Shadow Banking and the Likelihood of U.S. Recession

Greater reliance on the shadow banking system might reduce the Federal Reserve’s ability to inject liquidity into a flagging economy.

Money Grab

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Measures such as the Dodd-Frank Wall Street Reform and Consumer Protection Act, the Volcker Rule and Basel III curtailed bank risk-taking and balance-sheet utilization, resulting in improved bank solvency and stability in the aftermath of the 2008–’09 financial crisis. Yet despite these accomplishments — or perhaps because of them — our economy today remains vulnerable to another 2008-like shock.

One accomplishment that our banking regulators can be justifiably proud of, however, is the reduction in U.S. banking system reliance on wholesale funding. A high degree of reliance on wholesale funding implies that a bank’s financing may have greater exposure to flight risk during times of stress. Since the height of the financial crisis, the percentage of U.S. bank liability supported by wholesale funding has fallen from 43 percent to 26 percent — nearly the lowest level in 35 years.

Although the U.S. banking sector has made significant progress in reducing its dependence on wholesale funding, the financial system has grown increasingly reliant on the sinister-sounding shadow banking system, which consists of nonbank credit providers such as bond funds, insurers, pensions and hedge funds. Like banks, shadow banking provides credit to the U.S. economy by purchasing debt and loans issued by corporations. Unlike banks, however, shadow banking lacks access to a stable and unfettered source of short-term liquidity such as the Federal Reserve. The shadow banking system is therefore susceptible to episodes of forced liquidation and credit contraction.

For example, if a large number of investors decide to exit the bond market as the Fed begins to raise rates, the shadow banking system’s ability to provide additional financing to the economy could be diminished. An economy that is highly reliant on the shadow banking system is exposed to risks similar to those of a bank exposed to excessive wholesale funding: a greater likelihood of liquidity runs, increased funding volatility and gaps in credit provision.

As of the end of 2014, the percentage of U.S. private sector funding supported by the shadow banking system was the highest of any country in the Organization for Economic Cooperation and Development. World Bank data show that that proportion currently stands at its highest level since at least 1960 — nearly 80 percent of the U.S. private sector is now financed by the shadow banking system. We are thus more likely to witness rapid credit expansions and contractions during future episodes of market volatility and changing investor flows as a result.

Increased reliance on the shadow banking system is, by itself, not sufficient to create an economic crisis. But over time, it can begin to disintermediate — and perhaps even partially nullify — the Federal Reserve’s ability to dampen economic cycles by providing needed short-term liquidity to the market. Recent and upcoming developments in the economy and market may, along with the rising prominence of the shadow banking system, increase the likelihood of future credit disruptions. These developments include the impending interest rate hike by the Federal Reserve, a doubling of the size of corporate bond market since 2007 and the reduced market-making capacity of banks and broker-dealers in the postcrisis regulatory world.

Our economic prosperity depends on private sector access to a diverse and reliable set of credit sources. A private sector that is highly dependent on the shadow banking system is not beneficial to the long-term health of the economy. Since the U.S. economy is not policed by regulators who can mandate a lower reliance on the shadow banking system, one possible remedy is to revitalize the role of banks in the economy, preferably before a market-driven curtailment of shadow banking financing accomplishes the same in a much harsher fashion. To that end, we need to thoughtfully evaluate whether the various postcrisis legislative and regulatory actions, in addition to protecting the banking system, may have sown the seeds of future 2008-like economic crises.

Scott Peng leads the global portfolio solutions business at SECOR Asset Management in New York.

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