Big Banks’ Shadow Dance

WASHINGTON, DC – One of the great myths propagated by very large financial institutions is that, if they were to become effectively regulated again, many investors and financial transactions would flee to “shadow banks.”

That sounds bad. Anything that lurks in shadows must have nasty intent, potentially dangerous consequences, or both. And its very shadowiness implies that nothing can be done about it – whatever is there must be beyond the reach of regulation or effective supervision. So perhaps financial-system risk would increase, not decrease, if we regulated very large non-shadow banks properly.

So much for scary fairytales. In reality, there are three kinds of “shadow” activities, all of which are obvious, operate in plain sight, and could be controlled in a straightforward and responsible fashion. Whether we have the political will to implement effective controls is, as always, another question – in large part because the big banks are very powerful and they would like the shadows to remain as shadowy as they are now.

The first set of shadow activities includes those conducted by the banks themselves, for example, as a way to reduce the amount of equity funding that they need. The people who run big banks like leverage: More borrowed money (and less of their own) means that they get more upside, in the sense of a higher return on capital, unadjusted for risk. When things go against them, it also means more losses. But that is why it is good to be big – you can get more downside protection from the Federal Reserve or other official sources.