5 Big Shadow Banking Threats to Everyone and Everything

TheStreet.com

NEW YORK (TheStreet)-- Shadow banks -- entities that provide credit as banks do but aren't subject to the same types of regulations -- were arguably at the center of the 2008 financial crisis. However, while rules for banks have been tightened since 2008, most experts agree that little if anything has been done to regulate shadow banks more closely. 

"Nothing has changed in terms of the regulatory structure of shadow banking. It's certainly the case that top regulators and analysts are much more aware now of problems that could go wrong and we don't have all of these very shaky asset backed securities floating around that would lead to the kind of meltdown that we saw a few years ago," says Yale University professor Andrew Metrick. However, he adds, "the main pillars of the money market mutual fund system, securitization and repo are not regulated any differently than they were in 2008,"  

While Metrick and his Yale colleague Gary Gorton focus on those three main pillars, other experts have argued for a broader definition. 

An essay by Boston College finance professor Ed Kane, essentially defines shadow banks as entities that have persuaded their customers that they will be bailed out if necessary by a government--even though they are not formally protected by government guarantees.  New York University professor Viral Acharya, meanwhile, argues that governments themselves are shadow banks. 

"By allowing excessive competition, providing downside guarantees and encouraging risky lending for populist schemes, governments can create periods of  intense economic activity fueled by credit booms. This way, governments effectively operate as "shadow banks" in the financial sector. Such a government role appears to have been at the center of recent boom and bust cycles and continues to present a threat to financial stability," Acharya wrote in a paper published on the Federal Reserve's website

Shadow banks, in other words, aren't always easy to define and they often refer to markets rather than specific entities or institutions. What follows is a combination of both shadow bank markets, as well as institutions that--while not themselves shadow banks--have substantial exposure to the shadow banking system.   

5. Project Isobel (Securitization) 

At roughly EUR1.4 billion, this pool of troubled property loans originated by Royal Bank of Scotland and partially sold to Blackstone Group is, by itself, far too small to pose a threat to global markets. 

However, it represents just the beginning of a coming "wave" of similar transactions where European institutions pool together and sell off troubled assets, according to KPMG . The consulting giant estimates more than EUR1.5 trillion in nonperforming loans are still sitting on European bank balance sheets. 

The European debt crisis has been around for long enough that it is difficult to believe prospective investors or ratings agencies aren't aware of the risks related to Project Isobel or future securities of this type that get created from that EUR1.5 trillion in troubled loans. 

Still, the possibility of contagion from a European debt crisis is very real, according to Yale's Metrick. 

"It's very hard to know where the third degree exposures are to Spanish and Italian debt. If Spain and Italy are unable to maintain the Euro at some point and have to go out of it, it's not obvious that German debt will be safe at that point. What's the exposure to German debt? What's the exposure to the institutions that are exposed to German debt? Nobody knows that," Metrick says.   

4. Goldman Sachs and Morgan Stanley (Investment Banks) 

To avoid the fate of Lehman Brothers and Bear Stearns, Goldman Sachs and Morgan Stanley became bank holding companies in 2008. Since then, though, despite assertions they are gathering deposits, Goldman actually had fewer deposits as a percentage of liabilities at the end of 2011 than it did at the end of 2008, according to Bloomberg data. For Morgan Stanley, deposits as a percentage of liabilities are up only slightly--26.91% at the end of 2011 versus 25.99% at the end of 2008 

Short term borrowing data are even more troubling. At Goldman, short-term borrowing accounted for 40% of total liabilities at the end of 2011 versus 25% at the end of 2008. At Morgan Stanley, short-term borrowing accounted for 33% of liabilities in 2011 versus 29.4% at the end of 2008, according to Bloomberg

"The Federal Reserve calls them banks, but Goldman and Morgan Stanley are still financing themselves largely through markets and there's a general belief that they're safe investments to make, but that can change tomorrow," Metrick says.

3. Fidelity Investments and Federated Investors (Money Market Funds)

Tighter regulation of money market funds seemed like it would be a slam dunk after the $62 billion Reserve Primary Fund "broke the buck"--meaning it caused investors in the fund to lose money--in 2008. 

Top regulators on both sides of the aisle subsequently called for reforms of the industry. Even BlackRock Inc.--one of the largest money market fund managers in the U.S., was open to reform. However, resistance from much of the rest of the mutual fund industry, led by Federated and Fidelity, staved off a rule proposal from Securities and Exchange Commission Chairman Mary Schapiro that would have addressed important regulatory gaps.

"In particular the one that's the biggest travesty is the money market mutual funds because there was a very good proposal on the table that would have made a difference and that was shot down," says Yale's Metrick.

2. CME Group (Clearinghouses)

Clearinghouses are often run by exchange operators like CME Group and LCH.Clearnet Group. Their goal is to ensure that all parties to a trade have sufficient funds to pay for it, since big institutions trade using borrowed money.

The importance of clearinghouses has increased since the 2008 crisis as regulators are requiring an increasing portion of the $700 trillion dollar swaps market to be cleared through a centralized entity such as an exchange. In theory, exchanges have clearing members such as large banks standing behind them that would contribute capital to backstop the exchange if it required new infusions of capital. However Boston College professor Kane argues in his essay that "the more important swaps trading on a particular exchange might become, the better its clearing members will see that adopting a corporate form will limit their individual and joint liability in crises and would help them if the exchange itself should ever become insolvent to whip up the financial, political and administrative fear necessary to trigger the bailout reflex."

In a speech last year, Bank of England Deputy Governor Paul Tucker described a "big gap" in the legal framework for winding down clearinghouses. 

"What happens if they go bust?  I can tell you the simple answer: mayhem," Tucker said.

1. General Electric (Non-bank financial institutions)

GE ran into trouble in 2008 for much the same reason as the investment banks did--its reliance on short-term funding from the capital markets. While GE was not forced to sell preferred stock to the U.S. government as many other big banks and financial companies were, it made extensive use of emergency government guarantees for short-term debt issuance during the crisis.

At the end of 2011, GE had $599 billion in total liabilities, $138 billion of which, or 23%, were short term borrowings. That compares to $194 billion out of $684 billion, or 28% at the end of 2008, according to Bloomberg data.

In a report earlier this year, JPMorgan analyst Steve Tusa wrote that GE's reliance on funding itself in the capital markets is "a lingering long-term risk." However, he is encouraged by the fact that debt known as commercial paper--which matures in less than a year--now accounts for about 10% of GE's liabilities, where it had once accounted for as more than 50%. GE also will add $7.5 billion in deposits once it completes an acquisition of a bank from MetLife that was announced in December. Regulatory approval for the deal is still pending, however, some 10 months after its announcement. 

-- Written by Dan Freed in New York.

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