Road map that brings shadow banking out into the open

Gillian Tett

Entitled The Shadow Banking System, the graphic depicts how money goes round the modern world, particularly (but not exclusively) in the US.

At the top lies a smart section labelled the “Traditional Banking System”, in which a simple flow of boxes explains how investors’ funds are deposited with traditional commercial banks, which then transform this into long and short-term loans, and equity.

So far, so comprehensible. But most of the poster is dominated by two sections called “the “cash” and “synthetic” shadow banking systems, or those “financial intermediaries that conduct maturity, credit and liquid transformation without access to central bank liquidity or public sector credit guarantees”, as the associated NY Fed working paper says. These flows are so extraordinarily complex that hundreds of boxes create a diagram comparable to the circuit board of a high-tech gadget. Even as poster size, it is difficult to decode.

But it should be mandatory reading for bankers, regulators, politicians and investors today. Indeed, they might do well to hang similar posters next to their desks, for at least three reasons. For one thing, this circuit board is a reminder of how clueless most investors, regulators and rating agencies were before 2007 about finance. After all, during the credit boom, there was plenty of research being conducted into the financial world; but I never saw anything remotely comparable to this road map.

That was a striking, terrible omission. The Fed now estimates that in early 2008 shadow banking was $20,000bn in size, dwarfing the $11,000bn traditional banking system. And though this shadow system has now shrunk to a “mere” $16,000bn, this remains bigger than traditional banking, at some $13,000bn. Little wonder, then, that so few people immediately appreciated the significance of the seizing up of shadow banking in 2007.

But secondly, this poster is also a reminder that many things about the modern financial system remain mysterious - even today. On the edges of the circuit board, the NY Fed economists list all the government programmes that have supported the system since 2007 (and, in effect, replaced shadow banks when they suffered runs). This “shadow, shadow bank system” - as it might be called - looks complex and baffling too. And in practical terms, the sheer breadth and complexity of that box makes it hard to know what will happen if - or when - government aid disappears.

Then, there is the current regulatory debate. So far this year, the Financial Stability Board and other international bodies have focused most of their reform attention on issues such as bank capital, and systems of oversight for large, systemically important banks. Next year, though, Mario Draghi, head of the FSB, wants to start discussing the shadow banking world.

Many national regulators are keen to do this too as they recognise the danger of looking at regulation just in terms of institutions. After all, the crisis has shown how risky it is to have $16,000bn worth of maturity transformation without any backstop, or clear rules. This week, for example, Adair Turner, head of the Financial Services Authority, the UK regulator, promised more scrutiny. Earlier this year Paul Tucker, deputy UK central bank governor, suggested that it was time to see which parts of the system were benign - or not. The US government is now considering whether to extend the regulatory umbrella to large, non-bank institutions such as Citadel or GE Capital.

But whether this desire for a debate turns into sensible reform remains unclear. For getting politicians to focus on the issue may not be easy in 2011. There is already considerable regulatory fatigue. There are also other, more urgent distractions, such as the sovereign debt crises. And shadow banking issues rarely seem “sexy” in political terms, unless they involve hedge funds (which pose less systemic threat than, say, the vast $3,000bn-odd money market fund sector.)

So for my money, the best thing the NY Fed could do right now is print thousands of copies of that poster - and dispatch it across the world. I suspect it would be far more persuasive about the need for debate than any number of pious G20 speeches. After all, a key reason why that circuit board became so complex was that bankers were trying to arbitrage the last two sets of Basel rules. If shadow banking continues to be ignored (ie politicians focus just on the traditional banks) there is every chance Basel III will simply produce another complex labyrinth that will go largely ignored. Until the next crisis.

Banks Raiding Accounts to Pay Debts

Image via Wikipedia

Lindsey Rogerson
An increasing number of hard-pressed Scots, struggling with debt repayments, are finding themselves left without money to pay their rent, heat their homes, or even buy food, because their bank is snatching wage and benefit payments from their current accounts without warning.

Money Advice Scotland and Citizens Advice Scotland both confirmed to The Herald that they have seen a considerable rise in the number of their clients being left in extreme financial hardship as a result of set-off. This little known practice gives banks the right to take money without warning from a customer’s account if they fall behind with repayments elsewhere within the same banking group, such as those on a credit card or loan account.

Yvonne MacDermid, chief executive of Money Advice Scotland, said: “We have seen an increase in this [practice] and I think we will see more of this, especially as banks can’t bring in so much money through [bank] charges etc.”

The only way to stop a bank using set-off is to ensure that current account, savings account, credit card and personal loans are all held with separate institutions. However, it is often not possible for indebted consumers to switch banks. Indeed a CAS bureau in the North of Scotland had one client who was threatened with court action by her bank for attempting to move her current account to another bank. This threat was issued after the bank had taken £400 from her account without warning, leaving her with no money to live on.

Kaliani Lyle, chief executive of Citizens Advice Scotland, said: “While setting-off is legal, it can place severe hardship on a client if their bank uses all the wages or benefits that are put into an account to pay towards other commitments. And, as ever, the people who are most vulnerable to this are those who are struggling on the lowest incomes to begin with.

“If someone is struggling with debt, it’s not in anyone’s interest – including the bank’s - to put the client into even deeper financial trouble. We would ask all banks to look very closely at their procedures in relation to setting-off, and to be as flexible as possible – taking clients’ individual circumstances into consideration.”

However, questions have now been raised, by consumer groups, as to whether banks using set-off are in fact breaching their own voluntary code of practice. In many cases money is been snatched from accounts by banks, less than two weeks after a payment has been missed and just days before direct debits for mortgage, council tax and utilities bills are set to come out of a customer’s account. The guidance on the Banking Code, to which all UK banks are supposed to adhere, appears to forbid this.

It says that banks “should acknowledge that income should only be used to repay ‘non-priority’ debts once provision has been made for any ‘priority’ debts. The subscriber [bank] should leave the customer with sufficient money for reasonable day-to-day expenses”.

A missed payment on a credit card or unsecured personal loan is not a “priority debt”. The Banking Code Standards Board is currently investigating 12 UK banks over their approach to set-off, after a catalogue of suspected breaches was sent to it by consumer groups. One such case involved a client at an East of Scotland CAB whose bank moved all his part-time wages and benefits from his account to go towards arrears on a personal loan. This action left the client in financial hardship, with no access to funds for himself or his family. On the face of it this appears to be a cut and dried breach of the Banking Code.

However, the issue of how and when set-off is applied has yet to be resolved and the Banking Code Board will cease to exist at the end of this month when responsibility for bank accounts passes to the Financial Services Authority. The FSA told The Herald it had not written a specific rule which would prevent banks taking money from customer accounts via set-off without prior written notice as it insists they must do in the case of bank charges. However, a spokesperson said that they believed notifying customers about set-off would be covered under its more general “appropriate information“ rule.

“From 1 November the appropriate information rule will apply covering pre-sale, to the sale itself and post-sale. This means that even if a customer has an existing contract, the firm must continue to provide information to enable that customer to make ongoing decisions on an informed basis.”

In addition the regulator said any bank taking money which left a customer unable to meet priority debts or buy food could be held accountable under its treating customers fairly principle, pointing out that it expected banks to be every bit as thorough in identifying financial hardship cases with regard to set-off as it was with regard to the bank charge waiver.