The Financial Stability Board (FSB) was created at the G20 summit in April 2009, the time the world financial crisis was in full swing. By the end of 2012 it issued its Global Shadow Banking Monitoring Report, assessing the information on the activities of banks and other financial bodies in 2011 (1). The global shadow banking system grew to $67 trillion, a figure comparable to the same year’s global GNP. It strikes imagination and drastically changes the whole vision of the world economy…
The banking shadow dealings have been on the rise each year. The earliest assessment is dated 2002: $26 trillion. It was $62 in 2007, right before the world financial crisis. As many experts see it, the banking business going into shadow is what undermines the global financial system and creates conditions for the repetition of global financial crises. The writers try to make the picture look a bit rosier than it is saying the shadow transactions share of the total global financial intermediation has not grown since 2007. Still it has been 25%. The same figure goes for assets. One fourth of world financial turnover is exorbitant!
The US has the largest shadow banking system, with assets of $23 trillion in 2011, followed by the euro area ($22 trillion) and the UK ($9 trillion). The financial bodies of other countries (Japan, Canada, Australia, over ten European states, China, India, Russia, Brazil, all developing countries) make up for $13 trillion or 1/5.
Russia matches the world average with 25-30% of turnover and assets in the shadow sector. According to the Bank of Russia, the Russia’s banking assets make up for 47 trillion rubles ($1.5 trillion), that is 12-14 trillion rubles ($380-440 billion) (2).
USA and Great Britain are world shadow business leaders
The FSB report’s figures are noteworthy against the backdrop of Western state leaders and politicians saying the major part of world shadow economy is outside of the “golden billion” zone (golden billion is a term in the Russian-speaking world referring to the relatively wealthy people in industrially developed nations, or the West). The report says at least 90% of world shadow banking turnover falls on the bodies registered on the territories of “golden billion” states.
The Financial Action Task Force on Money Laundering (FATF) is an intergovernmental organization founded to develop policies to combat money laundering and terrorism financing under the OECD (the Organization for Economic Co-operation and Development) aegis. It should make the United States and Great Britain top the black list.
Relatively high share of shadow business falls on some off-shore financial centers and zones. The shadow banking relative to GDP was 520% of GDP in Hong Kong, 490% in the Netherlands. Let’s note the world shadow dealings were 86% of global GDP in 2011 (according to FSB, our estimations say the figure was 96%). Two countries stand out against the world average: Great Britain – 370% and the United States – 150%. The shadow operations bring in the major part of profit. In the first half of the XX century financial sector accounted for only 10% of total economic profit, in the 1970s – 20%, now it’s 50%.
It’s much less in the case of continental Europe (except the Netherlands).
The report writers considered as shadow the operations conducted outside the agencies oversight and control. Why the greatest share falls on the United States? According to the writers point of view, the reason is that there was a financial control liberalization reform carried out in the times of Bill Clinton. The Glass–Steagall Act was repealed. The law limited commercial bank securities activities and affiliations between commercial banks and securities firms. It did not allow investing in high-risk projects at the expense of depositors. The Act was adopted in 1933 in the conditions of full-blown crisis; the risky speculative operations with treasures were transferred to so-called investment banks (investment brokers). Financial regulators were not responsible for such banks operations; they were the investors’ headache. The repeal of the Act, as well as some other financial control liberalization measures taken in the days of Bill Clinton’s tenure, resulted in investors’ money deposited in the banks going to securities markets. The banking supervision system couldn’t control the whole lot of transactions, so the major part of them lost transparency. It all speeded up the financial crisis in the USA that spilled over its borders soon.
FRS on US shadow banking
The FSB data on the United States could be added by the recent statistics from the US Federal Reserve System. By the end of the third quarter of 2012 the total depository institutions (or to say simply – the commercial banks) assets were $14.76 trillion or, by and large, equal to the yearly GDP. The depository institution loans were $2.18 trillion, the credit market instruments – $11.29 trillion. 3 The credit instruments are loan treasures involved in stock exchange and other operations. They are mortgage, lease and bond and also con tine on debt. The financial control agencies surveyed only an insignificant part of active dealings related to loans. The US Securities and Exchange Commission did exercise at least some limited control over stock exchange dealings, but whatever took place outside was in the fog, or in the shadow to be more precise.
One should add that the major part of American banks treasure operations is not registered in the balance sheets. There are two options here.
First: the major part of bank operations is listed as off-balance sheet operations, neither regulators, nor clients, nor banks partners are aware of them. The Clinton era liberalization created many balance sheet loopholes for banks and companies. As soon as it happened Enron energy giant went down being involved in double-edged or even triple – edged accounting. Second: banks create pocket-size affiliate companies for speculative operations with treasures; then the dealings are registered in the small companies balance sheets.
According to the Federal Reserve, the total amount of the so-called credit market instruments was $38.83 trillion. Thus, if the banks are conditionally considered as “white” economy, then there are thousands of companies and funds involved in outside securities operations with turnover equal to $27.54 trillion. It is equal to 175% of the US GDP in 2012. 4 At first try this figure may be considered as equal to the US shadow transactions turnover (150% of GDP). But this is a rather a very conservative estimation.
Shadow banking ways
Thus, legal financial institutions become shadow business actors, involved in out of oversight activities. Hedge-funds are an example. Mutual and some other investment funds operate fully beyond any surveillance or control. The same thing applies to companies of various sectors of economy actively involved in stock exchange activities (trade and production activities serve as a cover or play auxiliary role). Formally there are various funds and companies that have no relation to the banking system, but in fact, they are its continuation, the instruments of large international banks.
Shadow banking system in substance is the investment-banking activity conducted within the framework of existing legal norms through intermediaries (funds, trusts created to meet specific goals of companies). These go-betweens don’t have a right to involve the people’s deposits and don’t have banking licenses. In other aspects their activities differ little from banks investment departments. Such “dark horses” are used to significantly increase the flexibility of lending financial services because they act outside of any oversight.
The banking schemes, highlighted by the FSB report, are different from traditional shadow dealings. The last ones included “dirty money laundering”, the transfer into cash to pay for different kinds of shadow economy transactions, financing terrorism, corruption, exporting benefits off-shore etc. According to the CIA data, the amount of such traditional operations is $3-4 trillion globally. (Let me note, it is $100 billion in the case of Russia). The specific feature of shadow dealings is the legal responsibility of bankers, sometimes it has criminal nature. The shadow business described in the report belongs to the category of legal activities.
The Financial Stability Oversight Council (FSOC) thinks that it’s mainly REPO operations that make up the bulk of legal shadow activities. REPO operations (or Reverse Repo Operace) are loans (or deposits) secured by the transfer of securities. Securities do not change their holder, but a note must be made in the securities register that they are subject to REPO operation. During the global credit crisis Lehman Brothers, a Wall Street major, temporarily took $50 billion of “problematic assets” away from the balance sheets by resorting to REPO option. This way it tried to make investors believe it was stable and reliable.
There are operations that take problematic assets away forever, not for the time being. The so-called securitization is the one on the rise. It is the financial practice of pooling various types of contractual debt such as residential mortgages, commercial mortgages, auto loans or credit card debt obligations and selling said consolidated debt as bonds, pass-through securities, or Collateralized mortgage obligation (CMOs), to various investors. The principal and interest on the debt, underlying the security, is paid back to the various investors regularly. Securities backed by mortgage receivables are called mortgage-backed securities (MBS), while those backed by other types of receivables are asset-backed securities (ABS). The companies involved in this type of activities are created and controlled by banks. A bank sells loans wholesale mixing up credits of different quality. The quality is below any standard in the majority of cases. A special company divides the “mixture” into packages of assets and resells it in retail to gullible investors at the stock exchange. Actually it’s a pig in a poke offered for sale. That’s how “explosives” were put under the American economy in the last dozen years: mortgage loans sold at stock exchange like hot pies on the street. It all ended up in 2008-2009 when the crisis hit the economy. In a nutshell, that’s what the securitizations means, something described as a “top achievement” of contemporary “financial engineering” in the textbooks devoted to economics. They offer detailed description of algorhythms, but nothing is said that in substance this type of the operations is monkey business. In 99% of cases it’s commonplace swindling or, even, a large-scale crisis. Formally banks have nothing to do with it, so they come through unscathed.
Shadow banking, FSB and Bank for International Settlements
After the 2008-2009 financial crisis many countries toughened control over stock exchange activities. It was enough to prevent the increase the percentage of shadow operations in the global financial activities. But it was not enough to limit the shadow dealings absolute value in global financial transactions. As practice shows, the tougher are requirements related to transparency and regulations, the more money flows to the shadow business sector. The financial authorities have to balance between Scylla and Charybdis: on the one hand the process of regulation shouldn’t become absurd to prevent actors going into “shadow”, on the other hand – they should control the systematic risks coming from the shadow sector.
The shadow banking practices issue is to be discussed at the Saint-Petersburg G20 summit in 2013. The Financial Stability Board (FSB) is to come up with proposals aimed at enhancing the efficiency of countering the shadow business operations .
Finally, a few words about what the FSB is like. Formally it is created to coordinate international efforts to provide for financial stability. The activities include monitoring, regulation and oversight of banks and other actors’ activities (exchange, currency, loans, and finances, insurance) by financial authorities. It is headed by Mark Joseph Carney, a Canadian central bank governor.
The FSB is based in Basel, Switzerland in the building of the Bank of International Settlements. De Facto the Board is part of the Bank, a body created to coordinate the central banks activities. The Committee on Banking Supervision functions within its framework to offer recommendations for central banks and other regulators to prevent mass bankruptcy cases and bank collapses. The recommendations on banking regulations are presented by voluminous documents that are usually called Basel Accords (Basel-1, Basel-2, and Basel-3). The Bank of International Settlements actually freezes the state of affairs when the emerged speculative thievish system generates crises (like, for instance, the global financial crisis of 2008-2009). There is nothing to be surprised at, the Bank is created by world money-lenders, but that’s a different story. In a nutshell, the Bank of International Settlements and the US Federal Reserve System are key components of world financial system.
It can be guessed the Financial Stability Board is not up to the task being incapable of enhancing financial stability. At least, it has failed to even slow down a bit the rise of shadow banking in the world during three and a half years of its existence.
(1) FSB Publishes Initial Integrated Set of Recommendations to Strengthen Oversight and Regulation of Shadow Banking. FSB Press release. 18 November 2012.
(2) Alexandra Lozovaya, an expert with the analytical department of the invest company “Vector Securities”//Mnenie.ru, November 20, 2012.
(3) Flow of Funds Accounts of the United States. Third Quarter 2012. Federal Reserve Statistical Release. – Wash., December 7, 2012, pp.75.
(4) Ibid., pp.76-77.