12. An Interim Conclusion: Shadow Banking as Market-Based Financing

FSB, (2015), Transforming Shadow Banking into Resilient Market-based Finance. An Overview of Progress, November 12, p. 1.

A contrario L.A. P. da Silva, (2018), In Defence of Central Bank DSGE Modelling, Speech of Luiz Awazu Pereira da Silva, Deputy General Manager, Bank for International Settlements at the Seventh BIS Research Network meeting on “Pushing the frontier of central banks’ macro-modelling” Basel, March 8, via bis.​org

See also T.J. Carter, (2017), Optimal Interbank Regulation, Bank of Canada Staff Working Paper Nr. 48, November. Two interesting observations Carter makes are that the literature has tended to make ad hoc assumptions about the interbank contract space, which makes it difficult to generate convincing policy prescriptions; second, the literature has tended to focus on ex-post interventions that kick in only after an interbank disruption has come underway. He also concludes that optimal policy requires careful coordination between ex-post and ex-ante interventions, with the ex-ante component surprisingly doing most of the heavy lifting. It was however concluded that ex ante is necessary albeit insufficient.

Known through the works of Schumpeter, but with a history going back to Hinduism and the Tandava dance. With application to contemporary monetary policy: J. Rambarran, (2015), Shiva’s Wrath – Divali, Creative Destruction and Central Banking, Speech by Mr. Jwala Rambarran, Governor of the Central Bank of Trinidad and Tobago, at the Central Bank of Trinidad and Tobago’s annual Divali celebrations, Port-of-Spain, October 25, 2015.

FSB, (2015), Ibid. pp. 2–3 & 13–14. The process was reinforced up till and when at the end of 2018, the Basel III was fully finalized.

FSB, (2015), Ibid. pp. 4–12 & BCBS, (2015), Finalizing Post-Crisis Reform: an Update. A Report to G20 Leaders, November.

The annual updates and working progress updates can be consulted through fsb.​org

See for an overview of what has been achieved so far: FSB, (2015), Ibid. pp. 3–12.

See T.A. Peltonen et al., (2015), Interconnectedness of the Banking Sector as a Vulnerability of Crises, ECB Working Paper Nr. 1866, November.

Also: T. Adrian, (2017), Shadow Banking and Market-Based Finance, IMF Speech, September 14, via imf.​org

S. Ingves, (2018), Basel III: Are We Done Now?, Keynote speech by Mr. Stefan Ingves, Chairman of the Basel Committee on Banking Supervision, at the Institute for Law and Finance conference on “Basel III: Are we done now?”, Goethe University, Frankfurt am Main, January 29, 2018, via.​org

See for good write-up regarding the constituents of a financial crisis: J. McAndrews, (2015), Modern Recipes for Financial Crises, Remarks by Mr. James McAndrews, Executive Vice President and Director of Research of the Federal Reserve Bank of New York, at the University of Iowa, Iowa City, December 4, 2015, pp. 2–3.

N. T. L. Chan, (2015), When Markets Fail, Speech by Mr. Norman T L Chan, Chief Executive of the Hong Kong Monetary Authority, at the 6th Caixin Summit 2015, Hong Kong, November 6, 2015, p. 1.

MnKinsey, (2018), Banks in the Changing World of Financial Intermediation, Report McKinsey Classics, Financial Services, November 2018.

See, for example, M. Carlson, et al., (2014), The Demand for Short-Term, Safe Assets and Financial Stability: Some Evidence and Implications for Central Bank Policies. Board of Governors of the Federal Reserve System Finance and Economics Discussion Series, November; A. Krishnamurthy, and A. Vissing-Jorgensen, (2015), The Impact of Treasury Supply on Financial Sector Lending and Stability, Journal of Financial Economics Vol. 118, Nr. 3 (December), pp. 571–600; R. Greenwood, (2015), A Comparative- Advantage Approach to Government Debt Maturity, The Journal of Finance, Vol. 40, Nr. 4 (August), pp. 1683–1772.

Or too little risk, for example, in the insurance sector: J. Loh, (2015), Managing Risks in an Uncertain World, Keynote address by Ms. Jacqueline Loh, Deputy Managing Director of the Monetary Authority of Singapore, at the 13th Singapore International Reinsurance Conference, Singapore, November 3, 2015, p. 1.

For example, the fact that there is no clear negative relationship between deflation and economic growth across countries. Furthermore, in the postwar period, bouts of deflation have been milder and less persistent than before, with average growth during deflation years exceeding that of inflation years; see: C. Borio. et al., (2015), The Costs of Deflation: A Historical Perspective, BIS Quarterly Review, March, pp. 31–54; and P. Ryska, (2014), Deflation and Economic Growth in Long-Term Perspective, Charles University in Prague, Institute of Economic Studies Working Paper Nr. 18/2014; as well: M. Sánchez, (2015), The Powers and Limits of Monetary Policy, Remarks by Mr. Manuel Sánchez, Deputy Governor of the Bank of Mexico, at the Cato Institute’s 33rd Annual Monetary Conference “Rethinking Monetary Policy”, Washington DC, November 12, 2015, p. 2.

It causes MMF to delve into riskier assets than their strategy can tolerate: G. La Spada, (2015), Competition, Reach for Yield, and Money Market Funds, Federal Reserve Bank of New York Staff Reports, Nr. 753, December.

S. Kleimeier, et al., (2015), Deposit Insurance in Times of Crises: safe Haven or Regulatory Arbitrage?, University of Maastricht Working Paper Nr. RM/15/026 and the case of sovereign debt regulation under Basel III: A. Dombret, (2015), Firm as a Rock – is Bank Capital an All-Purpose Tool? The Example of Sovereign Debt Regulation, Public speech by Dr. Andreas Dombret, Member of the Executive Board of the Deutsche Bundesbank, at Columbia University, New York City, December 4, 2015, pp. 3–4. See for a critical review: European Systemic Risk Board (ESRB), (2015), ESRB Report on the Treatment of Sovereign Exposures, March.

M. Sánchez, (2015), Ibid. p. 6.

E. Jondeau and A. Khalilzadeh, (2015), Collateralization, Leverage and Systemic Risk, University of Lausanne, Working Paper, June 3, mimeo.

M. Sánchez, (2015), The Powers and Limits of Monetary Policy, Remarks by Mr. Manuel Sánchez, Deputy Governor of the Bank of Mexico, at the Cato Institute’s 33rd Annual Monetary Conference “Rethinking Monetary Policy”, Washington DC, November 12, 2015, p. 4.

See for an evolution of US monetary policy: R.L. Hetzel, (2018), The Evolution of U.S. Monetary Policy, FRB of Richmond Working Paper Nr. 1.

M. Friedman, (1968), The Role of Monetary Policy, American Economic Review, Vol. LVIII, Nr. 1, pp. 1–17. To be read preferably in conjunction with R.L. Hetzel, (2017), What Remains of Milton Friedman’s Monetarism?, FRB of Richmond Working paper Nr. 9, July 13.

A. Nikolsko-Rzhevskyy, et al., (2014), Deviations from Rules-Based Policy and Their Effects, Journal of Economic Dynamics and Control, Vol. 49, and J.B. Taylor, (2015), A Rules-Based International Monetary System for the Future, October, Working Paper, mimeo.

For example, P. Behr et al., (2015), Cyclicality of SME Lending and Government Involvement in Banks, Deutsche Bundesbank Discussion Paper Nr. 39/2015.

For example, R. Levine, (2002), Bank-Based or Market-Based Financial Systems: which is better? Journal of Financial, Intermediation, Vol. 11, Issue 4, pp. 398–428.

See: A. Dombret, (2015), Firm as a Rock – is Bank Capital an All-Purpose Tool? The Example of Sovereign Debt Regulation, Public speech by Dr. A. Dombret, Member of the Executive Board of the Deutsche Bundesbank, at Columbia University, New York City, December 4, 2015, pp. 1–2; T. Adrian and H.S. Shin, (2010), Liquidity and Leverage, Journal of Financial Intermediation, Vol. 19, Issue 3, pp. 418–437; L. Gambacorta, J. Yang, and K. Tsatsaronis, (2014), Financial Structure and Growth, BIS Quarterly Review, March 2014, pp. 21–35.

Untested whether the CMU will improve access to finance for SMEs. There is to my knowledge no evidence for that available. Nor is there evidence that securitization leads to more and better SME finance coming through the bank channel. At best, these are stylized, hypothetical models with no direct relationship with reality as is. It seems to be a problem for policymakers these days: we make statement, the media magnifies it and then it becomes reality; see, for example, Draghi claiming that QE works without providing proof that it is so and in what way: ‘[s]o let me say this very clearly: we are doing more because it works, not because it fails. We want to consolidate something that’s been a success’: Mario Draghi, President of the ECB Introductory statement to the press conference (with Q&A), Frankfurt am Main, December 3, 2015.

A. Dombret, (2015), Ibid. op. cit. p. 4.

See: T. Adrian, et al., (2014), Dynamic Leverage Asset Pricing, Federal Reserve Bank of New York Staff Report, Nr. 625, December.

J. McAndrews, (2015), Modern Recipes for Financial Crises, Remarks by Mr. James McAndrews, Executive Vice President and Director of Research of the Federal Reserve Bank of New York, at the University of Iowa, Iowa City, December 4, 2015, pp. 4–7.

J. McAndrews, (2015), Ibid. p. 8.

Ibid. also for examples.

See for an investor-based review: CFA, (2015), Shadow Banking. Policy Frameworks and Investor Perspectives on markets-Based Finance, pp. 44–67.

See for an enjoyable review of that idea: D. Graeber, (2015), The Utopia of Rules, Melville House, Brooklyn, NY.

BCBS, (2015), Progress in Adopting the Principles for Effective Risk Data Aggregation and Risk Reporting, December 16, pp. 9 ff.

See for a number of these issues: V. Bavoso, (2016), High Quality Securitisation and EU Capital Markets Union- Is it Possible?, Accounting, Economics and the Law, pp. 73 ff.; S.L. Schwarcz, (2016), Securitization and Post-Crisis Financial Regulation, Cornell Law Review Online, Vol. 101, pp. 115–139.

A. Richards, (2015), Financial Services Place Too Much Faith in Flawed Risk Models, Financial Times, September 20.

N. Roubini, (2015), Rating Agencies Still Matter and That Is Inexcusable, Financial Times, August 10.

M. Kumhof and C. Noone, (2018), Central Bank Digital Currencies- Design Principles and Balance Sheet Implications, Bank of England Staff Working Paper Nr. 725, May. They find that if the introduction of (central bank digital currency) CBDC follows a set of core principles, bank funding is not necessarily reduced, credit and liquidity provision to the private sector need not contract, and the risk of a system-wide run from bank deposits to CBDC is addressed. These core principles are: (i) CBDC pays an adjustable interest rate. (ii) CBDC and reserves are distinct, and not convertible into each other. (iii) No guaranteed, on-demand convertibility of bank deposits into CBDC at commercial banks (and therefore by implication at the central bank). (iv) The central bank issues CBDC only against eligible securities (principally government securities). Also: K. Löber et al., (2018), CPMI Markets Committee Report Central bank Digital Currencies, March, via bis.​org; T. Mancini-Griffoli et al., (2018), Casting Light on Central bank Digital Currency, IMF Staff Discussion Note, Nr. SDN/18/08, November; B. Cœuré, (2018), The Future of Central Bank Money, Speech by Benoît Cœuré, Member of the Executive Board of the ECB, at the International Center for Monetary and Banking Studies, Geneva, May 14; J. Fernández-Villaverde and D. Saches, (2018), On the Economics of Digital Currencies, FRB of Philadelphia Working Paper Nr. 7, February. They see major issues for private digital currencies like Libra as private arrangement fails to implement an efficient allocation, even though it can deliver price stability under certain technological conditions; T. Keister and D. Sanchez, (2019), Should Central Banks Issue Digital Currency?, FRB of Philadelphia Working Paper Nr. 26, June.

F. Restoy, (2019), Market Integration: the Role of Regulation, Speech by Mr. Fernando Restoy, Chairman, Financial Stability Institute, Bank for International Settlements, at the IIF Market fragmentation roundtable, Washington DC, United States, April 10, via bis.​org

For a framework regarding cyber risk in the financial space see: A. Bouveret, (2017), Cyber Risk for the Financial Sector: A Framework for Quantitative Assessment, IMF Working Paper Nr. WP/17/143, June.

T. Hale, (2018), The Broken Conversation about Financial Regulation, FT September 19.

The failure to recognize the riskiness of government debt allows (and induces) domestic banks to ‘gamble’

with depositors’ funds by purchasing risky government bonds (and assets closely correlated with them). A sovereign default in this environment then results in a banking crisis. Critically, we show that permitting banks to gamble this way lowers the cost of borrowing for the government document D’Erasmo et al. See in detail: P. D’Erasmo et al., (2019), Banking Regulation with Risk of Sovereign Default, FRB of Philadelphia Working Paper Nr. 15, February. They also go back for proof to the 1998 Russia crisis as well as the more recent Euro crisis. Also about the implicit juniority of sovereign debt versus private claims: M. Schlegl et al., (2019), The Seniority Structure of Sovereign Debt, FRB of Minneapolis Working Paper Nr. 759, May.

A. Carriero et al., (2018), Endogenous Uncertainty, FRB of Cleveland Working Paper Nr. 5, March.

G.F. Hodgson, (2019), How Mythical Markets Mislead Analysis: An Institutionalist Critique of Market Universalism, Socio-Economic Review, January 9, online: https://​doi.​org/​10.​1093/​ser/​mwy049. Market universalism compromises the distinctive non-market nature of the political and legal sphere, and corrodes the conceptual separation of civil society from the state, Hodgson adds.

Admati has been arguing for years that there is no reason why banks cannot raise ‘normal’ equity levels and still earn returns, just like any other industry. Gimber and Rajan documented recently that when banks have more equity and less subordinated debt they have lower risk premia on both. When banks have more subordinated and less senior unsecured debt, senior unsecured risk premia are lower. So normal balance sheet behavior, also for banks. See in detail: A.R. Gimber and A. Rajan, (2019), Bank Funding Costs and Capital Structure, Bank of England Staff Working Paper Nr. 805, June 21.

I. Agur and M. Demertzis, (2015), Will Macro-prudential Policy Counteract Monetary Policy’s Effects on Financial Stability?, IMF Working Paper Nr. 283.

See regarding regulatory arbitrage on the Basel securitization framework: M. Efing, (2015), Arbitraging the Basel Securitization Framework: Evidence from German ABS investing, Deutsche Bundesbank Discussion paper Nr. 40/2015.

Has the world changed since the last crisis and has turned monetary policy into voodoo economics? The question is not so much if it has changed but what it tells us is how and to what extent regulation and policy should reflect those changing dynamics and increased complexity. See, for example, F. Luna, (2019), Mr. Taylor and the Central Bank: Two Inference Exercises, IMF Working Paper Nr. WP/19/33.

Schnyder et al. wrap it together with ‘how does law matter?’, providing an account of the disappointing state of the law and finance scene approximately 20 years after its emergence. See: G. Schnyder et al., (2018), Twenty Years ‘Law and Finance’: Time to Take Law Seriously, Socio-Economic Review, November 2, Oxford University Press, online: https://​doi.​org/​10.​1093/​ser/​mwy041

Step-in risk is the risk that a bank may provide financial support to a(n) ((shadow) banking) entity beyond or in the absence of any contractual obligations, should the entity experience financial stress. Basel just woke up to the issue and is looking to scratch together initial insights that would help to identify and measure them: BCBS, (2015), Identification and Measurement of Step-in Risk, Consultative Document, December, Basel.

See for extensive reporting of the financial reforms and their (alleged) impact: Banque de France, (2017), The Impact of Financial Reforms, Financial Stability Review Nr. 21, April. The FSB publishes regularly their own updates of where they feel things stand: FSB, (2017), Implementation of G20/FSB Financial Reforms in Other Areas, Summary of key findings based on the 2017 FSB Implementation Monitoring Network (IMN) survey, November 8, via fsb.​org. Most recent: FSB, (2019), Implementation of G20/FSB Financial Reforms in Other Areas, Summary of key findings based on the 2018 FSB Implementation Monitoring Network (IMN) survey, May 3, via fsb.​org

FSB, (2015), Implementation and Effects of the G20 Financial Regulatory Reforms, Report of the Financial Stability Board to G20 Leaders, Basel, November 9, p. 15.

Philip Stafford, (2017), Global Regulators say ‘Shadow Banking’ Market has Been Tamed, FT, July 3. See for a good recent compilation of how they feel about what has been achieved and how future risks are perceived: L.F. Signorini, (2019), Non-Bank Finance: Opportunities and Risks Speech by the Deputy Governor of the Bank of Italy Luigi Federico Signorini, Euromed Workshop “Non-Bank Finance and Financial Intermediation”, Naples, June 18, via bis.​org

What I’m prepared to underwrite is the position Carsten is taking in terms of where we’re in terms of a regulatory cycle that started after the financial crisis. Such a regulatory cycle is known by typical steps, which starts with design of regulation to address areas of regulatory and supervisory deficiency, followed by implementation (full, timely and consistent) to ensure that societies can reap the financial stability benefits. The third phase is the phase of testing and reflection, during a period when the experiences and memories of the last crisis start to fade. It is characterized by a weakening in the will to persevere with the ambition and implementation of the reforms. The third one however is key as the choices made in that phase determine the financial regulatory framework and its effectiveness in mitigating the impact of future crises. See in detail: A. Carstens, (2019), Keynote address by Mr. Agustín Carstens, General Manager of the BIS, at the Bank of Spain and CEMFI Second Conference on Financial Stability, Madrid, June 3, via bis.​org

N. Roubini, (2018), Is the Next Crisis already Brewing?, Ft Opinion Markets Insight, December 9.