Shadow banking, beware: your days in the shadows might soon be coming to an end. The Financial Stability Board, the Switzerland-based regulatory body created by the G-20, is considering expanding its definition of ‘too-big-to-fail’ beyond just massive banks. Meanwhile, Citibank’s CEO penned an op-ed for the Financial Times suggesting a different market-based method whereby financial regulators might reduce the systemic risk posed by these non-banks.

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Shadow Banking Might Face G-20 Scrutiny

According to Bloomberg, the Financial Stability Board might “sign up domestic lenders, clearing houses and insurers,” for their strict capital requirements. In November of last year, the FSB demanded that 29 “global systemically important financial institutions” — G-SIFIs, in their parlance — raise 1% to 2.5% more capital than Basel III required of them. These banks were so systemically important that the G-20 felt they needed still more capital to prevent a meltdown like the one we experienced in 2008, though Basel III already exists for that very purpose.

Bloomberg  hints that the FSB might expand this list to include shadow banks and insurers, in recognition of the danger they pose to the global financial system — consider AIG’s collapse under the weight of all their credit default swaps, for example. Banks have been forced to put up with all sorts of necessary regulation post-2008, but insurers and other financial institutions have largely avoided it, despite the fact that they played a major role in the collapse.

A Market Based Solution?

Also on Wednesday, Citibank CEO Vikram Pandit wrote an op-ed for the Financial Times with a rather artless title: “Apples v apples — a new way to measure risk,” but which contained an interesting argument. In it, Pandit does not rail against domestic and international regulations on banks like his own, but he proposes another market-based alternative that would help mitigate the risk that insurers and shadow banking institutions pose to our global financial markets.

The problem with shadow banking is right there in its name of course; if sunlight is the best disinfectant, this sector of our financial system is well past due for a dose. What Pandit proposes is that regulators create a benchmark portfolio against which banks and other financial institutions will have to use to measure their risk. This would be a completely transparent process. The hope is that banks that underestimate the downside risks in their own portfolios will be exposed, and capital will flow towards risk-averse businesses, thereby punishing banks cooking their books to meet capital ratio requirements.

When faced with capital ratio requirements like Basel III, some banks are inflating the amount of available capital on their books by underestimating downside risks on certain assets, instead of actually raising fresh capital. By doing this they can claim they have met new capital requirements without actually making their business any safer, according to an accompanying story in the FT.  Pandit’s solution would prevent banks and other financial institutions from behaving in this fashion because no one would invest their money with someone so blind to risk. It’s a market-based solution that’s elegant in its simplicity, and would introduce a well needed dose of sunlight to a murky industry.

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