Risky Shadow Banks Become Campaign Fodder For Democrats

Too-big-to-fail banks are generating plenty of anger from the public, but former Secretary of State Hillary Clinton says the real risks to the financial system lie in the vast, lightly regulated corners of the economy called shadow banks.

Under fire for her ties to Wall Street, Clinton increasingly has talked about the need to crack down on the hedge funds, private equity firms, money market funds and derivatives traders that perform many of the same functions as banks without being regulated the same way.

While shadow banks like these are more heavily regulated than they were before the 2008 financial crisis, the International Monetary Fund warned in October 2014 that their unchecked growth "could compromise global financial stability."

Clinton's opponent, Vermont Sen. Bernie Sanders, has emphasized shadow banking less, but maintains that his overall platform is much tougher on Wall Street than Clinton's.

Coined by former PIMCO economist Paul McCulley, the term "shadow banks" usually refers to institutions, such as money market funds, which take in trillions of dollars in assets from customers and then lend much of it out, by buying short-term debt or purchasing bonds, for example.

Unlike commercial banks, the holdings in such entities aren't insured by the federal government, which means that in a crisis, they may be susceptible to runs. They also don't have access to a key source of liquidity for banks, the Federal Reserve's discount window, according to a report from the Federal Reserve Bank of New York.

"They're sold and marketed as incredibly stable funds where you put in a dollar, you get a dollar out. But there's no guarantee of that, and there's no deposit insurance of that, as there is in a regulated bank," says Dennis Kelleher, president and CEO of Better Markets, a nonprofit group that advocates for reform in the financial sector.

In 2008, the Treasury Department was forced to insure the holdings of publicly offered money market funds, after a fund that had been caught up in the Lehman Brothers disaster "broke the buck" by paying back only 97 cents on the dollar.

Hedge funds represent a similar risk, says Lawrence White, professor of economics at New York University's Stern School of Business.

"The money you put into a hedge fund is not guaranteed at all by anybody, and if you're worried that your hedge fund is going to start losing money, you may start pulling that money out," White says.

While hedge funds and money market funds are usually too small to cause systemic problems for the economy, large bank holding companies are another story: Many of them engage in shadow banking through their less-regulated subsidiaries.

In the aftermath of the financial crisis, traditional banks tightened credit, and shadow banks increasingly filled the void, shifting the "locus of risks" to less-regulated parts of the industry. That shift could "compromise global financial security," the IMF warned in 2014.

Clinton has warned that focusing too much on breaking up the big banks — something she suggests Sanders does — obscures the bigger threat posed by these shadow banks.

"There were a lot of bad actors" behind the 2008 financial crisis, Clinton said at a Feb. 3 town hall meeting New Hampshire, "and if all you do is look over here, I'm telling you, they're going to be over there in the shadow banking sector just cooking up all kinds of ways to once again put our economy at risk."

She has proposed a number of steps to curb shadow bank activities, such as enhancing reporting requirements for hedge funds and private equity firms and imposing stricter collateral requirements on repurchase agreements, a risky form of short-term debt.

NYU's White says Clinton has a point when she talks about the continuing threat posed by shadow banking, in areas such as money market funds. Even so, he notes, "That shouldn't blind us to the fact that the regulatory system is much tougher and robust today than it was eight years ago. No question in my mind about that."

Global and U.S. regulators have imposed many changes on the banking system, making banks better capitalized and more closely scrutinized than they used to be, White says.

Anat Admati, professor of finance and economics at Stanford's Graduate School of Business, says many regulations are already in place to accomplish the reforms Clinton advocates, but regulators don't always want to enforce them.

"Yes, we know that there are all these risks, but we also have some tools to deal with them right now. So what is she saying to the fact that the regulators are not doing them right now?" said Admati, author of The Bankers' New Clothes: What's Wrong With Banking And What To Do About It.

Clinton campaign officials say she believes some regulations can be strengthened, such as those that apply to the Financial Stability Oversight Council, which is supposed to monitor excessive risk-taking by financial institutions.

A Sanders campaign official called "preposterous and absurd" any suggestion that Clinton's focus on shadow banks might make her a more effective opponent against Wall Street, noting her paid speeches to Goldman Sachs and other firms.

Warren Gunnels, policy director for the Sanders campaign, said Sanders' plans, which include a tax on all Wall Street financial transactions, would be much tougher on financial institutions, including shadow banks, than those proposed by Clinton.

"Bernie is committed to hiring the strongest regulators who will actually implement rules that would be stronger than Clinton's. And Bernie's regulators will actually enforce these rules," Gunnels said.

Copyright 2016 NPR. To see more, visit NPR.