The Shadow Banking System and The Return of Risk

Several articles in the Financial Times have highlighted how the political response to risk in the financial system, and indeed in society, have driven risk into a "shadow system" of institutions and individuals that are largely unregulated or known, driving risk, both financial and otherwise, in ways beyond control of any social institution. This is because risk does not simply disappear by fiat. Indeed, Western societies depend on risk, and need risk, for the regular social transformations that since 1000 A.D. have made Westerners ever more inter-connected, more specialized, more inundated by change, and more wealthy and secure. But now, risk is being pushed into the shadows, where it operates beyond the ken of our social institutions, including in areas beyond finance, in unhealthy ways that promise a terrible reckoning when inevitably, the costs of that risk come home to the West in bets gone bad.


The Basel III regulations, reported by the Financial Times, are complete. And while they deal with risk in banks, raising requirements for the amount and quality of the capital banks hold, much of the risk is simply being pushed into largely un-regulated hedge funds, private equity groups, energy companies, and agribusiness. The graph at the top of the post (courtesy of the FT) shows just how much money is at stake.

Most fundamentally, the practice of pure proprietary trading – whereby banks bet their own money dealing in anything from gold to Greek bonds – is being outlawed in the US within two years.
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Yet a nagging worry is expressed by some regulators, bankers and other experts within the financial services industry that these reforms, like others in the past, risk backfiring. What if those taboo, high-risk businesses cannot be stopped in their tracks as regulators and politicians would like? What if, instead, they just move to a new home – within the sprawling mass of hedge funds, private equity firms, trading houses, even energy companies, all of which are largely unregulated and free of the capital requirements imposed on the banks?

Few are prepared to talk openly about the issue for fear of seeming disloyal to the campaign for concerted action against the banks but in interviews conducted over several months the Financial Times has pieced together a picture of mounting unease that the focused crackdown on banking could just push risk out of the reach of the toughest regulation and into fast-growing “shadow” areas.

“I think this is a real risk,” says one influential European bank executive on condition of anonymity. “I don’t buy the argument that if it’s a hedge fund it doesn’t matter because it’s a bunch of rich people’s money and so the government isn’t going to have to bail it out if it fails.” With hedge funds growing far bigger, and being increasingly backed by big pension funds and insurance companies, it can be systemically important whether these funds fail or not. “Who says a hedge fund can’t be a systemic failure? Then you’ve just shifted the problem from the banks to somewhere else where you can’t really get at it.”

There is a pretty powerful precedent for the theory that a “shadow” banking system can cause or compound a crisis. The fall of Lehman, Bear Stearns and other banks around the world in 2008 was made possible because the financial risk that stemmed from the US subprime mortgage lending was being recycled around the market via shadow banking structures. These entities, from money market funds to investment products such as collateralised debt obligations, hid the real risk because they were not properly regulated.

It is impossible to know how another shadow banking market will evolve, but even top regulators suggest lightly supervised non-bank financial services companies could be the next accident waiting to happen.

The biggest concern probably surrounds the growth of prop-style trading operations within hedge funds and private equity companies. “Private equity and hedge funds could be winners, taking on more risk,” says Kian Abouhossein, banks analyst at JPMorgan. “Through derivatives, for example, you can imagine them taking on very big positions. This is all about risk fragmentation, which could be a good thing. But if you then get risk concentration within hedge funds, that’s the real danger.”

Simon Gleeson, an expert on financial regulation at Clifford Chance, the law firm, is clearer still. “There is a real danger that risk moves out of the regulated system – out of the bit of the industry that regulators can see. Non-banks – funds and insurers, for example – will have a significant cost advantage under the new rules on bank capital. It’s a third more expensive in regulatory capital terms to do business with a bank than with a non-bank. This is a powerful incentive to use non-banks as counterparties.”

As the FT reports, Goldman Sachs, BNP Paribas, and Deutsche Bank have seen traders set out for hedge funds as the opportunities end at their old institutions and the action (and money for traders) moves to the hedge funds. Or private equity, or energy companies, or agribusiness.

Nervousness also exists about the volumes of trading being done within energy companies and other commodity trading houses. Oil companies and trading houses have been steadily extending their reach beyond their traditional focus on physical commodities into exotic over-the-counter derivatives to serve customers, a trend that some expect to accelerate now that their capital advantage over banks is widening sharply.

Oil companies such as Total and BP and traders including Cargill and Vitol are in effect shadow banks for the commodities industry, replicating the services that the likes of Goldman Sachs and Morgan Stanley monopolised for years. That might mean selling an oil swap to an airline or an OTC corn option to a farming group.

Trading and oil company executives see their move towards derivatives as a natural extension of their business, saying the OTC deals help their clients to hedge price risk. But some analysts say the activities, which are largely unregulated, bring big risks to the system. Without the capital requirements imposed on banks, a default becomes more dangerous, they say. The shift also awakens unwelcome memories of Enron, the failed US energy company whose traders severely disrupted the California energy markets in 2000-01 as well as costing investors billions of dollars.

Recently, some trading companies have withdrawn from providing commodities derivatives services to customers after losing large amounts. Japan’s Mitsubishi Corp is to close its oil derivatives business by March 2012. The unit made heavy losses on jet fuel hedges related to the collapse of JAL, the Japanese airline.

As the world becomes far more interconnected, and herd-like behavior by the class of professional investors who control about 75% of the money invested globally (there are about ~100,000 of these investors, a small group globally, according to Michael Lewis in "the Big Short"), even savvy investors can get steamrolled by herd behavior. As pretty much every asset class, from equities to bonds to commodities, is correlated. Because the same few people trade them to make money. This is the downside of the global connectivity. It enables "smoothing" of global shocks such as food shortages by allowing US and Australian farmers to send grain out to the world when Russia has a terrible harvest. But it also connects said farmers to the global financial system, and can amplify shocks as well as mitigate them. By magnifying the effect of a bad bet.

The US housing market collapse, had CDOs and the like, not been sold globally, would have been a US concern only. But when the customers of the CDOs the writers of CDS were institutions like the German Landesbanken, then the US disaster threatened not just the wider US economy by potentially bringing down AIG (and much of the insurance it wrote) but German banks which needed to be bailed out by the German government, or UK institutions, or French ones, and so on.

The response of the regulators, particularly with the Dodd-Frank Financial Reform Law in the US, has been to over-regulate, areas without risk, and leave the "shadow system" untouched.

Insurers are facing uncertainty created by sweeping definitions in the Wall Street reform act, which leave open the possibility that their products will be covered by the new swaps regime.

The Commodity Futures Trading Commission has the power to use the ambiguity of wording in the Dodd-Frank financial reform act to extend its reach to financial products that share some of the characteristics of derivatives, lawyers have said.

Gregory Mocek, former director of enforcement at the CFTC, said the very wide definition of swaps – derivatives in which two counterparties exchange benefits – in the legislation left it “unclear as to how insurance will be covered”.
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“The most lethal thing about Dodd-Frank is that a lot of market participants don’t even know that they could be impacted,” Mr Mocek, a partner at law firm McDermott Will & Emery, said. “There are people out there trading metals or agriculture or energy who could be regulated and historically have never been under regulatory oversight on a daily basis.”

What is striking about the West is how risk has become the enemy of society, and has been pushed into the shadows. Part of that is the response to the two world wars in the Twentieth Century, destructive beyond belief. And, of course, the risk inherent in the Cold War duopoly, later joined by China, of dueling ICBMs staring down at the planet, ready to launch upon warning. Risk then, was very, very bad.

Risk of course, tends to destroy social institutions, or even familiar commercial institutions. Changes to marriage, family, and the like strike many as unnecessary and indeed, harmful changes, risk for little reward. Making marriage and family "gay" might indeed help a tiny few gays and lesbians seeking to raise children in a monogamous, life-long commitment, but tends to act very destructively upon heterosexual family formation. "Gay" marriage being not very attractive to men who are straight. The disappearance of say, Pan Am or Saturn or Pontiac, seems change with little benefit. Indeed, the people who lost jobs as corporate institutions fail, or disappear, generally find fewer opportunities even as good, let alone better, as most White and Blue collar workers are in an endless competition with lower-cost workers in China and India. Even Harvard Law is no longer a golden ticket, as most low level stuff can be outsourced to India for pre-trial preparation:

Many bloggers paint a similar picture, noting that even lower-ranked law schools still charge more than $100,000 for a three-year education and don’t prepare graduates to be competitive in the current job market.

They note that while there’s a glut of laid-off associates, more law firms are getting their basic legal work, such as document review, completed by contract attorneys who are paid hourly for temporary jobs with no benefits. This is the type of work that in flush times was handled by the new associates hired by firms. Those firms also are increasingly turning to India for cheaper document review.

Temporary Attorney blogs about the struggles of attorneys working hourly temp jobs. The author draws a contrast by posting law school profiles that show deans even at low-ranked schools are paid handsomely, as much as $500,000 a year.

“There are legions of underemployed document reviewers slaving away in unventilated basements so that morally bankrupt individuals [at law schools] can continue pulling down half a mil a year by scamming unsuspecting college graduates,” the blogger states.

The content isn’t all flaming hyperbole. The blogs link to mainstream media news stories about the harsh realities of the legal industry, and the plight of recent graduates who can’t find legal work or perform temp jobs for wages such as $10 or $20 an hour in places like Chicago and New York.

“Thirty people [working as legal temps] are absolutely miserable, but nobody has the courage to stand up and say anything,” one blogger stated, noting that the air conditioner in the room was set uncomfortably low. “The market is so rotten, so-called professional attorneys are afraid of rocking the boat and being frozen out of low-rate $20 an hour temp gigs.”
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“Does babysitting count as employment?” queried a third-year UConn law student who asked to remain anonymous. UConn reported this year that 89.9 percent of its 2009 graduating class found employment, but that figure includes temporary jobs and positions outside of the legal industry. Other law schools, such as Quinnipiac and Western New England, also count those jobs toward employment figures.

The third-year student said “it’s terrifying” to think where she and her classmates might end up after graduation next year. “The competition for crappy jobs is amazing,” she said. “The anxiety over getting jobs is palpable.”

And it reaches into the most prestigious schools.

“I have a friend from Harvard Law School who summered at a firm and didn’t get an offer last year,” she said. “If Harvard isn’t a golden ticket, then there’s no golden ticket anymore.”

By contrast, people in their twenties and thirties happily slaved away at fairly crummy jobs in the Dot-Com era, hoping that they could trade insane hours, and terrible pay, for a chance at the brass ring at the new Microsoft or Apple Computer. Risk in the start of the internet era was socially acceptable, now an attempt to tamp down risk has at least in part, led to a leveling of wages, globally, even in law. If Harvard Law is not a golden ticket, nothing is.

Indeed, the picture of risk in professional graduate schools, from Business to Law, is a few superstars earn considerable amounts of money, and everyone else gets next to nothing. Corporate clients and law firms alike can mitigate their risk in taking on higher cost employees, by outsourcing work to India or India like boiler rooms, but the long term cost, the transfer of risk, is the (mostly) White professional class becoming enraged at the lack of opportunity, suddenly, for upward mobility.

Some of the risk aversion shows up in cultural spheres. Movies and TV shows depicting male heroes who "risk it all" to restore moral order, from "Dirty Harry" to "Death Wish" to "Batman," are becoming increasingly rare, particularly in female dominated TV. In the 1950's and 1960's, Westerns were common, along with shows like "Hawaii Five O," and even in the 1970's, shows like "Streets of San Francisco" did not shy away from showing male heroes, loners among other men, leading efforts to clean up a city, or a town. From "the Rifleman" with Chuck Connors to Karl Malden in "Streets of San Francisco," TV did not find risky male efforts to restore a sense of order and justice something that lacked appeal to the audience.

But, as noted in When Did TV Get Girly?, TV changed to a female centric audience in the late 1970's, and was very female by the late 1980's. As Sonny Crockett and Hannibal Smith gave way to Jerry Seinfeld, the approach of risk in cultural spheres became a thing of the past. This is why the essence of male heroism has been driven out to big budget comic book movies (re-incarnated Westerns and Action movies). Male risk is inherent in the heroism, and women by and large don't like risk that much.

Risk of course, properly understood and managed by society, is critical to maintaining the West's social cohesion and civilizational advantage. Risk, if properly mitigated, allows young men to move up, advance themselves, and more and more risk is required for young men who are the equal of young women, to make themselves attractive, in a stable and prosperous society. Much of the risk taken by young traders, seeking to roll the dice on big bets, can be seen by pushing risk out into the financial sector, and away from the traditional venues of male risk-taking. The military, entrepreneurship, and the like, all entail very significant risk, but relatively little reward. Men do not come back from military service respected and honored, only as "victims" and those deserving of pity. Entrepreneurship, is difficult and pay-offs few and far between. Even those who hit it big, like Mark Zuckerberg of Facebook, lack social cachet and dominance, the way say a grade Z actor like Jared Leto would.

Much of the risk, and social changes, that would have been channeled in times past into more productive avenues (think the Wright Brothers or the birth of Television), has now moved into the financial realm. With mostly disastrous consequences. Paul Volcker famously opined that the only real financial innovation worth anything in the last fifty years was the ATM. High frequency trading promises rich returns to a few highly capitalized proprietary traders, but increases systemic risk (the "Flash Crash") without much reward for everyone else. Most of the ownership of Equities is in big, institutional hands.

Moreover, lack of social wealth building by properly managed risk in manufacturing, or energy extraction, and the like, have made all sectors of society "greedy" for risk. Bob Citron, former OC Treasurer, was not alone in taking on insane risk to get insane returns for a county strapped for funds to manage its obligations, from retirement to special projects. Naturally his bet, egged on by astrologers and Merrill Lynch alike, went bust. But the larger lesson is that from German Landesbanken, to pressed County Treasurers, when money cannot really be made by any other means, people of all stripes will seek it in financial markets. Where the risk is poorly understood, often sold to unsuspecting customers, and only a few insiders reap the rewards.

As "the Big Short" confides, America's smartest young men (and it is almost always young men) seek out big rewards by moving, now to hedge funds and private equity groups. Where they can make big money by making big bets, with mostly other people's money. "I'm short your house" is just another aspect of seeking risk in the only venues allowed.

But that risk takes place in the shadows. Poorly regulated, but even less understood. The Dodd-Frank law will simply push the risk out to places like Singapore, or Hong Kong, or Geneva, where the risk will be largely unregulated, but even worse, in the shadows, unseen, until disaster strikes and the risk, inevitably, transfers to Main Street. But the problem is not just "greedy bankers" and the like. Greed is a basic human emotion, you might as well exterminate the human race to get rid of it. So too is the desire for risk. Not everything can be regulated, certainly not by laws and regulators. There is too much money, in too much of the globe, and too many resources stacked against the regulators. We'd need a virtual army of tens of millions of regulators, paid top-dollar, just to winkle out every bit of risk and slap regulations and rules upon it. The cost of the regulation would be punishing, and like Canute's shield-wall, simply push the water around the shields as the tide came in.

What is needed is first, open-ness and social agreement, broadly in the West and particularly in America, about what risks society will and will not take. Loosening of the rules for risk-taking, in some areas where social benefits are large, and promoting the risk-taking culturally. Making entrepreneurs, or military men, or scientists, or technologists who take considerable risk at times, in one way or another, respected for their risks and accomplishments. Moving risk taking into these areas and away from financial areas. This is as much a cultural arrangement as one of regulation.

As even the Financial Times acknowledges, risk-taking cannot be simply outlawed by fiat, and regulation alone merely pushes it into the shadows. It is time for Western society to stop pushing risk into the shadows, and bring it out into the light, where it will continue to transform the West, for both good and ill, but maintain the critical advantage the West has always had: better appetite and adaptation for change. As technology shapes society to new heights of wealth and power.

Famously, both Oliver Stone and Michael Douglas were shocked to find young men admired Gordon Gekko from "Wall Street," even though the character was supposed to be a villain. Gekko was active, was important, his actions made him matter. Instead of passive victim-hood and status mongering, that does not get a young man the girl or much of anything else. This is not surprising.

Nor is the largely female-centric castigation of "male risk preference" in Wall Street, the City, or hedge funds. Women get overwhelmed by choice, so it is no surprise they'd want a system where men are static in status and power, where today's pauper could not be tomorrow's prince, and vice-versa. Indeed, people of both sexes get overwhelmed by choice, and prefer actions to narrow the choices. Women of course have far more choice in mate selection than men (men propose, women dispose). It is not surprising that an overlay of female-centric risk-avoidance, that mitigates risk that can be quite harmful to women (in childbearing and child rearing) and enhances accuracy/simplicity of mate choice, runs right up against the male preference for risk. To be Gordon Gekko, after all, is preferable to being the blue collar throw-away man of Charlie Sheen's character's father. Those guys don't matter, especially to women. In turn, the relative equality or even superiority in earning/status among professional women vs. men in their twenties, when it matters the most (when people choose mates in one way or another), unsurprisingly drives even more risk-taking among young, male traders like the "Fabulous Fab," Fabrice Tourre, of Goldman Sachs. Who famously boasted to his girlfriend in e-mail messages about just how fabulous he was, in being "the only survivor" of the deals he was pushing.

Guys like Fabrice Tourre will always want risk. It is up to culture and popular entertainment (which shapes culture) as much as regulators, to push that risk-taking in socially beneficial ways.