The Agenda

Shadow Banking Subtext

This week, President Obama came to New York City to attend a series of fundraisers, one of which, for the Democratic Senatorial Campaign Committee, was held in the home of Tony James, the president and chief operating officer of the Blackstone Group, a private-equity firm with $248 billion under management as of last fall. James, a Democrat who has been named as a possible future Treasury Secretary, is a prominent political fundraiser and a supporter of a wide array of left-of-center causes and institutions, including the Center for American Progress.

And earlier this month, James wrote an op-ed for the Wall Street Journal on market-based financing, or “the provision of capital by loans or investments to some companies by other companies that are not banks,” a poorly understood but important part of the U.S. financial system that is better known as “shadow banking.” James observes that market-based finance is significantly larger than the banking system by a significant margin, and that it fills a number of needs that the traditional bank financing has failed to meet, e.g., financing small and medium-sized firms and rescuing firms from bankruptcy:

Large banks concentrate risk in relatively few hands, which can pose a risk to the economic system. That is not the case for market-based financing. Risks are safely dispersed across many sophisticated investors who can readily absorb any potential losses. Unlike traditional banks, market-based funds do not borrow from the Federal Reserve, nor do they rely on government-guaranteed deposits. Substantially all their capital comes from well-advised institutional investors who know what they are getting into, and understand the associated risks. Bank depositors (and taxpayers) on the other hand, do not typically know what a bank’s investments are or how risky they may be.

Typically, market-based funds also lack the elements that are sources of systemic instability, including high leverage and interdependence. Each investment within a fund is independent and not cross-collateralized or supporting a common debt structure. Losses in any one fund are without recourse to any other fund or to the manager of the capital.

In addition, investors in many market-based funds, including credit investment funds, hedge funds and private-equity funds often cannot instantly withdraw their capital, unlike depositors in banks. Large, sudden withdrawals can lead to runs on the bank or force “fire sales” of assets. With stable, in-place capital, these funds can provide a critical source of liquidity to trading markets in times of turmoil.

So why bother making the case for market-based financing? Most of the claims James advances are uncontroversial. But the subtext of James’s op-ed seems to be that he wants to head off heavy-handed regulation of the sector:

Some regulation may be appropriate for nonbank entities that present bank-like risks to financial stability or that lend to consumers. But let’s not forget that it was the regulated entities that were the source of almost all the systemic risk in the financial crisis.

Regulations are far from a panacea and would need to be carefully constructed to ensure that the enormous economic benefits of market-based financing are not lost through inappropriate and stifling regulatory policies established for large, deposit-taking banks.

Specifically, a September 2013 report from the Office of Financial Research on “Asset Management and Financial Stability” warned that the activities undertaken by asset management firms could pose a threat to financial stability. The report been criticized by many within the asset management industry. Critics see it as part of an effort on the part of the Financial Stability Oversight Council (FSOC) to exert regulatory authority over the asset management industry on flimsy grounds, including an unrealistic assessment of the supposed similarities between banking finance and market-based finance (despite the fact that investors in the latter sector tend to be more sophisticated about the risks they face as investors).

Yet concerns about the threat the growth of market-based financing might pose to financial stability are pervasive on the political left. In “An Unfinished Mission: Making Wall Street Work for Us,” a report issued by the the Roosevelt Institute, a left-of-center think tank, and Americans for Financial Reform, Marcus Stanley makes the case for extensive regulation of the sector:

The financial fragility created by shadow banking can be contrasted to the situation of commercial banking. Commercial banking can be highly unstable due to depositor runs if there is no government insurance for deposits. When there is such insurance, commercial banking stability is still vulnerable to weak regulatory oversight, since access to government deposit insurance creates incentives for banks to take excessive risks. But the assumption that banks will hold credit to maturity (or at least for a long period) rather than trading it means that accounting valuations are generally based on historical cost, not current market prices. This can be problematic if regulators refuse to force banks to recognize losses on assets that are genuinely and permanently impaired. However, it also means that losses can be managed over a much longer time period, allowing much more time for planning and resolution than if bank stability was immediately threatened by volatility in market prices. Furthermore, in a commercial or a relationship banking system, the full nature of bank liabilities and assets should be much more visible to a supervisor, as there are fewer off balance sheet risk transfers and less dependence on long credit intermediation chains.

At the same time, Stanley touts the benefits of relationship banking:

While relationship banking certainly presents issues of its own, it creates significant benefits that are not present in the market-mediated and transactional relationships that characterize shadow banking. In addition, greater diversity of financial intermediation models could reduce systemic risk. This essay has already touched on some of the transparency and financial fragility issues related to the distinction between commercial banking and market-mediated credit. There is also clear evidence that relationship banking is beneficial to mid-market and smaller real economy businesses. There are a range of ways to expand the role of relationship banking, from the full restoration of an updated version of the Glass-Steagall Act as proposed in “The 21st Century Glass-Steagall Act” introduced by Sen. Elizabeth Warren (D-Mass.) and Sen. John McCain (R-Ariz.), to steps that regulators can easily take without statutory change, such as favoring originate-and-hold lending over originate-and-distribute in prudential rules.

I don’t have the sophistication to weigh the various issues at stake. It is noteworthy, however, that one of the president’s most reliable political allies in the financial sector seems to be trying to preempt a more aggressive regulatory effort. It could be that James and others like him recognize that by backing the president now, when his approval rating is quite low and the Democratic majority in the U.S. Senate is vulnerable, they might tilt the Obama administration against embracing Elizabeth Warren’s calls for a new round of financial regulation. My guess is that James, who is by all accounts a sincere liberal, is not being quite so strategic. (And my ideological bias is that James is probably right on the merits, Stanley’s serious and interesting arguments notwithstanding.) But if I were a Warren–de Blasio class warrior, I might feel differently.

Reihan Salam — Reihan Salam is executive editor of National Review and a National Review Institute policy fellow.

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