Shadow banking: Disintermediation could be disastrous

15th March 2012

Haldane's vision was that the Internet would make it increasingly easy for investors and savers to connect directly, cutting out the go-betweens. He says in the Times: "The banking middle men may in time become the surplus links in the chain," he said. "Where music and publishing have led, finance could follow." He pointed to sites such as which specialise in microfinance, lending money internationally to people in developing nations.

George Osborne is poised to announce similar initiatives in next week's budget: "The Government intends to invest up to £1bn alongside private sector investors on fully commercial terms through managed funds that lend directly to mid-sized businesses in the UK. The BFP aims to ease the flow of credit to businesses in the UK by helping to diversify the sources of finance available."

As Henry Ireton comments on the FT site; "Osborne's logic is simple. The banking system is broken so we need to build an alternative. The initiative is called the Business Finance Partnership; I quote HMT; ..'to stimulate the development of a deeper and more diversified non-bank lending market in the UK'."

Both these examples would appear to be worthy goals, but disintermediation of the banks has had other, less benign consequences in the past: This piece in the FT highlights FSA chief Lord Turner's concerns on the shadow banking sector: "The sprawling array of non-banks that extend credit and provide other bank-like services are "not something parallel to and separate from the core banking system, but deeply intertwined with it … We need to ensure that our regulatory response appropriately covers shadow banking as well as banks."

As David DeHavilland points out on the Times site, it may not be possible to have one without the other: "Wow ! Even significant figures in the BoE fail to understand the complexities of banking. I can imagine the site, I would like a loan to build a tunnel under the Atlantic with staged payments of 100 Billion over 10 years payable quarterley(sic), with 16 fx currency hedges, an interest rate hedge on the principal, with an accreting repayment structure. Please enter your credit card details and full name…. computer says no!"

Policymakers will want to see a separation between the adoption of traditional banking roles by fund managers and individuals, and the adoption of traditional banking roles by more aggressive institutions, such as the investment banks. The latter has already happened, with some unpleasant consequences, as this article explains : "Since shadow banks were not part of the formal commercial banking system, they were not subject to the same strict regulations as banks, and thus could use high leverage to gain quick and large profits in good times but also huge losses in bad times.  On April 28, 2004, the US Securities and Exchange Commission waived the net capital rule for the largest investment banks: Bear Stearns, Goldman Sachs, Lehman Brothers, Merrill Lynch, and Morgan Stanley, allowing them to take on as much debt as their internal risk management analyses deemed prudent….all five investment banks increased their leverage dramatically; Bear Sterns increased leverage to 30 to 1, double the net capital rule.  The shadow banking system is not a niche element in credit markets.  Indeed, shadow banks were estimated to provide as much as 60% of total lending; commercial banks only 40%."

Regulations have been put in place since the crisis, but the shadow banking sector continues to grow. There is a danger that in disintermediating the banks, traditional banking roles may not end up in the hands of someone better but – as it has in the past – with someone worse or, at least, less regulated. Lord Turner concludes: "We need to design a system which faces end-investors with reality, and does not allow the development of a set of claims whose apparent combination of risk, return and liquidity is in aggregate unsustainable." Answers on a postcard, please.


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