Will Shadow Banking Cause the Next Financial Crisis?

Policymakers, regulators and bankers were jolted from their collective complacency over the impact of nonbank companies on the financial system with Facebook's announcement of its Libra digital currency and Calibra digital wallet initiatives. The market reach and technological heft of Facebook, combined with its Libra Association partners, represents the kind of catalyst that could spark the next financial crisis.

After all, in its fully-matured state, Libra has many attributes for a crisis in the making: a potential investment bubble over an untested digital currency; extensive linkages between consumers, traditional banking and shadow banking that could spark a panic and liquidity crisis; and potential to disrupt the transmission of monetary policy during such a crisis.

Libra is the latest phase in a remarkable transformation of the traditional banking and regulatory landscape that is unlike anything witnessed in the last 100 years of financial services. Shadow banking, that murky and somewhat ill-defined segment of the market that harbors a variety of companies providing bank-like consumer and wholesale products and services, is alive and well - despite substantial regulatory focus to rein in some questionable nonbanking activities that contributed to the last financial crisis.

The seeds of the next crisis are already planted somewhere, known to us as shadow banking but with unknown consequences to the stability of the global financial system. There are, however, steps regulators and bankers can take today to better prepare for such a systemic risk.

Shadow Banking and Its Rise to Prominence

Ironically, traditional banking precipitated the nonbank financial revolution. Its roots go back to the period immediately following the 2008-09 crisis, where the banking system was exposed for its poor risk governance, inadequate risk management practices and vulnerability to excessive risk-taking. Regulators were lambasted for the seemingly unfair and somewhat ad hoc manner in which they picked winners and losers, and a crisis of confidence ensued where customers lost faith in the financial system's ability to control its risky urges.

Though barriers to entry were thought to be relatively high for banking, the industry generally was complacent in areas such as payments processing, customer service and connectivity, providing the opportunity for tech-savvy firms to bring to market competitive offerings faster, efficiently and in a more consumer-centric manner than ever before.

Popularized during the crisis, the term “shadow banking” generally described the activities of nonbank firms and markets such as hedge funds, money market mutual funds, tri-party repo markets and asset-backed commercial paper. However, given the important changes currently happening in financial services, that definition is too restrictive for today's shadow banking marketplace.

Large nonbank originators and servicers now dominate the mortgage industry, having crowded-out depositories in this market. Fintech companies, moreover, now compete side-by-side banks for an array of consumer banking products and investments. Likewise, hedge funds and private equity firms have showered enormous sums of capital on nonbank entities since the crisis, while simultaneously extending their reach into traditional banking and leveraged lending markets.

Punctuated by the Libra announcement, nonbank financial transformation is not just here - it's about to revolutionize and displace traditional norms in banking.

Risks on the Horizon

In 2005, few could envision the problems that shadow banking would pose to financial markets. In 2019, with Libra not much more than a concept in a white paper, creating a scenario where it leads to a systemic financial crisis seems far-fetched - but isn't that what known unknowns are about?

Indeed, it certainly isn't a stretch to conceive of such an outcome. Facebook, after all, has one of the largest followings on earth, tapping into more than 1.5 billion customers today. US regulators and policymakers might express righteous indignation about Libra's Swiss registration, and subsequently attempt to shackle it with legislative and regulatory edicts; however, Facebook could still build, test and deliver its digital currency and wallet capabilities outside the US.

Inevitably, after building a global consumer base, Libra would find its way to the US, with corporations more than willing to step in and transact in Facebook's currency to better serve their customers. Investors, as they did with Bitcoin and other cryptocurrencies, would naturally flock to Libra, looking to make a play on it as an investment - notwithstanding Libra's ties to a basket of purported stable currencies.

Keep in mind that a private currency does not have to adhere to the currency dictates of a sovereign entity, so no government will be able to mandate changes to how Facebook manages Libra's stability. (Remember all those supposed subprime private-label AAA securities, and you get the idea.)

Over time, it isn't difficult to imagine commercial banks developing Libra-based products to avoid being left behind; indeed, in addition to banks buying and selling the currency as interest in Libra takes off, we might even see the creation of derivatives linked to Libra.

Now imagine, after some years, a run-of-the-mill operational or reputational event - say, a hacking of Libra or Calibra, or an AML event - and you could envision a worldwide panic. Since Calibra accounts are not insured, such an event could destabilize consumer-based markets and all Libra-based banking activities, fueling a panic in the currency that could spill over into other weaker currencies and markets.

Given the increasing connection of consumers and technology in finance, such an event could lead to a loss of confidence on par with 2008-2009, but with even greater velocity.

How to Prepare

Technology-driven nonbank linkages to commercial and consumer finance are today's Glass-Steagall challenge to banking, but regulators and banks are struggling to keep pace with this transformation. The OCC's effort to establish a fintech charter is just one example.

Overall, regulators are ill-equipped, outmatched and too fragmented to handle these new sophisticated and diverse entrants in a rapidly-changing environment. Remember, the regulatory agencies fumbled any comprehensive cleanup of the shadow banking problems from 2008-2009.

Forcing nonbanks to obtain some variation of a bank charter is one idea that has been suggested, but that is exactly the sort of simple-minded, one-size-fits-all mentality that has caused problems for regulators in the past. Nonbank financial companies are vastly different from depositories. The regulatory approach and focus for these firms therefore must align to the increasing importance and complexity of nonbank companies.

One potential solution is to establish a super federal nonbank regulatory authority charged with oversight of nondepository companies that provide products (e.g., Libra) and services directly related to and/or in competition with traditional banks or sovereign entities and financial markets. Separate divisions within such a regulator could include FHFA (the GSEs and FHLBs, after all, are a type of nonbank financial company), mortgage nonbank entities, digital currencies, fintechs, hedge funds and related investment facilities.

Given regulators' limited success in addressing previous issues with credit ratings and credit reporting companies, these types of firms could also fall under the auspices of the nonbank supervisor. Coordinated actions between this supervisor and others, such as SEC and CFTC, would naturally be required.

On the banking side, firms need to closely monitor developments in the shadow banking space and leverage this in their strategic risk and planning assessments. Moreover, banks need to redouble their efforts to strengthen their competitive capabilities against generally more technologically capable nonbank firms, particularly around blockchain. (JPMorgan, Bank of America, Wells Fargo and Citigroup are among the large banks that have already initiated blockchain projects.)

Banks also need to understand exactly what their exposure is to the shadow banking sector, factoring in counterparties, portfolios and vendors.

Parting Thoughts

Following the financial crisis, banks were extremely vulnerable and consumers were disenchanted with the financial sector, opening the door to a new era. Today, banking is on the cusp of a transformation that will upend traditional notions of what it means to be a bank.

Along its rise to prominence, shadow banking has embedded itself deep in the consumer and funding markets product chain. But the success of nonbanks in a fragmented and outdated regulatory environment could prove to be a catalyst for the next financial crisis.

Clifford Rossi (PhD) is Professor?of?the?Practice and Executive?in?Residence at the Robert H. Smith School of Business, University of Maryland, and a Principal of Chesapeake Risk Advisors, LLC. He has nearly 25 years of experience in financial risk management, having held a number of C?level positions at major banking institutions. Prior to his current posts, he was the chief risk officer for Citigroup's North America Consumer Lending Division.