Sept. 5, 2012 – Financial regulators should turn their attention to the potential threats to financial stability lurking in the shadow banking system, according to a report released today by the C.D. Howe Institute. In “Combatting the Dangers Lurking in the Shadows: The Macroprudential Regulation of Shadow Banking,” David Longworth, former deputy governor of the Bank of Canada, argues greater regulation of the financial entities in the sector is required to mitigate the risks of another run on the shadow banking system exacerbating financial instability, as occurred in the 2008/2009 financial crisis.
Regulatory work, Longworth notes, has recently shifted to some extent to the shadow banking sector, which broadly refers to the system of credit intermediation outside the regular banking system, and consists of finance companies, commercial paper issuance, money market funds, the securitization process, and repurchase (“repo”) markets for the short-term financing of securities. This system has greatly risen in importance over the past 20 years.
Prior to the recent financial crisis, many of the system’s short-term liabilities were seen as nearly risk-free (“AAA”) assets, but some proved not to be so. Not only did the shadow banking system contract considerably during the financial crisis in both the United States and Canada, but so did the system’s provision of financing to regulated banks, which exacerbated their liquidity difficulties.
Longworth makes the case that some shadow banking entities ought to be regulated as banks or in a similar fashion to banks (for example, with capital and liquidity requirements) while in other cases regulation should cover banks’ relationships with them, their procyclical behaviour in certain markets (such as those for repos), or the ratings process for securitized products.
Taken together, says Longworth, the implementation of these policies should help reduce systemic risk and the probability of future periods of financial stress, for a stronger and more stable financial system.
Click here for the full report.
For more information contact: David Longworth, former deputy governor of the Bank of Canada and currently Adjunct Research Professor, Carleton University and Distinguished Fellow, Queen’s University; or Philippe Bergevin, Senior Policy Analyst, C.D. Howe Institute. 416-865-1904; email: cdhowe@cdhowe.org