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The Shadow System

One-third of the world’s financial system lurks in the shadows


Strategist Shadow System

What is worth $60 trillion, is largely unregulated, and is causing money to haemorrhage out of national borders? Chris Middleton and Matt Jones pulls the veil from shadow finance, and explain why it is strategically dangerous – as the Phones4u scandal sadly demonstrates.

World AffairsA thrill-seeking generation of financiers is heading offshore, where fewer regulations and higher risk attract hardened corporate gamblers – people whose real job is to look after people’s earnings and lend money to businesses.

Risk management lay at the core of traditional banking; returns were predictable and rarely stratospheric, based on the reliability of compound interest. But traditional banking is boring, so many bankers become addicted to the thrill of the chase. This much was clear in the wake of the 2008-09 financial crisis.

Merchants of Venice

It was always this way. Venice and other rich Italian cities were at the centre of the early banking networks, which sprung up in the Middle Ages and early Renaissance among grain traders.

A trading empire, the Republic of Venice adopted financial techniques that had been used for hundreds of years along the Silk Roads of Central Asia and applied them to their own networks in Europe. It was in this era that many banking instruments were devised that are still commonly used today, such as letters of credit.

But just as the Venetians discovered in the 14th century when banks failed in a silver crisis, the financial crash of 2008-09 and the lasting instability it left behind were the results of a collective abandonment of risk management in pursuit of greater excitement.

Despite appearances to the contrary, perhaps, formal banking has become more regulated. As a result, some organisations – including many banks – are turning to what has become known as ‘the shadow sector’ to slake their thirst for higher risk and higher potential rewards.

The shadow banking system – ‘shadow’ in the sense of a legitimate double that mimics its functions – is a quasi-banking network of financial entities, infrastructures and practices that operates with minimal oversight, compared with its formal counterpart.

1940s New York

The roots of the shadow system lie in 1940s America.

It grew thanks to a loophole in US financial regulation. The Investment Company Act of 1940 enabled funds that accepted stakes from one hundred or fewer individuals, each with more than a million dollars in net worth, to be exempted from most of the regulations that bound other investment companies.

This enabled investment houses for the rich to expand fast in post-war America, focusing on returns from trading rather than from traditional banking practices. Soon, those activities spread to fast-expanding economies and to regimes where minimal regulation attracts inward investment.

Collectively, the shadow sector intermediates credit through a wide range of securitisation and secured-funding techniques. And as the sector grows increasingly massive, it exerts ever greater influence over the formal banking sector, just as a large planet traps other bodies (in this case, national economies) in its gravitational pull.

Indeed, the growth of securitisation, an investment route for the shadow sector, provides increasing liquidity to the traditional banking market. But rather than a formal relationship, it is via ad hoc funding with minimal regulation.

A massive presence

Today, the shadow sector worldwide comprises between one-quarter and one-third of the entire financial system, according to international taskforce the Financial Stability Board. Its precise value is unknown, but some estimates value it at more than $60 trillion and rising, as money bleeds out of national borders – a haemorrhage towards high-risk offshore finance.

But why is any of this a strategic challenge for organisations’ leaders? The short answer is that it is always wise to consider the provenance of finance, and what the long-term implications may be of seeking offshore investment. The Strategist believes that a short-term, local financial hit in exchange for a long-term profit-bleed offshore is hardly a strategy for a sustainable national economy. It’s tactical, ideological, and loaded with risk. Too little effort is put into measuring local benefits.

For example, when the state decouples public services and sells them into the private sector, much of the serious investment now comes from offshore – such as the private backers behind Circle, the mutual that runs the former NHS hospital in Hinchingbrooke and provides services from an NHS treatment centre in Nottingham.

In many such cases, the ultimate beneficiaries are no longer taxpayers, but shareholders in financial havens – a shift in focus away from local taxpayer value and towards offshore shareholder value.

One of the bleakest examples of this has been the 2014 failure of Phones4u, bought for £200 million in 2011 by private equity company BC Partners and saddled with £205 million in debt, allowing investors to pocket millions of pounds in dividends while the company collapsed, with a probable loss of 5,600 jobs. Put another way, investors crashed a company that employed thousands of people into a wall of debt, and profited from its wreckage.

Warren Buffet

Superstar investor, Warren Buffet.

Hedging bets

Hedge funds are one part of the shadow system. According to legendary investor Warren Buffet, the first hedge fund was founded by his mentors Benjamin Graham and Jerry Newman in the 1920s.

At that time, a hedge fund manager bought stocks that he expected to increase in value and held them, while selling short stocks that he expected would decline.

In time, however, hedge funds simply became giant trading funds, the foundation of an alternative financial system. Today, hedge funds are essentially banks for the mega-wealthy, taking deposits from big investors and allowing them to withdraw their money at specified intervals.

Globally, there is an estimated $1.92 trillion invested in hedge funds alone, according to the FT. In recent years, the sector has appeared to attract increasing numbers of securities fraud allegations. The problem is that because many hedge funds are based in financial havens, their activities remain beyond the view of US and UK regulators.

Over time, incestuous relationships have developed between the formal and shadow sectors, with people moving from the formal banking world to the shadow system, where the rewards are much greater. But there is a distortion in the world financial system: it is the formal, national banking sector that bails out the gamblers – local taxpayers, in other words.

One of the best-known examples was Long-Term Capital Management (LTCM), the speculative hedge fund founded by superstar bond traders from Salomon Brothers. When it collapsed in 1998, a ‘lifeboat’ of conventional banks was press-ganged into rescuing it, because its borrowings of more than $124.5 billion and derivative positions of $1.25 trillion were considered a risk to the world financial system. But ten years later, Lehman Brothers was allowed to go under with positions many times greater than that.

Madoff with the money

Bernard Madoff and the Bull

‘Bernard Madoff and the Bull’, a sculpture by Chen Wenling, Beijing.

The links between formal banking and the shadow system were also graphically exposed by the collapse of Bernard L Madoff Securities, the investment fraud run by wealth manager Bernie Madoff. Big investors included Banco Santander, Fortis, Royal Bank of Scotland, Natixis, BBVA and BNP Paribas. 

Each of these banks had placed funds with the company because it claimed it could achieve returns well in excess of any they could make in house. Cons work when playing the game seems irresistible.

The shadow banking system has been vexing regulators since the global financial crisis first became apparent in mid-2007. While the formal system has been subject to ever more stringent oversight – including within the UK, which has publicly blamed traditional banks for the money markets’ failures – the shadow system has remained elusive.

Regulators fear that, while banks’ own activities have become more regulated, there is little to prevent them from investing customers’ money in less regulated systems.

Whether further waves of regulation will help is in doubt. The US Dodd-Frank Act of 2010 handed power to the Federal Reserve to allow it to regulate any financial institution of ‘systemic importance’. However, Eugene A Ludwig, comptroller of the currency in the Clinton administration, says that despite this, the tidal wave of regulations aimed at the formal banking system far outweighs the few that have been directed at its shadow.

Ludwig believes that further regulation within formal banking can only spur the growth of the shadow system. “Banking will be constrained by the new rules; at the same time, the capital markets will come back and become increasingly active, feeding non-bank financial activity. Indeed, the very fact that banks will be constrained makes capital-markets solutions all the more likely and attractive,” he wrote in American Banker.

Some analysts have suggested that the ‘financialisation’ of banking is all part of the decay of Western capitalism, with banks serving and supporting genuine economic activity less, while increasingly seeking higher returns from riskier speculation. Bank of England data published in March 2014 revealed that domestic lending to UK businesses fell by £600 million in January alone, with loans to small and medium-sized firms down by £300 million.

This is one reason why Bank of England Deputy Governor Andrew Bailey’s May 2012 campaign to end free banking was so insulting to every UK customer: banks collectively gambled with customers’ money and lost, not because they were forced to, but because they abandoned risk management and common sense in the pursuit of thrills. TS


The Strategist says

• The provenance of finance is a core consideration moving forward. • Consider whether raising money within the community is better than handing control to offshore investors who will demand swift profits. • Decoupling public services from the state and selling them to private bidders is not in itself a sustainable model. • This approach is rarely strategic, and frequently tactical and dogmatic. • Benefits to taxpayers should be measured and demonstrable. • Financial services organisations now need to put their customers first – every time – and begin demonstrating that they are more responsible custodians of people’s money. • Put human decision-making at the core of retail banking, not algorithms whose principles may be flawed and untested in the real world.

Matt Jones is a pseudonym. This is a new, bespoke feature loosely based on an article about outsourced finance, also by Matt Jones and Chris Middleton, that was first published in Professional Outsourcing magazine (edited by Chris Middleton).


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