January 18, 2014

Excessive exposures to what is “absolutely safe” by regulated banks could be much more dangerous than whatever lurks in the shadows.

Sir Tracy Alloway writes “Shadow banks, we are told, are unregulated institutions that lurk in the dark corners of the financial system – away from the supervised activities of run-of-the-mill commercial banks”, “Competition for banking business lurks in the shadows” January 18.

But perhaps we should keep in mind that those unregulated shadow institutions are not able to leverage remotely as much as the banks who operate in sunlight… so the question of safety is sort of relative.

And Alloway also comments “that there is perhaps an underappreciated danger: that non bank lenders will encourage riskier behavior at larger banks that find themselves compelled to try to compete with the shadows”. But that would only happen if banks are able to dress up that riskier behavior in such as way that it is perceived as “absolutely safe” so that they do not need to hold much capital.

As is, the real risky behavior of banks is building up excessive and dangerous exposures to what is perceived as “absolutely safe”… all a consequence of capital requirements which are portfolio invariant.

Alloway hopes that these “shadow lenders serve a purpose” satisfying “the needs of the real economy”. Indeed let us hope and pray it is so, because as is, the supervised banks, with the risk aversion imposed on them, are kept from doing so.