NIESR urges gov’t to crack down on shadow banking

Angus Armstrong, director of macro-economic research for the NIESR, said the government’s Independent Commission on Banking has not considered the characteristics of shadow banking and warned that without a resolution on this matter, the ICB’s reform proposals were unlikely to yield a workable solution.

He said the ICB recommendations were likely to lead to avoidance as more activity is shifted beyond the regulated sector and into shadow banking sector.

Mr Armstrong outlined his views in a six-page paper, entitled Beyond Vickers: NIESR Proposes Alternative Approaches To Bank Regulation.

In it he argued that although shadow banking provides useful functions, it has also been at the centre of the major financial crises over the past two decades.

He said: “The logical conclusion is that incentives must be changed to encourage retail banks that provide essential services to the economy to reduce their exposure to the shadow banking system.

“The incentives of retail banks must be such that they choose to avoid excessive risk taking in the shadow banking sector. The emphasis is on incentives rather than prohibition. This is best achieved by allowing these banks to grow strong franchise values. Banks with high franchise values are likely to hold more capital. This will require a more nuanced approach to competition and market entry than proposed by the ICB.”

He added that where there is a sound economic case for using shadow banking, these structures should be moved within the regulatory perimeter.

Mr Armstrong said: “There is a sound economic case for the sale of securitised mortgages to long-term domestic investors. Rather than allow banks to continue issuing securities which failed so spectacularly in the past, there is a public good case for supporting a regulated mortgage-backed securities market. Since there is a market failure, favourable regulatory treatment does not imply a subsidy.”

James Carter, IFA for London-based Independent James, said: “The shadow banking sector will always be difficult to regulate as it contains individuals who are frankly more intelligent than regulators and able to stay one step ahead.

“The Vickers report would minimise this effect on the retail banking sector – and hopefully the taxpayer - but unless you put a cap on individual’s annual earnings it seems impossible to regulate.”