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"Shadow banking replicates a type of bank activity without the bank’s safety nets"

Banks were at the epicenter of the Global Financial Crisis of 2007/2012. This sparked a regulatory wave that over a decade, consistently improved their resilience. Almost two years after the Covid-19 outbreak, the banking sector has been a source of strength and part of the solution during and after the pandemic. But shadow banking institutions like insurance companies, hedge funds, and investment vehicles, among others, keep growing and avoiding the same regulations that have strengthened the banking sector.

José Maria Roldán, Chairman & CEO of the Asociación Española de Banca, just participated in the inauguration session of the MSc in Finance. In this conversation, he talks with professor Carlo Sala, academic director of the MSc in Finance, on the risks posed by shadow banking and how to confront them.

TRANSCRIPTION:

Carlo Sala: Can you tell us what is the shadow banking ecosystem?

José Maria Roldán: Well, we have banks, and we all know what the banks are – but there is also something we call non-bank financial intermediation. What is non-bank financial intermediation? Well, this is done by insurance companies, pension funds, investment funds, and hedge funds, as well as a vast array of other types of financial institutions.

Within non-bank financial intermediation, if you are dealing with credit risk, you are using ‘maturity transformation’ and this means financing long-term assets with short-term liabilities. You are doing this with little capital and that means you have a lot of leverage. You are performing bank-like functions and so you could create the same instabilities as the banking sector. The shadow banking sector is this subsector of non-bank financial intermediation that is performing bank-like functions, and so may create bank-like risks.

Carlo Sala: Now that’s clear. Why does shadow banking pose a threat for the financial ecosystem?

José Maria Roldán: When you are dealing with credit risks, the origination of that credit risk is very important for the quality of the risk. If you are doing it with financing, meaning long-term assets with short-term liabilities and a lot of leverage, that means there is a risk of a ‘run’ outside the banking sector.

Your investors may suddenly reassess the quality of the asset – the quality of the credit risk they have bought – and then choose to run away from that risk. You may then find that you have long-term assets that cannot be financed in the short term, and so your company collapses without the type of guarantees you would find for a bank – in terms of capital, emergency assistance from the central bank, and so on. That is the danger – you may create threats to financial stability because you have replicated a type of bank activity without the bank’s safety nets.

Some 10% of big tech revenues come from financial services and they have just barely started to enter this field

Carlo Sala: Some of the shadow banking players are fintech and big tech companies. How are they changing the finance sector?

José Maria Roldán: They are adding another layer of complexity to an already very complex financial system and shadow banking sector. Fintechs are very different from big techs. Fintechs are small and do not tend to be systemic in terms of their impact. Fintechs are easier to cope with because there are thousands of them, and problems in a fintech will not create financial stability, or a systemic problem for the financial system.

In the case of big techs, we have totally different players with network externalities. They have competitive advantages that come from the way they were created. Nowadays, we cannot imagine that a new big tech will be created from scratch, and the reality is that they were created in a certain moment of time. The big techs are there because they are the best ones, but at the same time, it’s an ecosystem that is totally different. Right now, some 10% of big tech revenues come from financial services and they have just barely started to enter this field. I think that they pose a threat in terms of financial stability and the authorities need to think about how to tackle these issues.

Carlo Sala: Another important player in these ecosystems are green techs. How is the green revolution affecting the financial system?

José Maria Roldán: The green revolution is here to stay, there is no doubt about it. The acceleration post-covid has been incredible. We are talking about 1,000 initiatives just in the financial sector that are related to this area. If we include wider regulations or stress tests that have been done by the authorities, we would be counting 5,500 initiatives – and so we have a new age of regulations with new rules being created. You have new instruments being created: such as green bonds, green government bonds, social impact bonds, and derivatives to cover climate change risk. A whole new array of instruments is being created, and a new range of players are being created in the environmental, social, and ethical impacts world (ESE) for measuring ESE, creating new benchmarks for ESE, and so on.

The new green ecosystem is adding yet another layer of complexity

This new ecosystem that has been created from scratch in a couple of years is yet another layer of complexity. So, you have the shadow banking sector, you have the digital world that is adding a layer of complexity, and on top of that, the new green ecosystem is adding yet another layer of complexity. The authorities have difficulty understanding what is going on in the shadow banking sector. Now, the challenge is even greater.

Carlo Sala: Given this new ecosystem – the classical banking sector and green tech and fintech and all these new players and complexity – how are the regulatory institutions addressing this issue? And what should they take into consideration to manage these new complexities.

José Maria Roldán: It’s not an easy task. I have been on the other side for many years, and we must understand that this is a very important challenge that must be tackled. We cannot leave this issue undisturbed and without understanding where risks may be created, and what are the new fragilities that are being created within the financial ecosystem.

I think the authorities understand this challenge but they don’t know how to handle it

The authorities know they have a problem that they must deal with sooner rather than later, because the digital revolution and the ESE revolution are advancing very quickly. But I don’t think that they yet have a clear idea of what to do. For instance, in the digital world we have seen some very good analysis being done by BIS, the Bank of International Settlement, who really are the leaders in this area.

The problem I see is that when the authorities decide what to do, and they start to monitor with good data what is going on, it may already be too late. The digital world is moving so fast that the authorities must understand the need for speed. For example, from start to finish, some five years passed from the Basel Committee to the UE directive and regulations. We cannot let this happen again and we need to move very quickly. I think the authorities understand this challenge but they don’t know how to handle it.

 

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