Shadow Banks Are Not a Source of Systemic Risk

Last week, my friend Eugene Ludwig wrote an article on American Banker headlined: "Unregulated Shadow Banks Are a Ticking Time Bomb." The gist of the article was that there are risks building in the "shadow banking sector" — the term that bank regulators use to describe the capital markets — that could bring about a crisis similar to what we experienced in 2008. To Ludwig and others, the capital markets are dangerous because they are generally not subject to prudential regulation, which is fundamentally the regulation and suppression of risk-taking.

As reluctant as I am to disagree with Ludwig, a deservedly respected former regulator, I must. There are so many false assumptions in his article that they can't be allowed to go uncorrected.

First, it is necessary to understand what actually happened in 2008. Leaving aside the question of why there were so many subprime and other risky mortgages in the U.S. financial system, the question is why the meltdown of these mortgages caused a financial crisis.

The answer is that these mortgages were tied to debt on the balance sheets of the largest financial institutions, particularly banks. Obviously, when a widely held asset is carried with debt, and falls substantially in value, the result is a serious loss on the balance sheets of the affected firms. Liabilities remain the same, but assets decline. The firm's capital position deteriorates and it may look unstable or even insolvent. This is what happened to the banks and investment banks (and of course, Fannie Mae and Freddie Mac) that were holding large portfolios of mortgages or mortgage-backed securities when the great housing bubble began to deflate in 2007.

There are four important points that come out of this and show that we would gain nothing and lose much by introducing prudential regulation into the capital markets. First, of course, prudential regulation failed to prevent the financial crisis. The regulators, in many cases embedded in the banks that got into trouble, were unable to see the crisis coming. This included the Federal Reserve Board, with its extraordinary staff of first-rate economists. The Fed's chair, Ben Bernanke, was telling the markets that the subprime problem was "contained" until late 2007. As a result, while lightly regulated Bear Stearns, AIG and Lehman Brothers failed or had to be rescued, so did heavily regulated and supervised Wachovia, WaMu and IndyMac — in addition to hundreds of smaller heavily regulated banks. In other words, the prior presence or prudential regulation made no difference when the crisis struck. So we can conclude that there is no good reason to spread it to other sectors of the financial economy.

The second point is that leveraged entities, funded by debt instead of equity, were especially vulnerable to the mortgage losses that exacerbated the financial crisis. Where assets are backed with equity — as is true of the mutual funds, private equity funds, and investment vehicles and conduits of all kinds that were cited in Ludwig's article — a sharp decline in the value of those assets, as occurred in the financial crisis, will fall on the investors in those entities rather than on the entities themselves. That will not cause a financial crisis for the same reason that the collapse of the dot-com bubble in 2001 did not cause a financial crisis, even though the losses were even greater than the losses in 2008. The losses in that event fell on an enormous pool of capital — shareholders — not on individual large firms.

Third, even in cases where the entities that suffer the losses are carrying the assets with debt, no financial crisis will result unless many large entities are affected at the same time. That's why the mortgage meltdown was so devastating; it was the sudden collapse of a whole class of assets widely held by large firms. The bankruptcy of many relatively small entities — which characterize the capital market players that make up the shadow banking system — will not produce a financial crisis.

Indeed, there is good evidence that the failure of even large nonbank financial entities will not cause a financial crisis. Although there was chaos after Lehman failed, this was because the government had suddenly and accountably reversed the policy of rescuing large financial firms — a policy it had established with the rescue of Bear Stearns. The important point is that no other large financial institution failed as a result of Lehman's failure. All additional failures (such as AIG) resulted from the same exposure to bad mortgages. This shows that large nonbank financial firms are not dangerously "interconnected" as some have claimed; large nonbank firms are likely to be highly diversified and thus unaffected by the failure of counterparties, even other large ones.

Finally, there is the concern about risk-taking. Ludwig worries that risks are building in shadow banking. We should hope so. Risk-taking is the source of innovation and growth. Risk-taking among the various capital markets firms — broker-dealers, mutual funds, hedge funds, private equity and others — is what has been driving the meager growth we have had since 2008. Banks, hamstrung by excessive regulation, have not been able to contribute much to the recovery, especially for small-business startups.

What's behind the concern about shadow banking risk is the hope that banking regulators will eventually get the opportunity — in the name of stability — to impose prudential regulation on the capital markets sector. If that happens, growth will decline further.

Meanwhile, because of risk-taking, there will certainly be failures among the so-called shadow banks. That's the price that entrepreneurs pay for the right to innovate. We can be sure, however, that none of these failures, nor all of them together, will cause another financial crisis.

Peter J. Wallison is the Arthur F. Burns fellow in financial policy studies at the American Enterprise Institute. He is the author of "Hidden in Plain Sight: What Really Caused the World's Worst Financial Crisis and Why It Could Happen Again."