What is shadow banking and why did it grow after 2007?

Shadow banks are entities that operate like banks but don't take deposits. Their growth was driven one-third by technology and faster origination processes, and two-thirds by increased regulation on traditional banks, pushing activity into less regulated spaces.

Where does the risk go when shadow banks originate mortgages?

Much of the risk from shadow bank mortgage origination is transferred to Government-Sponsored Entities (GSEs) and the taxpayers. Furthermore, banks themselves fund a significant portion of shadow bank operations through short-term loans, creating a new layer of risk.

Why don't market signals effectively penalize bad behavior in the financial sector?

Market memory is often short, and significant government intervention distorts market signals. Even when financial professionals engage in misconduct, they frequently find new jobs quickly, indicating a lack of market-based punishment.

What is the speaker's proposed simple solution for banking regulation?

The speaker suggests significantly increasing the equity or retained earnings requirement for banks, proposing a shift from a system where banks hold 95.5% in loans to one where they hold 65% and 35% equity. This ensures banks have more 'skin in the game'.

Can regulators effectively catch up to new fintech entities?

It's difficult for regulators to keep pace with rapidly evolving fintech entities because data and detection always lag behind innovative activities. The core issue is identifying and managing where risk resides and who should bear it.

What are the challenges of counter-cyclical regulation?

Counter-cyclical regulation, aiming to build buffers in good times, is challenging because it's politically difficult to implement measures like raising interest rates when the economy is booming. Distorted markets due to existing regulations also complicate its application.

Key Moments

Challenges to Regulating the Banking Sector (Lessons from Hoover Boot Camp) | Chap 3

Hoover Institution

Education3 min read22 min video

Jun 15, 2021|76,324 views|438|15

Economy Banks Regulations Recessions Bank runs Surplus Regulators Financial Stability Financial Instability Finances Economic System Financial Crisis

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Key Moments

TL;DR

Banking regulation struggles with loopholes, political economy, and market signal distortion, suggesting higher equity requirements as a solution.

Key Insights

Post-crisis regulations often lead to more complex and intertwined financial systems, with risks migrating to less regulated 'shadow banking' entities.

Shadow banks, defined by not holding deposits, have significantly increased their market share in areas like mortgage origination, partly due to technology and partly due to increased regulation on traditional banks.

The growth of shadow banks is not solely driven by technological efficiency; a significant portion is attributed to regulatory arbitrage, where increased regulation on traditional banks pushes activity to less regulated sectors.

Risks originating in shadow banking often end up with government-sponsored entities (GSEs) or are funded by traditional banks through short-term loans, meaning the ultimate risk still resides with taxpayers or banks.

Political economy significantly influences regulatory design, leading to rules that are not always risk-sensitive and can distort market signals, making it difficult to assess true risk.

The financial sector often lacks market-based punishment for misconduct, as individuals who engage in bad practices can quickly find new employment, undermining market discipline.

THE LIMITATIONS OF POST-RESESSION REGULATORY RESPONSES

Following financial crises, the typical response is to increase regulation. However, this often results in a more complex and interconnected financial system rather than a safer one. A key issue is that regulations, if not designed holistically, create loopholes. These loopholes allow risk to migrate from regulated institutions to less scrutinized sectors, a phenomenon exemplified by the rise of shadow banking.

THE ASCENDANCY OF SHADOW BANKING

Shadow banks, essentially financial entities that do not hold deposits and are therefore outside the traditional regulatory perimeter, have dramatically expanded their market share. In the U.S. residential mortgage market, for instance, shadow banks now account for approximately 70-75% of origination activity. This shift is partly driven by technological advancements that enable faster and more convenient loan origination, but also significantly by regulatory pressures on traditional banks.

DRIVERS OF SHADOW BANK GROWTH AND RISK MIGRATION

Research indicates that about one-third of shadow bank growth is attributable to technological innovation, such as faster mortgage origination processes offered by fintech firms. However, the remaining two-thirds are linked to increased regulation on traditional banks. This regulatory burden pushes activity into the shadow sector, even though shadow banks may charge higher interest rates, which consumers accept due to convenience. Crucially, the risks generated by these shadow banks do not disappear; they are often transferred to government-sponsored entities (GSEs) or are funded by traditional banks, effectively re-concentrating risk within the system.

THE DISTORTING ROLE OF POLITICAL ECONOMY

The design and implementation of financial regulations are heavily influenced by political economy. This can lead to rules that fail to adequately price risk, as seen in the mortgage market where government-sponsored entities often set pricing structures that do not respond to risk variations. This lack of risk sensitivity in pricing, driven by external pressures, hinders the natural functioning of markets and allows risk to persist in unrecognized forms.

FAILURE OF MARKET DISCIPLINE IN THE FINANCIAL SECTOR

Traditionally, markets are expected to impose discipline on financial institutions and their employees through mechanisms like job loss or funding withdrawal for misconduct. However, in the financial sector, this discipline is often absent. Studies show that individuals who engage in misconduct are often rehired at similar rates to those who do not, indicating a failure of labor markets to penalize bad behavior effectively. This is exacerbated by extensive government intervention, which can distort market signals.

PROPOSALS FOR A SIMPLER REGULATORY FRAMEWORK

Given the persistent complexity and ineffectiveness of current regulatory approaches, a more straightforward solution proposed is to significantly increase the equity requirements for banks. The idea is that if banks have a much larger stake (e.g., 35% equity) as opposed to a smaller portion (e.g., 5%), they would have greater 'skin in the game.' This would ensure that banks themselves bear a substantial portion of the risk, aligning their incentives with financial stability and simplifying regulatory oversight. The speaker suggests that current debates over marginal adjustments to capital ratios miss the fundamental need for a robust equity cushion.

Mentioned in This Episode

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Banking Regulation: Key Principles

Practical takeaways from this episode

Do This

Be honest about the complexity of financial regulation.

Clearly articulate the goals for needing regulation.

Consider simple, direct regulatory approaches like higher equity requirements.

Rely on market signals where possible, but acknowledge government interference.

If employing counter-cyclical regulation, understand its political feasibility.

Avoid This

Assume regulations will be manipulation-proof.

Underestimate the rise of shadow banking and its risk displacement.

Ignore the role of political economy in shaping financial rules.

Develop overly complex and intertwined financial systems.

Blame markets solely when regulatory rules are poorly designed.

Rely on short market memory for governance solutions.