tag:theconversation.com,2011:/us/topics/shadow-banking-5177/articlesShadow banking – The Conversation2018-09-14T13:11:28Ztag:theconversation.com,2011:article/1031892018-09-14T13:11:28Z2018-09-14T13:11:28ZSleepwalking towards the next financial crisis? Here are the five biggest risks<p>Wall Street giant Lehman Brothers <a href="https://theconversation.com/anniversary-of-lehmans-collapse-reminds-us-booms-are-often-followed-by-busts-102758">filed for bankruptcy</a> on September 15, 2008, triggering the most significant global financial crisis since the great depression. Lehman’s collapse was not triggered in a day but over a much longer period, with assets of US$680 billion (£518 billion) supported by only US$22.5 billion of capital by the time it went under. As the subprime mortgage crisis began to eat up financial institutions, this once invincible bank was suddenly no more. </p>
<p>A decade later, with many of the world’s leading economies <a href="https://data.worldbank.org/indicator/ny.gdp.mktp.kd.zg?end=2017&start=1964">struggling</a> to grow consistently, one would have hoped that the banking industry and its regulators would have learned from what happened. Gordon Brown, UK prime minister at the time of the collapse, doesn’t think so. </p>
<p>Brown <a href="https://www.bbc.com/news/business-45504521">believes</a> we are “sleepwalking” into the next global financial crisis. He sees insufficient headroom to resuscitate economies by cutting interest rates or raising public spending. He describes a “leaderless world” in which it looks harder to achieve the global <a href="https://www.theguardian.com/business/2008/oct/13/creditcrunch-marketturmoil1">coordinated action</a> that was critical for avoiding even greater disaster ten years ago.</p>
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<a href="https://images.theconversation.com/files/236439/original/file-20180914-177953-k6vlpd.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=1000&fit=clip"><img alt="" src="https://images.theconversation.com/files/236439/original/file-20180914-177953-k6vlpd.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&fit=clip" srcset="https://images.theconversation.com/files/236439/original/file-20180914-177953-k6vlpd.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=600&h=469&fit=crop&dpr=1 600w, https://images.theconversation.com/files/236439/original/file-20180914-177953-k6vlpd.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=600&h=469&fit=crop&dpr=2 1200w, https://images.theconversation.com/files/236439/original/file-20180914-177953-k6vlpd.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=600&h=469&fit=crop&dpr=3 1800w, https://images.theconversation.com/files/236439/original/file-20180914-177953-k6vlpd.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&h=589&fit=crop&dpr=1 754w, https://images.theconversation.com/files/236439/original/file-20180914-177953-k6vlpd.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=754&h=589&fit=crop&dpr=2 1508w, https://images.theconversation.com/files/236439/original/file-20180914-177953-k6vlpd.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=754&h=589&fit=crop&dpr=3 2262w" sizes="(min-width: 1466px) 754px, (max-width: 599px) 100vw, (min-width: 600px) 600px, 237px"></a>
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<span class="caption">SOS.</span>
<span class="attribution"><a class="source" href="https://www.shutterstock.com/image-photo/on-edge-concept-man-standing-cliff-191337065?src=ueU-nvhYfCDXpPHr1h6wUQ-6-21">designelements</a></span>
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<p>Is there any room for cheer? Here’s my brief assessment of the indicators that will be crucial in any future crisis.</p>
<h2>1. Debt</h2>
<p>Global debt <a href="https://goo.gl/q5vssd">recently hit</a> a new record high of 225% of world GDP, amounting to US$164 trillion. The world is now 12 points deeper in debt than the previous peak in 2009, with advanced economies’ ratios at levels not seen since World War II. </p>
<p>This is forcing countries with large fiscal deficits to pay ever more interest to cover their bills. And if they can’t reduce their deficits, they will find it tough to deal with even the lightest economic downturn. Hence the <a href="https://www.imf.org/en/News/Articles/2018/04/09/spring-meetings-curtain-raiser-speech">recent call</a> from IMF director Christine Lagarde for countries to fix “the roof while the sun is still shining”, by cutting deficits, improving banking capital buffers and maximising exchange rate flexibility. </p>
<p><strong>G20 fiscal deficits, 2017</strong> </p>
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<a href="https://images.theconversation.com/files/236422/original/file-20180914-177947-1y68fsy.png?ixlib=rb-1.1.0&q=45&auto=format&w=1000&fit=clip"><img alt="" src="https://images.theconversation.com/files/236422/original/file-20180914-177947-1y68fsy.png?ixlib=rb-1.1.0&q=45&auto=format&w=754&fit=clip" srcset="https://images.theconversation.com/files/236422/original/file-20180914-177947-1y68fsy.png?ixlib=rb-1.1.0&q=45&auto=format&w=600&h=247&fit=crop&dpr=1 600w, https://images.theconversation.com/files/236422/original/file-20180914-177947-1y68fsy.png?ixlib=rb-1.1.0&q=30&auto=format&w=600&h=247&fit=crop&dpr=2 1200w, https://images.theconversation.com/files/236422/original/file-20180914-177947-1y68fsy.png?ixlib=rb-1.1.0&q=15&auto=format&w=600&h=247&fit=crop&dpr=3 1800w, https://images.theconversation.com/files/236422/original/file-20180914-177947-1y68fsy.png?ixlib=rb-1.1.0&q=45&auto=format&w=754&h=310&fit=crop&dpr=1 754w, https://images.theconversation.com/files/236422/original/file-20180914-177947-1y68fsy.png?ixlib=rb-1.1.0&q=30&auto=format&w=754&h=310&fit=crop&dpr=2 1508w, https://images.theconversation.com/files/236422/original/file-20180914-177947-1y68fsy.png?ixlib=rb-1.1.0&q=15&auto=format&w=754&h=310&fit=crop&dpr=3 2262w" sizes="(min-width: 1466px) 754px, (max-width: 599px) 100vw, (min-width: 600px) 600px, 237px"></a>
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<span class="attribution"><a class="source" href="https://www.cia.gov/library/publications/the-world-factbook/fields/2222.html">CIA</a></span>
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<h2>2. Emerging markets</h2>
<p>Nervous investors have been heavily selling assets in emerging markets, such that inflows into these countries <a href="http://www.theedgemarkets.com/article/currency-storms-rage-stocks-wipeout-nears-us1-trillion">plummeted</a> to US$2.2 billion in August compared to a high of US$13.7 billion only a month before. The <a href="https://www.businessinsider.com/investing-in-emerging-markets-reasons-benefits-and-mistakes-2018-9/?IR=T">outflow of money</a> has emaciated the currencies of Turkey, Indonesia and Argentina. Meanwhile, the US greenback <a href="https://goo.gl/2c34Ci">gets</a> stronger and stronger as investors seek to benefit from the <a href="https://goo.gl/CFe1r7">strength of</a> US treasury bonds and other dollar-denominated assets. These changes are bound to affect international trade, heightening the prospect of contagion to other countries. </p>
<h2>3. Trade</h2>
<p>The trade tensions between the <a href="https://theconversation.com/donald-trumps-economic-gamble-with-trade-wars-and-tax-cuts-he-could-win-big-or-lose-everything-101945">US and China</a> represent a massive geopolitical risk. These countries <a href="https://goo.gl/EdjfV1">have the</a> highest debt piles in the world, US$48.1 trillion and US$25.5 trillion respectively. Any economic fallout from their trade posturing could put global financial markets in a fix. </p>
<p>We are already seeing the impact on the Chinese stock market, which <a href="https://goo.gl/ELbuK6">has lost</a> about 20% of its value already this year. There are knock-on effects in Hong Kong, <a href="https://goo.gl/Rv6a85">dragging down</a> the Hang Seng trading index to a 14-month low lately. The contagion could soon spread around the globe, including to emerging economies already reeling from the aforementioned currency crises discussed above. </p>
<h2>4. Banking</h2>
<p>In the aftermath of Lehman, the world’s major banks <a href="https://www.nytimes.com/interactive/2018/09/12/business/big-investment-banks-dodd-frank.html">have moved</a> from depending on short-term borrowings to building larger capital buffers to help them steer through another credit crunch. Be that as it may, many other banks have still looked vulnerable – especially after the <a href="http://www.cadtm.org/Banks-are-responsible-for-the">Greek</a>, <a href="https://goo.gl/hs3thW">Spanish</a> and <a href="https://goo.gl/sgph95">Italian</a> banking crises of recent years. It is a strong signal that regulations are still insufficient to protect the system overall. </p>
<p>Then there is <a href="https://theconversation.com/explainer-shadow-banking-and-where-it-came-from-75692">shadow banking</a> – essentially financial institutions which aren’t banks, such as insurance companies or hedge funds, providing banking services such as lending. This <a href="https://themarketmogul.com/uk-shadow-banking/">grew</a> rapidly after the previous crisis, since the institutions in question are subject to fewer regulatory restrictions as the banks. </p>
<p>A mind-boggling <a href="https://goo.gl/XEsz5W">study</a> from the US last year, for example, found that the market share of shadow banking in residential mortgages had rocketed from 15% in 2007 to 38% in 2015. This also represents a staggering 75% of all loans to low-income borrowers and risky borrowers. China’s shadow banking is another major concern, <a href="https://www.bloomberg.com/news/articles/2018-01-23/china-s-15-trillion-shadow-banking-edifice-showing-more-cracks">amounting to</a> US$15 trillion, or about 130% of GDP. Meanwhile, <a href="https://newint.org/features/2018/07/01/the-next-financial-crisis">fears are mounting</a> that many shadow banks around the world are relaxing their underwriting standards. </p>
<h2>5. Cyber hazards</h2>
<p>Some analysts also <a href="https://goo.gl/D32Knt">worry that</a> the next financial crisis could be triggered by cyber attacks on today’s fully digital and interconnected financial system. This has <a href="https://goo.gl/Lu4PLd">consistently been ranked</a> as the number one concern by respondents to the Depository Trust’s Systemic Risk Barometer since its surveys began in 2013. </p>
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<a href="https://images.theconversation.com/files/236438/original/file-20180914-177941-spfpco.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=1000&fit=clip"><img alt="" src="https://images.theconversation.com/files/236438/original/file-20180914-177941-spfpco.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&fit=clip" srcset="https://images.theconversation.com/files/236438/original/file-20180914-177941-spfpco.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=600&h=400&fit=crop&dpr=1 600w, https://images.theconversation.com/files/236438/original/file-20180914-177941-spfpco.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=600&h=400&fit=crop&dpr=2 1200w, https://images.theconversation.com/files/236438/original/file-20180914-177941-spfpco.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=600&h=400&fit=crop&dpr=3 1800w, https://images.theconversation.com/files/236438/original/file-20180914-177941-spfpco.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&h=503&fit=crop&dpr=1 754w, https://images.theconversation.com/files/236438/original/file-20180914-177941-spfpco.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=754&h=503&fit=crop&dpr=2 1508w, https://images.theconversation.com/files/236438/original/file-20180914-177941-spfpco.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=754&h=503&fit=crop&dpr=3 2262w" sizes="(min-width: 1466px) 754px, (max-width: 599px) 100vw, (min-width: 600px) 600px, 237px"></a>
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<span class="caption">Game over?</span>
<span class="attribution"><a class="source" href="https://www.shutterstock.com/image-photo/computer-code-on-screen-skull-representing-1050436496?src=szgt-1mnKt9HT0UxnzAWbA-1-3">solarseven</a></span>
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<p>In sum, despite the efforts to strengthen the financial system, it looks far from failsafe. Gordon Brown is unfortunately right that the world has not managed to do enough to prepare itself for the next shock, and the growing divisions within the international community make the situation look particularly dangerous. We have not been able to curb the tendency of financial institutions to take on excessive risk, and as Brown also said, there is still not enough of a corrective mechanism for those who act irresponsibly. </p>
<p>JP Morgan <a href="https://www.smh.com.au/business/markets/the-next-financial-crisis-will-strike-in-2020-says-jpmorgan-20180914-p503o7.html">is predicting</a> the next crisis will strike in 2020, if not earlier, and this does seem quite foreseeable. So brace yourself and stay prepared, and let’s hope that things don’t turn out as badly as they potentially could.</p><img src="https://counter.theconversation.com/content/103189/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>Nafis Alam does not work for, consult, own shares in or receive funding from any company or organisation that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.</span></em></p>Gordon Brown is worried. So should we all be.Nafis Alam, Associate Professor, University of ReadingLicensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/756922017-04-10T20:15:27Z2017-04-10T20:15:27ZExplainer: shadow banking and where it came from<p>The term “shadow banking” often has connotations of dodgy lending and borrowing practices, out of reach of regulators. And while its use may contribute to risk, in reality shadow banking does serve a purpose in our economy, one that is increasingly connected to our day-to-day lives.</p>
<p>Shadow banking affects not only the property market, but also superannuation, central banking policy and, increasingly, fiscal and social policy. It refers to the non-bank financial intermediaries that supply services similar to commercial banks. </p>
<p>This system provides funding for credit, by converting risky and long-term assets that can’t be sold quickly or easily (like mortgages) into a money-like, short-term debt (like mortgage-backed securities). </p>
<p>Shadow banking is not a bank in the sense that we know it but more a strategy or accounting technique. A range of institutions deploy these strategies including superannuation funds, insurance companies and <a href="http://www.corrs.com.au/publications/tgif/federal-court-sets-the-standard-with-standard-and-poors/">local governments</a>. Asset managers, like Macquarie Group in Australia and BlackRock in the United States, also employ these techniques. </p>
<p>In short, shadow banking provides institutions the means to create accounting entities to isolate risks, transfer profits, avoid regulation and increase the range of money-like financial products available for investment. </p>
<h2>Where shadow banking came from</h2>
<p>There are both supply and demand reasons for the emergence of the shadow banking system. Shadow banking has emerged as a means for financial firms to bypass regulation (for example by using tax havens) and increase opportunities for financial innovation and speculative activity. </p>
<p>Banks have an incentive to lower the number of risky assets on their balance sheets, in order to reduce the amount of capital they need to hold to cover these risks. Because of this the banks create off-balance sheet entities (assets that use shadow banking).</p>
<p>Shadow banking also offers a means for investors to access different forms of money across the financial system. Institutional investors trade in volume, and cannot physically <a href="https://www.financialresearch.gov/working-papers/files/OFRwp2014-04_Pozsar_ShadowBankingTheMoneyView.pdf">“handle billions in cash in the form of currency”</a>.</p>
<p>This type of finance is normally best met by Treasury bills and government bonds (which presently offer low returns) and repurchase agreements - a form of short-term borrowing in these sorts of bonds. The shadow banking system then fills the gap in the absence of availability of other secure assets.</p>
<p>However these supply and demand explanations only tell part of the story. </p>
<p>The global environment is characterised by a <a href="https://www.nytimes.com/2016/01/24/magazine/why-are-corporations-hoarding-trillions.html">small population</a>) of individuals and institutions with large pools of money seeking safe returns; and, cash-poor individuals with stagnant incomes and a need for credit. One example of this is the growing investment class of securities based on private debt, for example credit cards, mortgage debt and <a href="http://www.smh.com.au/small-business/finance/pretty-close-to-extortion-mars-kelloggs-and-fonterra-pushing-loans-on-small-business-20170331-gvb56f.html">small business loans</a>.</p>
<p>Low inflation across the globe and governments not spending or encouraging investment in assets that offer good returns, means investors are limited in the ways they can currently make money.</p>
<h2>The problems with and solutions for shadow banking</h2>
<p>Shadow banking has made the task of governments more difficult. However it would be mistaken to assume that governments do not have some control over shadow banking. All levels of government are already linked to aspects of shadow banking whether they like it or not. </p>
<p><a href="http://www.theaustralian.com.au/business/legal-affairs/councils-win-landmark-case-against-standard-and-poors-abn-amro/news-story/ec62f52b82a904467f0019635aa54773">Local governments</a> were stung by exposure to shadow banking practices in the lead up to the global financial crisis. Councils were persuaded to invest in a structured financial product that offered unrealistic, and deceptive returns. </p>
<p>The NSW government is currently following shadow banking trends by borrowing and <a href="http://www.afr.com/street-talk/macquarie-gets-westconnex-funding-talks-underway-20160620-gpnt9p">partnering with asset managers</a> to build long-term infrastructure like Westconnex and the Sydney Light Rail. </p>
<p>At the national level, the Rudd-Gillard Government followed trends that originated in shadow banking by developing institutions like the <a href="http://www.cleanenergyfinancecorp.com.au/">Clean Energy Finance Corporation</a> and the National Broadband Network. Both policies tried to diversify the investment base in Australia, but have been held up by the Abbott-Turnbull governments.</p>
<p>Australia can’t do much to remedy global uncertainty. However, policies it pursues do link into shadow banking practices in multiple ways. </p>
<p>Policies that erode the standard employment relation and <a href="http://www.smh.com.au/federal-politics/political-news/former-rba-governor-bernie-fraser-says-penalty-rate-cut-will-produce-inequality-not-jobs-20170406-gvezd1.html">cut pay rates</a> increase consumer demand for <a href="http://www.news.com.au/finance/money/costs/payday-loan-mountain-to-top-1-billion-as-irresponsible-lending-skyrockets/news-story/e875ffc54b981d25df6fd3b779708824">short-term credit</a> products. This increases private debt for consumers, but feeds its attractiveness into an asset class for institutional investors.</p>
<p>Reserve Bank of Australia Governor, Phillip Lowe, was surprisingly strident in his <a href="http://www.abc.net.au/news/2017-02-24/philip-lowe-house-committee-economics/8299714">critique</a> of the cut to corporate tax rates and negative gearing last week. Reading between the lines you can sense frustration with the lack of attention on how Australia stands to benefit or lose from current global investment trends. </p>
<p>Institutional investors don’t need more piles of cash (via company tax cuts), they need ways to invest it. If you think about Australia from the perspective of institutional investors, it lacks a diverse range of assets (besides property!).</p>
<p>Australia only registers <a href="https://industry.gov.au/Office-of-the-Chief-Economist/Publications/Documents/Australian-Innovation-System/Australian-Innovation-System-Report-2014.pdf">17 specialised goods industries compared</a> with 35 for New Zealand and 44 for Canada. Consequently, real estate and infrastructure debt are some of the only things available to sop up the pile of <a href="https://www.ft.com/content/9ab40034-a4db-11e6-8898-79a99e2a4de6">cash</a> currently sloshing around the global economy. </p>
<p>This leads to <a href="http://www.brokernews.com.au/news/breaking-news/smsfs-and-property-a-ticking-time-bomb-224584.aspx">claims</a> that self-managed super funds (those run by institutional investors) are potentially exacerbating Sydney and Melbourne’s already expensive property market. </p>
<p>There are three growing areas of shadow banking: catastrophe bonds, which bet on the risk of natural disasters; renewable energy infrastructure banks, and <a href="http://www.telegraph.co.uk/business/2017/04/09/legal-general-biggest-house-builder-never-heard/">build-to-rent</a> investments. These examples offer the two sides of shadow banking.</p>
<p>Catastrophe bonds are parasitic in the way they provide finance - betting on the destruction from disasters. Renewable energy and build-to-rent show the potential for using finance for potentially progressive outcomes, to provide sustainable energy and housing. Australia could harness this progressive side of finance to create a more diverse economy.</p><img src="https://counter.theconversation.com/content/75692/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>Huon Curtis does not work for, consult, own shares in or receive funding from any company or organisation that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.</span></em></p>Shadow banking provides investors with the means to isolate risks, transfer profits, avoid regulation and increase the range of money-like financial products available for investment.Huon Curtis, Senior Research Analyst, University of Technology SydneyLicensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/653282016-09-14T20:16:04Z2016-09-14T20:16:04ZShadow banking increases the risk of another global financial crisis<p>Banks may still be evading increased regulation by shifting activities to shadow banking. This system is well established as part of the financial sector, but it provides products that separate an investor from an investment, making it more difficult to evaluate risk and value.</p>
<p>This lack of transparency increases the risk in our financial system overall, making it vulnerable to the types of shocks that caused the 2008 global financial crisis. A current example is the so-called <a href="http://www.bustle.com/articles/136706-what-is-a-bespoke-tranche-opportunity-the-big-short-ends-with-a-big-warning">“bespoke tranche opportunity”</a> offered by shadow banks. This is similar to the notorious collateralised debt obligations, packages made up of thousands of mortgage loans some of which were sub-prime, blamed for the global financial crisis.</p>
<p>Shadow banking is comprised of hedge funds, private equity funds, mutual funds, pension funds and endowments, insurance and finance companies providing financial intermediation without explicit public liquidity and credit guarantees from governments. Shadow banking is usually located in lightly regulated offshore financial centres.</p>
<p>In the period leading up to the global financial crisis, a large portion of financing of securitised assets that allowed regulated banks to exceed limitations on their risk-taking was handled by the shadow banking sector.</p>
<p>To this day, shadow banking continues to make a significant contribution to financing the real economy. For example, <a href="http://www.fsb.org/2015/11/global-shadow-banking-monitoring-report-2015/">according to the Financial Stability Board</a>, in 2013 shadow banking assets represented 25% of total financial system assets. While the average annual growth in assets of banks (2011-2014) was 5.6%, shadow banking growth stood at 6.3%.</p>
<p>A comparison of country-based share of shadow banking assets between 2010 and 2014 reveals the largest rise for China from 2% to 8%, while the USA maintains its dominance of the shadow banking markets with around 40%. </p>
<p>The failure of private sector guarantees to help shadow banking endure the global financial crisis can be traced to underestimated tail risks by credit rating agencies, risk managers and investors. Credit rating agencies <a href="https://theconversation.com/why-credit-rating-agencies-economic-advice-shouldnt-be-trusted-63253">lack of transparency</a>, when it comes to explaining their methods (often disguised as “commercial-in-confidence”), continue to make it difficult for a third party to check assessments.</p>
<p>An excess supply of inexpensive credit also contributed to risk before the global financial crisis of 2008. This was because investors overestimated the value of private credit and liquidity enhancements.</p>
<p>One of the key challenges for regulators now is to devise rules and standards requiring shadow markets to hold enough liquidity to be sufficiently sensitive to risk. However, where investors and financial intermediaries fail to identify new risks, it is less likely that the regulators – who have fewer resources – will succeed. </p>
<p>Raising capital requirements can limit the capacity of financial intermediaries to expand risky activities, although monitoring overall bank leverage may be better. This is because credit ratings cannot be relied upon in the presence of neglected risks. Similarly, monitoring rising exposure of regulated banks to shadow banking or untested financial innovations can also become part of the regulator’s arsenal. </p>
<p>But there remains a major problem that is unlikely to be resolved by any regulation. Regulation is meant to strike a fine balance between close supervision and allowing space for financial innovation because loss of diversity can create stronger channels of transmission and could expose financial systems to greater systemic risk. </p>
<p>Too little regulation encourages excessive risk taking, while too tight a regulation is bound to strangle the financial sector that provides the lifeline for the economy. Striking such a fine balance is next to impossible in a dynamic, global financial sector.</p>
<p><a href="https://theconversation.com/au/topics/basel-iii-2557">The Basel Accords</a>, set up to strengthen regulation after the financial crisis, will continue to play a key role in helping manage systemic risk like this. For example regulations can collect data that would be useful in macroprudential regulation, taking action to reduce various risks and remaining alert to unfolding trends on the ground. </p>
<p>Regulators need to heed the trends in shadow banking as part of this, to ensure transparency. However the nature of this sector, the long chains and multiple counterparties with unclear financial obligations, will continue to make the job of the regulator very difficult.</p><img src="https://counter.theconversation.com/content/65328/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>Necmi K Avkiran does not work for, consult, own shares in or receive funding from any company or organisation that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.</span></em></p>The financial products offered by the shadow banking sector allow investors to be further removed from their investments and banks to escape regulation, increasing the risk in the sector overall.Necmi K Avkiran, Associate Professor in Banking and Finance, The University of QueenslandLicensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/405492015-04-21T02:51:11Z2015-04-21T02:51:11ZChina’s monetary easing to bolster growth, tackle shadow banking<figure><img src="https://images.theconversation.com/files/78674/original/image-20150421-25715-t5tils.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=496&fit=clip" /><figcaption><span class="caption">The cut to China's reserve requirement ratio (RRR) can also be seen as a move against China's unregulated shadow banking sector.</span> <span class="attribution"><a class="source" href="https://www.flickr.com/photos/mikebehnken/5118469004/in/photolist-8NiuvA-D5RT6-cGVtb1-imCc3j-cH1Vdy-ceErmC-chwBA3-nqqD7-9uVYKX-ds7DPT-bxCtTG-bLA6bg-m5zWf-4h3pBv-bXoj9Q-b5Q5rp-aRHkVp-aAfeaa-fAC9Tn-fneERN-b4cwiv-aNn16H-553EfE-6PQFpV-bvn7zw-81Sebu-bxB1CG-bayqtp-brcdsM-4uaSnx-bYC2aW-bnrMsG-5sVma5-ptmnjV-bCUmDL-9SStn-e754TW-jUWUB-o32tv9-e1yfcH-ayaYjK-4Qniam-axnDgP-cbhEC5-mS9gAi-jTioQ9-aZFwHt-ayWNAt-q6NKLd-anLuKL">Flickr/Mike Behnken</a>, <a class="license" href="http://creativecommons.org/licenses/by/4.0/">CC BY</a></span></figcaption></figure><p>The decision by the People’s Bank of China to lower the reserve requirement ratio (RRR) by 100 basis points for the whole banking sector has <a href="http://www.abc.net.au/news/2015-04-20/china-frees-up-us200-billion-for-bank-lending/6406640?section=business">been greeted</a> as “an aggressive new attempt to combat a slowing economy”. </p>
<p>However explaining the move simply by reference to a fixation on raw percentage GDP increases is inadequate.</p>
<p>For one, the move is potentially aimed as a blow against shadow banking. The sheer size of private funds involved in the largely unregulated shadow banking sector poses significant risks to the financial system overall. </p>
<p>For example, financing through the shadow banking system in Zhe Jiang Province alone constituted 58% of total investment in fixed assets in 2008. While small business contributed to more than 60% of national GDP in 2009, only 22.2% of all corporate lending by banking institutions was extended to small business at the same financial year. The change will certainly make the sector comparatively less attractive for borrowers. </p>
<p>Also, the change must be seen in the context of reining in stimulus policies that were put in place in response to the global financial crisis of 2008-2009, particularly local governments borrowing through the Local Government Funding Platform scheme.</p>
<p>This caused a major headache for the central government. By the end of 2009, the debt outstanding under the scheme against some local governments had ballooned to approximately 400% of local GDP. Earlier this year, the government ordered local governments to convert bank loans into government bonds. In turn, this improved the asset quality of the banks, and this can been seen as under-pinning the reduction of the RRR. At the same time, further money-raising through the scheme has been prohibited. </p>
<p>But fears of a Chinese stock market bubble as a result of the easing are not unrealistic. One might argue that this is already the case. However, it’s not clear how much this really matters in an economy where securities markets and government/corporate bond markets remain undeveloped as funding sources for business, and whether the risk is offset by directing investor attention to the exploitation of these devices. </p>
<p>The stock of total domestic securities in China currently is about 45% of GDP. In comparison, in the US, it is about 160% of GDP. Ordinary investors and the government instrumentalities are all being encouraged to access the securities markets. For example, on 12 April, the China Securities Registration Company announced the abolition of the “one person and one account” policy in relation to the securities markets. Individuals is now allowed to hold up to 20 accounts. The move allows individuals to trade stock more freely and enables them to trade through multiple intermediaries. </p>
<p>On the other hand, the government has also tightened controls on margin lending. So one should not assume that easier credit will automatically flow freely into the secondary stock market.</p>
<p>In short the reduction in the RRR should not be seen in isolation. The Chinese economy remains highly government-directed, and the government has available to it a great many more controls than pushing and pulling on the fiscal and monetary levers. This move is one of a number of co-ordinated actions by the central government and the picture is more complicated than the implementation of a simple general monetary loosening as per a western free market economic model. </p>
<p>What is being aimed at is probably not merely short-term expansion, but the use of a device to aid in a change in the financial market “mix” of the economy in a way that the government sees as conducive to longer term development.</p><img src="https://counter.theconversation.com/content/40549/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>Weiping He does not work for, consult, own shares in or receive funding from any company or organisation that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.</span></em></p>The 100 basis points cut by the People’s Bank of China is as much as about containing unregulated credit within China as a bolster to slowing growth.Weiping He, Lecturer in Law, Monash UniversityLicensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/317942014-09-18T05:27:36Z2014-09-18T05:27:36ZWhy Lord Hill’s role as EC finance commissioner is a poisoned chalice for Cameron<p>In announcing his <a href="https://theconversation.com/juncker-commission-line-up-shows-hes-a-man-with-a-plan-31590">team of commissioners</a>, European Commission president-elect Jean-Claude Juncker appears to have taken to heart Machiavelli’s oft-repeated dictum: “keep your friends close and your enemies closer.” </p>
<p>British peer, Jonathan Hill’s appointment as the commissioner in charge of financial services, was one of many key portfolios given to politicians from leading member states, the specific responsibilities of which are actually the cause of significant concern for those countries.</p>
<p>Despite his appointment being considered a <a href="http://www.theguardian.com/world/2014/sep/10/european-commission-tory-peer-economic-post">coup for Cameron</a> by many, the reality is that Hill must balance serving two masters and his new job may actually be a poisoned chalice for the UK government. As a UK-nominated commissioner, he will be expected to strive to protect the interests of the City of London and the leading global position of the UK financial services sector. </p>
<p>But, in fact, his role is to work towards improving the oversight, supervision and regulation of the EU banking sector, which continues to be shored-up following the 2008 financial crisis.</p>
<p>There are three pressing economic and political challenges that Hill is tasked with tackling: the banker bonus cap, regulation of the shadow banking sector and a proposed financial transactions tax. Many of these policies are well on their way to completion and so Hill – and Cameron – risk being tarnished by their association with the implementation of tighter regulation. </p>
<h2>Bonus cap battle</h2>
<p>The most high profile issue is that of the bankers’ bonus cap. Already approved by the European Parliament in April 2013 and due to be applied fully in January 2015, the City of London and UK government continue to raise their objections to it. The cap limits bankers’ bonuses to 100% of their salary or 200% by shareholder agreement. This has already been breached in the UK, including payments exceeding the cap to the chief executives of Lloyds and RBS, both of which were bailed out by the UK taxpayers in 2008 (who still own 81% of the latter). </p>
<p>The UK government has also filed a challenge to the bonus cap at the European Court of Justice, arguing that the cap is contrary to other European treaties. The governor of the Bank of England, Mark Carney, has also spoken out against the cap. So Hill’s task is to tread a fine line, balancing the City of London’s interests with EU legislation and the will of the EU parliament. And, with a UK general election on the horizon in 2015, the Conservative-led government is unlikely to gain any political mileage from opposing the cap, unless the court in Strasbourg comes to the rescue.</p>
<h2>Shadow banking</h2>
<p>A second issue that Hill must deal with relates to European Commission’s proposals for greater regulation of the shadow banking sector, which includes hedge funds, private equity funds and securitisation vehicles. These proposals reflect widespread concern about the overly loose regulation and supervision of the sector – notably its lack of access to central bank support and deposit insurance. </p>
<p>The global financial crisis highlighted the sector’s inherent vulnerability, given the magnitude of the risk inherent in its operations and the role these financial groups played in <a href="http://econpapers.repec.org/article/blgreveco/v_3a60.1_3ay_3a2012_3ai_3a1_3ap_3a22-58.htm">transmitting financial instability and contagion</a>. Global shadow banking assets are <a href="ec.europa/news/economy/130904_en.htm">estimated at €51 trillion</a>, equivalent to around half of the regulated banking sector, with around €23 trillion in the EU – a significant proportion of which is in the UK. </p>
<p>The <a href="http://ec.europa.eu/internal_market/finances/shadow-banking/index_en.htm">proposed regulations</a> aim to improve transparency so as to monitor risks, increase financial stability and limit contagion channels. They also aim to ensure access to liquidity by introducing capital requirements of 3%. In addition, the proposals will require EU banks to separate their risky trading activities from deposit-taking business, as is the case in the United States. </p>
<p>These measures remain at the proposal stage and can expect to generate further conflict between the “light touch” regulation and supervision advocated by the City of London and the more interventionist approach generally favoured by the European Commission and European Parliament. Implementing this legislation will again require Lord Hill to seek a regulatory and supervisory balance, albeit with greater policy room to manoeuvre than on bankers’ bonuses.</p>
<h2>Financial Transaction Tax</h2>
<p>Finally, there is the thorny issue of the Financial Transaction Tax, originally due to be introduced in January 2014 but postponed until 2016 because of legal challenges, notably from the UK. This tax is effectively a “Tobin Tax”, imposing a transaction tax on short-term speculative deals (0.1% on bonds and equities and 0.01% on derivatives). </p>
<p>While several member states already impose similar taxes, UK opposition (among others) means that this tax will not gain the unanimous support required for EU-wide legislation. Instead, it has been proposed for the eurozone. The UK position on the Financial Transaction Tax, however, may soften, depending on the outcome of the 2015 general election.</p>
<p>These proposals for the EU financial services sector match Jean-Claude Juncker’s guidelines for his term as president of the EC, <a href="ec.europea/news/eu_explained/140715_en.htm">A New Start for Europe</a>, which focus on improved regulation for growth.</p>
<p>Ultimately, Hill’s job is non-political, he is neither Cameron’s servant, nor the UK’s – but the EU’s. In reality he can do very little to protect the City of London and so may ironically find himself at the heart of implementing legislation to which his government at home is opposed.</p><img src="https://counter.theconversation.com/content/31794/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>Robert Read receives funding from: The African Caribbean & Pacific Group of States, The British Commonwealth, The CTA, The European Commission, The European Parliament, The Government of The Netherlands,The Inter-American Bank, T^he International Centre for Trade & Sustainable Development, The UK Government, The World Bank, The World Trade Organization.</span></em></p>In announcing his team of commissioners, European Commission president-elect Jean-Claude Juncker appears to have taken to heart Machiavelli’s oft-repeated dictum: “keep your friends close and your enemies…Robert Read, Senior Lecturer in International Economics, Lancaster UniversityLicensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/132062013-04-08T03:54:57Z2013-04-08T03:54:57ZLight among the shadows: the upsides to a financial crisis in China<figure><img src="https://images.theconversation.com/files/22156/original/73vhb2hm-1365386474.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=496&fit=clip" /><figcaption><span class="caption">The scale of China's off-balance sheet lending may seem extensive, but it's not the scary beast that many commentators have made it out to be.</span> <span class="attribution"><span class="source">Philip Jagenstedt/Flickr</span></span></figcaption></figure><p>In recent months, talk of an emerging crisis in China’s financial sector has been getting louder. A few weeks ago such chatter reached a crescendo, at least in terms of a narrative, when two Nomura economists argued that <a href="http://blogs.wsj.com/chinarealtime/2013/03/18/economists-china-mirrors-u-s-on-eve-of-financial-crisis/">China was looking increasingly like the US</a> on the eve of the sub-prime mortgage meltdown. And we all know how that ended.</p>
<p>China’s financial crisis, the Nomura economists contended, is rooted in the massive amount of credit that is extended off the balance sheets of banks. This credit takes two forms. Firstly, banks can <a href="http://money.msn.com/investing/chinas-undercover-banking-crisis">move funds off their balance sheets</a> by contracting with less regulated financial vehicles, such as trust companies. Secondly, informal credit markets, such as when a property developer raises funds through networks of friends and acquaintances promising a generous return in the future.</p>
<p>To the extent that off-balance sheet lending is opaque, nervousness on the part of investors and other interested onlookers is easily understood. If, as the story goes, a significant proportion of such lending is simply fuelling speculative activities, such as in the real estate sector for example, then a downturn in general economic conditions could quickly see the Ponzi scheme come crashing down.</p>
<p>To date, <a href="http://www.abc.net.au/news/2013-03-27/garnaut-warns-of-chinas-debt/4598544">much commentary</a> has been devoted to assessing the extent to which China’s banks are exposed to such potentially risky activities, or the ability of China’s central government to recapitalise them in the face of such an event.</p>
<p>A perspective that has been missing, however, is the basic point that off-balance sheet activity is not necessarily a bad thing. In a country such as China, in net terms it can be a distinct positive.</p>
<p>There is a very good reason why financial activity off the balance sheets of banks is more extensive in China than it is in Australia: the banking system in China performs its core tasks poorly.</p>
<p>Consider the predicament for savers. Interest rates in China are set by the State Council and the one year time deposit rate currently sits at 3.25%. Meanwhile, inflation is officially at 3.2%, and it is widely regarded that China’s <a href="http://english.caixin.com/2010-11-17/100199519.html">CPI underestimates price increases</a> for many items, particularly big-ticket items such as housing.</p>
<p>On the lending side, the picture is no better. As they have done for the past three decades, China’s banks continue to lend to state-owned enterprises in gross disproportion to their importance in total output. That is, the banks channel the savings of the household sector to the least efficient firms, while the private sector, which has been responsible for most of China’s growth, is starved of funding.</p>
<p>To the extent that off-balance sheet activity is motivated by, and acts to alleviate the detrimental effects of such perverse practices, it ought to be viewed as a positive, not a negative.</p>
<p>Put another way, the grey financial system that many presently find so concerning and in need of reining in is the same financial system that has been responsible for fuelling much of China’s growth to date. Curtail it, and it may be found that the cure is worse than the disease.</p>
<p>That said, there are sound reasons for preferring a greater proportion of financial activity to be conducted on the balance sheets of banks. For example, when private sector borrowers are forced into informal credit markets to raise funds, the interest rates charged <a href="http://english.caixin.com/2011-04-13/100247864.html">can be exorbitant</a>. Likewise, investors can lack even basic protections in the event of default.</p>
<p>With this in mind, even if a significant proportion of off-balance sheet lending does turn bad, a number of positive outcomes will likely result.</p>
<p>Most importantly, such an event would provide much needed impetus for an accelerated pace of reform in the banking sector. After a flurry of reforms following WTO entry in 2001, the pace of reform in China’s banking sector has slowed to a snail’s pace.</p>
<p>If the authorities wish for a greater proportion of financial activity to occur on the balance sheet of banks, then they will have no choice but to liberalise interest rates and offer savers a better rate of return, and cease the practice of state-owned banks discriminating against private sector firms in their lending decisions. By boosting household income, interest rate reform would also help in achieving other key policy objectives, such as engineering the switch to a more sustainable growth model driven by domestic consumption.</p>
<p>It has also been reported that local governments have been amongst the most active borrowers in China’s grey financial markets. This is not surprising given that in China’s fiscal mix, local governments are responsible for the bulk of expenditure obligations (education, health, social security, etc), while at the same time lacking sustainable revenues sources. Thus, any reforms implemented in response to financial fragility will need to extend beyond the banking system if they are to be effective.</p>
<p>To be sure, a financial crisis in China would not be good news for Australia or the global economy in the short term. But off-balance sheet lending in China is not the new or scary beast it has recently been portrayed to be. And while any financial crisis would necessarily involve temporary pain, if the end result was reforms along the lines of those mentioned above, then China’s long-run growth prospects will be enhanced, and that is very much a positive development.</p><img src="https://counter.theconversation.com/content/13206/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>James Laurenceson does not work for, consult, own shares in or receive funding from any company or organisation that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.</span></em></p>In recent months, talk of an emerging crisis in China’s financial sector has been getting louder. A few weeks ago such chatter reached a crescendo, at least in terms of a narrative, when two Nomura economists…James Laurenceson, Senior Lecturer, School of Economics, The University of QueenslandLicensed as Creative Commons – attribution, no derivatives.