The FSB's "shadow banking" confusion: the G-20's true intentions are anyone's guess.

• Author: Wallison, Peter J.

At the 2011 Cannes summit, and again at its Los Cabos summit in 2012, the G-20 leaders called on the Financial Stability Board--a largely European group of central bankers and financial regulators--to strengthen the oversight and regulation of "shadow banking." It would be interesting to know what the G-20 leaders thought they were approving when they endorsed a regulatory program for something as technical as shadow banking, but we now know what the FSB had in mind when it picked up this baton.

As defined by the FSB, shadow banking is "credit intermediation involving entities and activities (fully or partially) outside the regular banking system." Taken literally, this language is absurdly broad, since it covers all financial intermediation that is not subject to bank-like regulation, but in subsequent statements the FSB has not stepped back from the breadth of this definition.

It would be easy to define shadow banking narrowly and get at least some buy-in from the financial community. The defining characteristic of banks is that they perform something called maturity transformation--that is, they turn their short-term deposits into long-term assets by making loans. It's a risky business, and in the modern world is somewhat protected by deposit insurance, which reduces the tendency of depositors to withdraw their funds (often called a run) when they believe the bank's financial condition is weak.

During the financial crisis there were a number of institutions--Lehman Brothers and Bear Steams being two--that failed or came close to failing because they attempted to use short-term repo financing to carry long-term assets such as mortgages. If we ignore the pejorative connotation associated with the term "shadow," the non-banks that did what banks traditionally do could logically be called "shadow banks."

But although this might be a reasonable inference from what happened in the financial crisis, it would not cover much of the shadow banking world. Thus, in 2012, the FSB noted that

"[Experience from the crisis demonstrates the capacity for some non-hank entities and transactions to operate on a large scale in ways that create bank-like risks to financial stability (longer-term credit extension based on short-term funding and leverage). Such risk creation may take place at an entity level but it can also form part of a complex chain of transactions, in which leverage and maturity transformation occur in stages, and in ways that create...