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Bates Research  |  04-03-15

Regulating Shadow Banks

Stone Mountain, Georgia played host to a meeting of prominent U.S. policy-makers and economists earlier this week. The event, held by the Federal Reserve Bank of Atlanta, met to discuss "shadow banking" and its implications for monetary policy and stability. Shadow banking, in brief, refers to those financial market participants who serve the same credit creation function as banks but are not subject to the same regulations that banks face. While shadow banking entities saw their rate of market participation drop during the aftermath of the credit crisis, they have made a strong comeback as of late, reaching a market value of $75 trillion to end 2013. Resumed GDP growth, coupled with low interest rates and spreads, have created the perfect environment for shadow banking growth.

The Atlanta Fed's conference focused on one salient issue: has everything that has been done to regulate the banking sector in the aftermath of the credit crisis actually strengthened the ability of the economy as a whole to withstand shocks? In his keynote address, Fed Vice Chairman Stanley Fischer noted that he expected further regulation, and that "we should not be complacent about the stability of the financial system." Since the Federal Reserve is primarily involved in overseeing banks, this would mean more responsibilities for the SEC, something SEC Chief Economist Mark Flannery (speaking at the same conference) seemed to agree with, concluding that "It’s not clear at all to me that making the banks safer has made the economy safer, and so there is a lot of pressure to regulate the shadow banks."

Regulation fatigue is a key concern for financial industry participants today, and the Federal Reserve (and other policy-makers) must be careful to find the right balance between additional oversight and growth. Financial intermediation is clearly necessary, and shadow banking is meeting a distinct market demand in that regard. Regulators will attempt to find a balance that provides stability, without stifling credit and growth. Besides a massive overhaul of bank regulatory standards, key reforms have also been undertaken to strengthen our financial infrastructure in general. Namely, regulators have already introduced tri-party requirements in repo markets, central-clearing requirements for OTC derivatives, and new rules governing money market fund pricing. Can they continue to find the right balance, making the system safer without stopping it cold? Shadow banking entities, if they are found to be centrally important, must have the ability to remain liquid in times of stress. If maintaining order during economic turmoil in shadow markets requires government support, then the necessary cost of that support must be regulation. This conference highlights regulators’ efforts to make sure they get those regulations right.