Wallison on Shadow Banking: If It Isn't Broken, Don't Fix It

In a piece published June 14, Peter J. Wallison, Fellow at the American Enterprise Institute, argues against imposing any new regulation on shadow banking markets and firms without without convincing proof they need it.  According to Wallison, the calls from regulators and others for additional regulation of so-called “shadow banks” are simply a rush to judgment.  Further, he believes that the failure of Lehman and failures and bailouts of other non-financial firms during the financial crisis are not evidence that shadow banking firms and markets are inherently unstable and need regulation.  In his view, the financial crisis was a one-of-a-kind event that overwhelmed all forms of regulation, and took both regulated banks and unregulated non-banks by surprise.  Failure under these conditions, according to Wallison, says nothing about the inherent stability of shadow banks.


Wallison takes the Financial Stability Board to task for defining "shadow banking" so broadly, that it sweeps almost the entire securities industry into its ambit. 

The broadest definitions of shadow banking suggest that the entire securities market is part of the shadow banking system and presumably should be subject to banklike regulation to assure its stability. For example, the Financial Stability Board, established by the G20 leaders at their 2009 summit, defines shadow banking as “credit intermediation involving entities and activities outside the regular banking system,” and notes that the concept is interchangeable with entities engaged in “market-based financing” or “market-based credit intermediation.”[footnote omitted]

He also takes Ben Bernanke to task for suggesting that shadow banking is inherently unstable because, unlike banks who have access to the Fed windows, shadow banking depends for liquidity on alternative sets of contractual and regulatory protections (e.g., the posting of collateral in short-term borrowing transactions).  Wallison points out that the protections afforded traditional banks by regulation and access to the Fed window didn't save some of the biggest banks.

In reality, of course, deposit insurance and access to Fed’s discount window—the elements that Bernanke refers to as ensuring the “stability” of the banking system—did not work any more effectively for regulated banks than the absence of these factors worked for the nonbanks or shadow banks in the financial crisis. Four large banks (Citigroup, Wachovia, Washington Mutual, and IndyMac) and hundreds of smaller ones had to be taken over or rescued by the government. . .

Mr. Wallison thinks that these calls for new and presumably more stringent regulation of at least some portions of the securities system seem to be more than a bit hasty.  He sees the events of the financial crisis as a mere data point in the short history of shadow banking practices; insufficient history to justify a raft of regulatory reforms.

There is not a long history of failure by firms that many include within the term shadow banking, or indeed even a single case before 2008 of a shadow banking firm causing a systemic event or endangering the stability of the US financial system. Instead, many observers rely on a single extraordinary event—the 2008 financial crisis—to claim that large portions of the securities market should be subjected to a system of regulation roughly akin to that employed for commercial banks.

While Wallison agrees that shadow banking, regardless of its definition, was clearly a part of the financial crisis, it was no more at fault for what happened in the crisis than was regulated deposit banking. It is therefore, in his opinion, not sensible to argue that we should abandon a highly successful system of financing economic growth to achieve greater stability by imposing more regulation.