was the widely held view (among both investors and regulators) that these safeguards would protect shadow banking activities against runs and panics, similar to the protection given to commercial banking by the government safety net. Unfortunately, this view turned out to be wrong.
This overconfidence in in the safety of shadow banking created a blind spot with regard to risk management, another key vulnerability Bernanke feels must be addressed urgently.
Although the vulnerabilities associated with short-term wholesale funding and excessive leverage can be seen as structural weaknesses of the global financial system, they can also be viewed as a consequence of poor risk management by financial institutions and investors, which I would count as another major vulnerability of the system before the crisis. Unfortunately, the crisis revealed a number of significant defects in private-sector risk management and risk controls, importantly including insufficient capacity by many large firms to track firmwide risk exposures, such as off-balance-sheet exposures.
This lack of capacity by major financial institutions to track firmwide risk exposures led in turn to inadequate risk diversification, so that losses – rather than being dispersed broadly – proved in some cases to be heavily concentrated among relatively few, highly leveraged companies.
Not only did this blind spot exist in the private sector, but in the public as well. Bernanke said that regulation failed to appreciate what was happening on the ground, and regulations were inadequate to keep up with constant financial innovations.
But even as private-sector activities increased systemic risk, the public sector also failed to appreciate or sufficiently respond to the building vulnerabilities in the financial system – both because the statutory framework of financial regulation was not well suited to addressing some key vulnerabilities and because some of the authorities that did exist were not used effectively.
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In retrospect, it is clear that the statutory framework of financial regulation in place before the crisis contained serious gaps. Critically, shadow banking activities were, for the most part, not subject to consistent and effective regulatory oversight. Much shadow banking lacked meaningful prudential regulation, including various special purpose vehicles, ABCP conduits, and many nonbank mortgage-origination companies. No regulatory body restricted the leverage and liquidity policies of these entities, and few if any regulatory standards were imposed on the quality of their risk management or the prudence of their risk-taking.
Further, gaps in regulations and inconsistencies between regulatory jurisdictions had the effect of limiting the information available to regulators and, consequently, may have made it more difficult to recognize the underlying vulnerabilities and complex linkages in the overall financial system. These gaps in the statutory framework, according to Bernanke, were an important reason for the buildup of risk in certain parts of the system and for the inadequate response of the public sector to that buildup.
So, what does Bernanke envision happening next? His conclusion was short on details, but he made clear that he sees shadow banking as a remaining glaring vulnerability, and that extraordinary amount of international consultation and coordination is currently underway to bring shadow banking activities under regulatory discipline.