1.1 Introduction: The Concept of Shadow Banking
If we want to be successful in analyzing what has become a global phenomenon, we need to jump through the complex and difficult hoop(s) of trying to define the concept of shadow banking (SB). That is likely to pose significant problems, at least if we try to be fully comprehensive and as accurate as we possibly can be. We will most likely end up with a cascade of different components of different (existing) definitions and partial descriptions of what altogether might turn out to be a reflection of the shadow banking world. In that sense, shadow banking is effectively somewhat of a parallel universe.
1.2 An Industry with Many Faces
We are therefore at risk of defining âshadow bankingâ as everything that happens behind the curtain, while everything that happens on the podium, in the limelight and therefore subject to regulation, would then become the officially regulated (and therefore licensed) banking sector. The tone is set: weâre on a mission but unsure yet where we want to end. If we can agree on the fact that the shadow banking industry historically has grown driven by innovation, it will be no surprise to experience that the shadow banking industry is not an accurately defined industry where regulation built a nice framework around and which is now for everybody consistently observable. It has multiple layers, looks and feels different in different parts of the world as it is continuously co-shaped by (different) regulation trying to work its way into the caves and dens of that part of the financial industry happening behind the curtain. Just like water flows to its lowest point regardless of the many hurdles it may face, capital will always flow to that part of the spectrum where it can operate freely (i.e. as unregulated as possible) and generate the returns it is looking for undone of restrictions that the formal banking sector imposes. Not surprisingly that shadow banking therefore is characterized by moving paradigms (or is âoneâ moving paradigm) with many different layers that requires puzzling together. That way it has become a house with many rooms, each with its own particularities, shenanigans and intricacies.
But letâs not be mistaken: the shadow banking industry is considered a USD 60â75 trillion + industry (depending on how you measure it; on more of that later). To compare: the global economy is valued at around USD 100 trillion. It is therefore not something we can sweep under the carpet, in particular because it is linked to âMain Streetâ and the âregulated part of the global financial infrastructureâ. It has generated the attention of policy makers and regulators globally. They are trying each from their perspective, to channel the operations and intrinsic risks of the system via regulation, with a minimum objective of sheltering the official part of the industry and protect the real economy from a potential fallout.
That makes sense as long as we could possibly stick to a reasonable way of regulating industries. For over 100 years now, regulators try to find that equilibrium where regulation can play its role without disproportionately hampering economic activity. We have, during that period, explored every corner of that equation: from communism to socialism to the other extreme opposite which society has come to qualify as neoliberalism. We learned that centralizing policy leads to an implosion of the system and it literally faints under its own weight, caused by the fact that the market dynamics couldnât play properly and therefore resources were not optimally allocated. It leads many to believe that Western capitalism (and aligned market liberalism) was the only valid model left.1 Recent times have learned us otherwise. The aforementioned âneoliberalismâ has been claimed as the major cause underlying the market meltdown in 2008 and everything that followed from there. I beg to disagree. Neoliberalism and its most recent advocates like F. von Hayek, L. von Mises, M. Friedman and the likes indeed have been using varying strategies to submit society to market imperatives assuming that would optimize resource allocation and maximize prosperity for all or at least those that meaningfully used the opportunities a free market provides. Regulatory impact needs to be limited as much as possible as it would unbalance the natural equilibrium the market always will move toward. However, during the last 2â3 decades, the regulatory impact in many countries around the world, including those in many Western capitalist nations, has only increased and in a very significant way. A quick check taught me that in many countries the volume of the âofficial journalâ where legislation is published after it successfully went through the national parliamentary process often quadrupled during the last 2â3 decades. For example, in my own country Belgium, the âofficial gazetteâ in 1991, when I started Law School, counted a âmiserableâ 25,000 pages. That has, in 2018, crept up to well over 100,000 pages. So, there is apparently no lack of regulation but a lack of proper, effective and adequate regulation.
To prove my point, I will go back for a second to the very early days of neoliberalism, that is, right after the crash of 1929. In the early â30s of the last century, the mood was understandably anti-liberal. Those remaining liberals joined forces and created the Walter Lippman Colloquium that had its first session in Paris in 1938. During that session where people like Hayek, von Mises and RĂŒstow were present, they discussed the recent book of W. Lippman called The Good Society. In short: their conclusion was that the âoldâ or âlaissez faireâ liberalism had failed and that the world was in need for a new sort of liberalism which was coined by RĂŒstow âneoliberalismâ. Already during the first meeting, it was clear that there was a schism in the group: on the one hand von Hayek and Von Mises and the others represented by RĂŒstow. Von Hayek and von Mises were not prepared to let go of the old âlaissez faireâ capitalism. RĂŒstow c.s. took a different approach and wanted neoliberalism to create an alternative for the failed classical liberalism while at the same time provide an adequate alternative to the rising communist threat coming from the East. Their proposition, which is the original neoliberal axiom, is that the effective functioning is subject to a strong rule of law (that could avoid concentration in industries as was the case in the last two decades of the nineteenth century in Germany). The rule of law would have to be a partner of the free market to ensure it effective and optimally functioning. To that end the regulator was best placed to provide a regulatory framework within which the free market adequately functions. The regulator was not best placed to do enhanced handholding for the free market as it had proven in previous decades that it could not adequately replace the free market. The free market and the regulator were partners, yin and yang; they were communicating vessels through which society could indicate which values they prioritized at any given point in time and which mechanism re-established the equality of society versus economy. Only 50 years later, J. Habermas, âavant la lettreâ, concluded that the economy was colonizing other spheres of private and social life. These were the first steps of the submission of society and political life to the imperatives of what was then the beginning of a (globalizing) free market.2 It does not only demonstrate how neoliberalism got adrift already in the early days (it got so bad that Hayek and von Mises called RĂŒstow c.s. âsocialists of the worst kindâ at later gatherings of the group especially after the group restarted the meetings in Europe after the end of the Second World War), but also that anno 2019 we are still not in a position (by far not) to get that equilibrium right. The regulator, as always, in white heat enacts legislation that tries to micro-manage the industries it tries to regulate rather than provide a framework for effective performance. The regulator wants the market to contribute to its wider objectives and the market needs the ârule of lawâ in order to not get out of whack and not become subject to the Schumpeterian âcreative destructionâ competitive markets are continuously exposed to. Iâm afraid the shadow banking sphere will undergo the same faith as the rest of the regulated financial sector.
But first we need to go back to our (attempt) of a definition. While the name âshadow bankingâ seems to conjure an image of a strange, mysterious and parallel universe, the term itself is commonly used, and this despite its pejorative connotation,3 to refer to market-funded (i.e. in contrast to bank funding) credit intermediation techniques. Although the ...