The usually sound Jonathon Shapiro at the AFR, today does a royal gloss job on the history of Australian shadow banking:
The term “shadow banking” is being uttered with increased frequency by politicians and central bankers as they sound warnings about the next big scourge on the stability of the financial system.
Clearly, there’s a dark side to shadow banking – which refers to any lending that is not done be a registered bank – where providers of capital are trying to earn higher returns than traditional banks while avoiding the rigorous scrutiny that applies to banks. At its peak, the shadow banking sector was as large as $US27 trillion. Now it is estimated to be a third of the size.
In Australia too, an undesirable and poorly regulated shadow banking system emerged to lend to commercial property developers. These bank-like institutions raised deposit-like funding to make bank-like loans, but were allowed to use a lot more debt – which made their owners’ profit potential large and their investors highly susceptible to losses.
To cut a long story short, shadow banking is off-balance sheet credit intermediation without the traditional backstops of capital reservation and a lender of last resort.
Despite Shapiro’s impressively short list, Australian shadow banking was also of epic dimensions pre-GFC. The mortgage secrutirisers were generating some 40% of Australian household credit and faced the music big time when their off balance sheet activities hit the wall.
Not only that, just as in the US, Australian shadow banking was heavily integrated with traditional banks at the regional level. The entire sector hit the wall in the GFC just as certainly as it did elsewhere with securitisers like RAMS collapsing overnight and banks like St George and Bank West basically bailed out via acquisition. Let’s just say Macquarie was fortunate.
I have argued elsewhere too that the major banks were not as separate from shadow banking activities as they would like us to believe. They became heavily reliant on short term global money markets pre-GFC and were using derivative instruments en masse to hedge the interest rate and currency risk in their offshore borrowing. Of course, like all shadow banking activities, they ignored the liquidity risk, which is what brought the entire edifice down in the end and required government guarantees across the board.
I note that in a recent study the Bank if International Settlements includes Australia in a list of countries that have experienced a recent financial crisis. That we rewrote all of the rules to prevent disaster doesn’t alter this underlying fact. Australia was almost brought to its knees by the meltdown in its shadow banking sector.
But Shapiro is not finished:
Most central banks are exploring the use of “macro-prudential” policies that will limit bank lending to combat excessive asset price rises in a world of low interest rates.
The RBA doesn’t think these policies will work because if it limits the formal banking sector’s ability to write loans when the demand for credit is strong, the unregulated non-banks will step up and provide it.
So why is everyone else doing it? My view is that liquidity will dry up for securitisers if the RBA or APRA begin tightening LVRs. The RMBS market has barely climbed back to its feet after years of direct government support, which Shapiro also completely ignores.
If not, use MP on securitisers as well. Make them retain a larger equity tranche. Or don’t use LVRs, use debt to income ratios as Deep T. has suggested. It’s not rocket science.
While I don’t expect banks to never fail, nor that all banking remains tied to balance sheets, I do expect that we rigorously evaluate how the interplay of regulation and finance can best serve the interests of the country. Why is Shapiro not asking any of these questions? Where is the discussion of the shortcoming of shadow banking, as well as how they might be addressed or fixed?
Perhaps the answer lies in his conclusion:
…More shadow banking might be just what the credit markets need.
Let’s do it again, no questions asked. The GFC bailouts have created an extraordinary culture of moral hazard in our financial press.
