Shadow Banking Sound Worse Than It Actually Is

Over at The Economist there is a piece that suggest that imposing higher capital requirements on banks could “push people into the arms of shadow banks”, who do not face the same level of regulation as banks. (H/T Tyler Cowen).

I don’t like the phrase “shadow banks”. It takes a good idea – risk being managed by those better able to manage it – and repackages it as an evil, nasty finance sector conspiracy.

With respect to competition in finance lowering the liquidity premium and leading to higher leverage to maintain shareholder returns, that’s not a big deal. Barriers to entry in banking are reasonably high – but barriers to entry for potential shadow banking activity are higher because you are entering into a world that has a far shorter timeframe than prudential regulation can reasonably deal with. Some repo loans could be less than 24 hours. Some money market funds could have 200 counterparties to monitor.

The irony of it all is that even banks subject to Basel capital and liquidity requirements will engage in “shadow bank-like” activity. Overnight repo lending is a prime example of this. If you kept up with the literature you’d be aware that banks have greatly increased the complexity of their collateral security agreements to offset higher counterparty default risk – they’re regulating themselves reasonably well thank you very much people who know nothing about shadow banking activity.

I believe that there are macroeconomic consequences of higher levels of regulation – less credit is granted, and because entrepreneurial trial and error includes a lot of error, the less projects that get started, the less likelihood that we’ll move out of the silent recovery into recovering the completely wasteful puritan deleveraging of the past few years.

As long as shadow bank credit losses are borne by shareholders and there are no more bailouts, there’s nothing wrong with it. In fact, given that banks seem only interested in propping up real estate prices instead of performing their function as a utility and lending for productive activity, the sooner New Zealand’s own shadow bank sector – finance companies – gets back up and running in a big way, the sooner housing affordability dreams will be realised and the sooner the silent recovery will turn into the boom we need so desperately to get low marginal product workers back into employment and out of part-time / casual purgatory.