by Alistair Barr
reporter for MarketWatch in San Francisco.
June 20, 2008
SAN FRANCISCO (MarketWatch)
- A network of lenders, brokers and opaque
financing vehicles outside traditional banking that ballooned during the
bull market now is under siege as regulators threaten a crackdown on the
so-called shadow banking system.
Big brokerage firms like Goldman Sachs, Lehman Brothers, Morgan Stanley and
Merrill Lynch which some say are the biggest players in this non-bank
financial network, may have the most to lose from stricter regulation.
The shadow banking system grew rapidly during the past decade, accumulating
more than $10 trillion in assets by early 2007. That made it roughly the
same size as the traditional banking system, according to the Federal
While this system became a huge and vital source of money to fuel the U.S.
economy, the subprime mortgage crisis and ensuing credit crunch exposed a
major flaw. Unlike regulated banks, which can borrow directly from the
government and have federally insured customer deposits, the shadow system
didn't have reliable access to short-term borrowing during times of stress.
Such vulnerability helped transform what may have been an uncomfortable
correction in credit markets into the worst global credit crunch in more
than a decade as monetary policymakers and regulators struggled to contain
Unless radical changes are made to bring this shadow network under an
updated regulatory umbrella, the current crisis may be just a gust compared
to the storm that would follow a collapse of the global financial system,
"The shadow banking system model as practiced in recent years has been
discredited," Ramin Toloui, executive vice president at bond investment
giant Pimco, said.
Toloui expects greater regulation of big brokerage firms which may face
stricter capital requirements and requirements to hold more liquid, or
easily sellable, assets.
"The bright new financial system - for all its talented participants, for
all its rich rewards - has failed the test of the market place," Paul
Volcker, former chairman of the Federal Reserve, said during a speech in
April. "It all adds up to a clarion call for an effective response."
Two months later, Timothy Geithner, president of the
Federal Reserve Bank of
New York, and others have begun to answer that call.
"The structure of the financial system changed fundamentally during the
boom, with dramatic growth in the share of assets outside the traditional
banking system," he warned in a speech last week. That "made the crisis more
difficult to manage."
On Thursday, Treasury Secretary and former Goldman Chief Executive
the Fed should be given the authority to collect information
from large complex financial institutions and intervene if necessary to
stabilize future crises.
Regulators should also have a clear way of taking
over and closing a failed brokerage firm, he added. See full story.
The bedrock of traditional banking is borrowing money over the short term
from customers who deposit savings in accounts and then lending it back out
as mortgages and other higher-yielding loans over longer periods.
The owners of banks are required by regulators to invest some of their own
money and reinvest some of the profit to keep an extra level of money in
reserve in case the business suffers losses on some of its loans. That
ensures that there's still enough money to repay all depositors after such
In recent decades, lots of new businesses and investment vehicles have
evolved that do the same thing, but outside the purview of traditional
Instead of getting money from depositors, these financial intermediaries
often borrow by selling commercial paper, which is a type of short-term loan
that has to be re-financed over and over again.
And rather than offering
home loans, these entities buy mortgage-backed securities and other more
A $10 trillion shadow
By early 2007, conduits, structured investment vehicles and similar entities
that borrowed in the commercial paper market and bought longer-term
asset-backed securities, held roughly $2.2 trillion in assets, according to
the Fed's Geithner.
Another $2.5 trillion in assets were financed overnight in the so-called
repo market, Geithner said.
Geithner also highlighted big brokerage firms, saying that their combined
balance sheets held $4 trillion in assets in early 2007.
Hedge funds held another $1.8 trillion, bringing the total value of asset in
the "non-bank" financial system to $10.5 trillion, he added.
That dwarfed the total assets of the five largest banks in the U.S., which
held just over $6 trillion at the time, Geithner noted. The traditional
banking system as a whole held about $10 trillion, he said.
While acting like banks, these shadow banking entities weren't subject to
the same supervision, so they didn't hold as much capital to cushion against
When subprime mortgage losses started last year, their
sources of short-term financing dried up.
"These things act like banks, but they're not," James Hamilton, professor of
economics at the University of California, San Diego, said. "The fundamental
inadequacy of their own capital caused these problems."
Big brokers targeted
Geithner said the most fundamental reform that's needed is to regulate big
brokerage firms and global banks under a unified system with stronger
supervision and "appropriate" requirements for capital and liquidity.
Financial institutions should be persuaded to keep strong capital cushions
and more liquid assets during periods of calm in the market, he explained,
noting that's the best way to limit the damage during a crisis.
At a minimum, major investment banks and brokerage firms should adhere to
similar rules on capital, liquidity and risk management as commercial banks,
Sheila Bair, chairman of the Federal Deposit Insurance Corp., said on
"It makes sense to extend some form of greater prudential regulation to
investment banks," she said.
After the stock market crash of 1929, the U.S. Congress passed laws that
separated commercial banks from investment banks.
The Fed, the Office of the Comptroller of the Currency and state regulators
oversaw commercial banks, which took in customer deposits and lent that
money out. The Securities and Exchange Commission regulated brokerage firms,
which underwrote offerings of stocks and corporate bonds.
This separation dwindled during the 1980s and 1990s as commercial banks
tried to push into investment banking - following their large corporate
clients which were selling more bonds, rather than borrowing directly from
By 1999, the Gramm-Leach-Bliley Act rolled back Depression-era restrictions,
allowing banks, brokerage firms and insurers to merge into financial holding
companies that would be regulated by the Fed.
Commercial banks like Citigroup Inc., Bank of America and J.P. Morgan Chase signed up and developed large investment banking
However, big brokerage firms like Goldman, Morgan Stanley and Lehman didn't
become financial holding companies and stayed out of commercial banking
partly to avoid increased regulation by the Fed.
Run on a Shadow Bank
The Fed's bailout of Bear Stearns in March will probably change all that,
experts said this week.
Bear, a leading underwriter of mortgage securities, almost collapsed after
customers and counterparties deserted the firm.
It was like a run on a bank. But Bear wasn't a bank. It financed a lot of
its activity by borrowing short term in repo and commercial paper markets
and couldn't borrow from the Fed if things got really bad.
Bear's low capital levels left it with highly leveraged exposures to risky
mortgage-related securities, which triggered initial doubts among customers
and trading partners.
The Fed quickly helped J.P. Morgan Chase, one of the largest commercial
banks, acquire Bear.
To prevent further damage to the financial system, the
Fed also started lending directly to brokerage firms for the first time
since the Depression.
"They stepped in because Bear was facing a traditional bank run
were pulling short-term assets and the firm couldn't sell its long-term
assets quickly enough," Hamilton said. "Rules should apply here: You should
have enough of your own capital available to pay back customers to avoid a
run like that."
A more worrying question from the Bear Stearns debacle is why customers and
investors were willing to lend money to the firm in the absence of an
adequate capital cushion, Hamilton said.
"The creditors thought that Bear was too big to fail and that the government
would step in to prevent creditors losing their money," he explained. "They
were right because that's exactly what happened."
"This is a system in which institutions like Bear Stearns are taking far too
much risk and a lot of that risk is being borne by the government, not these
firms or the market," he added.
The Fed has lent between $8 billion and more than $30 billion each week
directly to brokerage firms since it set up its new program in March. Most
experts say this source of emergency funding is unlikely to disappear, even
though it's scheduled to end in September.
"It's almost impossible to go back," FDIC's Bair said on Wednesday.
With taxpayer money permanently on the line to save big brokers, these firms
should now be more strictly regulated to keep future bailouts to a minimum,
Bair and others said.
"By definition, if they're going to give the investment banks access to the
window, I for one do believe they have the right for oversight," Richard
Fuld, chief executive of Lehman, told analysts during a conference call this
week. "What that means, though, particularly as far as capital levels or
asset requirements, it's way too early to tell."
Next year, Congress likely will pass legislation forcing big brokerage firms
to be regulated fully by the Fed as financial holding companies, Brad Hintz,
a securities analyst at Bernstein Research and former chief financial
officer of Lehman, said.
Legislators will probably also call for tighter limits on the leverage and
trading risk taken on by large brokers, while demanding more conservative
funding and liquidity policies, he added.
Restrictions on these firms' forays into venture capital, private equity,
real estate, commodities and potentially hedge funds may also follow too,
This may undermine the source of much of the surging profit generated by big
brokerage firms in recent years.
A newly empowered "super Fed" will likely encourage these firms to arrange
longer-term, more secure sources of borrowing and even promote the
development of deposit bases, just like commercial and retail banks, the
This will make borrowing more expensive for brokerage firms, undermining the
profitability of businesses that require a lot of capital, such as fixed
income, institutional equities, commodities and prime brokerage, Hintz said.
Such regulatory changes will cut big brokers' return on equity - a closely
watched measure of profitability - to roughly 15.5% from 19%, Hintz
estimated in a note to investors this week.
Lehman and Goldman will be most affected by this - seeing return on equity
drop by about four percentage points over the business cycle - because they
have larger trading books and greater exposure to revenue from sales and
trading. Goldman also has a major merchant banking business that may also be
constrained, Hintz added.
Morgan Stanley and Merrill Lynch will see declines of 3.2 percentage points and 2.2
percentage points in their return on equity, the analyst forecast.
If you can't beat them...
Facing lower returns and more stringent bank-like regulation, some big
brokerage firms may decide they're better off as part of a large commercial
bank, some experts said.
"If you're being regulated like a bank and your leverage ratio looks
something like a bank's, can you really earn the returns you were making as
a broker dealer? Probably not," Margaret Cannella, global head of credit
research at J.P. Morgan, said.
Regulatory changes will be unpopular with some brokerage CEOs and could
result in a shakeup of the industry and more consolidation, she added.
Hintz said the business models of some brokerage firms may evolve into
something similar to Bankers Trust and the old J.P. Morgan.
In the mid 1990s, Bankers Trust and J.P. Morgan relied more on deposits and
less on the repo market to finance their assets. They also operated with
leverage ratios of roughly 20 times capital. That's lower than today's
brokerage firms, which were levered roughly 30 times during the peak of the
credit bubble last year, according to Hintz.
However, both firms soon ended up in the arms of more regulated commercial
banks. Bankers Trust was acquired by Deutsche Bank in 1998. Chase Manhattan Bank bought J.P. Morgan in
End of Story.