The"Shadow Banking System" includes hedge funds, private equity, and structured investment vehicles and depending on whose definition you accept investment banks. The amount of money handled by these entities is huge. I have seen estimates that run from $10 trillion up to above $50 trillion, in any event their assets are almost certainly larger than the regulated commercial banks. Participants are lightly regulated or not regulated at all; therefore very little reliable information about activity in this sector is available to the individual investor. Because they deal with large individual investors and institutions they have successfully avoided regulation in the past by claiming that they need to protect proprietary trading techniques; or that they deal only with sophisticated investors. I think that the events of the last two years have proved the argument to be inadequate. The dramatic growth of these businesses in the last ten years means that this sector now present systemic risks World's economic well being.
The purpose of financial regulation should be to protect the health of the country's economy and the interests of the investing public. Because the shadow banking system has become such a large factor in the World's economy it can no longer be just the concern of just its players and their investors.
As a devout believer in the importance of free markets, I have always been reluctant to support new regulation, but in a time such as this, it is painfully obvious that some regulation is helpful in tempering the markets animal spirits. Implicit in this conclusion is the qualification that there are good regulations and bad regulations, and that since legislators are no better than the rest of us at seeing into the future the second category will always be a good deal bigger than the first. The experience of the Great Depression brought a great deal of pointless paper work and unintended consequences , but there are definitely examples of rules that have proven successful over time. I am thinking of the FDIC, and banking regulations that govern reserve requirements, and require disclosure of financial data. How much worse the current crisis could have been if it were not for the existence of federal deposit insurance?
The Securities and Exchange Commission has been largely a disappointment, and been pretty much a total failure in its basic function which was to protect investors from fraud. Nothing seems as effective in exposing ponzi schemes as a good bear market. Yet I would argue that some of the legislation that established the SEC has been beneficial. Specifically the rules that increase transparency. 10K's, 10Q's, 13F's, and 14F's are very boring reading but the information they provide is absolutely basic to any informed investment decision. Of Course, there is no guarantee that all the information in these documents is correct and honest, still the great mass of information provided by these documents certainly makes capital markets much more efficient.
As things stand now we know somewhere between very little and nothing about what was going on in the shadow banking system. It is quite clear the present system that does not give an investor the information he needs to understand the systemic risks presented by the activity in this sector. Future investors clearly would be in a much better position if the shadow banks were required to report data on the same basis as commercial banks, investment banks and insurance companies do today.
The private equity bubble led to more than $1,000 billion of LBOs that should never have happened. To the extent that they borrow short to leverage their equity positions they are operating in the Shadow banking system, and doing so without any meaningful regulation. Ignoring for the moment the risk to our financial system when they do something stupid, there is a simple question of fairness. Why should this segment be relieved of the financial burdens and the risk of exposure of their financial data that are born by commercial and investment banks?
With Private Equity it may take a while before we start to see death spirals similar to what the SIVs and hedge funds have already experienced. Private equity has contracted for much of their debt with of "covenant-lite" clauses, and without traditional default triggers, and "payment-in-kind toggles", which allow borrowers to defer cash interest payments and accrue more debt, but these only delay the eventual refinancing crisis and will make for uglier bankruptcies in the future. We are beginning to see hints of these problems at GMAC, Delphi, and Chrysler continue their path toward the courts. Yet with the regulated banking system due for ever more restrictive regulation the hedge funds and private equity players that survive may be in a good position to steal market share from there heavily regulated competition.
While the initial impact for the liquidity crisis may be to shrink the size of the private equity and the rest of the shadow banking system the long term result may be quite different as new regulatory restrictions placed on conventional banks and brokers force business and talent to leave for a less restrictive environment.
Without a substantial leveling of the regulatory playing field (this would have to include essentially applying same rules to both sectors) any effort by congress to demand a more conservative financial sector is likely to be self defeating as it drives business from regulated banks and results in rapid growth in the Hedge funds and private equity and whatever new unregulated vehicle wall street can dream up. It was, after all, a regulatory advantage that nurtured the explosive growth of this sector in the last ten years. Further regulation of conventional banks is unlikely to have the desired result until there is a lot more information on the shadow banks is made available to the public by required regulatory filings.