De-leveraging the Shadow Banking System

What a difference an SEC accusation can make. The once out-of-reach Lincoln bill was approved by the Agricultural Committee 13-8 today, with marginal bi-partisanship. Lincoln's bill calls for the most sweeping overhaul of the financial system to date: the separation of derivative desks from the broader banking system.

Within modern megabanks, there exist the commercial side of activities (which focus on deposit-taking and lending) as well as the investment banking side of activities. Within the investment banks we typically split into traditional investment banking (debt and equity underwriting, mergers and acquisitions), capital markets and wealth management/advisory services.

In a manner of speaking, the Lincoln bill is a tamed-down version of Glass-Steagal. It focuses on separating portions of the capital markets group from the broader financial institution, rather than the entire investment bank. Derivatives are well-considered to be the instruments that create the difficulties associated with "inter-connectedness" and "systemic importance".

Recent regulatory proposals have focused on a combination of consumer protection measures as well as addressing Too Big to Fail. The proposals surrounding the latter have been as tame as requiring companies to create a disaster plan in the event that they collapse (a "living will") and as stringent as the above-stated Lincoln bill. Somewhere in-between is increased regulation (oversight) and further capital constraints (holding more money to protect against losses).

In effect, the large majority of these proposals serve to shrink the shadow banking system (leverage and loans outside the traditional bank realm). Most conservatively, increased capital requirements divert equity away from other investments and into banks (the impact of this would be small). Alternatively, swap desk spin-offs will require some new capital to be raised by the spun-off institutions. Furthermore, the cost of this capital will be higher (as it does not have a government guarantee, nor a form of funding as cheap as deposits). With the higher cost of capital comes a higher cost for leverage, and in all likelihood, a decrease in available leverage. This may be further exacerbated by declines in bridge financing (temporary financing for business or investment opportunities) and other non-traditional forms of lending.

Although it has become increasingly clear that re-regulation is necessary, there are always unintended consequences. I personally think that a decrease in leverage in the financial system would increase stability in the long run. The short-term impacts may be much more significant if executed improperly. It is no small secret that Bernanke views credit contraction as a major cause of the Great Depression. We will need to plan for our own short-term leverage-adjustment for the sake of increasing stability.