The relatively rapid rise of the shadow banking system in its current form is a by-product of the growth of the market-based financial system (Pozsar et al., 2014). Shadow banks play a role in maturity, credit and liquidity transformation that often cannot be performed by the traditional banking sector due to regulatory issues. This has all been performed – at least, so far - without central bank liquidity or public sector guarantees. Pozsar et al., (2014, p.10) suggest that the term, ‘shadow banking’ is in itself pejorative for such a large and important part of the financial system and as such, suggest the term, ‘parallel banking system’ instead.
I would suggest, as with Pozsar et al., that too much emphasis is placed on the negative aspects of shadow banking while the positive aspects do not receive adequate attention. Thias has the effect of undermining the positive impact of shadow banking on the global financial system, particularly at a time when there are already signs that trade barriers are going up again rather than coming down as they had been for some years. Above all, there are continuing signs through the rapid growth of hedge funds, money market funds and even new platforms such as peer-to-peer lending, that the shadow banking sector is fast occupying many of the spaces that traditional banks once did, often in a more efficient manner.
Examples of this are most easily illustrated in emerging markets, where shadow banking has played a role in improving the financial infrastructure, even where traditional banking has in some cases, lagged behind. The example of M-Pesa providing traditional banking services in developing markets to individuals and small businesses is a case in point. A further example is illustrated well by the microfinance schemes which began in South East Asia, providing access to credit to people who stood no chance to otherwise receiving credit . This in turn led the Norwegian SWF to invest in the Norwegian Microfinance Initiative (http://www.nmimicro.no/), illustrating the growing crossover between shadow banking and SWFs.
Expanding on the work of central banks is another tenet of shadow banking. In the book, ‘The Partnership: The making of Goldman Sachs,’ Ellis (2008) outlines how governments used to leave their many bullion bars of gold in the vaults of their central banks. This gold sat there, ineffectually not making any return. Goldman Sachs realized that this gold was an asset going to waste and offered a annual return of 0.5%. It then short sold the gold in the capital markets at the same time as hedging with gold futures to yield an annual return of around 8%. The gold bullion example is a prime example of how governments and central banks were misallocating (or not allocating) assets before the advent of shadow banking.
Valckx (2014, p.66) makes the point that, contrary to being a large liability, shadow banking can in fact complement the traditional banking sector by ‘expanding access to credit or by supporting market liquidity, maturity transformation, and risk sharing.’ The example is given of finance companies and microcredit lenders providing credit and investments to individuals and firms who might not meet the thresholds required for traditional banks to provide financing. Even individuals are now entering the shadow banking industry in the form of peer-to-peer lending. Likewise, as the banking sector has found itself shoring up its balance sheets since the financial crisis of 2007-2009, other forms of funds have entered the market to provide long-term credit to the private sector.
In terms of securitization, Valckx, (2014, p.66) notes how it has the ability to mobilize illiquid assets, while their structured finance techniques can be used to tailor risk and return distributions to better fit the needs of end investors. As the following section will illustrate, these end investors are increasingly comprised of so-called Sovereign Wealth Funds (SWF), an umbrella term used to describe investment pools into which governments channel money (Economist, 2007a).
Enter Sovereign Wealth Funds
Sovereign Wealth Funds, as the previous section alludes to, are investment pools which governments use to purchase assets, typically outside their own country. While there is much skepticism surrounding these vehicles, it could be suggested that they are merely the next generation of trade missions, which have existed for decades in most developed countries. These missions allow and indeed, encourage, companies from the home country to take part in government-subsidized trips to foreign (host) countries where the net result is FDI. Perhaps using a combination of experience and capital beyond most of the firms on these trade missions, governments decided to take on some of the opportunities on behalf of the public.
The total current size of SWFs is estimated at around US$5 trillion, an increase of around US$1 trillion in 2014 on the 2013 figure (Hurst, 2014). Most commonly, the money comes from oil revenues (such as the SWFs of Norway, Russia and Venezuela) or accumulated foreign-exchange reserves (such as that of China). I forward that their increased presence in the international financial markets – including a presence in shadow banking – has the potential to provide positive effects for the global finance industry and the world economy at large.
SWFs are not without their own critics. The Economist once referred to SWFs as lacking so much transparency as to ‘make private-equity partnerships look like paragons of transparency.’ (Economist, 2007a). In the same article, it is correctly stated, that for almost all SWFs, little is known about the checks and balances or if an investment strategy is in place and what it might be. However, the likelihood is that whoever is on the receiving end of the capital will be only too willing to take it on without having clear ideas about the fund’s strategic or commercial goals.
SWFs have traditionally invested in liquid assets such as U.S. Treasury bonds, and indeed, continue to do so. By way of example, one study (Warnock, F.E., Warnock, V.C., 2006) found that purchases of these bonds by foreign entities has a statistically significant impact on long-term interest rates. The study estimated that the prevailing yield at the time of the study would have been 90 basis points higher were it not for these foreign purchases. The motive behind SWFs doing this was that the debt could be sold quickly if required.
Park (2010) notes that there is a theoretically optimal level of foreign currency reserves and having decided that they have reached that stage, a country must make policy adjustments to improve welfare. As the author points out, the easiest way to achieve this is by not accumulating the reserves in the first place but this would most probably require large structural adjustments in the economy. The example of China is indicative of this: a country with massive foreign currency reserves derived from an economy based on exports, the government is free to invest in more illiquid assets, seeking to achieve a higher yield in the process. Hence, in 2007, China established a sovereign fund (Economist, 2007b).
As an extension of Park’s contention, I forward that SWF’s also have the ability to make the management of public money (i.e. taxpayers’ money) more efficient than it historically has been. Public companies have been held back in many instances by a combination of perceived public interest (labour unions) and bad management. By instead investing public money into private companies, the capital – in theory, at least – can be put to more productive gains than in publicly-managed companies. The added benefit from the perspective of the government is that i) there is almost certainly less chance of union agitation in the private sector firms that they have invested in and ii) there is more likely to be a return on the capital over a longer period of time.
Perhaps for this combination of reasons, SWFs have grown significantly over the past two decades, in line with the shadow banking industry at large. Even countries which have no significant natural (or indeed, financial) resources have their own SWFs, Singapore and Ireland being examples of this phenomenon. The tendency has also been for the list of global SWFs to grow over the past twenty years, suggesting that more and more money will be invested in this manner. The question then arises – what happens when huge amounts of capital is invested in assets, which anecdotally at least, are more illiquid than those that governments have traditionally invested in? The answer to the question will have a major say in how the shadow banking industry evolves.
Where Shadow Banking and SWFs intersect
The limitations of how influential (and thus, systematically risky) SWFs can become is illustrated by the case of cross-border acquisitions. A mass of evidence on such cross-border transactions shows that many are obstructed by governments on grounds of the national interest. This suggests countries are suspicious of any foreign countries’ investments, which could be seen to raise the influence of that foreign country in the target company’s country. This also stands to reason. What it means is that, despite there being a lack of developed official regulations to deal with SWFs, there is a form of unofficial policing of their activities which should keep them in check.
Numerous examples of governments using protectionist measures to stop ‘national champions’ being required have occurred even in the past twenty years. Examples include China’s CNOOC proposed acquisition of American energy firm Unocal or the German energy firm E.ON’s attempted takeover of Spain’s Endesa in 2006. Perhaps sensing a growing trend in cross-border mergers and acquisitions which threatened to take over some of its more strategic assets, the US government launched the Foreign Investments and National Security Act of 2007, which effectively allowed it to block non-US acquisitions of its infrastructure, technology and energy assets. Where does this protectionism stop?
The Santiago Principles of 2008 take on this mantle and will be discussed later.
SWFs will increasingly form part of the shadow banking industry – providing capital and holding equity where traditional banks once did. As they form part of the shadow banking industry, they are not market-based in the traditional sense. To take one example, Norway’s SWF is unusual among these vehicles in that its policy is to hold no more than 5% of any firm (Economist, 2007b). This minimizes the risk of over-exposure that is sometimes spoken about when SWFs are mentioned. Other SWFs seem to approach companies with a view to importing expertise and skills through investing in them. Temasek of Singapore is an example of this, with its focus on telecom and banking firms.
Singapore’s SWFs are arguably just the most well-known of an array of those that exist on the Asian continent. After the Asian financial crises of 1997-1998, many Asian countries began stockpiling foreign currency reserves in an effort to avoid or at least, offset future such crises. Having huge foreign reserve assets then provides the country with an opportunity to place some of those reserves in longer-term investments. Fixed-income is one such option. However, if liquid assets are not a requirement, the question arises: why not invest in assets outside of fixed income such as stocks, start-ups or in infrastructure? This has been one of the major factors behind the growth of SWFs in the shadow banking industry. For example, central banks (or SWFs) such as the Hong Kong Monetary Authority are already managing a liquidity tranche (traditional reserves) and an investment tranche (surplus reserves) (Park, 2010).
SWFs blur the line between what is public and what is private, which may have yield benefits on some level. For example, if a government has assets in renewable energy both in the home country and a host country (through its SWF), as Norway’s government has, the private asset in the host country creates a performance imperative on the public asset in the home country. So, while public companies have historically sought to maintain employment when compared directly against the asset in the host country, the question will inevitably arise, ‘why are you running one asset more efficiently than another, comparable asset?’
As an addendum to the last point, the location of many of the SWFs is significant. To take the Qatari SWF, the Qatari Investment Fund, as an example. To invest all of the money in Qatar (a country with a population of fewer than one million people) would incur huge inefficiencies. But more than this, by leaving the country, there is an increased chance that they will, in turn, drive corporate governance standards in Qatar. So far, however, the evidence for this is scant but hope springs eternal.
Regulation of Sovereign Wealth Funds
The regulation of SWFs is still largely a set of ‘best practices’ as opposed to outright regulation. However, there is plenty of anecdotal evidence to suggest that a commonly held theory goes that they work in a completely unregulated framework. This is untrue. Mezzacapo (2008, p.63) notes that ‘as with any other foreign investors, SWFs are already subject to a comprehensive set of rules governing foreign investors’ operations, both at international and European level.’ That is to say that a generalized lack of transparency does not exclude SWFs from the same regulations that every other investment fund confronts.
Nevertheless, As Valckyx (2014) notes, ‘the continued expansion of finance outside the regulatory perimeter calls for a more encompassing approach to regulation and supervision that combines a focus on both activities and entities and places greater emphasis on systemic risk and improved transparency.’ But finding a one-fits-all solution for funds as large, diverse and as difficult to monitor (because of their lack of transparency) as SWFs will prove difficult, if not impossible while only a select band of countries manage SWFs.
Geopolitical motives cannot be excluded on the part of the SWF or on the nation in which investment is being made, but these motives, in turn, aren’t independent of commercial motives. So, for example, the recently formed Asian Infrastructure Investment Bank (AIIB) may allow China to invest in the infrastructure of other South-East Asian nations to the benefit of both commercial and geopolitical aims of China. On the other side of the investment, the host nation could perceive an investment by an SWF as a strategic threat, when indeed it may not be. The commercial gain is far more transparent than any potential motive behind it.
One way that countries and trading blocs have sought to avoid conflicts with SWFs is to draw up policy charters surrounding the behavior of these funds (Mezzacapo, 2009). For example, the author cites policy endorsed by the European Union which aims ‘to promote a cooperative effort between recipient countries and SWFs and their sponsor countries to establish a set of principles ensuring the transparency, predictability and accountability of SWFs investments.’ The presence of a framework for SWFs on the EU agenda may even suggest at further such vehicles run by EU members in the future.
As part of this framework, the EU commission has so far set a five-point set of guidelines for EU members to deal which organizations outside of the EU, including SWFs. In particular, each EU member should:
- Provide an open-investment environment for foreign capital and an investor-friendly climate, in line with the Lisbon Strategy for growth and jobs. Clearly, this is subject to some wide interpretation between EU nations; in 2011, Germany’s government rejected a bid from the Qatar Investment Fund for EADS as it was decided that selling a share in the firm to an SWF would have been ‘a difficult message to convey’ (der Spiegl, 2011);
- Provide support to multilaterial work carried out by international organizations such as that of the IMF and OECD;
- Take advantage of the considerable legal instruments at their disposal to formulate approporiate responses to any risks or challenges raised by cross-border investments on the grounds of ‘public policy’ and ‘public security.’ This seems to be somewhat at odds with the number (1) above, or if not, can at least be cited as grounds for objecting to most SWF approaches for investment.
- Respect the EU’s international commitments.
- Provide proportionality and transparency on the decisions taken with regard to (3) above.
The EU-designed measures are an effort on the part of that trading bloc to build on the framework already set out by the ‘Santiago Principles,’ and latterly the IMF.
The advent of the Santiago Principles by many of the existing SWFs in October 2008 by 23 countries with their own SWFs was a move towards finding regulation in the industry. This set of principles signal that the SWF industry is maturing, if not yet fully mature. Home and host countries alike are recognizing the importance of estbalishing an institutional framework, which ensures that economic and financial criteria are the motive behind investments, rather than potentially harmful strategic motives. However, given that the measures adopted by the signatories to the principles are self-designed as well as self-policed, the purpose of the principles in the short to medium-term may be more about creating positive feedback loops about SWFs. Whether or not this is enough is a source of some disagreement in the academic literature. Some, such as Bagnall and Truman (2011), believe that the rate of compliance among signatories of the Santiago Principles is exaggerated, which one might expect in a lightly-regulated area of shadow banking.
The Santiago Principles are based on a set of broad guiding objectives for the behavior of its signatories. As outlined by Park (2010), these are:
- To contribute towards global financial stability and cross-border flow of capital and investment;
- To comply with regulations and disclosure requirements set forth by host countries;
- To invest purely on the basis of financial and economic risk and return;
- To establish a transparent and sound governance structure which can ensure adequate operational controls, risk management and accountability.
The Santiago Principles are broadly speaking, in the commerical self-intersts of those countries that drew them up. Adherence to them, therefore, can mostly be taken as a given. Other prominent international organizations, notably the IMF and OECD have also sought to define a set of paramaters for SWFs. The OECD (2008), in conjunction with 14 other non-OECD governments, have committed to the following principles, as part of its ‘Freedom of Investment and National Security’ project:
i) Non-discrimination between foreign and domestic investors;
ii) Transparency and predictability, where relevant laws should be made public;
iii) The ‘standstill clause’ – whereby OECD members cannot circumvent their responsibilities by hastily introducing new legislation; and,
iv) The ‘no reciprocity principle’ – whereby OECD members cannot force liberalization measures on other countries.
In the same document (OECD, 2008), a set of principles were drawn up with regard to safe-guarding national security. These are: non-discrimination, transparency/predictability, codification and publication, prior notification (of investment policies), consultation (with investment parties when considering making changes to legislation), procedural fairness and predictability, disclosure of investment policy actions, reguluatory proprotionality, narrow focus, appropriate expertise, tailored responses, last resort (where restrictive investment procedures should only be used as a last resort) and accountability.
These documents offer us some indication of where future legislation in shadow banking and SWFs may lead to. Tobias and Shine (2009) suggest four useful additions to the legislation for shadow banking. These are:
i) An explicit leveral ratio bound that limits leverage, not unlike the capital restrictions suggested by the Basel Accords. The authors note that Switzerland has recently put such a system in place, while Canada has had one in place for some years. It is notable that both countries avoided the worst of the global financial crisis, although there may not be direct causality here. The Financial Stability Forum of 2009 also recommends research into such a leverage ratio.
ii) A forward-looking provisioning scheme, notably used by Spain, where a provision is created at the time of the loan and the provision goes through the income statement of the bank. I would suggest that this is not altogether different from merely establishing a ste of capital controls – a measure already undertaken by the various Basel Accords.
iii) Countercyclical capital rules such as those advocated by the Geneva Report (2009) and the Joint FSF-CGFS Working Group (2009) on the role of valuation and leverage in procyclicality; and,
iv) Base capital adequacy rules explicity on measures of systemic risk of particular institutions. I believe that this deserves particular attention in the shadow banking industry, given that the events of the most recent global financial crisis were driven in no small part by systemic risk.
It does seem as though much of the legislation or best practise, which has been enacted so far is highly open to interpretation. Where this openness exists, there will surely be further friction between host governments and SWFs in the future. As such, a more concrete set of rules should be enacted, which account for all of the realities that SWFs bring: increased capital but also the possibility of strategic interests. It does seem strange, for example, that a different class of share has not yet been established for SWFs and other such entities. A non-preference share or B-share, for example, where an SWF could receive the investment return but have no say in the strategic direction of the company it has invested in.
Likewise, in the self-interest of the SWFs, it would surely seem a wise move to draw up a charter of governance standards and transparency above which they could all agree to operate. Perhaps even a tiered-system whereby a country could agree to differeing levels of corporate governance. At least this would have the effect of throwing more light on the intentions and actions of SWFs which draw eternal suspicion from host countries. Unfortuantely, the Santiago Principles of 2008 fall far short of this, even if they represent a good starting point for future additions to the legislation.
Conclusion
Shadow banking has the potential to greatly enhance the efficiency of the capital markets by enabling better risk sharing and maturity transformation by increasing liquidity in the market (Claessens et al., 2012). As traditional banks seem to be moving away from the one-fits-all model of the first decade of this millennium (whereby they operated as retail banks, merchant banks, asset management firms and investment banks), new opportunities are being created in shadow banking. It is my contention that SWFs would be well served by not excluding these opportunities from their scope.
Acceptance of the shadow banking industry at large, and SWFs in particular, is likely to increase and decrease in tandem with the prevailing economic conditions. In 2008, at the height of the global financial crisis, Markheim (2008) noted: ‘the current financial crisis has given SWFs a boost in popularity – these days, nations are happy to get capital from any source.’ That may have been true at the time for SWFs and the shadow banking industry but it is sure to be less true in 2015, after a relative recovery of the world economy as the example of Qatar’s attempted share purchase in EADS in 2011 illustrated. This suggests that in the short- to medium-term, SWFs will be most successful as counter-cyclical investors.
This is not necessarily a trend for host countries to be wary of. Park (2010) notes that ‘the shift from passive to more active, profit-oriented management of excess reserves is analytically equivalent to a shift from central banks to SWFs.’ The comparison is justified; countries have always invested in the debt of other countries, either through extending loans or purchasing on the secondary market. In fact, taken from a certain perspective, the investment by foreign countries in the debt of a host country could be seen to be more of a strategic threat than say, investing in the infrastructure of the host country.
Legislation is playing, and will continue to play, a role in the acceptance of SWFs and the shadow banking industry. The implementation and expansion of GAPP practices, perhaps combined with more signatory countries to the principles, should lead towards a less-hostile investment environment that currently faced by these funds. There is still much progress to be made in this area, however. The fact that SWFs have been in existence for over forty years and that the first time regulation was addressed was less than ten years ago points to a need for legislation to catch up with the reality. Hopefully, the suggestions made in this document can go a small way towards addressing this need.
Financial market players prefer transparency whenever possible. This is as true for shadow banking (where nobody is quite sure of the size of the industry) as it is for SWFs (where only Norway, and Singapore to a lesser extent, have exhibited any real degree of transparency). The likelihood is that both shadow banking and SWFs will become more transparent over time. It is unrealistic to expect a country like Qatar (to take one example) to have poorly developed corporate governance standards and yet hold its SWF to a higher standard. What is notable about a long-list of SWFs is how many of them are in mineral-rich firms and on anecdotal evidence, burdened by the ‘resource curse.’
The example I provided of Russia is a case in point. Whereas there may be geopolitical issues associated with allowing a country such as Russia to partake in capital markets, over the long term, it has the potential to bring positive effects: improving corporate governance in Russia, mutual co-operation and perhaps even improved transparency. It is my contention that the shadow banking industry will evolve into the parallel banking industry (as mentioned previously) and that SWFs will have a major role in that process.
Above all, what the shadow banking industry illustrates in quite clear terms, is that modern capital flows faster and more cheaply than at any other stage in history. The call for higher trade barriers, capital controls and taxes have limited merit in this environment. The new reality is that individuals, companies and SWFs will tend towards NPV-positive opportunities, wherever they happen to be. In the long run, the efficient use of capital will be for the betterment of everyone – not just SWFs.
The journey to that point will not be without its obstacles but it will be for the good of the global financial industry and the world economy at large.
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