Unregulated Shadow Banks Are a Ticking Time Bomb

Signs of the subprime mortgage crisis were obvious long before the 2008 meltdown. A few observers recognized the danger and shared their concerns, but most dismissed the threats, arguing that a deep, widespread decline in home values would never happen. Other signs of distress went unnoticed or unappreciated.

I am increasingly convinced that we confront similar circumstances today in the shadow banking sector. We define the sector by its participants — finance companies, hedge funds, money market mutual funds, private equity funds, investment vehicles, and conduits, among others — because its activities are largely indistinguishable from commercial banking. Risks are building in the sector, but they are hard to identify and measure because the shadow banking system is opaque by nature, if not by design.

The illusion that high-risk practices in shadow banking can build without consequence will burst in the coming months or years; once popped, the bubble will have serious and widespread impact on the entire financial sector.

Having participated in the rescue negotiations for Long Term Capital Management, I know how even modestly sized shadow banking operations threaten the entire financial system. These companies are inextricably linked with regulated financial institutions because they perform similar functions and are interconnected — mostly systemically as counterparties in securities and funding markets. A collapse in the shadow banking sector cannot be contained to the shadow banking sector.

While reforms adopted since the financial crisis have placed stiff rules around the regulated financial sector, we’ve seen essentially none for the nonregulated or shadow financial sector. That means that many, if not all, of the practices that led to the last financial crisis can be practiced almost without restraint in the shadow system.

Accordingly, we haven’t gotten rid of the practices and risks that most merit our close attention. Instead, we have allowed them to move out of banks and in many cases broker dealers and into market lenders, hedge funds and other unregulated entities. Some of these products, services and practices proliferate in corners of the market where we frequently can’t even observe what is taking place. Perhaps even more than during the lead-up to the 2008 crisis, many of the signs that the system is going off track are hidden from plain view.

The little we can see is worrisome: 60% of the market for U.S. Treasury securities is handled by small private funds with high-speed, algorithmic trading capabilities. This market is at the heart of our economic and financial system. Fortunately, the Treasury Department recognizes this issue.

The lure of greater compensation and the freedom to innovate in the shadow sector weakens our regulated entities in other ways as well. Many regulated financial institutions have lost their best talent and struggle to recruit the brightest new graduates.

The Dodd-Frank Act of 2010 attempted to avert another financial crisis by creating the Financial Stability Oversight Council, charged with identifying and mitigating future systemic risks. But designating the largest institutions as systemic — and thus part of the regulated system — misses much of the point. One consequence of the attention paid to the council’s designations has been to focus on size and less so on function — frustrating the initial intent of giving the council the latitude to determine what constitutes systemic risk, and to make sure that risky practices are appropriately, effectively and uniformly regulated.

To get at the heart of this problem, we need to abide by a simple organizing principle: “like kind, like size, like regulation.” In some cases this means regulating smaller shadow entities and in others it means regulating by financial product.

Take leveraged lending as an example. If regulators are sufficiently worried about these practices to believe they warrant serious regulatory scrutiny and restrictions, then all leveraged lenders — including those that are not banks — should be equivalently regulated. Placing restrictions on a single category of suppliers within a market does not by itself change the market. The practices that triggered the concerns are likely to persist, as will the risks within the market. A principle of regulatory equivalency should apply to all financial products. And enforcement should be just as strict for nonbanks as it is for banks.

The shadow banking sector does not lack for innovative and valuable practices, nor does it lack for skilled and accomplished participants. But the current anomaly of regulating only one portion of the financial system in and of itself gives rise to substantial risks and troubling incentives.

I believe the “like kind, like size, like regulation” principle would be an important step in solving the problem, and yet that concept alone may still not be enough to fix the problem completely of how to regulate risk in financial markets. Given the consequences for the real economy, the stakes couldn’t be higher. We need our great financial thinkers and our nation’s regulators to pay serious attention to this emerging trend and develop ways to manage these deep risks. Whatever the solution, we must act with urgency.

Eugene Ludwig is the founder and chief executive of Promontory Financial Group. He was comptroller of the currency in the Clinton administration.