Not so fast

GE’s planned sale of its financial division – GE Capital – looks like a home run for systemic regulators. It adds to a string of recent announcements that big intermediaries are responding to improved financial oversight. Deutsche Bank’s decision to shrink its investment banking business and sell Postbank is another example, as is the more general pruning of oversized balance sheets elsewhere: UBS assets are now less than half the pre-crisis level.

If the regulatory reforms in the United States and elsewhere really work to reduce systemic risk, the list of Systemically Important Financial Institutions (SIFIs) would become an historical artifact: either these financial behemoths become safer, or they go out of existence.

But the ultimate goal of systemic regulation is much broader than just eliminating SIFIs and curing the disease of too-big-to-fail. It is to reduce systemic risk in a way that significantly diminishes the frequency and severity of crises, while still ensuring that finance is able to support real economic growth.

We see two ways to do this. The first is to reduce the largest firms’ contributions to systemic risk through a combination of taking the most systemic activities out of the institutions and providing more resilient internal buffers for those that remain. But this strategy will only work if the new capital and liquidity regulations, combined with other changes like requirements for central clearing, do not merely shift systemic activities and risk into other parts of the financial system. The second is to safeguard systemic activities wherever they arise: the mantra is to regulate economic functions, regardless of legal form. So far, the focus is primarily on the first approach, under the assumption that systemic risk arises principally in a small number of large institutions, rather than a large number of small ones.

Is this strategy working? The fact that GE Capital appears to be looking to sell at least some its lending business to Wells Fargo leaves us uncertain. Granted, a portfolio of $75 billion in commercial loans isn’t much when added to a balance sheet of more than $1.7 trillion, but Wells has been growing steadily. (The bank’s quarterly reports show an asset increase of roughly $500 billion over the past five years.)

Put simply, there are still plenty of financial giants. According to the FDIC’s latest Global Capital Index, which allows us to compare the largest global banks on an equivalent accounting basis (we’re partial to IFRS), there are 20 global institutions with assets of more than $1 trillion. (This excludes the three large Chinese institutions, each of which currently has assets estimated at more than $2 trillion.)  Many of these shrank modestly in recent years, but they remain extremely large. Indeed, these banks collectively have assets that exceed 50 percent of global GDP.

Assets of the largest global banks (Billions of U.S. dollars), 2014 Q4 (bars) and 2012 Q4 (diamonds)

Note:  Ranked by size in 2014 Q4 on an IFRS basis. Source: FDIC    Global Capital Index   . We are grateful for the extraordinary work of FDIC Vice Chairman Thomas Hoenig in gathering and publishing this data on a semi-annual basis.

Note: Ranked by size in 2014 Q4 on an IFRS basis. Source: FDIC Global Capital Index. We are grateful for the extraordinary work of FDIC Vice Chairman Thomas Hoenig in gathering and publishing this data on a semi-annual basis.

If you read and listen to the people running these banks, they will emphasize that their institutions are better capitalized than they were before the crisis. This is correct to a point: according to the FDIC, the weighted average leverage ratio for these giants has risen, with tangible equity climbing from less than 4% of total assets to nearly 5%. But, as we highlighted in an earlier post, pre-crisis capital requirements were miniscule, and we believe that current requirements remain insufficient to prevent a systemic crisis. In other words, the biggest banks remain extremely large; some are growing; and they still pose significant risks to financial stability.

The good news so far is that rising capital and liquidity requirements do not appear to have pushed systemically risky activities into the shadow banking system.  

To see this, consider the following chart, which displays the quantity of financial intermediation in the United States broken down into the portion that is provided by traditional banks, and the remainder (labeled “shadow banks”). First, notice that since 1980 the overall volume of non-bank intermediation expanded more than ten-fold from roughly $2½ trillion to over $30 trillion. We can judge that against the fact that nominal GDP grew by a factor of 6½ from $2.7 trillion to $17.7 trillion.

But that’s not the most interesting part of the chart. Looking at the red line in the chart, we can see that the fraction of intermediation attributable to banks plunged from over 80% in 1980 to less than 43% in 2007 – just ahead of the financial crisis – before recovering to nearly 60% today. Put differently, a bigger fraction of intermediation is inside the conventional bank regulatory perimeter than at any time since 1992.

U.S. financial Intermediation (Trillions of dollars), 1980-2014

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   Source: Updated version of Figure 1 from Zoltan Pozsar, Tobias Adrian, Adam Ashcraft and Hayley Boesky, “   Shadow Banking   ,” Federal Reserve Bank of New York Staff Paper No. 458, revised February 2012.

Source: Updated version of Figure 1 from Zoltan Pozsar, Tobias Adrian, Adam Ashcraft and Hayley Boesky, “Shadow Banking,” Federal Reserve Bank of New York Staff Paper No. 458, revised February 2012.

A different, more detailed, breakdown of intermediation by type reinforces the conclusion that shadow banking (with the exception of certain bond mutual funds) has retreated substantially in the United States since the financial crisis. The following table, which compares the pre-crisis and latest volumes of the main shadow banking activities, makes this pattern clear. On average, shadow banking intermediation has declined by 23%.


U.S financial intermediation (Dollars in trillions)
March 2008Most recent*Percent change
Traditional bank intermediation
Bank Credit$9.0$11.1+23%

Shadow bank intermediation
Primary Dealer Repo$4.5$1.7-62%
Money Market Mutual Funds$3.4$2.6-24%
Securities Lending$1.7$0.9-43%
Asset-backed Commercial Paper$0.8$0.2-75%
Bond Mutual Funds$0.9$2.3+156%
(Corporate and Foreign)

Other nonbank intermediation
Commercial Paper$1.8$1.0-44%
Corporate Bonds$5.4$7.8+44%
*The most recent observation is either the fourth quarter of 2014 or March 2015.
Sources: Federal Reserve, Markit and Sifma.

These developments tempt us to be guardedly optimistic. As regulation has gotten more stringent, banks have increased their capital levels and decreased their leverage, while the shadow banking system has shrunk. At the same time, there is little evidence that finance now is incapable of supporting a more robust economic expansion. (See our recent post.)

But, as economists, our next thought is about incentives. What is driving intermediaries to do this and will it continue? What we are seeing is an ongoing reaction to the changed regulatory environment, but that adjustment process is far from over and there are other factors at play. Two things concern us. First, the current financial landscape is characterized by very flat yield curves, so that funding long-term assets with very short-term liabilities is far less appealing than it was before the crisis. Partly as a result, banks have been terming out their liabilities, if for no other reason that there is little opportunity cost of doing so. The incentive to rely on short-term funding will climb again once the yield curve reverts to some semblance of normality. When that occurs, we may see a revival of repo and other shadow-banking vehicles.

Second, and more importantly, our sense is that the arbitrage of the new financial regulations hasn’t really started; not in earnest, anyway. And, it probably won’t until both the regulations are finalized and the interest rate environment has returned to some semblance of normalcy. If banks eventually try to return to the status quo pre-crisis, regulators now know where to look and what to do. But they remain far less prepared for a return of shadow banking, especially if – as is likely – financial innovation produces a variety of new shadows.

Where does all of this leave us? The answer is that policymakers still have substantial work to do.  On banks, as we continue to emphasize, there is scope and cause to increase capital requirements significantly further to reduce systemic risk. As that occurs, regulators will need to redouble their efforts to oversee financial activity by economic function, rather than legal form.  Money market mutual funds, repurchase agreements, securities lending, and securitization are part of a wide range of intermediation activities occurring outside of regulated banks. In every case, the overseers of financial safety will need to ensure that these forms of intermediation do not become incubators for systemic risk.

For now, we’ll score the GE Capital sale as a good at-bat for the financial reform team, but we are still in the early innings.