When the first wave of the coronavirus pandemic hit in the spring of 2020 it provoked, along with lockdowns, a sudden financial crisis. It was a mercy for the global economy, however, that the banks at the bedrock of the monetary system were for the most part not involved. Instead the trouble was in the growing and poorly regulated “non-bank sector”, which the Bank for International Settlements estimates now accounts for nearly half of all financial assets. It is time for these shadow banks to step out of the shadows and be regulated more like their conventional peers.
On Monday the BIS, the co-ordinating body of central banks, sensibly called for stricter regulation of the sector, which has become ever more fundamental to much of the basic operation of finance. The call should be heeded. Tougher rules on banks, introduced after the 2008 financial crisis, helped make the banking system more resilient — showing its worth during the turmoil in March 2020 — but it has also pushed some risk-taking into the “shadow banks”, such as bonds funds and private lenders.
These non-banks can, however, exacerbate an economic downturn just like their more traditional cousins. Last year, open-ended bond funds faced a rush of redemptions, similar to a bank run. The funds offer complete liquidity for investors, allowing them to instantly receive the value of their investment back, but the funds themselves own more illiquid assets. With investors spooked by the pandemic, the funds were forced to sell their most liquid assets, often US Treasuries, at steep discounts to meet the redemptions. The fire sale of assets and the disorder in the world’s most important asset market was only halted when the US central bank, the Federal Reserve, stepped in as the “dealer of last resort”.
As the BIS writes in its call for tighter regulation, it would be far better to address the causes of the problem at their root rather than relying on such ad hoc central bank interventions. If speculators believe that the central bank will ultimately step in at times of disarray then there will be less reason to manage the risks themselves. The need to stabilise the shadow banks through easy monetary policy could then conflict with other goals, such as taming inflation.
The first step is to encourage more transparency, especially to make the links between the shadow banks and more normal banks clearer. It is essential for regulators to see the channels for financial contagion as well as the extent of “hidden leverage”. This will, eventually, need to be followed up by even more comprehensive disclosure requirements. The BIS similarly calls for the shadow banks to have, like regular banks, “countercyclical buffers” — in this case principally stocks of highly liquid reserves to meet redemptions in times of crisis.
Ideally, the market would also provide more “discipline”. Small upsets in financial markets provide a salutary reminder to investors that prices can fall as well as rise. Indeed the “taper tantrum” of 2013 when the Federal Reserve began to reduce the pace of its asset purchases after the 2008 crisis reminded investors that stock and bond prices do not inevitably rise.
Policymakers, however, cannot choose the timing nor severity of such episodes. Nor should they deliberately engineer a downturn or credit scare themselves. A far better option is to follow the proposal set out by the BIS, by shining a light into the murky corners of the financial system, ensuring that what they find there is prepared for the next crisis.