Regulators worry stricter rules encourage ‘shadow banking’

At the dark end of wall street

(Jerome Favre/Bloomberg/Getty)

(Jerome Favre/Bloomberg/Getty)

The most powerful global banking-standards body recently had to do some rare backpedalling. In July, the Basel Committee on Banking Supervision admitted that new rules introduced after the financial crisis may be too complex—and they could be having some unintended consequences, one of which is the expansion of a “shadow banking” system, where scrutiny from regulators is weaker.

Shadow banking refers to the activities of non-bank financial institutions—hedge funds and investment banks, for example—and while the term sounds ominous, these companies serve a number of legitimate purposes. In Canada, the shadow banking system allows the Big Six banks to securitize mortgages to free up lending capacity. But non-bank lending has also produced such notable blow-ups as the collapse of Lehman Bros.

China’s shadow banking sector—which includes an array of alternative lenders, even pawnshops—has dominated headlines as analysts fret about the quality of the country’s loans. But the risks extend far beyond China, and could be exacerbated by efforts to rein in traditional banks.

“If regulators prevent the banks from doing certain things, they are worried that hedge funds will do them instead, and cause similar problems,” says Laurence Booth, a finance professor at the Rotman School of Management. Indeed, a recent report from the Federal Reserve Bank of New York predicts liabilities in the U.S. sector will grow beyond the current level of US$15 trillion because reforms have done “little to address the tendency of large institutional cash pools to form outside the banking system.”

At the same time the Basel Committee acknowledged the complexity of its reforms, it also published suggestions for how to simplify its rules and better regulate interactions between traditional banks and shadow banking entities. With any luck, regulators will be able to pull some financial activity back out of the shadows.