Tags: shadow | banking | Xie | too big to fail

Economist Xie: Failure in Shadow Banking Would Be 'Dangerous'

By Michelle Smith   |   Tuesday, 21 May 2013 08:01 AM

Governments, which have yet to resolve the problem that some banks are too big to fail, face another potentially larger problem — the shadow banking system has also become too big to fail warns Shanghai-based economist Andy Xie in an article for Caixin Online.

According to Xie, Lehman Brothers revealed that even a mid-sized bank couldn't be allowed to go belly up.

The banks that survived the financial crisis have grown to represent a larger share of the global financial system, and Xie claims that failure of any of these institutions would result in a global recession.

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Even a bank among the top 100 cannot be allowed to go under. If it did, at least one nation would go down with it. Therefore, he deems failure among the upper echelon of banks to be "unimaginable."

Governments have intervened in big banks' operations aiming to eliminate some of the risk associated with their existence. For example, Xie notes, that in the United States, there are efforts to regulate banks' activities. In Europe, governments are trying to control what executives are paid, and in China, the government tries to dictate who gets loans.

Such government intervention and monetary policies that spit out cheap money and impose low interest rates have ultimately incentivized shadow banking, Xie writes.

But he warns that failure in the shadow banking system could be even "more dangerous" than the failure of too big to fail banks.

The shadow banking system includes institutions such as hedge funds, non-bank lenders and insurance companies. These entities are not subject to the same regulations imposed on banks. Yet, they have financial influence that is greater than many banks.

Xie points to hedge funds and the fact that some are multi-billion dollar operations. And they have the ability to use derivatives to leverage up to 20 times.

Failure within the shadow banking system could create a cascade effect on investors and borrowers, and that could lead to a systemic breakdown, according to Xie.

Moody's agrees. According to Businessweek the firm issued a report last week warning that "shadow banking poses systemic risks."

The Federal Reserve has also called attention to the matter.

"While the shadow banking sector is smaller today than before the crisis ... regulators and the private sector need to address remaining vulnerabilities," the Financial Post quoted Federal Reserve Chairman Ben Bernanke as saying at a conference sponsored by the Chicago Federal Reserve Bank.

If there is failure within the system, governments and central banks may be forced into bailing out speculative outfits in the next crisis, Xie warns.

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