When markets are unable to value an asset properly, financial intermediaries are in position to take advantage of other market participants. This moral hazard-problem is central to understand the destabilizing impact of shadow banking activities, and to effectively address problems involving valuation of complex financial instruments in illiquid markets. The guiding principles for regulation are straightforward : radical disclosure, shifted burden of proof and the rule of precaution applied to financial engineering.
“Financial crises take place because economic units need or desire more cash than is available from their usual sources and so they resort to unusual ways to raise cash” (Minsky 1982, p. 125). Rarely has Hyman Minsky’s (profoundly Keynesian) thesis of endogenous financial instability been illustrated with such clarity as in the last years’ financial turmoil. What has become known as “shadow banking” played a crucial role in this process ; indeed, it is a key feature of the finance-led era of capitalism. As such, it also is a major source of instability and systemic risk.
Many commentators observed that the financial meltdown of 2007/2008 started outside traditional banking, and yet that banks were key players in the chain of events that unfolded. These non-quite-banking activities require particular attention from regulators and supervisors, and we need to better understand the threats they pose to economy and society.
Acknowledging this fact, the European Commission published recently a Green Paper on shadow banking, launching a new round of consultations on future regulation of the banking and finance activities in Europe. The aim of the Commission is “to examine existing measures carefully and to propose an appropriate approach to ensure comprehensive supervision of the shadow banking, coupled with an adequate regulatory framework” (European Commission 2012, 10). Previously the issue had been raised at G20 Summits in 2010 and 2011, and last year the Financial Stability Board (FSB) published a report with recommendations on oversight and regulation (FSB 2011). All these steps are very much needed as substantial evidence points out shadow banking as a major risk factor for future crises.
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