Our manufacturers must consent to regulations; our gentry must concern themselves in the education as well as in the instruction of their national clients and dependents, and must regard their estates as offices of trust, with duties to be performed in the sight of God and their country.
Samuel Taylor Coleridge, ‘A Lay Sermon
(“Blessed are ye that sow beside all Waters!”)’1
The purpose of regulation is to set the rules of the game within which the private sector plays. The purpose of the private sector is to pursue profits while staying within the rules of the game.2
This conventional post-WW2 consensus on how economies operate has guided the formulation of policy everywhere—in competition policy, privatization, regulation of monopolies, investor protection, corporate governance, and corporate law, to name a few. It is based on the premise that regulation is there to stop people and organizations doing things—driving too fast, polluting too much, pricing too high, and building too precariously. It restrains where we fail to refrain. It is a response to our innate irresponsibility, imposing rules of reason where reason fails to rule.
And reason has failed the most where it is most required—in finance. Nowhere are we more dependent on our ability to trust than when we hand over our money to others. Nowhere is there a worse alignment between the provider and the purchaser. Making other people wealthy is not an innate source of personal satisfaction. We do not in general relish other people getting rich; better to prosper ourselves while others fester.
And nowhere is it easier to steal. Money is fungible, odourless, and untraceable. Finance is complex, opaque, unfathomable, populated by smart, ambitious specialists, who understand the incomprehensible. We part with our farthings on the promise of a fortune. No wonder we need regulation. Finance without regulation is a licence to steal.
The question is not then whether but how. How should we regulate finance to convert a cesspit of self-interest into a cockpit of high principles? It is not easy but we should start by asking, what is the purpose of finance?
The conventional answer is to enhance economic prosperity. The way it does it is through financial institutions and markets that intermediate between savers and borrowers and facilitate the allocation of capital to where it is most effectively employed. These institutions collect and process information that is otherwise unavailable or inadequately provided and reduce the costs of reallocating capital to its most productive uses.
There is a large amount of evidence of a relationship between financial development and economic growth. Several studies report an association of the size of financial systems at the start of a period and subsequent economic growth, and, controlling for other factors, financial development appears to contribute to growth. A variety of measures of financial development are relevant, for example, the volume of monetary assets, the size of banking systems, and the size of stock markets.3
The primary channel through which financial development contributes to growth and wealth creation is via the external financing of firms. Comparing the growth of different industries across countries reveals an inter-relationship between their growth rates, the degree to which they are dependent on external finance and the development of financial systems in which they operate.4 Financial development therefore benefits industries and companies that depend on external finance.
These results suggest that a primary purpose of financial institutions is to improve allocation of funds within an economy. Institutions that direct financing to activities that are most dependent on external finance assist corporate, industrial, and economic growth. The studies therefore provide empirical confirmation at an aggregate or industry level for the theoretical underpinning of financial institutions.5
However, in 1995 two US economists made an interesting observation that ‘in the United States, the importance of commercial banks as a source of funds to nonfinancial borrowers has shrunk dramatically. In 1974 banks provided 35 percent of these funds; today they provide around 22 percent.’6 They went on to consider the implications of what was termed ‘financial disintermediation’ for the stability and regulation of the US banking system. They were not alone in documenting this phenomenon and perceiving significant implications for the conduct of financial and regulatory policy.
Disintermediation is a reversal of the cost and information advantages of banks and other intermediaries. With the growth of electronic trading, communication, and information, the benefits of employing middlemen between the suppliers and purchasers of financial securities diminished. Instead of economizing on distributing securities, collecting information, and monitoring performance, intermediaries just introduced a layer of costs that added little to what investors and firms could do directly themselves. In fact one study shows that over the last 130 years of massive investments in the financial sector, in its people, buildings, and technology, there has been no, literally no, improvement in the productivity of the financial sector whatsoever.7
With the growth of ‘fintech’—computer-driven finance—the process of disintermediating traditional providers of financial services has accelerated. However, the limitations to this process have also become more evident. Electronic systems facilitate direct communication, information, and transactions between parties but do not of themselves overcome problems which afflict goods and services markets in general but are especially prevalent in financial markets, namely deficiencies of information about uncertain and frequently distant prospects. Evaluating the quality of information that is available to market participants is complex, and while electronic systems increase the volume of information, they do not necessarily improve its reliability. Reputations, relations, and trustworthiness remain critical components of financial markets, and although technological advances might have altered the way in which these are established, they have not eliminated or diminished their significance.
Therefore, while the 1980s and 1990s saw a shift from funding from banks and other intermediaries to securities markets, the 2000s and 2010s are seeing the re-emergence of market-facilitating intermediaries. Essentially these span the functions traditionally performed by financial intermediaries and markets, and complement their respective activities. The most significant example of this is the growth of financial institutions as intermediary investors.
Individuals and institutions frequently employ investment managers (asset or fund managers) to manage portfolios of shares on their behalf. Investment management has been one of the fastest growing areas of the financial industry. It includes wealth management on behalf of wealthy private clients and hedge funds investing predominantly on behalf of institutional investors. Alongside institutional investors that hold securities, investment banks that issue them, and investment managers who manage them are advisors, analysts, consultants, and credit-rating agencies which collect and process information on behalf of investors and firms. They facilitate financial investments by improving information flows in markets.
So in short succession we have observed intermediation, disintermediation, and reintermediation in the financial sector. In addition to technology, one key influence on this process has been regulation. Whereas regulation is traditionally viewed as a response to conduct in financial markets, it is equally a cause. The way in which financial transactions are structured and the conduct of participants in financial markets are also responses to regulation. The directions of causation between financial conduct and regulation therefore run both ways.
The most significant response to regulation is to encourage the emergence of financial institutions and practices that replicate those of banks but are not classified and therefore regulated as banks. These institutions are frequently categorized under the general heading of ‘shadow banks’ or ‘non-bank financial intermediaries’. Shadow banks have similar purposes to banks and perform their traditional functions of liquidity, maturity, and credit transformation. What distinguishes shadow from formal banks is that they are not deposit-taking institutions and do not have access to lender of last resort or deposit insurance schemes. They are institutions that perform similar functions to banks in regard to payments, liquidity, savings, and lending but they are not banks and not regulated as banks.
Herein lies the cause of the emergence of this shadow system and the seeds of its own destruction. Similar activities are being regulated in different ways, thereby creating strong incentives to take activities out of the formal regulated sector and put them in the informal unregulated one. Along with technology, regulation is driving financial innovation. Still more seriously, a regulatory system that is based on institutional form rather than purpose and function is not well placed to respond to the resulting financial failures. It does not matter whether an activity is performed in a bank and therefore subject to banking regulation or in a market intermediary and therefore subject to securities regulation, but it does matter a great deal if there is a lack of equivalence between the two. The way in which regulation is structured by institutions, not purpose and function, means that it is both a distortion to financial innovation and an impediment to the avoidance of the failures that are thereby created. As we will see, this will potentially be a cause of a systems-wide financial failure that will be more serious than the financial crisis of 2008.
There are four functions of a financial system: to undertake intermediation between savers lending their financial assets and borrowers using them; to provide safe-keeping of financial assets; to operate a payments system of transferring monies in the settlement of transactions; and to manage risks. Technology and regulation are causing profound changes in all four of them. We begin by describing the changing nature of intermediation and the emergence of a parallel system of shadow banking.
The drive to disintermediation that occurred from the 1980s was in part a reflection of technological advances that allowed individual and institutional investors to undertake transactions themselves electronically without relying on banks to do it for them. These reduced the costs of transacting and encouraged a shift from organizing transactions within to outside banks. Examples of such developments are peer-to-peer lending and crowd sourcing which provide direct access of borrowers to lenders and savers to speculative investments via the web.
There was in addition a second factor that played an important role in promoting this shift and that was regulation. The regulation of banks is extensive and relates to their structure, personnel, conduct, and products. It impedes the activities in which banks can engage and in the process it raises the costs of undertaking transactions. Regulation therefore encourages a search for lower cost, unregulated activities and ways of doing business, and the emergence of market processes was therefore a natural reaction to the costs of bank regulation.
An early example of this was Regulation Q, which prohibited US banks from paying interest on demand deposits from 1933 onwards. One of its effects was to encourage the emergence of money-market funds as substitutes for demand deposits. Another was the stimulus it gave to the growth of the Eurobond market, which allowed issuers to circumvent domestic regulation of bond markets by issuing foreign-currency-denominated bonds. US investors could thereby earn significantly higher returns on US-dollar-denominated bonds issued in Europe than on US bank accounts. A more recent example is the imposition of increased capital requirements as part of Basel III to correct the failures of the financial crisis. These raise the cost of bank capital and encourage the diversion of banking activities to non-bank intermediaries.
The influence of regulation on the growth of market-based finance is illustrative of a general principle that regulation encourages substitution of lower cost activities that are subject to less onerous forms of regulation. It suggests that, first, one should not regard the structure of financial systems as independent of regulation or regulation as just a product of the financial system but recognize that, in addition, there is a reversed causation running from regulation to the financial system which makes the structure of financial institutions a product of regulation. Second, since there is a range of institutions that undertake similar activities, the imposition of regulation on some but not all of these institutions distorts competition and artificially diverts activities to the less regulated. One should not therefore think about regulation on an institutional basis but rather in relation to the financial purposes it is seeking to promote, for example, not focusing on the regulation of banks per se but on institutions that perform equivalent lending and savings functions.
Market intermediaries illustrate this principle very well because in many cases they have similar purposes and perform similar functions to equivalent bank-based institutions. The shift to market finance has created a need for a new type of intermediary associated with market activities. There are three fundamental drivers of such market-based intermediation—transaction and portfolio diversification economies, information collection, and governance and control.
A primary function that market intermediaries are supposed to perform is economizing on transaction costs—the costs of buying and selling securities that reflect fees and the spread between bid and ask prices. These are particularly significant in relation to small transactions as a consequence of the fixed as well as variable costs incurred. As a result, there are economies of scale in transacting in large amounts. A justification for financial intermediaries is therefore the costs that they can save by aggregating together the transactions of a large number of investors.
A related source of economy in investing comes from portfolio diversification. By spreading their risks across a large number of securities, investors are able to take advantage of the reduced risks that are associated with the uncorrelated, ‘idiosyncratic’ components of risk. So, for example, when investors hold the stock of one particular corporation, e.g. Apple, they incur the idiosyncratic risk of the performance of Apple being worse than expected, as well as the market risks that affect all shares on a stock market. When an investor holds a large number of shares then they still bear the market risk of the correlated movements in share prices across a large number of firms, but they extinguish the idiosyncratic risks of Apple’s own performance. There are therefore substantial portfolio diversification benefits of holding a large number of shares in a portfolio and costs associated with purchasing and managing the portfolio of shares. There are therefore diversification economies of pooling together the investments of a large number of investors.
Theories of banking place a great deal of emphasis on the role of banks in collecting information on borrowers. There are similarly substantial economies in collecting and processing information on market transactions. Much market intermediation is therefore associated with economizing on the collection of market information. In addition, to ensure that their investments are properly managed, investors will have to monitor them. They will need to establish that executive remuneration reflects the performance of their investments and that it properly incentivizes management to act on their behalf. They will have to intervene where management is failing and seek to replace them if necessary. In other words, investors will be responsible for the governance of firms in which they invest. There are significant free-rider problems of monitoring and governance reflecting the fact that the benefits of any such activities accrue to all investors not just to the particular investor undertaking them. There will therefore be under-provision of monitoring and governance and benefits from coordinated actions by financial intermediaries acting on investors’ behalf.
Transaction costs, portfolio diversification, information gathering, monitoring, and corporate governance all have substantial economies of scale associated with them and justify intermediation by institutions between investors and the companies in which they invest. Disintermediation of banks by markets does not therefore obviate the need for financial intermediaries so much as change the nature of the intermediation that is required. Instead of banks managing their own portfolios of investments, market intermediation involves a range of institutions assisting with the process of gathering information, monitoring, portfolio diversification, and transacting in securities. That is what has driven banking into the shade.
Traditionally the functions of liquidity, maturity, and credit transformation were performed in one institution, a bank. Shadow banking disaggregates these functions into component parts and engages different institutions in the process. It relies on market sources of finance rather than deposits to provide funding and enhances the credit worthiness of loans by providing a variety of forms of insurance and risk spreading. In particular, since it does not raise funds from deposits, the institutions involved are not classified as banks, they are not regulated as banks, and they do not enjoy access to lender-of-last-resort facilities.
The total value of liabilities associated with shadow banking is estimated to have reached a peak of over $20 trillion in the United States alone in the immediate pre-financial crisis period in 2007. It subsequently shrank to around $15 trillion in 2011. To put this in context, total bank liabilities in the United States amounted to around $10 trillion in 2007; so the size of the shadow banking system was at one stage double that of the formal banking system. By 2011 bank liabilities had risen to almost the same amount as shadow banking liabilities.
Shadow banking originated approximately eighty years ago in the US institution Fannie Mae, which was founded in 1938 after the Great Depression as part of the New Deal. The Federal Home Loan Mortgage Corporation, Freddie Mac, then joined Fannie Mae in 1970. The purpose of Fannie Mae was to securitize the mortgages of banks freeing them up to extend further loans to the housing market. It did this by buying mortgages in the secondary market, pooling them, and selling them as mortgaged-backed securities in the open market. Its source of funding was not therefore deposits but the capital markets and in particular the mutual funds. Fannie Mae was privatized in 1968 to remove it from the government’s balance sheet but Fannie Mae and Freddie Mac both enjoyed implicit government guarantees.
Shadow banks perform the functions of pooling and securitizing assets but in addition originate loans and structure them in such a way that they can be packaged to different classes of investors, reflecting their risk appetite. A traditional bank originates, funds, and risk-manages loans while a shadow bank uses special-purpose vehicles to sell the loans on to investors in the securities markets. As a consequence, shadow banking involves a range of institutions, namely banks, broker-dealers, and asset managers, and is funded through global capital markets.
In particular, the purpose of shadow banks is to perform the three functions of credit, maturity, and liquidity transformation. Credit transformation is performed through packaging together individual loans and then selling them in tranches of different credit ratings. The best quality loans are put together and sold as, for example, AAA bonds, the worst as low-grade, investment, or below-investment-grade bonds. Maturity transformation occurs by loan origination of, for example, auto loans, leases, and mortgages being transformed into asset-backed securities and collateralized loans that are funded through wholesale markets by money-market funds. Liquidity transformation occurs through illiquid loans being backed by asset-backed commercial paper and repurchase agreements (what are termed repos), which are sales of securities together with agreements for the seller to buy back the securities at a later date. Through the intermediation process, shadow banking transforms long-term loans in, for example, the subprime mortgage market into risk-free, short-term, liquid money-market instruments.
The advantage of shadow banking over traditional banking is that it spreads risks across a large number of investors and engages investors beyond depositors in securities markets. Second, it segments risks into component parts allowing investors to specialize in particular parts of the risk chain. Third, it takes risks out of the formal banking system in which there are government guarantees to a part of the financial system where there is no formal government underwriting. Fourth, by disaggregating activities that are internal to banks it augments the amount of information in capital markets and provides price signals that were previously absent.
While these are supposed advantages of shadow banking, the financial crisis revealed many of them to be either spurious or over-stated. First, the notion of risk-spreading does not apply if the investors are interconnected in such a way that the failure of one or more investing institution impacts on others through an indirect chain. Second, the segmentation of risks is only advantageous if risks are properly priced. A significant problem that was revealed by the financial crisis is the difficulty of determining the true risks and therefore appropriate pricing of different bundles of securities. Third, far from removing risks from the banking system and taking them off balance sheets, residual or implied risks often remain within banks. Furthermore, to the extent that banks themselves purchase the assets that have been securitized then the shadow banking system can intensify the risks borne by banks.
The most serious problems relate to government guarantees and information flows. The creation of markets in place of intermediaries in principle places greater reliance on price signals and less on government underwriting. However, information in fragmented markets often only allows participants in the market to see a small part of the total picture. It is therefore difficult for investors to look through the web of complex interactions to gauge an understanding of the broader risks that prevail in a market. So while in principle governments can stand back and allow such informal market-based processes to operate, in practice it is difficult and potentially inefficient for them to do so. It is difficult because the repercussions of widespread failures amongst financial institutions has significant ramifications for a broad class of investors and threatens to impact on formal as well as informal banks. It is inefficient because the failures are of a systemic nature reflecting the inability of markets to price the system-wide risks appropriately. A central regulatory or public body is in a better position to provide that system-wide oversight than individual institutions.
There is, in addition, a reversed causation between shadow banking and regulation. Not only does the emergence and growth of shadow banking create a need for government intervention in the face of failure but the emergence of shadow banking is itself a response to regulation in the formal banking system. The regulation of banks in, for example, the imposition of capital and liquidity requirements raises their cost of capital and their cost of doing business. As a consequence, there is an incentive on financial intermediaries to organize their activities in a shadow-banking form that is not subject to the same regulatory requirements and undercut the formal banking system. The emergence of shadow banking may therefore itself be a response to the costs of regulation rather than just a more efficient way of disaggregating, packaging, and selling financial products to investors.
As shadow banking grows in significance and economies become increasingly dependent on their shadow-banking sectors, it becomes difficult to argue with conviction that it can remain unsupported by government guarantees. In the event of a widespread failure of shadow banks, the economic consequences of a failure of shadow banking would not be dissimilar to that of the formal banking system—the consequences for the financing of the corporate sector, for the savings of investors, and for the operation of money-market funds would be on a par with those associated with failures of formal banks. Just as banks appreciate that as they grow they become too big to fail and come under the umbrella of an implicit government guarantee to bail them out in the event of failure, so too the implicit guarantee of the shadow-banking system strengthens as it grows in scale. Placing shadow banking outside of the formal regulatory system therefore risks creating a parallel financial system that overtime has come to dwarf the formal banking system as it enjoys similar privileges to banks but without the regulatory structure to which they are subjected.
This leads to the first principle of financial regulation—functional equivalence: financial institutions that have similar purposes and perform equivalent functions should be regulated in similar ways. Failure to do so results in ‘regulatory arbitrage’, by which institutions avoid regulatory costs through engaging in similar activities in the least regulated way, and the emergence of parallel systems of finance, with potentially catastrophic consequences. The next major financial failure will happen in the shades of the banking system, and, in the absence of formal mechanisms of regulating, providing emergency lender-of-last-resort facilities, or bailing it out, its repercussions will be far more widespread and difficult to control than the last.8
Key components of shadow banking are the other three functions of a financial system mentioned above—storage, payments, and risk management. We discuss the first two of these in relation to one of the most striking and significant examples of how technology is changing the nature of financial services.
Mobile money is the use of mobile phones to make financial transactions. It is most in evidence in Africa and originated in Kenya in 2007 when the telecommunications company, Safaricom, working in conjunction with the Department of International Development in the United Kingdom and Vodafone, launched a new service called MPesa. Mobile money allows users to store, send, or withdraw money on their mobile phones.9
The impact on Kenya has been extraordinary. In the ten years from 2006 to 2016, financial inclusion in Kenya in the formal financial sector has increased from 27 per cent to 75 per cent of the population. The speed of take-up of mobile money has been approximately twice as fast as mobile phones in Kenya and nearly ten times as fast as cell phones in the United States. The revenue from mobile money has increased by nearly twenty times since 2008.
Transformational as this is for developing and emerging economies in which access to banking was previously restricted to a small proportion of the population, mobile money also has important lessons for banking and regulation everywhere. Indeed, given the cheapness, speed, convenience, and transparency of payments transacted by mobile phones that bypass banks, it may transform payments in developed economies as well if it is not derailed by regulation or vested banking interests.
The real insight it provides comes from the way in which it unbundles banking into its core functions: exchange of money, storing money, transferring it, and investing it. MPesa provides two functions. It stores money with a custodian and it transfers it. People storing money with MPesa are rewarded in the same way as if they had stored the money in a safe-deposit box: they get no interest and the nominal value of the money is preserved. The system requires reliability and integrity enforced by normal standards of commercial law and consumer protection but no prudential regulation or capital requirements.
In essence, this is a form of narrow banking—no fractional banking and no investment of monetary deposits—just pure custodianship. But perfect security and mobility of money come at a price because the predominant form in which most people hold their savings, namely cash deposits, is no longer available for investment. One of the most significant sources of capital, monetary assets that are used for transaction purposes, is removed from the savings net. That is the price of narrow banking, and what mobile money demonstrates is that a perfectly safe and efficient monetary system can be created but at the price of raising the cost of capital for those parts of the economy, such as small- and medium-sized enterprises, which traditionally benefit from banking.
In the case of MPesa the custodians are banks that can employ the monetary deposits in normal banking functions. This reintroduces an element of prudential risk into mobile money but to the benefit of those who are funded by the banks from the monetary deposits. What this demonstrates is that by allocating the cash deposits of mobile money between pure independent custodians and banks, the regulatory authorities can determine an appropriate point on the trade-off between creating a perfectly safe but comparatively unproductive payments system and a useful but riskier one that supports normal banking functions.
The case of mobile money raises questions about whether payments should, in fact, be regarded as a core function of banking. But it also demonstrates the potential distortions caused by regulation. The reason why mobile money first flourished in Kenya is that the authorities took an enlightened view of its regulation. Despite pressure from existing banks, MPesa was not regulated as a bank and was not subject to the same prudential requirements as banks. Had it been then it might have been strangled at birth. Elsewhere, where existing banks have exerted more influence on regulation, for example in India, mobile money has been much slower to develop.
Mobile money, therefore, illustrates the second principle of financial regulation and that is purposeful regulation—the importance of regulating for a clearly defined public purpose, how a failure to do so can lead to inappropriate regulation, and how changing technology is rapidly altering the regulation that is appropriate for a particular form of financial service. This is particularly important as banks morph from their traditional function as receptacles for depositing and dispersing money to their role in the information age as repositories for the safe-keeping of data on their savers as well as borrowers. It will require regulation to recognize its changing role from scrutinizing capital structure and depository security to certifying computer systems and data storage.
The risk management of a financial system illustrates how purposeful regulation requires a detailed understanding of the way in which different financial institutions perform similar functions.
Asset managers provide services to individuals, governments, public agencies, banks, pension funds, insurance companies, and charities, to name a few. They are the interface between investors on the one hand and financial markets and companies on the other. As securities markets, insurance companies, and funded pension schemes grew in significance relative to deposit-taking and bank-lending, asset management played an increasingly important role in economic activity around the world. It performed the functions described above of economizing on transaction costs, portfolio diversification, and governance.10
Traditionally, asset management has been primarily associated with the ‘stock-market’ economies of the United Kingdom and United States. It has been much less significant in Continental Europe, the Far East, and other ‘bank-dependent’ countries, where savings have been primarily through deposits and debt instruments, in particular pay-as-you-go pension schemes. Countries at similar stages of economic development have very different asset management businesses. This manifests itself in several different forms. The size of the business varies markedly across countries. One reason for these disparities is that Continental Europe has traditionally had less well-developed stock markets and therefore had less need for a substantial asset-management business.
A second aspect of this diversity is that the nature of the asset-management business differs appreciably across countries. While the United Kingdom dominates the European pension fund and insurance asset-management business, historically it has been a smaller player in mutual funds, though this has changed significantly in recent years with the growth of exchange-traded funds (ETFs) as well as mutual funds. Differences in the size of pension-managed funds reflect the greater emphasis on funded pension schemes in the United Kingdom than in other European countries, where state pensions, pay-as-you-go, and in-house corporate pension schemes predominate. The distinction in asset-management businesses is not simply an Anglo-American versus Continental European one; there are significant variations within Continental Europe. For example, insurance companies are dominant in Germany, while the amount of mutual funds and insurance company funds in France are similar.
One implication is that both the business that is being regulated and the type of investor differ significantly across countries. In some countries, clients of asset management firms are predominantly large institutional investors, and, in others, they are private clients. In some countries, most investments are through pooled funds and, in others, through defined mandates (for example in Germany, the Netherlands, and the United Kingdom). Regulation therefore has a potentially different impact on investor protection across countries because of differences in the nature as well as the size of asset-management businesses.
Third, countries differ in the ownership as well as the activities of asset-management firms. Outside the United Kingdom and the United States, asset-management firms have been predominantly owned by banks and insurance companies, many of which may be classified as parts of large financial conglomerates. While this is the case in some of the largest asset-management firms in the United Kingdom, there are also a large number of small independent firms, and in the United States there are many more asset-management firms than in the United Kingdom. Concentration of ownership is therefore higher in Continental Europe than in the United Kingdom and the United States. Furthermore, there are differences within Continental Europe, where France has seen a rapidly increasing number of small, independent asset-management firms.
The significance of this observation is that the organization and ownership of firms crucially affect investors’ exposure to loss. Firms that are part of large groups have more financial resources upon which to draw than independent firms, and may have more incentive than independent firms to provide protection to investors in the event of failure. If parent firms believe that either the intrinsic value of their asset-management firms or the loss of their own reputations outweigh the cost of compensating investors then they will protect investors against loss. Where asset-management firms are large and part of larger groups, investor exposure to loss is reduced by the ability of one part of a group to bail out another.
However, this presumes that losses across different parts of groups are uncorrelated and insufficiently large to threaten the solvency of the entire group. The financial crisis revealed the extent to which correlated risks across the different activities of financial conglomerates can suddenly emerge. In sum, the design of regulation has to be sensitive to the fact that the size, the clients, the activities, and the ownership of asset-management businesses differ across countries, and that this affects the desired pattern of regulation.
The nature of asset management also varies appreciably in terms of their clienteles, from mutual fund businesses that are targeted primarily at relatively unsophisticated individual investors to hedge funds which are designed for sophisticated wealthy individuals and institutions. The degree of investor protection that might be expected to be required of the two classes of investors is very different. Investors in mutual funds might anticipate a high degree of regulatory protection whereas the clients of hedge funds should be expected to evaluate the risks of the investments for themselves.
The degree of systemic risks associated with asset-management firms will also be quite different from many other financial institutions. Some asset-management firms are essentially pass-through vehicles that pass on the risks of investments to their investors. They do not, therefore, for the most part take positions on their own account in the sense of leveraging up the investments they make on behalf of their clients. They are not, therefore, vulnerable to the same types of risks of failures as leveraged financial institutions and in particular banks. The case for imposing capital requirements on asset-management firms to provide protection against systemic risks is therefore weaker than in many other financial institutions.
Other asset-management firms, and in particular hedge funds, take significant positions on their own account and leverage their business. Their risks of financial failure are potentially much more significant than those of mutual funds which do not have equivalent financial obligations. Even unleveraged asset managers may have operational leverage arising from the fixed costs of running the business, such as the administrative overheads and their IT systems. Others may have contractual obligations in the form of guarantees that promise their clients particular profiles of returns, for example, limitations on the downside risks of losses to which they are exposed. In such cases, asset-management firms are not pure pass-through vehicles but institutions with financial risks, which justify the holding of capital to provide protection against the possibility of failure.
The other types of risks to which investors are exposed are first and foremost fraud and misrepresentation. Fraud of the type associated with the activities of Bernie Madoff is in general associated with individuals and institutions that promise returns to their investors which are or prove to be unattainable. Fraud therefore emerges as a way of trying to disguise the inability to generate anticipated returns. Beyond fraud and theft, investors are at risk from failures on the part of the management process—buying instead of selling securities, purchasing the wrong securities, violating the terms of an investment fund, acting beyond the authority delegated to asset managers by their investors, and a failure of computer systems.
A significant degree of protection can be provided to investors from a variety of structural arrangements. For example, the use of custodians to hold client funds establishes a degree of segregation between the funds of clients and those of the asset-management firm itself. Designated client funds offer greater protection than the pooling together of the funds of many investors. Oversight of the activities of asset-management firms by trustees offers investors the protection of supervision by independent parties. The auditing of clients’ accounts is an important part of record-keeping.
Regulators frequently impose conduct rules that specify how asset-management firms should undertake their business. These relate to segregation of client funds, the use of custodians, the operating and computer systems that the firm employs, the price at which securities are bought and sold, the extent to which firms are able to purchase securities on their own account as against those of their clients, and the timing of such purchases in relation to those of clients. All these rules are designed to limit the exposure of investors to the investment-management process as against risks to financial systems as a whole, which is the pre-occupation of regulatory authorities in relation to banks and other financial institutions.
The above issues are as relevant to the newly emerging technologies such as peer-to-peer lending and crowdfunding as they are to more traditional investment vehicles. The central questions that they pose are as follows. (a) Do the institutions bear risks of failure themselves or are they pure pass-through vehicles with investment risks being borne entirely by the ultimate investors? (b) Are they financially or operationally leveraged or simply equity funded? (c) Do they offer any forms of guarantees to their investors? (d) Are they standalone institutions or embedded in other institutions which could fail as a result of their failure? (e) Do systematically important institutions invest in them or are their investors individuals? And (f) are their investors sophisticated and informed or relatively uninformed?
Pure pass-through standalone lenders that are unleveraged, investing on behalf of well-informed individual investors without any forms of guarantees, pose relatively little risk of contagious failures and arguably can be expected to operate on a caveat emptor basis. Where the vehicles are independent and unconnected but leveraged or offer guaranteed products, or investors are uninformed, then various forms of investor protection as described earlier should be employed. Where they are also embedded in other institutions or other institutions invest in them then they also pose systemic risks.
What the above demonstrates is the third principle of financial regulation—a focus on failure. It is only once the precise failures of financial institutions, the nature of their investment processes, their financial liabilities, their degree of interconnectedness, and the nature of their investors have been identified that appropriate regulatory responses can be determined.
The emergence of new forms of financial activity that bypass traditional financial institutions, in particular banks, is altering the structure of financial markets in profound ways. It is superficially undermining the role of financial intermediaries but in practice it is changing rather than eliminating them.
This chapter has recorded how shadow banking is disaggregating the traditional roles of banks into their component parts and undertaking them in a variety of financial institutions that access securities markets rather than deposits as their sources of finance. Deposit-taking functions may remain of primary importance but payments outside of the traditional banking system and investing by non-bank financial intermediaries are of growing significance. The relevance of different activities to economic performance is changing rapidly.
It is reflected in the dramatic rise of mobile money in Africa, which demonstrates how a combination of technological innovation and well-conceived regulation can transform the lives of the poorest people in the world through financial inclusion. It is also captured in the growth of asset management, peer-to-peer lending, and crowdfunding to facilitate savings activities, which substitute for many of the functions performed by banking in economizing on transaction costs, portfolio diversification, and monitoring and control of investments.
In principle, the disaggregation of functions associated with these expanding forms of market intermediation has significant benefits of specialization and extends the range of potential participants in the intermediation process. In practice, it can create serious risk of failures that are not as transparent as they are in single institutions. It therefore requires a good understanding of the nature of risks that can arise, and the purposes and benefits of different parts of the financial system.
In particular, it raises questions about the validity of the traditional approach of regulating on the basis of institutional form rather than purpose and functional equivalence. Regulation can be a cause as well as a product of disintermediation. The regulation of banks is arguably a cause of the growth of disintermediation. This is especially so for shadow banks, in so far as it has increased the cost of raising capital and doing business of regulated banks. This distorts resource allocation by promoting the development of institutional forms that have little underlying economic rationale or benefit except in avoiding the costs of regulation.
The first principle of financial regulation is functional equivalence. Different institutions can have similar purposes, perform the same functions, and have identical effects on both the real and financial side of the economy. Regulation by institutional form rather than purpose and function encourages the emergence of new institutions with similar purposes, performing the same functions but subject to less onerous regulation than existing ones.
Where the post-WW2 consensus on regulation errs is in presuming that regulation is predominantly there to constrain particular types of activities—charging too-high prices in utilities, polluting the environment through burning fossil fuels, endangering financial stability by holding too little financial capital. It fails to recognize that regulation should have a more noble ambition: to encourage companies and institutions to commit to purposes that respect their public as well as private obligations. This is the second principle of financial regulation—purposeful regulation. In attempting to draw a ring-fence around particular parts of the financial system and seeking to limit the scale of government protection, careful consideration needs to be given to purposes of financial institutions and the contribution that they make to economic activity. It is a critical component in encouraging the good, not just stopping the bad.
Purposeful regulation requires a detailed understanding of the functions of institutions and the way in which different institutions perform similar functions. It risks creating both over- and under-inclusive regulation. It is over-inclusive in applying regulation to institutions to control particular types of risks that only form a part of their overall function. It is under-inclusive to the extent that institutions, such as shadow banks, which perform equivalent functions to deposit-taking banks, remain unregulated. The type of regulation that is appropriate to different activities within the same institution may be very different, while the regulation that is required of activities in different institutions may be very similar. This points to the third principle of financial regulation—a focus on failure.
The focus on failure has to be on the protection of systems—water supply, environment, or financial systems as a whole—as well as its individual parts to avoid the unaffordable costs of systemic collapse. Shadow banking creates significant risks of systemic failures through interactions between banks and non-bank financial institutions. The involvement of large parts of the financial sector, including commercial banks through their investments in relevant money-market instruments and lending to shadow banking entities, makes economies vulnerable to their shadow banks. They have grown to a point where, in the event of widespread failure, their bailing out by governments is inevitable, complex, and unsustainable in imposing unaffordable burdens on national states.
The above principles of functional equivalence, purposeful regulation, and a focus on failure require a fundamental reassessment of regulation which starts with a careful consideration of the purpose of an activity, its functions, its risks, its requirements for success, and its measures of performance—exactly the same analysis as Chapter 5 sought of responsible companies. Regulation is one but only one part of the armoury available to governments. More generally, governments should seek to promote much deeper and more enduring partnerships between public and private sectors than have existed to date through the range of instruments from taxation to ownership that are available to them. In the process the private sector needs to be able to demonstrate its good intentions in respecting its side of the social bargain—and there are strong grounds for us to be deeply suspicious of this.