The annual World Economic Forum at Davos had raised the problem of
shadow banking, pointing at the nebulous world of fast-growing structures
that were slowly encroaching on the business of traditional banking
institutions, escaping the kinds of legal constraints imposed by regulatory bodies.
‘In 2008, the Western world’s banking system underwent a huge crisis of
extraordinary proportions. Only government intervention prevented a catastrophic
meltdown,’ commenced a report submitted to Fitzwilliams by his think-tank. The
report continued: ‘In spite of the massive quantities of money poured into the
economy almost all the countries concerned fell into a recession that still endures
and will almost certainly get worst.’
Fitzwilliams indifferently tossed the report onto the table and looked at the
ceiling.
‘So what now?’ he asked Francis.
‘That’s difficult to say, but we certainly need less leveraging and more liquidity.
‘We?’
‘Banking in general. If you look at Ireland the problems have been related to
traditional banking, that’s to say relatively conventional lending, you know
mortgages and all that, rather than complex derivatives and shadow banking.
‘That doesn’t really affect us,’ said Kennedy.
‘I wouldn’t agree with that Pat. One of the dangers to traditional banking
activities stems from the fact that the shadow banking system provides services
similar to traditional commercial banks.’
There was a silence.
‘For the benefit of those of us not familiar the term shadow banking,’ he said
looking at the banks’ key deciders seated around the huge boardroom table, ‘it
implies entities such as hedge funds, money market funds and structured
investment vehicles, that’s SIVs for short.’
T
‘Are investment banks classified as part of shadow banking system?’
‘Most are not shadow banking institutions, but they do conduct business through
such themselves.’
‘Are we part of this system?’
‘Yes, partly, to be precise through our Russian partners. You see most of our
activities are subject to regulation and monitoring by central banks and other
government institutions, but our Russian side conducts a lot of business that
doesn’t show up on their balance sheet, which is not visible to regulators.’
‘I see.’
‘In the US, prior to the financial crisis, investment banks financed mortgages
through off-balance sheet securitizations and hedged risk through off-balance sheet
credit default swaps. So you can see the danger.
‘At the beginning of the crisis fear concerned banks’ off-balance sheet vehicles,
“structured investment vehicles”, SIVs, rather than their declared balance sheets.
We should remember that Bear Stearns and Lehman Brothers were not really
banks, they were broker-dealers, and AIG was an insurance firm.
Heads nodded in agreement as Francis continued.
‘Our specific problem, given our broad international business, is the sheer
complexity of shadow banking. It defies the definition given the number of
financial institutions. Our Russian activities and the contractual relationships that
bind them escape the regulatory controls that govern our business in the City.’
‘What are you trying to say John?’
‘Bluntly put, we have to be very careful, keep our noses clean.’
Fitzwilliams did not need telling.
‘We must not lose from view the problems of unregulated banking. They may
create growth, but also the kind of crash seen with Lehman Brothers, and even
systemic failure that the British banking system avoided by the skin of its teeth.
‘We’ve since moved much of our assets from riskier credit markets and reduced
the kind of off-balance sheet activities that are exposed to shadow banking risks,’
protested Fitzwilliams.’
‘What about your property funds?’
‘What about them, we’ve focused on prime property in London for example, not
sub-prime home loans. I don’t share the idea that our funds are part of the so-called
shadow banking system. Our reporting systems provide the kind of transparency
required by regulatory bodies.’
‘I’m not the decider Michael. I’m simply recalling the risks involved in certain
sectors of the banks activities, and more especially those overseas.’
Fitzwilliams did not miss the point.
‘Risk is risk,’ said Fitzwilliams. ‘We’re focusing on the kind of asset value grow
related to prime property and seeking safe haven shelters for our clients and
investors. If you’re concerned that regulators will see that as moving the risk to a
less regulated, more opaque sector, then I think you’re wrong John. I appreciate
your concerns, but I think we’ve got things well under control.’
Barton smiled to himself as he thought of INI’s other half in Moscow, where
everything was several degrees of opacity greater, with their special purpose
vehicles to leverage finance for Russian interests in oil and mineral resources. As
for the banks’ funds, and funds-of-funds, they acted like banks: accepting
investors’ money, offering loans set up by the bank for property transactions. The
Europa Property Fund’s loan book now looked bigger than those of many small
traditional banks.
The risk was that losses arising from the funds’ bold buy-outs, financed by
leveraged loans incompatible with the underlying capital, could seriously
destabilise the bank and even provoke a catastrophic collapse.