What Kind of Problem Is Shadow Banking?
How you diagnose a policy problem is often just as important as the solutions you propose. This is certainly true when it comes to financial reform, as competing theories of what is wrong with the financial sector tend to be more important than the technical solutions proposed. This has become even more relevant with a recent speech by Bernie Sanders that laid out his financial reform agenda in advance of the Democratic primaries, contrasting his approach even more strongly with Hillary Clinton’s.
The biggest point of contention is Sanders’s plan to break up the banks within one year, which we’ll talk about in a minute. He also argues that his plan tackles the problem of “shadow banking.” This phrase has become important to the debate between Sanders and Clinton, but there’s a lot of confusion over the term and how each would approach it.
Here’s a useful way to think about it: Bernie Sanders sees the problem of shadow banking primarily as a problem of major institutions. Tackle the biggest banks, weakening their political power and their ability to engage in questionable financial practices by breaking them up, and that largely solves the problem. Hillary Clinton, however, sees the problem of shadow banking as primarily one of activities. In this case, you need to cast a wider regulatory net, aiming at the specific types of actions financial people are taking rather than the size and strength of specific institutions.
At this point most people would say that this is a “both/and” kind of problem, and there’s no reason we can’t confront both. That’s normally good advice. But the way this debate is evolving tends to limit the degree of overlap that’s possible. Addressing shadow banking as a type of activity means formalizing it within the regulatory infrastructure we have. Approaching it as a problem of the largest institutions tends to limit and silo those activities, which leaves them outside the regulatory system. These approaches point to two different problems and, consequently, two different theories of what must be done. Let’s dive in.
So what is shadow banking? The New York Fed defines it as an “intermediation chain” of “banking activities consist[ing] of credit, maturity, and liquidity transformation that take place without direct and explicit access to public sources of liquidity or credit backstops.” So you have the risks of banking, amplified because lending happens across a chain of different financial firms, without any of the “public sources of liquidity, such as the Federal Reserve’s discount window, or to public sources of insurance, such as that provided by the Federal Deposit Insurance Corporation (FDIC).” 
There are two related ways shadow banking can be a problem: a micro-level problem concerning information and a macro-level problem concerning panics and systemic collapses. With lots of links in the chain of credit, there’s potential for fraud and other issues. If you are making a loan knowing you will sell it to someone who will sell it to someone else, there’s a lot of temptation for you to cut corners.
The second problem comes from potential for panics and systemic risks. Since shadow banks borrow short and lend long, panics can become self-fulfilling, and you can have a “bank run” except in the capital markets. The normal way you deal with this is through public backstops, but by definition shadow banks don’t have access to these sources of public insurance.
What Can Be Done?
Sanders’s approach is to block the largest institutions from trying to engage in any types of shadow banking. In addition to breaking up the banks by size, you break them up by activity. This is how I understand the centrality of a 21st century Glass-Steagall to the Sanders plan, which prohibits firms from being able to “invest in a structured or synthetic product,” thus blocking the largest banks from engaging in shadow banking.
There are two problems with this approach. The first is that it’s often difficult to structurally reform banks along these lines. Glass-Steagall, even before its repeal, didn’t prevent banks from lending to mortgage-backed securities and getting involved in the crisis, which is a normal banking function. Either you draw the lines vaguely enough that banks can maneuver around them, or you draw them so tough that it’s difficult for normal banks to do anything that banks do.
The second is more important. These activities will simply migrate elsewhere, often to places where there is less regulatory infrastructure. That’s part of the problem of shadow banking – it exists in places where the backstops in times of emergency are poorly defined or privately provided and prone to collapse.This will happen even more as regulations are tightened on the biggest banks. So if you focus on the largest institution, you need to emphasize the broader regulatory net even more, not less.
But there’s a narrative that the problem of shadow banking is just one of FDIC deposits being put at risk. In this story, if we limit taxpayer exposure to shadow banking, or get government subsidies out of the way, then we’ve solved the problem. I worry this dominates the conversation among reform too much, limiting our ability to engage in a “both/and” analysis, because what the crisis showed is that banking using credit markets, not deposits, can cause massive problems. The real challenge is how to bring the practices and activities of shadow banking under a regulatory umbrella, not exclude it entirely.
The other approach is to formalize shadow banking by extending regulations to the activities themselves. Hillary Clinton’s plan calls for margin requirements on short-term “repo” lending, leverage requirements on broker-dealers, transparency on hedge funds, and revisiting the money market fund industry. These are the links that make up the shadow banking chain, and tightening the rules for them is a necessary component of reform, in addition to confronting the political power of the largest players. I hope they get emphasized more as the election continues.
Breaking Up the Banks ASAP
Bernie’s plan is to use the powers within Dodd-Frank to break up the largest institutions within one year. The timeframe seems unrealistic, since you would probably need to replace Janet Yellen with someone who’s on board with this project, and her term won’t expire until early 2018. But there is a process within Dodd-Frank that would allow for it if you appoint the right people. Two, in fact.
- Say that a financial firm poses “a grave threat to … financial stability” and is Too Big to Fail. This requires a two-thirds vote of regulators and requires an affirmative process to start. (Section 121.)
- Say that if a financial firm fails it would pose too much of a risk, and that the “living will” this firm has submitted is not a credible plan for the event of failure. If that were the case, the Federal Reserve and the FDIC could “impose more stringent capital, leverage, or liquidity requirements, or restrictions on the growth, activities, or operations of the company.” (Section 165d).
Sanders emphasized the first approach in his speech, but the second is already happening, with the FDIC and Fed finding initial plans not credible. This would be an avenue to push further, since the regulators are already on the case. It’s also the avenue that Martin O’Malley’s financial reform plan emphasizes, with “Right-Size Big Banks Using Living Wills.” 
It’s not just that it’s easier, since you need fewer parties on board to break up the banks. Emphasizing this second approach may also better convey the seriousness of the situation, since the FDIC, which will be blamed if a Dodd-Frank bank resolution goes terribly, is sending out emergency flares about the problem. This also shows the importance of appointments, because regulators in charge set institutional priorities, and someone who emphasized size as a risk has the ability to shake things up.
 I like the New York Fed’s definition because it allows that “shadow banking” can take place to some degree within traditional banking structures. Other definitions focus more on the non-prudential regulatory component of being outside traditional banking, which includes far too much and too little.
 For instance, there’s a lot of debate over Sanders’s statement that funding for shadow banking “came from the federally-insured bank deposits of big commercial banks – something that would have been banned under the Glass-Steagall Act.” I don’t believe this is true, which shows the porousness of a lot of these restrictions.
 There are ways of restructuring financial institutions to mostly eliminate the problem of shadow banking, but they tend to involve “Chicago Plans” that have 100 percent equity requirements (see: the IMF, John Cochrane). Here you’d need to go 100 percent equity on all intermediation, not just banks—a radical shift outside the normal policy discussion.
 O’Malley’s plan also calls for a 15 percent capital requirement. I’m surprised that higher capital requirements haven’t dominated the Dem primary, and worried cheap talk around them will be the way the GOP nominee looks tough on financial reform.