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Shadowboxing the Banking Apocalypse

Wall Street sign
Paul Giamou | Aurora | Getty Images
Wall Street sign

The battle has been joined—and the belligerents have hewn to precisely the war plan one would expect of each.

Francesco Guerrera foreshadows a great deal of the looming hostilities between banks and the shadow banking system in his aptly named article "Monsters that lurk in the shadows of Wall St," which appears in today's Financial Times.

As Guerrera points out, it was Jamie Dimon who fired the first shot with charges that regulatory reform would create "non-bank monsters."

Not long after that, Citi's CEO Vikram Pandit elaborated on the point by saying, "Shifting risk into unregulated or differently regulated sectors won’t make the banking system safer."

Finally, Goldman Sachs' president Gary Cohn joined the fray at Davos: "What I most worry about is that in the next cycle, as the regulatory pendulum swings, we are going to have to use taxpayer money to bail out unregulated businesses."

Not surprisingly, the shadow banking sector—principally represented by hedge funds and private equity groups—fired back.

The charges were, also not surprisingly, that the banks were just trying to protect their turf.

(Additionally, the hedge fund folks pointed out, rather sensibly, that hedge funds didn't cause the banking crisis in the first place—and that hedge funds didn't get bailout money to stay afloat, for that matter, either.)

So where does that leave us?

Both sides have said precisely what one would expect them to say.

Guerrera digs in deeper:

"But the real danger lurking in the shadows of the financial system is 'tail risk' – the possibility that a hedge fund, or even an insurer, might become too big or too reckless. It is true that hedge funds have, on average, less debt on their books than banks. But there is little stopping them from loading up on leverage if they want to juice-up returns. And, as Long Term Capital Management showed in 1998, one big failure is enough to shake the entire system."

All the questions that Guerrera raises, explicit and implicit, have taken on additional urgency as regulators attempt to decide on a list of systemically important non-bank institutions.

As the article notes, all non-bank financial institutions with greater than $50 billion in assets will automatically be included on the list.

But what of other scenarios involving smaller institutions?

How does one categorize the risks inherent in the possibility of a cascade of failures involving smaller non-bank financial institutions?

Establishing a framework for to evaluate those risks will involve a much more complex calculation than AUM.

What provisions will be made for the risk amplification caused by leverage? Will standard rules for collateral quality be applied across all financial institutions—bank and non-bank? What risk might a single rogue institution pose to the broader financial system in the event of bright-line wholesale fraud?

As regulators wrestle with these and other questions look forward to another barrage of accusations and counter accusations from bank executives, hedge fund managers, and private equity potentates.

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