Can Regulators Shine Light on the Next Shadow System?

Some financial industry critics blame the so-called shadow banking system for many of the problems that occurred leading up to the 2008 crisis. The growth of non-depository financial firms with weak regulatory oversight may have resulted in excessive risk-taking. A few commonly cited examples include the very high leverage at failed investment banks like Bear Sterns and Lehman Brothers and the unregulated credit default swap market that caused big problems for AIG. Might the shadow system return, and if it does, can regulators do better?

Floyd Norris of the New York Times reports that Citigroup CEO Vikram Pandit worries that Basel III's new capital requirements could cause a new shadow system. At a conference this week, Pandit said:

Any time the amount of capital required by regulation exceeds the levels judged necessary by the market, opportunities for arbitrage arise. It probably won't be mortgage brokers who fuel the next bubble. But some unregulated financial niche will arise, posing similar -- or greater -- dangers.

Of course, the natural response to this comment is that the market isn't likely to judge that the new capital requirements are excessive. Even some of the most pure free marketers agree that higher capital and liquidity levels than what were in place before the crisis are desirable, just ask former Fed Chief Alan Greenspan.

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But if Pandit is right, and the financial industry does again play in the shadows, are regulators better equip to prevent a bubble now that the sweeping Dodd-Frank financial regulation bill is in place? Norris isn't so sure:

The Dodd-Frank law does give regulators authority to oversee the next A.I.G. -- a huge financial institution that is systemically important even if it is not fully in the conventional regulatory system. But Congress rejected proposals to let regulators go after shadow sectors -- ones that are taking over areas of business previously done by the regulated system.

This isn't precisely right. The new Systemic Risk Council will, or at least should, be considering potential shadow systems arising. After all, one of its explicit purposes is to serve as a forum for all major financial regulators to get together and talk about new developments in the market. Several years ago, had such a council existed, you might imagine it noting the increasing role that credit default swaps were playing in the market, for example. In theory, by the securities regulators explaining how big the market had become, perhaps insurance regulators would have taken note and demanded more power over setting rules for the derivatives.

Or perhaps they wouldn't have. One practical problem with regulation is that it's very hard to be proactive. Because no one has a perfect crystal ball, it's difficult to know whether a financial innovation will turn out wonderfully or horribly. So regulators don't want to constrain a new product with promise, but they also don't want to allow a dangerous imbalance to build.

If a new shadow system does blossom, then regulators may be able to spot it more quickly and effectively than before. But even if they were provided with more rulemaking flexibility, it's not clear that they would exercise it anyway. Regulator hesitance is precisely why it's important that other mechanisms are in place to ensure that crises don't result when several firms or products go bad. Hopefully the new non-bank resolution authority will help prevent a repeat of past disaster, even if another shadow system arises.